Building Liquidity the Right Way
Secondary Trading in Tokenized Securities — Opportunities and Pitfalls
**Co-Authors @RachaelQualls of Venture360 and Liquifi, and Robb Miller
One thing marketers and communicators understand well is that the human mind likes to make complex things simple in order communicate them efficiently and effectively.
One example of overly simplified marketing-speak that permeates materials of several new ‘STO Platform’ providers is that tokenization somehow equals liquidity. Let’s be clear that creating a digital asset of any kind does not mean that asset can or will be freely traded. The distilled marketing message that “if you tokenize it, it’s tradable” without qualification, is quite dangerous and misleading.
The SEC provides some clear guidelines on trading private securities, so this post will dive into what it really means to be SEC compliant in a secondary trading environment. Many of the STO Platform providers promise to create SEC compliant secondary trading in previously illiquid assets. We dig into the enabling regulatory environment, and explore!
Secondary Trading Exemptions — how capital is raised determines how it trades.
Securities may not be offered, sold or resold unless they are registered under the Securities act, or an exemption from registration is available.
When you raise new capital by issuing new shares — this is an initial issuance. Most companies generally issue their securities and raise capital under an SEC registration exemption, such as Regulation D (Accredited Investor exemptions), or under one of the crowd-funding regulations, such as Regulation A/A+, CF, or some combination thereof.
Once a company issues securities under an exempt offering, holders of those securities may only transfer those securities in accordance with the Company’s rules for doing so, which typically include strict transfer restrictions, and (importantly) in compliance with all federal and local law, including using a registered Transfer Agent for legend removal.
There are 4 possible ‘compliant’ pathways for a holder of a restricted security to sell his or her security under US federal securities law: Rule 144, Rule 144A, the Section 4(a)(1½) Exemption or the Section 4(a)(7) Exemption.
Trading Option 1: Section 4(a)(7)
This exemption provides a safe harbor for a resale transaction in which:
1) The relevant securities have been authorized and outstanding for at least 90 days
2) Each purchaser is an accredited investor
3) No general solicitation is used; (you can’t advertise the securities for sale)
4) Certain limited informational requirements are satisfied
Securities sold under the Section 4(a)(7) exemption will be qualified as covered securities under Section 18(b)(4) of the Securities Act, and, thus, are exempt from registration under state “blue sky” securities laws. (This ‘exemption’ however may be somewhat misleading; the reality of state law observances is more complex and needs to still be considered).
Trading Option 2: Rule 144
For non-affiliate holders of restricted securities, Rule 144 provides a safe harbor for the resale of such securities without limitation after one year in the case of non-reporting issuers. After that one-year holding period, a resale of these securities by non-affiliates will no longer be subject to any other conditions under Rule 144.
Rule 144 provides one pathway through federal resale restrictions, and the conditions vary depending on important bespoke facts regarding each of the issuer, the seller, and the buyer, including whether the issuer is a listed company, registered, an OTC company or otherwise, the seller and the buyer, including geographical residence and other elements. Issuer will always need to file a Form 144, and there are limits on the amount of shares that can be transacted under Rule 144.
1. Holding Period
A six-month holding period is required for “restricted securities” of an issuer
that has been a reporting company for at least 90 days. A one-year holding period is required for “restricted securities” of a non-reporting company.
2. Adequate Current Public Information
Specified current information concerning the issuer must be publicly
available, including financials.
3. Volume Limitation
The amount of securities that can be sold in any three-month period for
companies with over-the-counter securities is limited to one percent of the shares or other units of that class outstanding. Rule 144 also has an alternative volume limit of up to 10% of the tranche (or class) outstanding for debt securities.
4. Manner of Sale
Equity securities must be sold in unsolicited “brokers’ transactions,” directly
to “market makers,” or in “riskless principal transactions.”
5. Notice of Sale
The seller must file a Form 144 with the SEC at the time the sell order is placed with the broker if the seller is an affiliate and intends to sell during any three-month period more than 5,000 shares or securities with a value in excess of $50,000.
Other Considerations for Trading:
1) Shareholder Limits
The JOBS Act revised the threshold under Section 12(g) of the Securities Exchange Act of 1934, so that any private company with $10M assets may only remain private so long as the number of holders of record at any time does not exceed a threshold level of two thousand investors total. Thus a private company with $10M in assets is allowed to have up to 1,999 holders of record without the registration requirement of the Exchange Act. (There is also a relevant threshold of 500 non-accredited investors).
2) Legend Removal
Restricted securities will typically bear a legend explaining their restricted status. The legend will disclose to prospective purchasers that the security is restricted, was acquired in a transaction not registered under the Securities Act and that it cannot be resold absent registration under the Securities Act or an exemption from registration, and in the latter case, along with the delivery of opinion of counsel to the same effect. Without the removal of the legend, the seller cannot resell the security to the public. The removal of the restricted legend must be done by the transfer agent for the securities.
Issuer’s counsel will only issue the required opinion if it has received from the proposed seller a certificate that contains representations indicating the seller is in compliance with Section 4(a)(7) or Rule 144, including:
(1) the affiliate status of the seller,
(2) the manner in which the seller acquired the securities,
(3) when the seller acquired the securities,
(4) whether the purchaser can be reasonably considered to not be a Bad Actor, and (5) if relevant, any other securities of the issuer sold by the seller in the past three months. Such representations may also be set forth in a Rule 144 Representation Letter.
The Platform Promise.
Several STO Platforms are in a race to provide Securities issuers a ‘compliant token’ that builds a pathway to liquidity into the token smart contract and transferability provisions. Such platforms include LIQUIFI and Securitize.
