Game of Regs: The STO Context
Disclaimer: This article does not constitute or substitute for legal advice or reading the rules and regulations we have summarized. In any particular case, you should consult with lawyers with experience on the topic of this article. Depending on your specific situation, answers other than those outlined in this article may be appropriate. Your use of this article alone creates no attorney-client relationship between you and any author of this post or any entities associated with the authors. Do not include confidential information in comments to or other feedback on this article, as these are neither confidential nor secure methods of communicating with us.
Although many uncertainties exist under U.S. law with respect to initial coin offerings (ICOs), security token offerings (STOs) are, by definition, securities and must follow the same rules as traditional securities offerings. U.S. Securities and Exchange Commission (SEC) regulations come into play anytime a company is selling securities to U.S. residents or the company’s shareholders are U.S. residents. We know what you are thinking. And yes, even if you domicile in Malta (or another crypto-haven), these regulations may still apply.
For the purposes of this discussion, an STO may refer to the issuance of:
- Smart Securities — traditional securities, such as equity, debt, revenue share, convertible note, or bond, that rely on distributed ledger technology to establish their terms, features and transferability (often referred to as programmable securities).
- Compliant Network Tokens — a utility token or right to receive a utility token for use in a distributed network (currently or in the future) that constitutes an investment contract under U.S. laws at the time of the STO.
If you are considering an STO, here are a few rules to get you started. Ready?
SEC: Registered vs. Exempt STOs
Any offering made to U.S. residents must either be (1) registered with the SEC or (2) exempt under the Securities Act of 1933. To further clarify this point, an issuer must create a public offering by filing for registration with the SEC, a lengthy and costly process, or seek a private placement exemption, a potentially cost-effective process.
Let’s break these down…
(1) Registered STOs
Registering your STO will give the most rights to your token holders. U.S. companies must file a Form S-1, while foreign companies must file a Form F-1. Once filed, the SEC reviews the forms and provides comments and declares the registration effective, significantly decreasing the likelihood that the offering will be challenged for securities laws violations. This is the basic process for the first public sale of a company’s securities.
Benefits of registration:
- Diverse Investor Pool — companies may include accredited and unaccredited investors
- General Solicitation — companies may publicly advertise their offerings
- Freely Transferable — securities have immediate trading and liquidity
- Unlimited Capital Raise — companies are not subject to a regulatory limit on the amount they raise
Drawbacks of registration:
- Cost — the entire process of the public sale costs from $2MM to $6MM
- Time — the preparation of the filing can take several months, while the review by the SEC is expected to be longer for STOs than traditional securities filings (expect a 12 months process)
- Disclosure — as part of the filing, companies must include audited financial statements
- Periodic Reporting — expect to publicly report details about the company on a quarterly basis, at least.
- Waiting Period — before a registration statement is filed, no oral or written offers for the sale of securities may be made, and, after the registration statement is filed but before it becomes effective, no written offers to sell the securities may be made
- State Law Preemption — a registered offering is not exempt from blue sky laws and must register their STO in each state where they will be offered or be exempt from registration (except for securities listed on a national securities exchanges such as NASDAQ, sold to qualified purchasers or sold by registered investment companies)
- Additional Disclosures — if the STO serves as vehicle to sell a smart security, then the disclosures will be similar to other equity offerings. If the STO is a vehicle to sell compliant network tokens, however, then the disclosures will not fit and companies will need to work closely with the SEC to create a new path.
Note: Until recently, Overstock.com was the only registered STO. Since then, two additional companies have filed registration statements for STOs: Monster Products, Inc. and The Praetorian Group. A further disclaimer — our citing of the above filings is not intended to indicate support for the quality of the filings or the STOs.
(2) Exempt STOs
Moving on a more manageable and cost-effective way to issue your STO, here are some exemptions to the registration requirements above.
Are you still with us?
- The Founders Exemption
Section 4(a)(2) of the Securities Act is the least well known but the most commonly relied upon exemption. Every time founders issue themselves stock, they are relying on this exemption. Section 4(a)(2) exemptions the sale of securities that do not constitute a public sale. When securities are delivered pre-STO to founders and early team members, the company may often choose to rely on Section 4(a)(2).
2. Reg D
Rule 506(c), frequently referred to as the accredited investor crowdfunding exemption, is currently the most commonly used exemption for STOs. It is also frequently criticized for making the rich richer by reserving the best investment opportunities for the 1%.
- Unlimited Capital Raise — since registered offerings have become more expensive and complex, raising an unlimited amount pursuant to exemptions has gained importance
- General Solicitation — a general solicitation includes an offer to sell securities with the use of an unrestricted and publicly available website. Most STOs, in the way they are currently conducted, constitute general solicitations. If you are also doing a sale abroad pursuant to Reg S, general solicitation can become tricky and you should consult with local counsel.
- State Law Preemption — “covered securities” are exempt from blue sky laws
- Accredited Investors Only — limiting the pool of investors is less of a drawback than many believe as past securities offerings show that a significant majority of funds are raised from accredited investors
- Restricted Securities — with limited exception, securities sold under Rule 506(c) cannot be transferred for 12 months. This restriction may be problematic for any company who is offering a compliant network token with the expectation that it can be quickly used in transactions in its network.
