Blockchain and the Broken Revenue Model: Complexities of Securities Laws and Blockchain

Long gone are the days of the quick and dirty non-securities token offerings (i.e., securities offerings that simply ignored US securities laws). The industry underwent a shift from non-compliance to attempted compliance. Now, many token issuers attempt to comply with securities laws and issue tokens pursuant to registration exemptions available. However, many available exemptions do not neatly fit the goals of the issuer.

As a primer, Section 5 of the Securities Act of 1933 effectively requires all securities that are marketed/sold in more than one state to be registered with the SEC or be issued pursuant to an exemption therefrom. There are many different exemptions (e.g., Reg. CF, Reg. D, Reg. A). However, each of these exemptions carry specific rules regarding issuance and secondary trading.

Traditionally, the nuanced rules of these exemptions do not pose many problems, because the exemptions lend credence to the way traditional securities are issued and traded. However, the tokens issued within most blockchain start-up “ecosystems” create various issues, and the current regulations do not neatly fit therein, due to such companies’ revenue model.

In this article, I will describe the model addressed above, the issues I see therewith, and offer a solution.

Description of the Broken Revenue Model.

Most blockchain start-ups employ an ecosystem wherein they issue a token, and the token is the currency that is used to transact on the platform. For example, a supply-chain solution may have the transfer of the tokens operate as payment for goods and/or services while simultaneously logging the shipment information on the blockchain; or a data analytics solution may permit discounts when using payment in the form of a token while it aggregates data in various ways (e.g., predictions, surveys, etc.) and records it on the blockchain.

How do the companies that create these solutions generate revenue? They take a small percentage of the token they initially issued each time it is transferred as a transaction fee. This means they need to liquidate the tokens taken as transaction fees, because the only other thing they can do with it is use it on their own platform. Thus, they must re-issue these tokens back to the public in exchange for other currencies to pay for their operations. The end result is an “ecosystem” wherein everyone, including the issuer, realizes the token as a primary revenue source.

Issues With Current Regulation Exemptions.

Regulation D.

Regulation D (“Reg. D”) (See CFR Section 230.500 et. seq.) is commonly relied upon in the blockchain space. It permits a non-public sale of securities and provides three safe-harbors (Rules 504, 506(b), and 506(c)). For efficiency, I will skip Rule 504 and 506(b) because they are rarely, if ever, relied upon in this space. Rule 506(c) permits the public solicitation and sale to accredited investors only (See CFR Section 230.501(a)) and preempts state registration requirements (i.e., an issuer need not register the securities in each state it is offered). The securities sold pursuant to a Reg. D offering are deemed “restricted securities” (See CFR Section 230.502(d); see also CFR Section 230.144), which imposes, among other restrictions, a twelve month prohibition of trading on the open market (the “holding period”).

In any event, the issuer must exercise reasonable care to assure that the purchasers of the securities are not underwriters. Pursuant to Rule 144(d), this is traditionally achieved by (1) reasonable inquiry, (2) written disclosures; and (3) placement of a legend on the stock certificate setting forth the transfer restrictions. However, if the preceding requirements are not possible, any other reasonable actions, determined on a case-by-case basis, will suffice.

In sum, an issuer of a token can choose to sell only to high net-worth individuals and postpone an exchange listing for 12 months in reliance on Reg. D. Presumably, the issuer can impose an absolute 12 month lock up. Subsequently, an issuer may undertake listing the token on the exchange or simply permit peer-to-peer transfers of the tokens freely among interested parties (accredited and non-accredited investors).

This sounds great! We found a compliant way to raise our funds! While the preceding sentiments are correct, the revenue model discussed above creates three major issues: (1) when the issuer liquidates its own holdings, it must track a new an separate holding period; (2) potential registration requirements pursuant to Section 12(g) of the Securities Exchange Act; and (3) getting the tokens in the hands of the end-user.

Issuer Liquidation

To clarify, when an issuer reacquires its securities and resells it to the public, this will constitute another issuance of securities. Of course, such re-issuance may be conducted pursuant to Reg. D again, but the issuer will then have to figure out a way to track the holding period for the new offering. Moreover, if the tokens issued in the first Reg. D offering are now trading on exchanges, the issuer will have to figure out how to prevent the trading of the newly issued tokens on the applicable exchanges and/or prevent peer-to-peer transfers for the applicable holding period. Lastly, such re-issuance is likely to reoccur on a regular basis, because the company will need fiat to further its operations as it grows. Thus, over time, the liquidation problem will grow worse.