The message from many STO Platform providers is that “the combination of Regulation D, Section 4(a)(7), and Rule 144 offers a practical way forward. “
In this scenario, “the company raises initial funds from accredited investors, then issues the shares via digital assets to those accredited investors. After a relatively short 90-day lockup, those initial accredited investors are free to trade with any other accredited investors. Nine months after that, all investors, not just accredited, are free to own the token.” (David Sacks and Josh Stein, Introducing the Private ICO (PICO))
We take a look at this suggested pathway below, and then dig a little deeper into the enabling regulatory provisions. We suggest that if the full rigor and complexity of the enabling (and surrounding) securities regulations are not ‘built-in’ to the smart contract from the outset, the token platform provider (and any issuer using the token platform provider) run a real risk of enforced transaction reversal, and potentially fines and other enforcement measures.
One company that is comprehensively building in the complexity to their smart contract platform is Liquifi. We’ll explain further below.
The STO Ecosystem
Several tokenized securities offerings have been launched on various STO Platforms already.
Real estate and other large assets have been tokenized, and are trading now (witness Harbor and Securitize). Morgan Creek announced yesterday they were leading a round of $3.1 Million into RealBlocks, a tokenized Real Estate Platform. (Please also check out the Liquifi custom capitalization platform).
There are numerous tangible and understandable benefits for tokenizing any financial instrument offering by any company, real estate investment group, or any other physical asset. A pathway through the complex regulatory environment can and does exist — Accredited Investors will be able to sell be able to sell to non-Accredited Investors after requisite holding periods, early employees will be able to derive near-term value of their perks and Founders will be more liquid.
Yet many of the actual ‘smart contracts’ promoted by STO Platforms presently provide extremely basic functionality, often as an Ethereum DAPP. These MVPs may eventually become ‘compliant’ with federal and state securities rules, but an actual ‘compliant’ smart token remains elusive.
Try to actually register your ‘tokenized offering’ or ‘securitized token’ on the respective platforms, and the user-flow often finds an abrupt premature end. In most cases, you need to email the tech folk with your desire to issue a token, and then you are told to engage an Attorney and provide your own compliant offering documents to the platform developers who will then create your smart contract, with your designated regulatory restrictions ‘baked-in.’
The compliant pathway to liquidity involves taking an inherently ‘restricted’ security, and mashing it up with an inherently ‘transferable’ token. A truly ‘compliant token’ will actually ‘build-in’ the myriad complex restrictions from the Securities Act, the Exchange Act, various state laws and private resale restrictions, incorporating the often incongruous definitions and restrictions directly into the token itself. As well, US Federal Securities will also always interact with State and foreign jurisdiction securities regulation, depending on the residence of specific players in any transaction.
Every transaction is unique (including the later secondary transactions). This presents a non-trivial and labyrinthine drafting issue at the outset of any tokenized offering. As well, US Federal Securities will also always interact with State and foreign jurisdiction securities regulation, depending on the residence of specific players in any transaction. Many of the STO Platforms begin with the ‘token’ technology and marketplace, and are working backwards to install the bare minimum restrictions so that they can enable trading.
Even platforms are regulated.
In light of recent SEC enforcement actions against inter alia AirFox, Paragon, Crypto Asset Management, TokenLot, and EtherDelta’s founder, the SEC recently the SEC clarified its position a recent Public Statement on Digital Asset Securities and Trading (released November 18, 2018), as follows:
Any entity that provides a marketplace for bringing together buyers and sellers of securities, regardless of the applied technology, must determine whether its activities meet the definition of an exchange under the federal securities laws. Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. An entity that meets the definition of an exchange must register with the Commission as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system (“ATS”) in compliance with Regulation ATS.
This very clear ‘caution’ should be taken seriously by any STO Platform provider that aims to create liquidity by enabling secondary trading in tokenized securities. STO Platforms should be extra-diligent in assessing their own technologies in light of Regulation ATS. (Its worth taking a glance at the SEC Order and fine, against EtherDelta Founder Zachary Coburn). In the same Public Statement on Digital Asset Securities and Trading mentioned above (released November 18, 2018), the SEC commented directly on this issue as follows:
A system “brings together orders of buyer and sellers” if, for example, it displays, or otherwise represents, trading interest entered on a system to users or if the system receives users’ orders centrally for future processing and execution.
A system uses established non-discretionary methods if it provides a trading facility or sets rules. For example, an entity that provides an algorithm, run on a computer program or on a smart contract using blockchain technology, as a means to bring together or execute orders could be providing a trading facility. As another example, an entity that sets execution priorities, standardizes material terms for digital asset securities traded on the system, or requires orders to conform with predetermined protocols of a smart contract, could be setting rules. Additionally, if one entity arranges for other entities, either directly or indirectly, to provide the various functions of a trading system that together meet the definition of an exchange, the entity arranging the collective efforts could be considered to have established an exchange. [Emphasis Added]
Play by the rules or…
The most rigorous adherence to the fact-specific details of each federal, state and foreign securities regulatory environment (and their effect on every transaction) will ultimately determine the most effective ‘compliance token’ and allow access to private IPOs to the largest and most diverse group of individuals. STO Platform providers that miscue the rigorous elements of each specific resale exemption, and the constituting elements, run the risk of enforced transaction reversal and some real potential for fines against the platform, issuers and sellers of securities. That’s why we suggest you look at Liquifi token platform, which is building the smart contract from the ground up, with relevant securities exemptions serving as the guideposts in their tokenized security platform development.
All comments and input are welcome. Please feel free to contribute to the conversation, and only comment appropriately please.
Please also check out the Liquifi custom capitalization platform.