- Accredited Investor Verification — the issuer must take reasonable steps to verify each investor’s accredited investor status.
Rule 506(b) is the most commonly used U.S. securities law exemption in traditional securities offerings. It has the same features as Rule 506(c), except:
- No General Solicitation — no marketing or advertising of the offering
- No Accredited Investor Verification — the company must not have any reason to believe that any investor is not an accredited investor
- Up to 35 Unaccredited Investors — they can participate in the offering, but the company’s disclosure obligations become much greater
Rule 504 is not frequently used. Basic features include:
- Diverse Investor Pool — the STO is open to accredited and unaccredited investors
- No General Solicitation — no marketing or advertising of the offering is permitted
- Capital Raise Up To $5MM — this amount was raised from $1MM recently to give more opportunities to rely on this exemption
- No State Preemption — blue sky laws apply, and the company must register its STO or its STO must be exempt from registration under those laws
3. Reg A+ (The mini IPO)
Reg A+ is the only regulation that gives a U.S. incorporated company an exemption to sell smart securities or compliant network tokens in an STO pursuant to a general solicitation that will be immediately transferable after delivery. Reg A+ offerings are subject to an SEC review after filing Form 1-A. Even though the SEC does not technically approve the filing, it does provide comments to be addressed.
- Diverse Investor Pool — the STO is open to accredited and unaccredited investors
- Immediate Transferability — securities are freely transferable immediately after the STO
- Capital Raise Up To $50MM (under Tier 2) — in most circumstances, $50MM will be plenty of capital for a company to grow its business
- State Law Preemption (under Tier 2) — the issuance of securities is exempt from blue sky laws but transfers are not exempt unless the securities are listed on a national securities exchange (e.g., NASDAQ) or transferred to qualified purchasers
- Marketing — a properly planned Reg A+ offering can be a great marketing tool that provides value beyond the capital raised
- SEC Review — this process is time consuming, expensive and can take up to 12 months for STOs. To our knowledge, at the time of publishing this article, there have not been any Reg A+ token offerings qualified
- Audited Financial Statements — companies must include audited financial statements in the offering statement
- Ongoing Reporting Obligations — the company must file annual reports and semi-annual reports, creating an additional cost and distraction for management
- U.S. or Canadian Entity — if the STO is for smart securities that do not represent equity or debt in the company or for compliant network tokens, then the company often will need to pay U.S. (including state) and/or Canadian taxes on the entire amount of the capital raised as opposed to using a more efficient structure with little taxes paid in a more tax-friendly jurisdiction
- State Preemption — blue sky laws apply to secondary trading
- No Investment Company — a company meeting the definition of an investment company cannot rely on Reg A+ (see below for further detail on this point)
4. Reg CF
Reg CF, also known as the crowdfunding exemption, has been popular with startups looking to raise seed capital from unaccredited investors. It also serves as a great marketing tool when combined with another larger exemption for STOs by including early fans and users of the product. The lack of a marketing budget often denies companies of many of the potential benefits of a Reg CF offering.
Basic features include:
- Diverse Investor Pool — accredited and unaccredited investors may participate
- Limited Capital Raise — a company may raise up to $1.07MM
- Transfer Restrictions — no investors can transfer the securities for 12 months
- Domicile — the company must be a U.S. entity
- Reporting Obligations — the company must file an annual report
- No Investment Company — the company must not be an investment company
5. Reg S
Reg S is an exemption from registration for offers and sales of securities that occur to non U.S. citizens outside of the U.S. Think of it as the exemption in which the U.S. decided it does not care what happens in securities transactions outside of the U.S., that is, until someone outside of the U.S. wants to send securities into the U.S. The extent of the transfer restrictions back into the U.S. generally depend on the ties of the securities, the company and the stockholders to the U.S., and on the nature of the securities (i.e. debt vs. equity).
The exemption has been the focus of many entrepreneurs in the blockchain space as a means of escaping U.S. laws. However, escaping U.S. laws is not that easy.
When relying on Reg S, companies face the following complications:
- Solicitation — Reg S requires that the offer and sale of the security occur in an “offshore transaction” and that there be no “directed selling efforts” within the U.S.
- Domestic Companies — An offer and sale of securities by a U.S. company or U.S. founders requires additional steps be taken to comply with Reg S and benefit from the exemption.
- Failed Compliance — The failure to comply will result in a blown exemption and the company will have sold unregistered securities in violation of U.S. securities laws.
Many U.S. based companies and founders will find that, after analyzing the secondary trading restrictions under Reg S, the benefits of a Reg S compliant offering are not what they expect. In the context of an STO, those issues are exacerbated because of the difficulties of balancing the decentralized nature of blockchain technology with the legal requirements around Reg S resales.
The Investment Company Act of 1940 is designed to minimize conflicts of interest that arise when companies invest and trade in securities through appropriate disclosures regarding the company structure and investment philosophy. The following exemptions are of particular importance to tokenized VC funds.
