GUEST BLOG: Blaming Nobody by Aegis Frumento Esq

December 6, 2018

Most interviews with government officials are lame. The interviewer, usually knowing less about the subject than the official, asks dumb questions. This lets the official give snowfalls of answers that make things even less clear than before. 

So it was a treat last week to watch SEC Chairman Jay Clayton discuss securities regulation for over an hour with The New York Times's business columnist Andrew Ross Sorkin. Sorkin is at least as smart and well-informed as Clayton, and this allowed Clayton to be himself, both thoughtful and philosophical. Their conversation focused largely on how existing regulations should deal with cryptocurrencies and blockchain technologies.

Clayton called the designers of our current securities laws "geniuses." They understood, he said, in the wake of the 1929 crash, the need to foster investor trust in the integrity of the markets. They designed a regulatory system that requires full disclosure of material information by securities issuers, and fair dealing in securities markets. But to make it work, they imposed obligations upon particular persons, and then held those persons civilly or criminally responsible if anything went wrong. Consistent with that theory, Clayton said, the SEC's current goals focus on deterring bad human conduct, punishing bad human actors, and compensating victims from those bad humans.

But the geniuses who designed our current regulatory theories were reacting to a particular reality, one in which transactions required paper instruments to be transferred from person to person. They imposed responsibility on humans because they understood that humans make mistakes, and cheat, lie and steal. Liability, they reasoned, would keep humans careful and honest. 

I don't disagree with any of that. But it does raise this question, and it is fundamental to blockchain-enabled securities transactions: Who can you blame when no humans are involved?

In his path-breaking book, The Structure of Scientific Revolutions, philosopher of science Thomas Kuhn showed how science progresses in predictable cycles. A scientific genius like Isaac Newton observes falling apples and formulates a theory of gravity to explain it. From then on, for hundreds of years, normal (that is non-genius) scientists diligently conduct experiment after experiment that "prove" Newton's theory. Over time, the theory becomes so validated by experimental results that we start calling it a "law." But eventually -- and inevitably -- some observations crop up that the theory can't explain. As those oddball observations pile on, they nag at researchers until a crisis is reached. Does one abandon Newton and his theory? Or does one ignore the inconsistent reality?

Lesser lights will prefer to crouch safely in the embrace of venerable theory, but reality being what it is, one can't ignore it. The crisis builds until another genius, like Albert Einstein, resolves it by dreaming up a radically different theory of gravity that explains both Newton's original observations and all the inconsistencies. Then work-a-day scientists can breathe a sigh of relief and go back to doing "normal" science, now validating the new theory -- until, of course, the next crisis.

Kuhn called the redirection of normal science in response to a new theory, the "paradigm shift." It's still an important concept despite being reduced to a cliche through overuse by those who don't understand it.

In all my years practicing securities law, blockchain is the first technological development that is really "new." Blockchain technology, once you understand it, is not analogous to anything that came before it. Existing securities law theory cannot fully explain it. A Kuhnian crisis is building.

Chairman Clayton is smart enough to sense this, but he is wise enough to admit he doesn't know how things will develop. He is waiting to see how blockchain will actually be used. Until then, the SEC seems committed to enforcing the existing regulatory structure upon the new technology, no matter how ill the fit. 

He didn't have to wait long to be confronted with a perfect example of how ill-fitting the regulations are. A member of the audience posed a problem that showcased the inconsistency between current regulatory theory and blockchain reality. Here it is:

Issuers of privately placed securities must identify a transfer agent who will be responsible for ensuring that those securities are not improperly publicly distributed. As Chairman Clayton had said earlier, one of the cornerstone concepts of the securities laws is to hold particular persons responsible when things go wrong, and transfer agents are "it" when a private security mistakenly ends up in public hands.

However, as this questioner pointed out, a security issued and transferred on a blockchain does not need a transfer agent. In fact, there would be nothing for a transfer agent to do. The blockchain itself ensures that a tokenized security, through preprogrammed smart contracts, cannot be transferred to someone who is not legitimately authorized to own it. Any attempt to do so would just fail. Why, then, would the regulations require the identification of a transfer agent who will have absolutely nothing to do?

Good question, right? Chairman Clayton couldn't answer it. Rather, he asked a rhetorical question in response: Without a transfer agent, who would be held responsible if the security token escaped into public ownership?

This exchange highlights the inconsistency between our regulatory theory and the reality of blockchain technologies. The regulatory mandate of holding a person responsible for things going wrong puts the cart before the horse. In the world that gave rise to our current regulations, issuance and transfer functions were performed by humans -- you know, prone to mistakes and fraud and all that. But a blockchain automates issuance and transfers, taking humans out of the equation. 

Odysseus told the Cyclops his name was "Nobody." The Cyclops later complained to his neighbors that Nobody had blinded him. "If nobody hurt you," they responded, "it must be the gods, and you'll just have to live with it." 

That is pretty much where we are if a blockchained transaction goes awry. Who do you blame when your roof leaks or your computer crashes? When we finally have fully automated cars, who do you blame for an accident? When a function is automated to act appropriately without human involvement, one can't hold any human responsible for errors. Present regulatory theory doesn't admit of such a possibility -- but that's the reality of it nonetheless. Another source of recompense -- probably an insurance -- can likely be found. But with no humans to blame for screw-ups, deterrence and punishment become meaningless.

For now, the SEC will just let the conflicts generated by blockchain transactions mount until new geniuses come up with new regulatory theories. But the good news is that as the regulatory paradigm shifts, we get to watch a new cryptosecurities law develop. That will be fun.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.

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