Longfin's rise and fall casts a shadow over the blockchain industry

Is the spectacular collapse of the trade-finance group a cautionary tale?

A chain of bitcoin replicas
Regulators have begun cracking down on initial coin offerings, which raise money for virtual tokens

The spectacular collapse this month of Longfin Corp., the trade finance group with a blockchain arm, may serve as a warning to other companies in the upstart and volatile crypto industry that they are in the sights of regulators.

Trading in Longfin shares has been halted on the Nasdaq since April 6 and the Securities and Exchange Commission has accused the company and its chief executive of breaking securities laws.

The move by the SEC to obtain an emergency freeze of US$27mln worth of the trading proceeds of Longfin’s chief executive and founder Venkat Meenavalli and his associates and accuse them of securities fraud comes at a time of tremendous uncertainty surrounding the regulation of blockchain and cryptocurrency companies. And the ongoing probe by the SEC into Longfin is regarded by some as an attempt by regulators to send a warning shot to the largely unregulated blockchain industry.

Read: SEC complaint

“Even before the implosion of Longfin, alarms about block chain and crypto currencies were already ringing for regulators,” says William Galvin, Massachusetts Secretary of the Commonwealth. “Block chain is the pixie dust of the month. Cryptocurrencies, blockchain. These sorts of companies have become synonymous with get rich quick schemes.”

Galvin last month ordered five Massachusetts firms --18 Moons, Mattervest Inc, Pink Ribbon, Sparkco and Across Platforms, which allegedly were using block chain technology -- to stop their initial coin offerings (ICOs), which raised money in exchange for virtual coins. Secretary Galvin categorized the coins as “unregistered securities” and told the groups to stop offering them and reimburse people who had bought them.

His crackdown on these ICOs comes months after Jay Clayton, the SEC’s chairman, expressed the SEC’s reservations about cryptocurrencies and ICOs.

“If you choose to invest in these products please ask questions and demand clear answers,” Clayton wrote last December in public comments on the SEC's web site. “It is especially troubling when the promoters of these offerings emphasise the secondary market trading potential of these tokens.  Prospective purchasers are being sold on the potential for tokens to increase in value.”  

Going forward, the divide is likely to widen between the scams and legitimate blockchain technology groups, which have the potential to revolutionize and simplify and perhaps even replace trading and clearing and the business of settlement operations.

Setting a precedent first

Blake Estes, a corporate and finance lawyer with the law firm Alston & Bird LLP in New York, says regulators want to go after easier cases first to set a precedent for what can’t be done in the industry.

“Longfin was a pretty easy case for the regulators to make. They didn’t register their securities for sale,” says Estes. “The SEC wants to get wins early and go after the easy cases first to get scalps. The hope is they send a chill out in the market and say this could happen to you.”

The problem for legitimate blockchain companies – which eliminate the need for centralized ledgers by using cryptocurrencies and sophisticated encryption to record ownership and transactions across a range of computers – is the lack of guidance from regulators including the Securities and Exchange Commission about how the industry will be regulated.

It's still unclear whether platforms that use blockchain technology will be required to register with the SEC as an exchange or a broker dealer or an alternative trading system.

“If entities are trying to seek investors and they’re not registered, that’s a problem,” says Galvin.

Estes says his clients who run blockchain companies would welcome clarity from regulators to help them structure their businesses appropriately. “Our clients are assuming there will be some level of regulation,” he said. “But they just want to be clear about what it looks like.”

Abberation or poster child?

Whether the probe into Longfin offers much of a cautionary tale for the industry is up for debate. Estes sees Longfin as an exception to the rule. “I’m dubious that Longfin was much of a company at all,” Estes said. “I don’t know whether you’ll see broader implications from this.”

 The dramatic rise of Longfin, which saw its shares jump by more than 1,000% last December in the two days after its acquisition of the blockchain company Ziddu.com was followed by its implosion on April 6, marked by the unveiling of the SEC’s lawsuit.

The SEC alleges that three associates of Venkat Meenavalli, Longfin’s chief and founder -- Amro “Andy" Izzelden Altahawi, Dorababu Penumarthi and Suresh Tammineedi – illegally sold large blocks of their restricted Longfin shares to the public while the group’s stock price soared in the wake of its takeover of Ziddu, which the SEC describes as a “purported” cryptocurrency business. Through their sales, these three men reaped more than US$27mln in profits.

The SEC claims that Meenavalli had the company issue the unregistered shares to these three men to sell them, which they did.

The SEC’s suit charges Longfin as well as Meenavalli and his three associates with committing securities fraud by violating section five of the Securities Act of 1933.

“There could be very severe consequences for the executives involved at Longfin,” concludes Estes.

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