I would like to thank all the readers for their fantastic response to the first part of this article series. If you haven’t read it yet you can find it here. In this article, I compare the practices relating to the public and private issue of securities in the 1920s with practices relating to ICOs.
New Issue of Securities — the 1920s
In the 1920s, the condition precedent to the listing of any security on an organized stock exchange was that there be a substantial initial or primary distribution of the security among the public. The more widely distributed the security the better. To achieve this distribution the companies relied on investment bankers. The investment banker acted as the intermediary between the issuer and the investing public. The distribution machinery for securities was established as a result of the methods of financing employed by the government during the World War, where the government sold the war bonds directly to small investors. This enabled the government to raise large sums by taking a small contribution from a large number of investors. The rules governing the issue of securities were not very comprehensive as the issuer in most cases was the government and there was a limited need for investor protection measures. However, after the war was over the government stopped issuing new securities and the same distribution machinery was then employed by domestic and foreign issuers without additional investor protection measures being put into place.
To aid in the selling of the issue, the bankers prepared a prospectus which purported to incorporate all the authentic and pertinent facts regarding the issue. The congress subcommittee hearings exposed flagrant misrepresentations and concealment in these prospectuses upon which members of the public implicitly relied and this became one of the most important grounds for the passage of the Securities Act, 1933.[1]
While promises of “getting rich quick” were made to investors, the typical offering circular prior to 1933 contained little of the information needed to estimate the worth of a security. A circular usually included “very little information as to the use of the proceeds, a rather brief description of the securities themselves, and very few if any material facts relating to the business of the issuer.’’ The public, however, was caught up in a current of optimistic speculation. They wanted their savings invested in securities with the hope of getting rich overnight. Stocks of new industrials such as radio companies, aeroplane manufacturers, and transportation companies attracted many investors- “each company [was] assumed to be a potential Ford Motor Co.’’ Accounts of the swindles and fraudulent practices perpetrated on the public, including bankers and other businessmen, were numerous. For example, George Graham Rice defrauded investors of over $200Mn through the sale of securities for bogus corporations. Rice “touted the stock of Idaho Copper, a corporation which he formed. He had its stock listed on the Boston Curb. Its property consisted of a water-filled, abandoned mine, the entrance to which was so overgrown that the federal investigators had difficulty locating it.[2]
The consequences of unregulated activities of investment bankers were disastrous. According to congressional reports, in the decade after World War I, approximately $50Bn of new securities were floated in the United States, and half of them were worthless. [3]
Initial Coin Offerings — Today
The way investors participate in ICOs are distributed today is quite similar to the way new issues were distributed in the 1920s with few important distinctions. Today the issuers no longer need to rely on investment bankers to distribute their issue. The role of distribution machinery today is played by the internet and social media. Cryptocurrencies, when combined with the power of the internet, makes it possible for any person in any corner of the world to participate in an ICO. The issuers rely on viral marketing tactics and the promise of outsized returns to raise vast sums of money from a large number of small investors.
Issuers today create a white paper which plays the same role as the prospectus. However, adequacy and reliability of information disclosed in the whitepaper is a big problem as it has not been vetted by independent professionals like investment bankers or lawyers. This problem is further compounded by lack of standard rules and market practices with regard to the issuance process. There is no set of well-defined standards with respect to what needs to be disclosed and in what detail it needs to be disclosed.
As we know from the 1920s when there are no specific rules governing disclosure made by issuers and no independent agency to verify the truthfulness of the claims made, issuers tend to be quite lax in disclosures. They have a tendency to hide material facts that may adversely affect the marketability of the issue and worse many of them tend to make blatantly false claims and promises designed to aid in selling the issue.
This is evident from a number of investigations that have been conducted by the SEC in ICOs. For example in Centra Tech ICO the issuers claimed that they had “partnerships” with Visa, Mastercard and The Bancorp. However, in reality, none existed. The SEC also discovered that “Michael Edwards” and other Centra executives pictured in its promotional materials were fictional, and the photographs used to identify the fictional executives were photos taken from the internet or pictures of other individuals.[4]
According to various estimates around 800–1,000 coins have been declared dead and in which people have lost billions of dollars.
Private Offerings — the 1920s
Another practice for distribution of securities that was prevalent in the 1920s was making private offerings. This method is a bit counterintuitive but it worked quite well. It was frequently used by the top investment banks of the day like JP Morgan and Co. In each case, a portion of the stock purchased by bankers was offered to a select list of influential individuals. These influential people included many prominent politicians and top executives of various banks, financial institutions, insurance companies and pension funds. As a result of these offerings, which received considerable publicity, the interest of the general public was captivated and market levels materially above the price of original offerings were quickly established. Availing themselves of the opportunity afforded by intense public interest, the bankers disposed of large blocks of their holdings at substantial profits, with entire immunity from the legal liability which would have accompanied a public offering and the issuance of the prospectus.[5]
Private Offerings — Today
The trend of private offerings in ICOs has been growing due to strong enforcement action by the SEC and other regulators worldwide. The SEC considers pre-functional utility tokens as securities. Hence, to avoid getting into crosshairs with SEC many prominent projects have resorted to private placement via SAFTs. For eg Telegram Open Network made biggest fundraise to date by any ICO of USD 1.7Bn. This was entirely made via private offerings. The private offering got a huge publicity and it was reported that some of the biggest VC investors in Silicon Valley like Kleiner Perkins Caufield & Byers, Benchmark and Sequoia Capital had expressed their interest in the Telegram ICO.[6] The result is that Telegram has raised a substantial sum of money and has at the same time avoided any liability that would have accompanied by doing a public crowd sale. The tremendous interest in the Telegram ICO has created a thriving grey market in these tokens which are now being traded at substantially higher prices than at which they were issued. [7] So, we can see that history does repeat itself. Some things haven’t changed much in last 100 odd years.
