FTX, Tokenomics And Lawyers As Gatekeepers
Financial media and market participants are following closely the FTX implosion and bankruptcy. Sufficient ink has been spilled on the timeline of events, and the fraudulent actions of FTX, Alameda Research, and their leaders, especially founder Sam Bankman-Fried. I won’t repeat that work here. But, I don’t think sufficient attention is being given to how the crypto industry financed itself through the sale of tokens.
In 2017 and 2018, I was a partner in the Seattle office of the law firm KL Gates, and co-head of its venture capital practice. Those were the years of the initial coin offering (ICO) craze. To raise capital to fund operations, crypto companies issued “tokens” to investors, including retail investors. Crypto companies raising capital in the United States took the position that the tokens were not securities, and therefore not subject to regulation by the SEC and state securities regulators.
Every security issued in the US must either be registered with the SEC, or an exempt from registration. In early stage company capital raising transactions, the exemption typically relied on is Rule 506 of Regulation D of the federal Securities Act. Regulation D does not permit the sale of a security to an investor who is not “accredited”, unless the issuer has a pre-existing relationship with the investor, and then may do so only if detailed disclosure is provided to the investor prior to the sale of the security.
To avoid the “pre-existing relationship” marketing limitation, many crypto entrepreneurs argued the tokens they sold were not securities, but rather just a right use the product created by the crypto project. The term of art was a “utility token”. By assuming the tokens were not securities, the crypto companies could and did market the tokens to the public (i.e. no pre-existing investor relationship) through social media and other digital channels distribution, usually via “white papers” describing their to-be-built product. The more brazen crypto projects completed ICOs, often raising tens and hundreds of millions of dollars, without seeking any legal advice. Others did seek advice from counsel. Some lawyers provided informal advice, and even formal written opinions, that indeed tokens were not securities, relying primarily on the “utility” argument.
The legal precedent that most all lawyers apply to determine the legality of ICOs was the United States Supreme Court’s decision in the Howey case. The “Howey test” states that an investment contract (a type of security) is formed when there is an investment of money in a common enterprise, with the expectation of profit, to be derived from the effort of others. Based on this test, my team at KL Gates concluded that the tokens we were asked to advise on were in fact securities, and any sale of tokens needed to comply with applicable federal and state securities laws. Why? All projects we advised on had an expectation of profit to be derived from the efforts of others. This seemed straightforward to us. The founders of at least a couple of those projects hired different lawyers, received advice that the tokens were not securities, and received the advice they desired, and completed ICOs. Both at the time and especially in hindsight, this advice was wrong. I say this with humility — the pressure at that time to sign off on ICOs was high, and it’s always hard to leave cutting edge work on the table. However, lawyers are not just advocates for clients, but gatekeepers for our rule of law system. I take this duty very seriously, as do nearly all lawyers.
While the SEC has yet to issue formal guidance in this area (which would be very helpful to market participants) Chairman Gensler has stated numerous times that Bitcoin is the only non-security cryptocurrency he has seen. Bitcoin is truly decentralized, so its value does not depend on the efforts of others.
The details emerging from the FTX debacle provides a great example of a digital asset — the FTT token sold by FTX to fund FTX operations – that was marketed as a “utility token”, but is clearly a security. The FTT token enabled its holder to receive discounted trading services on the FTX exchange, and that feature is what FTX relied on the take the position the token was not a security. FTT was publicly marketed and sold. We have now learned that (i) Binance accepted FTT tokens as consideration when FTX bought back Binance’s investment in FTX, (ii) FTX listed its FTT tokens as a current asset on its balance sheet, (iii) FTX and others used FTT as collateral to secure financing (iv) the value of the FTT token was tied to the success or failure of FTX, a centralized digital asset exchange and (v) the announcement on Twitter by Binance that it was selling its FTT tokens into the market caused the collapse of FTX, and now the failure of other big crypto industry market participants, including BlockFi and potentially Gemini Lending. That’s a lot of collateral damage caused by a token that just gave its holder a right to discounted trading fees on FTX. . .
I remember attending conferences, meet ups and other events in 2017 and 2018 where crypto industry pioneers argued passionately that tokens were not securities, regulators simply did not understand this new industry, and a determination that tokens were securities would unfairly stunt the growth of decentralized products and services. Lawyers supported these claims. To push against this narrative as a lawyer was hard, especially when even understanding how a blockchain worked was hard. It was easy to tell yourself, maybe they are right and my failure to fully understand blockchain is why I am misapplying the Howie test.
Now that the wreckage is upon us, even those within the crypto industry are adamant that harmed investors have been wronged, and deserve relief through the legal system. I continue to believe in blockchain technology, and my conviction with bitcoin has actually grown through this crisis. But, industries that reflexively eschew regulation will be rife with bad actors. Technology may change, but fraud endures.