Crypto Regulation: Crypto-Founders beware – are you prepared for the heavy hand of the regulators?

Crypto regulation has been in the headlines over the past few months sending the crypto world into a tizzy. Previously highflying enterprises like Terra Labs, Tornado Cash and Three Arrows Capital have crashed to earth. Founders and principals find themselves under the extreme scrutiny of bankruptcy courts, regulators in various countries and even criminal law enforcement agencies.

How well these founders are weathering this tempest depends upon the preparations they undertook when the seas were calm. They are in the middle of the hurricane now, so for them, the time for preparation is long past.

However, what about founders in areas like stable coins and crypto exchanges? At the moment they may still be enjoying calm waters, but the storm clouds are inescapably building on the horizon…

In this article, I’m going to use case studies as lessons for these other crypto founders to draw upon, as they prepare themselves for the on-coming regulatory tsunami with specialised Back-Up plans.

Crypto regulation: is the myth of Crypto freedom dying hard?

Just a few short years ago, the world of cryptocurrency was filled with new possibilities. However, this excitement seemed to ignore one stark reality; the international financial world has long-established and heavily enforced rules and regulations. Since its inception, many founders involved in cryptocurrency believed that traditional “market rules” did not apply to them. This was probably because their dealings had an air of anonymity; and of course they take place on platforms not under direct government authority.

As a result, many involved in developing the crypto universe have been a little short sighted. They failed to realise that the world of regulation would eventually coming knocking. Moreover, despite crypto-founders knowing that the storm of government regulations were coming,  many were too slow to recognise how this would impact them personally… and since they were so closely identified with their crypto product, their businesses also.

What is the difference between the founders of Three Arrows Capital and Terra Labs Do Kwan

We all know the story of the downfall of Three Arrows Capital and its eventual filing for Chapter 15 bankruptcy. One of the biggest mysteries in the crypto world has ensued… just where are Three Arrows founders, Kyle Davies and Su Zhu?

Crypto Regulation Where are Kyle and Zhu?
Where on earth are Kyle and Su?

The obvious implication is that Kyle and Su have, in traditional terms, “done a runner”. This would naturally make them instant suspects of fraudulent conduct. However, no criminal charges have yet been laid against them! While asked by the media and the civil bankruptcy court, they have no legal reason to disclose their location. Indeed they have many strategic reasons to remain quiet. In short, if and until they are formally criminally charged their life and location is their own business.

The case of Terra Labs and Do Kwan

Do Kwon’s case is quite different. The South Korean cryptocurrency developer who co-founded and is CEO of Singapore-based Terraform Labs has now been criminally charged. South Korean authorities maintain that he has fraudulently contravened capital markets laws.

Crypto Regulation Do Kwon
There is an international man hunt for Terra Labs founder Do Kwon

It is worth noting that Terraform Labs is the company behind the stablecoin TerraUSD (UST) and network token Terra (LUNA). TerraUSD and Luna both collapsed in May 2022. This wiped out almost $45 billion of market capitalisation over the course of a week. This, in turn, drove Three Arrows Capital into bankruptcy.

In addition to the criminal fraud charges, Do Kwon and many fellow employees of Terraform Labs have had their Korean passports cancelled. Do Kwon himself has also had an Interpol Red Notice issued against him. Do Kwon was last seen in Singapore but his current whereabouts are unknown. In response, Do Kwon has claimed that he is not “on the run”. He asserts he is keeping his location private to avoid harassment by disgruntled customers (aka, “Luna-Tics”). His lawyers have also claimed that the charges are not valid. They say Luna is “not a security”; therefore Korea’s capital market laws are not applicable. Whether this argument has any merit will, I suspect, soon be tested when Do Kwon is arrested and appears in a Korean courtroom.

However, the key point to recognise is that Do Kwon has been criminally charged. The Korean government believe their case so strong that they have sought the international assistance of Interpol to apprehend him. In contrast, Kyle and Su only have civil regulators and bankruptcy courts interested in them.

Protect yourself from Crypto Regulation. Previously unregulated industies like cypto need to avoid regulators abuse by use of a Backup Plan.

In the 1990s, former New York Attorney General Elliot Spitzer mastered the technique of “Doing a Spitzer”. This involved arresting Wall Street executives on dubious criminal charges and making them do the “perp” walk. Then, hours before the market’s opening bell, Spitzer would call up the executive’s board and offer them a plea bargain deal. Negotiating from a position of great weakness, the boards would capitulate. They conceded to charges that Spitzer really had no real chance of winning at trial in an attempt to save the company share price. 

In the mid 2000s, a previously unregulated industry exploded on the scene. Namely on-line gaming and sports books. Initially, the bricks and mortar gaming industry did not take on-line gambling seriously. However – the internet caught fire. Vegas suddenly realised that a significant amount of their market share was being lost. The Casino owners fought back. They pressured US state regulators to make elements of the on-line industry illegal in the US.

One of my clients laid out their dilemma succinctly by stating, “If I walk onto a football pitch in the UK, I will be applauded. If I fly through Newark, I will be arrested”.

The solution to their problem was for the founders to avoid “Being Spitzered” while their corporate lawyers adjusted their businesses to new U.S. regulatory rules. All these founders continued to legally live and operate in more friendly jurisdictions during this negotiation period. Their competitors, who fell into the hands of the U.S. authorities during this same period, saw their businesses collapse. They were subsequently bought up for pennies on the dollar by my clients! 

This is the playbook that Kyle and Su seem to be following – and one which other crypto founders should adopt.

Which Crypto Founders need to get their Backup Plans in place now?

One only has to look at the headlines to understand which elements of the crypto world will soon face overwhelming regulatory pressure. The leading candidates are stable coins like Tether and crypto exchanges like Binance, FTX and others.

Regulations as varied as capital reserve requirements, securities laws, anti-money laundering, tax reporting and sanction busting are knocking at their doors. To date, there have not been charges of criminal behaviour.

These companies are busy devoting significant resources to bringing their operations into regulatory compliance. However, at the same time they need to make sure that they do not place themselves at a negotiating disadvantage. Everything from acquiring second citizenships and residences in the correct combination of jurisdictions to replacing personal appearances with video appearances needs to be immediately done.

Pioneer founders in previously unregulated industries, such as gaming and crypto, have always needed to maintain a power balance when the regulators inevitably come to call. When negotiating to adjust business practices to the newly established standard, it is good practice to maintain parity in the relationship. This is best done at a distance. This way it is difficult for the regulator to bully: it allows company lawyers to negotiate with liquidators, courts, and regulators on an even playing field.

As my on-line gaming clients learned, an effective Backup Plan can mean the difference between their business collapsing and thriving. Personally, it can mean the difference between a Perp Walk and freedom. However, as Do Kwon is discovering, if your actions have contravened current criminal laws then no Backup Plan will ever save you.

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