In sum, having the token as the primary source of revenue for the issuer creates a revolving door of Reg. D offers that will create logistical issues and increase the cost of compliance.

Exchange Act Section 12(g)

Section 12(g) of the Securities Exchange Act of 1934 requires that an issuer with total assets exceeding $10M and a class of equity securities held of record by either 2,000 accredited investors or 500 non-accredited investors, register with the SEC and thereafter be subject to the reporting requirements of the Exchange Act.

This is problematic, because that effectively means there can only be a maximum of 2,000 holders of an issuers token; even more problematic is that the more realistic maximum is 500 holders due to the likelihood that end-users are not accredited. Whereas an issuer can limit the number of holders in various ways (e.g., code, contract) so that only 499 wallets are able to hold the tokens, this would likely kill whatever problem the issuer is attempting to solve and prevent widespread adoption.

Admittedly, this begs the question whether such tokens would constitute equity securities or debt securities, and I have heard arguments both ways. However, this article will not dive therein and provides this issue as is.

In sum, if the tokens are classified as equity securities, then 12(g) would require either: (1) a company to register shortly after its ICO; or (2) limit the number of holders of record, stunt the growth of the platform, and thwart widespread adoption.

Getting Tokens in the Hands of End-Users

At the end of the day, the tokens issued pursuant to Reg. D will unequivocally be in the hands of investors. Thus, there needs to be a road to the end-user. Otherwise, the problem that the “ecosystem” is supposed to solve will never be solved due to non-use. Whereas this issue exists regardless of whether the tokens are classified as securities or not (i.e., the overwhelming majority of purchasers are simply interested in speculation and not use), it is exacerbated in the case of a Reg. D offering. To clarify, the tokens will be held only by wealthy individuals/entities that have no interest in deploying the functionality thereof.

Moreover, I am hard-pressed to believe that once the tokens are legally listed on exchanges, there will be a rush from end-users to purchase them. Instead, there will likely be less wealthy individuals pining to speculate on the price of the tokens, as evidenced by reviewing the 2017 markets (i.e., I can’t think of an actual use case from a company that launched in 2017).

In conclusion, a blockchain company may get through its raise without legal problems. However, it will likely find the cost and burden of compliance higher than expected and/or not worth the undertaking. Reg. D is a great option to get a blockchain company through an equity raise, whether tokenized or not, because there is no revolving door of Reg. D offers. However, Reg. D should not be used as a corner stone of a company’s revenue model.

Regulation Crowd Funding

Regulation Crowd Funding (“Reg. CF”) (See Title III, JOBS Act of 2012, Section 4(a)(6)) is an exemption from registration that permits a maximum raise $1,070,000 through a crowd-funding portal (e.g., Kickstarter, Indiegogo, StartEngine) that is registered with the SEC.

To keep it brief, Reg. CF has such a small limit to the amount that can be raised. Thus, tying the companies’ revenues to its ICO conducted through Reg. CF would likely lead to extremely weak revenues, because the value of the token would be too low. However, Reg. CF might be a good alternative for a company to bring in some seed money to hire an attorney that can help them with their raise.

Regulation A

Regulation A (“Reg. A”) (See CFR Section 230.251) is an exemption that provides two tiers of offerings. In the interest of expediency, I will only address Tier 2 offerings here, because Tier 1 offerings do not preempt state blue sky laws and is highly unlikely to be relied upon. A Tier 2 offering is limited to $20M and imposes ongoing reporting requirements, which increases the cost of compliance. However, a Reg. A Tier 2 offering: (1) does not require the securities be classified as “restricted securities” and imposes no transfer restrictions; (2) both accredited and non-accredited investors may participate in such offering; and (3) has a conditional exemption for the Exchange Act 12(g) registration requirement if the issuer uses a transfer agent, has a public float of less than $75M as of its last annual or semi-annual report (or revenues of less than $50M at the end of its last fiscal year if no public float), and is current on its annual reports. Thus, there can be immediate liquidity, the road to the end-user appears easier, and the issuer can indefinitely avoid registration. Whereas, Reg. A is also limited to equity securities, this article will not undertake such analysis as that is a separate discussion in itself.

