Commissioner sees opportunity to "enable innovation . . . without compromising the objectives of our securities laws"
Friday, February 15, 2019
By Ted Knutson
In 13 months on the Securities and Exchange Commission, Hester M. Peirce has pushed for openness to innovation, even criticizing the SEC majority last July for rejecting the listing of a Bitcoin exchange-traded fund.
A University of Missouri Law School forum on February 8 was Peirce's latest platform for considering the tension between regulation and innovation, balanced with the SEC's mandates for investor protection and capital-markets oversight.
Peirce contended that every innovation carries some risk - along with the possibility that it can take years for value (or harm) to be fully measured.
“Technological progress in the financial industry offers the same mix of hope, promise, and risk that technological progress in other parts of our society offer,” she said. “As regulators, therefore, we must allow innovation to proceed, even as we put in reasonable safeguards and watch for unanticipated consequences.”
The commissioner devoted a significant portion of her remarks to blockchain and cryptocurrency issues and why regulators around the world “are asking how existing rules apply in this space and whether a new regulatory framework would work better.
“If we act appropriately,” Peirce said, “we can enable innovation on this new frontier to proceed without compromising the objectives of our securities laws - protecting investors, facilitating capital formation, and ensuring fair, orderly, and efficient markets.”
She also stepped back, acknowledging the influence of the University of Missouri law professor who introduced her at the forum, Thomas A. Lambert, author of “How to Regulate: A Guide for Policymakers.”
“His definition of 'regulation' as 'any threat-backed governmental directive aimed at fixing a defect in private ordering,'” Peirce said, “reminds us of the gravity of the regulator's task . . . Regulation involves overruling private arrangements, substituting a government mandate, and imposing a penalty of some sort on people who fail to comply with that mandate. Given the potential consequences of doing these things, the regulator and the people on whose behalf it regulates must think carefully about whether and how regulation should be employed.”
Sensitivity to Bias
Noting the hiring late last year of Martha Miller as the SEC's first advocate for small-business capital formation - and conceding that the agency had historically “not been particularly open to thinking about the benefits that come from eliminating regulatory barriers to small issuers seeking capital” - Peirce stated, “It is not the SEC's job to shift capital flows toward small or emerging businesses; capital should flow to the companies - old, new, large, or small - that can best use it.
“We ought, however, to consider whether the rules we have in place have the effect of putting a thumb on the scale in favor of large and established companies. Having someone at the SEC whose job it is to ensure that the commission is aware of the types of difficulties small companies face in the capital markets is an important step.”
Peirce's perspectives have won praise from, among others, Steven Lofchie of Cadwalader, Wickersham & Taft, who commented on the Missouri speech in the Cadwalater Cabinet newsletter: “It's a great thing when we have regulators who are thoughtful about the exercise of regulatory power, and are willing to weigh in a public forum the benefits and detriments of the use of that power.”
Peirce, who before joining the SEC in January 2018 was senior research fellow and director of the Financial Markets Working Group (now Program on Financial Regulation) at the Mercatus Center at George Mason University, has become popularly known in the cryptocurrency community as “Crypto Mom” because, in the words of a CoinDesk headline, “Inside the SEC, Hester Peirce Is Putting Up a Fight.”
Decentralization and the Howey Test
Complicating the regulatory approach to that area of innovation is the notion of decentralization and the fact that “blockchain-based networks offer a new way of coordinating human action that does not fit as neatly within our securities framework.”
Following the principles of the 2008 Satoshi Nakamoto white paper, the objective of many blockchain projects “is to build networks that run on diffuse contributions, rather than to create centralized entities that run networks. In the end, there may not be anyone steering the ship. Yet many of these projects begin in a centralized manner that looks about the same as any other start-up.
“A group of people get together to build something, and they need to find investors to fund their efforts so they sell securities, sometimes called tokens, Peirce continued. “The SEC applies existing securities laws to these securities offerings, which means that they must be conducted in accordance with the securities laws or under an exemption. When the tokens are not being sold as investment contracts, however, they are not securities at all. Tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.”
The SEC commissioner said that a June 2018 speech by Division of Corporation Finance director William Hinman, relying in part on a so-called Howey test from a 1946 Supreme Court case, “provided a useful framework within which people can analyze their token offerings in connection with the securities laws.” But Peirce also expressed concern “that the application of the test will be overly broad.”
Weight of Compliance
“It is possible that some projects may simply not be able to work under the existing Howey framework and the applicable securities laws,” Peirce said, adding a note of regret that a well-funded cryptocurrency project, Basis, has announced that it is closing because of the difficulty of complying with securities regulations.
“I am not going to comment on what I think about the merits of any particular project or how the securities laws apply to it,” she said, “but my antennae will go up when apparently legitimate projects cannot proceed because our securities laws make them unworkable.”
“I am concerned that our approach with respect to [exchange-traded] products borders on merit-based regulation, which means that we are substituting our own judgment for that of potential investors in these products,” Peirce added. “We rightfully fault investors for jumping blindly at anything labeled crypto, but at times we seem to be equally impulsive in running away from anything labeled crypto. We owe it to investors to be careful, but we also owe it to them not to define their investment universe with our preferences.”
Sponsors of initial coin offerings (ICOs) “that want to succeed will make voluntary disclosures to signal their quality. Disclosure will happen regardless of whether the securities disclosure regime applies to ICOs. Moreover, the platforms that trade cryptocurrencies can play a role in forcing such disclosures, much as the stock exchanges did before the securities laws took effect.”
GARP editor-in-chief Jeffrey Kutler contributed to this article.