Digital Token Offering Securities Regulation: Are you an ICO or STO? A question that for some folks is harder to answer than whether asked if your product is butter or margarine. Blockchain token sales (aka initial coin offerings or “ICOs”) reportedly topped $5 billion in 2017, with approximately $1 billion ICO offerings originating in the United States, according to a December 2017 report by Ernst & Young. Blockchain technology has a variety of prospective applications, and blockchain tokens can have a variety of features and functionality. For example, some blockchain tokens may function as a virtual currency, or as a license or right to receive a good or service or to use certain software. Even traditional assets like real estate or stock in a company may be “tokenized.” That said, a token’s characteristics and the manner in which the token is sold drives the determination as to whether US securities laws –as well as a growing universe of securities regulations in other jurisdictions-may be applicable, explaining the more recent industry labeling:“securities token offering” , also known as STO.
While much has been said and much has been written on the topic of securities regulations within the context of digital token offerings, it would seem that many are still clueless (or perhaps have bananas in their ears and blinders on their heads). Evan Fisher, a finance industry veteran and business plan consultant at Prospectus.com LLC stated, “Of the several dozens of initial conference calls between the staff at Prospectus.com LLC and crypto cool kids seeking white paper writing and/or investor offering document preparation for respective ICOs, the take away is that many crypto entrepreneurs still suffer from blind eye syndrome and are advancing capital raises in direct violation of established law. ” Adds Peter Berkman, a US securities and real estate attorney who also advises clients of Prospectus.com LLC, “Regrettably, ignorance of the law is not a viable defense strategy for those charged with violating securities laws and/or anti-money laundering laws.” Added Berkman, “the popular argument held by many start-up entrepreneurs in ‘crypto land’ is that their token is not actually a security-which is fine-as long as they’ve set aside several hundred thousand dollars to defend that argument when they wind up wearing court order to appear.”
That said, there should be two rules of thought for those who believe they have a great, industry disrupting idea that leverages their fintech fluency and the blockchain ecosystem: (i) The 3 Duck Rule-If it looks like a duck, walks like a duck and quacks like a duck, regulators will call it a duck and (ii) advancing the notion that your ‘token’ is a utility device and the pitch to investors is that the value of the token will increase as usage of the token increases–hence the reason for investing in it-is a thesis that has been advanced by each of the 800+ ICOs that have died on the vine before reaching puberty. Leading many investors to ask in retrospect, “what the f*&k happened to the money I invested?!” In turn, leading this author to answer: “Your money has been carefully distributed to a variety of real world assets, including luxury homes, vacation homes, cars, NetJet contracts and other toys purchased by the folks who you sent your money to.” If you’re a cool crypto kid and your value proposition is ” If we build it, they will come and they will play” and hence, “its the balls and bats that we provide that will have value and the more folks play, the greater the value of the bat and balls” we congratulate you for socialistic leanings.
On the other hand, sophisticated investors are rapidly losing interest in pitches that are based on the same premise advanced by dot-com busters–the one that suggested “if we get enough users, we’ll be profitable!” Yes, because these business models were based on advertising sales. Yes, it’s worked beautifully for Alphabet Inc, FaceBook, YouTube and a select universe of others. Yes, you can also go to the dot-com graveyard and locate the thousands of others who never got enough users, or never got advertisers to pay those sites to install a click-able link. In the Software as a Service (SaaS) model, people pay for using a software application on a subscription basis. In the utility token construct, payment to use the software application and who receives those payments is often complex–but investors in the token are generally not sharing in that revenue. They can only look to a return on their investment if a whole bunch of people are using it and if a whole bunch of people are using it, they will need to procure more tokens for continued usage. If there are a limited number of tokens available for using the application, the value of the token will therefore increase. Not to suggest the ‘pay-to-play’ model is bad (its actually a good one), the rubber meets the road at the point where users don’t want or don’t need to play with your token–because nobody else cares to play with it.
The Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act), defines a security within the context of whether what is being sold includes an investment contract. Supreme Court decisions dating back to SEC v. W. J. Howey, 328 US 293 (1946), define an investment contract as “an investment of money in a common enterprise premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” According to the US Securities and Exchange Commission, the Howey test is often applied to determine whether a blockchain digital token sale is a securities offering.
Barring an applicable exemption, Section 5(a) of the Securities Act prohibits the sale of securities in interstate commerce unless a registration statement containing the required disclosure has been filed with the SEC and become effective. Thanks to the surge of ICOs it should be no surprise this activity has been accompanied by regulatory scrutiny over whether ICOs constitute securities offerings, and must therefore comply with federal securities registration requirements or be exempt therefrom. For example, in June 2018, the SEC created a new advisory position to coordinate efforts across all SEC Divisions and Offices regarding the application of US securities laws to emerging digital asset technologies and innovations, including initial coin offerings and cryptocurrencies.
For issuers of ICOs or STOs (securities token offering), who aspire to remain inside the regulatory goal posts and do not want to be put into the penalty the box, there are several paths to choose from, including options that would exempt you from registration with securities regulators, and options that can pave the way for a broad based offering and eventual listing on a public exchange.
Digital Token Offering Securities Regulation / Exemptions from Registration
Regulation D and Regulation S
Issuers looking to offer securities to investors without registration typically utilize one of two exemptions from registration under the Securities Act: Regulation D and Regulation S. Under Regulation D, issuers can offer securities without registration in a “private placement,” as long as the offering complies with the provisions of Rule 506 of the Securities Act. Under Rule 506(c), an issuer may broadly solicit and generally advertise an offering and still be in compliance with Regulation D, so long as all purchasers are “accredited investors,” as defined by SEC rules, and the issuer takes reasonable steps to verify that each purchaser is in fact an accredited investor. Under Regulation S, issuers may offer securities to non-US investors in offshore transactions without registration, as long as the offering complies with the provisions of Rule 903 of the Securities Act.