The problem with Reg. A is similar to the Reg. D problem above in that there will be multiple Reg. A offerings in order to properly liquidate the revenue generated (i.e., the percentage of the tokens issued garnered as transaction fees), but it differs in that there is no logistical issues with tracking and ensuring the integrity of the holding period. Instead, the problem nests in integration, which is simply the treatment of two separate Reg. A offerings as one. This is a problem due to the $50M cap.

For example, an issuer initially raises $35M in Q1; then the issuer reaps $20M worth of tokens in transaction fees in Q2. If the issuer wants to liquidate its earnings pursuant to a subsequent Reg. A offer, then the two offers might be too close in time and/or terms and be considered integrated as a single offering. If this occurs, then the issuer has now raised $55M, which destroys reliance on Reg. A. A company may choose to liquidate only so much as to make sure not to run into this problem. However, that effectively limits the company’s growth.

In conclusion, Reg. A seems to be the more appealing exemption for the reasons described above, but it invites integration problems. Whereas a company may be fine through its initial raise, 1 year out, or even 2 years out, this issue will likely rear its head as the company grows.

A Solution: the Dual Token Model

I admit that my opinion may not be the most popular, but I believe the concept of an “ecosystem” is a non-starter. Securities laws aside, the concept of the “ecosystem” misaligns incentives. It places an issuer in a position to be primarily concerned with the token’s value instead of the solution it proposes to solve. Moreover, limiting the number of tokens that have a variable rate dependent on market forces and the company’s efforts (even though every issuer claims it is only market forces) only begs speculation. Remember, if there is no use of the platform, then what problem is the company really solving?

My proposed model is not new, and I do not take credit for coming up with it. It is the product of discussion among myself and other attorneys in the space. However, the proposed model is a dual token model wherein the fundraising is not attached to the functionality of the platform. Remember, tokenized equity can very well occur without the problems we see above, due to the fact that it does not cause a revolving door of offerings. Thus, a company should separate the fundraising tokens from the functional tokens. In so doing, a company can issue tokenized equity in the same manner as an ICO pursuant to any of the exemptions described above. This will permit an initial capital raise, and the equity can be structured in various ways to protect the interests of the issuer. Subsequently, the company can simply sell the functional tokens in perpetuity and at a fixed price on their website.

Admittedly, the big issue with this model is that there is a need for an ecosystem and validators (e.g., miners) in order for a blockchain to work, to which I agree. However, there is a difference between a company that launches its own blockchain and garners widespread use and a company that merely piggy backs off another blockchain. For example, the majority of blockchain companies build on top of the Ethereum blockchain. Whereas the Ethereum blockchain needs the “ecosystem,” the companies built thereupon do not.

For example, a company providing a title registry on the blockchain need not limit the total number of tokens and require the use thereof for the purchase of assets that are recorded on a blockchain. Instead, such a company can simply sell title tokens at a fixed price from their website for a person who purchases and/or sells goods/services to be used simply for the act of recording.

To further illustrate, I own a company that wants to create a registry for cars. I first tokenize my equity and provide a profit sharing agreement that operates mostly as a royalty. Then I sell those tokens to investors pursuant to Reg. D. Subsequently, I develop an ERC-20 token whereby a user can record car maintenance, repairs, transfers, etc. on the Ethereum blockchain. I market this solution to insurance carriers, and the insurance carriers require the use of such blockchain to record all relevant information. How do the insurance carriers get the tokens in order to record such information? Simple, they come to my website, buy a package of 500 tokens for $30, and they use them. Once they run out of tokens, they will return to my website and buy more. There is no need for liquidity, no reason for speculation, and no securities laws implications.

I am often met with the same question at this point in the conversation, “well, how do I raise $50M overnight then?” At that point, the question really becomes, “how bad do you want to solve the problem you say you want to solve?” At the end of the day, we must remind ourselves that a company does not need to start with a massive raise in order to become a large and successful company. There is no shame in annual growth over time instead of an overnight spike and likely decline therefrom.

Conclusion

In conclusion, functional tokens do not neatly fit within the securities laws framework, and they are usually implicated therein due to the “ecosystem” revenue model. Moreover, an ICO in conjunction with the “ecosystem” revenue model has problems (e.g., path to the end-user) independent from securities laws. Thus, separating the fundraising and function of these tokens eliminates these problems and creates a better path for a company to raise modest (but enough) funds and operate a company in a more compliant manner.