[In]Securities Guest Blog: Blinded by the Light by Aegis Frumento Esq

February 27, 2020


Blinded by the Light

The Tampa Bay Rays just reported for spring training in Port Charlotte, Florida. The Port Charlotte Sports Park is a cozy place for pre-season and minor league games. The Class A Charlotte Stone Crabs play there when the Rays don't.

Port Charlotte wasn't always. In the 1950s, the General Development Corporation (GDC) bought about 180,000 acres of grazing land for about $45/acre. This land eventually became Port Charlotte and adjacent North Port. But that land was pasturage because it sat at sea level. Just over the wall in deep left field at the Port Charlotte Sports Park is what the brochures call a "lake," which connects to an intricate network of "canals." They cover Port Charlotte and North Port. Those are really drainage ditches, which you need when you're trying to convince people to build homes in a swamp. See, e.g., https://www.florida-backroads-travel.com/lot-sales-towns.html .

In the 1960s and 70s, GDC sold  quarter-acre building lots to folks up north who, blinded by the light of the Florida sun, eagerly bought in to the idea that for a few dollars they could own a piece of land in the Sunshine State. I know this because my father was among them.

I think he paid something like $1,200 for his lot in the mid 60s. As swampy pasturage, that land was worth, well, about the $12 that GDC paid for it. It is in the $1,188 price difference that our story rests. GDC's pitch was that it would build the infrastructure that would make Port Charlotte and North Port places where people would clamber to live. That meant all the subdividing, building roads and sewage systems and drainage ditches . . .  er, I mean canals . . . and everything else needed to make a swamp habitable. It was pure Field of Dreams. If GDC built it, they who owned all those quarter-acres would come. When the critical mass of a city emerged, vibrant and valuable, the $1,200 paid for the lot would become the bargain it was hyped to be.

Now, let's shift to that other swamp, on the Potomac. The SEC has been trying to make sense of how crypto assets fit into the world of securities regulation. There are essentially two kinds of stable cryptoassets. Debt and equity interests in traditional businesses that are distributed on a blockchain rather than as traditional stocks or bonds clearly are securities. And cryptocurrencies that can be used as money, like bitcoin and ether, are not. Utility tokens that can be used to buy goods and services within a fully developed decentralized blockchain network are a form of cryptocurrency, and so they are not securities either. See https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm

But in between the two is a transitional state where the troubles lie. 

What makes a security turns on the so-called Howey test. A thing is a security when it represents an expectation of profit from the managerial efforts of others. Traditionally, those "managerial efforts"are the day-to-day running of an ongoing business. In Howey, investors were sold interests in an orange grove. But investors expected the orange grove to be cultivated and the fruit harvested and sold -- in other words, they expected the orange grove to be managed so as to turn a profit, and that made the orange grove interests securities. 

Howey's orange grove was more like a traditional business than is the development of a crypto network. The oranges were expected to grow year after year and be profitably managed indefinitely. But token development is expected to be a short-term project. The blockchain should soon become autonomous, operating without any human management. That's the whole point of a blockchain. In extending the Howey test to cryptoassets, the SEC essentially determined that the necessary management effort need not be ongoing. The effort needed to build a crypto infrastructure and to support a token economy until that infrastructure is fully self-sustaining is enough to make a token a security -- even though that management effort is not intended to last indefinitely

We can see this rationale in a recent SEC enforcement action against Telegram Group. Telegram sold tokens, called "Grams," that would someday be usable to send instant messages through a decentralized blockchain called TON. As the SEC put it in its complaint:

Grams are securities because the Initial Purchasers and subsequent investors expect to profit from Telegram's work: the development of a TON "ecosystem," integration with Messenger, and implementation of the new TON Blockchain. Grams are not a currency because, among other things, there are not any products or services that can be purchased with Grams. Rather, there is an expectation on the part of investors that they will profit if Telegram builds out the functionalities it has promised.

https://www.sec.gov/litigation/complaints/2019/comp-pr2019-212.pdf. With this comes the understanding that once that network is fully functional, those Grams will have morphed from regulated cryptosecurities into unregulated cryptocurrencies. For tokens, then, being a security is a passing phase. 