Both Regulation D and Regulation S offer issuers a relatively quick and straightforward route to selling an unlimited number of securities to investors in compliance with the Securities Act. Because Regulation D and Regulation S are exemptions from registration, investors who purchase securities in such offerings will receive “restricted” securities that are not easily resold absent compliance with the requirements of Rule 144 of the Securities Act. In addition, issuers are limited as to the profile of investors to whom they can sell the security. In a Regulation D offering, securities generally may only be sold to “accredited” investors who meet certain income or net worth thresholds. In a Regulation S offering, securities may only be sold to non-US investors in offerings conducted outside the United States and, depending on the issuer, resale restrictions may be required to limit “flow back” into the United States. For issuers looking to sell tokens to a larger investor base, Reg D or Reg S will prove limiting at best.
All is not lost or insurmountable for those seeking to secure investments from non-accredited investors. Issuers can sell securities pursuant to Regulation A under the Securities Act by filing a Form 1-A for review and qualification with the SEC. The Jumpstart Our Business Startups (JOBS) Act-mandated amendments to Regulation A on July 19, 2015 and Regulation A has become a much more attractive option for issuers, which has led to several companies having filed Forms 1-A for token offerings, though as of this writing, none have been qualified by the SEC.
Regulation A+ permits most non-public US and Canadian companies to sell up to $50 million of securities in a 12 month period without registration. Offerings made pursuant to Regulation A are often referred to as “mini IPOs,” as they are public offerings that can be made using general solicitation and advertising. Before an issuer may offer securities under Regulation A, it must first file an offering statement on Form 1-A with the SEC, which includes an offering circular (OC) for distribution to investors. Form 1-A filings are subject to review and comment by the SEC. Once the SEC has reviewed a Form 1-A offering statement, an issuer will receive a “notice of qualification” and it may commence its offering.
Subject to compliance with certain conditions, an issuer may “test the waters,” both prior to and after filing a Form 1-A. However, an issuer may not sell any securities until the offering has been qualified by the SEC, and any testing the waters communications must include a legend that complies with the requirements of Rule 255 of Regulation A.
Regulation A includes two offering tiers: Tier 1, which provides an exemption for offerings of up to $20 million in a 12 month period, including up to $6 million of secondary sales by affiliates; and Tier 2, which provides an exemption for offerings of up to $50 million in a 12 month period, including up to $15 million of secondary sales by affiliates. Because of the larger offering size permitted by Tier 2, the requirements for conducting a Tier 2 offering are significantly more stringent than for a Tier 1 offering.
Companies that conduct a Tier 1 offering are required to file up to two years of unaudited financial statements. They must also file an exit report on Form 1-Z upon the termination or completion of an offering. However, there are no other ongoing reporting requirements for Tier 1 companies.
In contrast, companies that advance a Tier 2 offering must provide up to two years of audited financial statements. Tier 2 companies are also subject to ongoing reporting requirements similar to reporting companies, and are required to file annual, semi-annual and current event reports with the SEC, similar to Forms 10-K, 10-Q and 8-K, respectively, that reporting companies are required to file.
However, there are many benefits to conducting a Tier 2 offering as opposed to a Tier 1 offering. Tier 2 offerings are exempt from state registration and qualification requirements (aka state blue sky laws. In addition, Regulation A contains a condition exemption from Exchange Act registration for Tier 2 issuers who are subject to, and current in, their Regulation A periodic reporting obligations, even if an offering might otherwise take them over the threshold for registration. Alternatively, an issuer may utilize a simplified process for entering Exchange Act-reporting company status when they complete a Tier 2 offering, streamlining the process for listing securities on the NYSE or NASDAQ.
Another key benefit to sales under Regulation A is that, unlike sales made pursuant to Regulation D and Regulation S, securities sold in reliance on Regulation A are not restricted securities. This means that they may generally be freely resold by non-affiliates of the issuer.
Preparing for and executing a registered offering is the initial step in becoming a public company. It is intensive and time-consuming and requires issuers to wade through the registration process administered by the SEC, which has discretion over whether or not a registration statement will be declared effective.
The advantage of a registered ICO is that it permits an issuer to sell securities to all types of investors, and there is no limit to the amount of money that may be raised. In addition, registered securities may be freely resold and traded. That said, when contrasted to conducting an exempt offering, a registered offering involves extensive regulatory requirements and is significantly more expensive due to increased filing, legal and accounting fees. Further, since the issuer will become a full reporting company, it will be required to file periodic reports disclosing financial and other material information about the issuer’s business and operations. The challenges of undertaking a registered offering, including the relatively higher cost and perceived difficulty of successfully shepherding the registration statement through the SEC comment process, may be why most security token offerings to date have relied on an exemption from the registration requirements of the Securities Act.
Depending on the characteristics of the token and the manner in which the token is sold, a token sale may be a security offering requiring registration or an exemption therefrom. Issuers considering a token sale should consider whether the securities laws will apply to their token sale and, if so, which of the offering structures best suit their goals. Although many issuers have utilized the exemptions from registration provided by Regulation D and Regulation S to sell securities, these exemptions are subject to numerous limitations. As a result, issuers seeking to sell securities to a broader investor base with greater liquidity for secondary transactions may find that Regulation A+ or a registered offering is a more attractive option for them. Presuming of course the issuer has the financial resources to underwrite the assortment of fees and costs that are inextricably linked to the capital raising process.