Lessons from 1920s
You cannot get rich overnight: When it comes to speculative manias there is one element which is common to all i.e they promise to make common people rich overnight. Time and again people have fallen into this trap and the only people who have become rich in the process are the scammers and people who perpetrate such schemes. Ironically the common man who is supposed to get rich by investing in these schemes has always been left poorer. As Benjamin Franklin said, “The way to wealth is through work.”
People don’t always act rationally: Everyone desires to get rich overnight. Its normal human tendency we want to minimise the effort and maximise the result. So, it’s difficult for people to resist the fact that some questionable asset is gaining in value and could be sold at a handsome profit shortly. It is another feature of speculative mood that, as time passes, the tendency to look beyond the simple fact of increasing values to the simple reasons on which it depends greatly diminishes. And there is no reason why anyone should do so as long as the supply of people who buy with the expectation of selling at profit continue to be augmented at a sufficiently rapid rate to keep prices rising.[8] Which explains why many projects with nothing but a unique name raised millions of dollars in investment during the cryptocurrency boom in late 2017.
People tend to overestimate their abilities: In the 1920s, a man in Wall Street or Chicago could take unabashed pride in the fact that he was a financial genius.[9] Same is true with the crypto community today. Many early investors in Bitcoin and Ether consider themselves financial geniuses. They believe that it is their superior ability that enabled them to earn a fortune and it was not pure luck. So, with this overconfidence, they think they can spot the next coin which will go to the moon.
Regulation is necessary for long term development of an asset class: The experience of the 1920s shows us that appropriate regulation is indeed necessary for the long-term development of any asset class. The Securities Act of 1933 and the Securities Exchange Act of 1934 played a crucial role in restoring the confidence in the securities markets in light of the great crash of 1929. These regulations were instrumental in developing US market as one of the most trustworthy and desirable securities markets in the world. During the initial years of its implementation the Securities Act, 1933 was severely criticised by the business community as it made it costly for businesses to raise money for new projects. But today not many people would feel the same about the Securities Act, 1933.[10]
Concluding Remarks
Today there is a great amount of debate among the crypto community as to how ICOs should be regulated or should they be regulated at all. The SEC has faced a lot of criticism from the community for trying to apply the traditional securities laws to ICOs. Many in the community feel that the existing securities laws are archaic and are not suitable for the realities of today. So new set of laws which are specifically suitable for cryptocurrencies should be established. Despite all the debate, one principle which I feel that has stood the test of the time is “putting the burden of telling the whole truth on the seller”. It is really crucial for any investor to know that the information provided to him is truthful and reliable. As it is based on this information that the investor makes his investment decision.
For cryptocurrencies to achieve even broader adoption and truly become an asset class it is necessary that common people can trust them and trust will develop only if they are appropriately regulated with a strong enforcement mechanism as has been the case with securities.
If you like the article, please show your support by giving atleast 50 claps and sharing it with your friends. Let me know your thoughts on this article. The last part of the article series will be published soon.
[1] Stock Exchange Practices, Report of the Senate Committee on Banking and Currency, dated June 6, 1934.
[2] Elisabeth Keller. “Introductory Comment: A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934.” Ohio State Law Journal 49, (1988): 329–352.
[3] Elisabeth Keller. “Introductory Comment: A Historical Introduction to the Securities Act of 1933 and the Securities Exchange Act of 1934.” Ohio State Law Journal 49, (1988): 329–352.
[4] SEC Order against Sohrab Sharma, Robert Farkas and Raymond Trapani dated April 20, 2018 available at https://www.sec.gov/litigation/complaints/2018/comp-pr2018-70.pdf
[5] Stock Exchange Practices, Report of the Senate Committee on Banking and Currency, dated June 6, 1934.
[6] https://www.ft.com/content/790d9506-0175-11e8-9650-9c0ad2d7c5b5
[7] https://qz.com/1194612/telegram-ico-allocations-are-being-flipped-for-millions-before-going-on-public-sale/
[8] The Great Crash, 1929 by Galbraith
[9] The Great Crash, 1929 by Galbraith
[10] A Brief History of the 1930s Securities Laws in the United States — And the Potential Lesson for Today by Larry Bumgardner, Graziadio School of Business and Management, Pepperdine University available at http://www.jgbm.org/page/5%20Larry%20Bumgardner.pdf