By this logic, my father's quarter-acre in North Port was also a security, because he bought it expecting to profit from the short-term managerial efforts of GDC to build the infrastructure that would make it a valuable piece of land. I don't know if GDC was ever charged with violating the securities laws, but the analogy to crypto seems almost too close today. His quarter-acre would not be worth, as land, anything close to what he paid for it unless GDC successfully built a community around it. No doubt that's what he expected, because that's what GDC promised to do and his piece of land would be just a bit of swamp until it did.

That is the context of SEC Commissioner Hester Peirce's recent informal proposal for a "safe harbor" to protect token developers from SEC enforcement actions. http://www.rrbdlaw.com/5048/securities-industry-commentator/#peirce . Commissioner Peirce identifies a real conundrum. In order to fully develop a decentralized blockchain network, its constituent tokens need to be widely dispersed. That implies the need for a registered public offering. But few can afford registered offerings; in fact, there haven't been any involving cryptosecurities. She poses the issue thus:

We have created a regulatory Catch-22. Would-be networks cannot get their tokens out into people's hands because their tokens are potentially subject to the securities laws. However, would-be networks cannot mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts unless the tokens are distributed to and freely transferable among potential users, developers and participants of the network. 

https://www.sec.gov/news/speech/peirce-remarks-blockress-2020-02-06. Her solution is to create a safe harbor for token developers who do the following:

1. "Intend" and "work in good faith" to make the network fully decentralized and/or fully functional within 3 years;
2. Publicly disclose key information;
3. Offer tokens only "for the purpose of facilitating access to, participation on, or the development of the network";
4. Make reasonable efforts to make the tokens liquid (like on a coin exchange); and
5. File a form with SEC.

And, of course, they can't commit fraud.

The key to, and the key flaw in, this scheme is in No. 1. The other four components seem reasonable, and also reasonably enforceable. But No. 1 depends entirely on the good intentions of the developers. You will be well down the road to hell before you ever figure those out. By then, the tokens will have been sold and the money gone, and any enforcement actions will be too little, too late. 

Still, I doubt we can do any better. We know that most crypto schemes will crash. But they should still be tried, and investors should still be let to gamble on them, because we likewise know that some won't. Liars should be jailed, but good-intentioned entrepreneurs, no matter how delusional, and their investors, no matter how gullible, should be allowed to try their luck. I don't know how else to say it.

Today, Google Maps shows my father's empty lot surrounded by other empty lots. Fifty years later much of North Port still seems unbuilt. See http://www.city-data.com/forum/punta-gorda-port-charlotte/2331201-why-city-half-empty.html Of course, it's not very encouraging when residents find 7-foot alligators in their pools (https://www.nbc-2.com/story/40845075/port-charlotte-finds-a-7foot-alligator-in-pool-early-saturday-morning) and a legitimate question on TripAdvisor by someone looking to move there is "Will I be eaten?" (https://www.tripadvisor.com/ShowTopic-g34575-i2824-k1210635-Will_I_be_eaten-Port_Charlotte_Florida.html). The latest sea-level rise predictions show the whole place under water in 30 years. 

Still, I think my father got some pleasure from his ownership. Even if now it rings too close to that famous scene in Love and Death 

I don't think I would have deprived him of his little piece of land merely because it wasn't -- or didn't turn out to be -- a "prudent investment." 

Commissioner Peirce referenced Bruce Springsteen, but she picked the wrong songs. We all believe what we want to, token developers and buyers alike. We can only go so far in protecting us from our own dreams, and we really shouldn't try too hard. Good faith visionary developers, be they of cryptotokens or swamplands, and those who buy into their visions, all alike are "Blinded by the light, revved up like a deuce, another runner in the night." We should let them run.


Aegis J. Frumento

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 BrokeAndBroker.com Blog.