Is Gresham's Law Coming for Stocks?

If crypto tokens are not securities, then maybe companies will prefer to issue crypto...

Gresham’s Law is a story about why bad money changes hands and good money disappears when different kinds of money circulate simultaneously. The idea is simple enough to explain to a six-year-old¹:

Imagine you want to buy a box of cookies. You have a gold coin and a silver coin. If you melt the gold coin, the gold can be sold for $5. And if you melt the silver coin, the silver can be sold for $4. The person selling the cookies has to accept one coin as payment, whether it’s the gold coin or the silver coin. Which coin do you give him?

And indeed even a six-year-old knows that you give the seller the silver coin. The bad money circulates because it’s deemed to be more valuable than it is. The good money stays in the piggy banks.

Proposals for the ‘tokenization’ of stock are threatening to create a parallel regime for issuing shares in a corporation. One can issue shares to the public according to Securities and Exchange Commission rules, which require significant information disclosures and compliance with the rulebook of a regulated exchange. In the future, one might issue shares to the public using crypto tokens, without the information disclosures or regulated exchanges. If this second regime is allowed to emerge, you can guess which one will be preferred by issuers.

Crypto Industry Whining About ‘Regulatory Uncertainty’ Creates Regulatory Uncertainty

Lobbyists for the crypto industry are wont to complain about the “regulatory uncertainty” surrounding their product. But as I pointed out back in October 2021, there was (and is) no regulatory uncertainty. Under Gary Gensler’s SEC, the regulatory treatment for all crypto (with the possible exception of bitcoin) defaulted to the regulatory treatment for securities. And while securities regulation is sprawling and complex, it is not so diffuse as to be uncertain. Ninety years of practice have put some useful stakes in the ground.

Really the crypto industry was saying they didn’t like this regulatory regime. Because there was no uncertainty, they created regulatory uncertainty themselves by spending more than $100 million to influence the 2024 elections, making them by far the largest lobbying group in action.

And they won. President Trump got on board — grift respects grift — and so did members on both sides of the congressional aisle. The SEC got a pro-crypto Chairman. And even though the SEC had prevailed in virtually every instance, they promptly dropped their litigation against crypto issuers for violations of securities law.

Legislation on stablecoins has passed the Senate and is pending a vote in the House. The so-called GENIUS Act asserts that stablecoins are not securities and makes the Office of the Comptroller of the Currency (OCC) the regulator for stablecoin issuers. So far there is no legislation pending for the remainder of the crypto world, but the SEC has de facto backed away from treating crypto as securities.²

Though it is early days, you can see a second regulatory regime emerging for crypto where almost anything goes.

A New Metaphysics of Corporate Finance?

Crypto-friendly regulations for crypto are a problem for securities litigation. For generations the SEC has relied on the “Howey test” to judge whether something is a security. According to Howey a security exists whenever there is "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party."

The four points of Howey put substance on the definition of a security. Because of Howey, you can’t dodge securities rules simply by issuing “not securities” to investors.

By dropping its enforcement actions against crypto issuers, however, the Trump SEC has dignified “not securities” as a legal designation. And so now corporations may have a genuine choice: Issue securities through underwriters and disclose audited financial statements according to securities laws, or issue “not securities” on a blockchain more or less however you want.

If this choice is tolerated based on a metaphysical distinction between blockchains and registered securities, it will make a complete mockery of securities law. Admittedly, the current administration does have a certain appetite for mocking laws of all kinds. We may revert to 1920s-era fundraising, but with more issuers and more investors exposed to shenanigans. Investors will have recourse under common law fraud statutes, which are higher bars to clear than securities fraud rules.³ Underwriting and auditing may largely disappear.

But isn’t this more efficient?

For many people, a world without underwriting fees and auditors and archaic GAAP rules sounds pretty great. A company that wants to issue stock can bring it straight to the public the next day, without the friction and the cost typically involved in issuance.

This view of the world gives short shrift to the notions of accounting and accountability. Faithful accounting is essential to preserving the contract between employees and managers, managers and investors, bondholders and shareholders. Without agreement about revenues, costs, values, and other such matters, every distribution to every stakeholder becomes contentious.

Outside participants like underwriters and auditors keep companies honest. While auditors will test financial statements and internal controls, underwriters go further into the operations of the business, the quality of management, and what markets say about the prospects of the business. Like auditors, underwriters link their reputations to those of the issuing company.

Many people may concede these points, but nevertheless insist they are free to invest their money as they wish, and to accept the risks of a world with no assurance. Such a position may even appeal to their masculinity. But these individual decisions create a negative externality: If enough people waive their right to public information disclosures from companies, then that information won’t be produced any more.

The value of the whole of corporate disclosure is much greater than the sum of its parts. Many people can invest without using it, but they can only do that because someone is looking at it. Efficient markets incorporate all public information into prices. Reduce the amount of public information and you will get more volatile prices.

Corporate disclosure is also egalitarian by law. An officer of a corporation can’t share new results with a small group of investors in confidence. Whatever is said about the company has to be disclosed to everyone at the same time. A lack of disclosure will fragment the information environment. Investors who are happy to accept the risks of non-disclosure now may not like their chances as much if they’re at a severe informational disadvantage.

Financial markets collapse in a frictionless world, so claims about eliminating frictions in finance should always be viewed skeptically. Claims about eliminating frictions in finance from the crypto lobby should be viewed especially skeptically. I’m not confident that rational policy will prevail, but now I can say I’ve seen the unintended consequences coming.

Matt Sekerke has been involved in securities litigation long enough to have developed a kind of Stockholm Syndrome about it. He is stockpiling good policy ideas for another time.

1. Proven by a friend with a six-year-old daughter, but withholding names for privacy.

2. My guess is that they’re daring a future administration to bring lawsuits against all of the actors they wave through during the Trump administration.

3. Securities fraud embeds a presumption of reliance on market prices, which allows investors to become aware of fraud through a shortcut. Common law fraud requires more proof about reliance and scienter. I’m not a lawyer—if you are, please feel free to correct me.