Generally, a company will be deemed an investment company under the Investment Company Act if it is or will be primarily engaging in the “business of investing, reinvesting, or trading in securities” or if it has more than 40% of its total assets invested in investment securities. If a company is deemed to be an investment company, then it must register with the SEC, unless an exemption applies.
An investment company that is required to register with the SEC needs to have:
(1) at least $100,000 in investment capital,
(2) 100 or more investors in the company,
(3) explicitly defined investment objectives, and
(4) no more than one class of securities.
After becoming a registered investment company, a large number of regulations limit the company’s operations:
- All securities of an investment company must be registered with the SEC
- 75% of the board of directors of an investment company must be independent
- Investment choices are restricted
- Custody requirements must be satisfied
- Affiliated transactions are generally prohibited
- The net asset value must be calculated daily and redemptions must be permitted on a daily basis
- An adviser to an investment company must be a registered investment advisor
The scope of the registration and ongoing compliance requirements of investment companies results in most companies seeking to rely on an exemption.
Section 3(c)(1) Exemption (99 Investor Rule)
Section 3(c)(1) exempts any company that has outstanding securities beneficially owned by fewer than 100 people and that are not making or currently proposing to make a public offering of its securities.
This becomes complex when dealing with STOs because companies must look through both digital wallet addresses to determine owners of the securities as well as the beneficial ownership of the investment entities.
Section 3(c)(1) Exemption ($10MM Venture Fund)
In May 2018, Section 3(c)(1) was expanded to permit a company deemed to be “qualifying venture capital fund” to have 250 rather than 99 investors. To be considered a qualifying venture capital fund, the company must be a venture capital fund with no more than $10MM in aggregate capital contributions and uncalled committed capital. A venture capital fund is a company that would be an investment company had it not relied on an exemption under Sections 3(c)(1) or Section 3(c)(7), represents that its strategy is a venture capital strategy, uses a limited amount of leverage and invests principally in private operating companies. This exemption was created for venture capital funds, especially those with first time managers putting together smaller funds, which can now each a broader investor base.
Section 3(c)(7) Exemption
Section 3(c)(7) exempts any company that has outstanding securities owned only by qualified purchasers, which include, among other things, family-owned companies and natural persons who own at least $5MM in investments, any company or person with at least $25MM of investments invested on a discretionary basis or a company owned entirely by persons otherwise meeting the definition of qualified purchasers. In addition, the company must not be making or be currently proposing to make a public offering of its securities.
Any company exempt under Section 3(c)(7) has no limit on the amount it may raise from qualified purchasers. As the STO market continues to develop and institutional investors show increased interest and activity in the market, Section 3(c)(7) likely will be increasingly relied upon by potential investment companies.
Integration, Secondary Trading and Reporting Obligations
Although in-depth discussions of integration and secondary trading issues as well as reporting obligations are beyond the scope this article, the following are common pitfalls in STOs. The descriptions are lengthy but important.
Integration refers to two or more different offerings being treated as the same offering. These rules exist to prevent circumvention of limitations in the securities laws through a series of private and/or public offerings that could not have been achieved in one non-exempt or non-registered offering.
Although the integration rules amongst private offerings are complex, there are additional complexities when private offerings are followed by public offerings. It is important to note that both registered offerings and Reg A+ offerings are deemed to be public offerings. A securities offering cannot be commenced as a private offering and finished as a public offering. Therefore, no convertible note or SAFT offering should be commenced as a private offering and converted into a token offered in a public STO because those offerings would be integrated and would render the private STO a non-exempt offering that violated securities laws. The private offering of the convertible note or SAFT is not deemed to be closed until the underlying security into which it will be converted is issued to its holder.
Although nothing about an STO inherently increases the risk that separate token offerings will be integrated, the likelihood that a company seeks to undertake a Reg A+ offering to immediately benefit from the transferability of the tokens is higher. Therefore, it is more likely that an early-stage company will undertake a Reg A+ offering on the back of an offering of a convertible security.
In all of the exemptions set forth above, except Reg A+, the securities issued will be restricted securities, which are subject to limitations on the ability to resell those securities during at least a 12-month period.
Key secondary trading provisions:
- Rule 144 (resale safe harbor for sale of restricted securities)
- Rule 144A (resale safe harbor for sale of restricted securities to qualified institutional buyers)
- Section 4(a)(7) (resale safe harbor for sale of restricted securities to accredited investors)
- Section 4(a)(1–½) (resale exemption for sale of restricted securities in private transactions)
If a company that would not otherwise be subject to public reporting obligations has more than 2,000 persons or 500 unaccredited persons holding any class of equity securities, then it generally becomes subject to the reporting requirements under the Exchange Act. Debt securities do not trigger any reporting obligations unless they are sold in registered offerings. There currently is lack of clarity on whether offerings in the form of profit sharing or revenue sharing will trigger any public reporting obligations based on whether they would be deemed to be equity securities.
Securities sold in Reg CF and Reg A+ offerings benefit from an exemption to the trigger for reporting obligations as long as companies are current in their filing requirements and have engaged a transfer agent and companies are below certain specified thresholds for the value of their total assets (Reg CF) or public float (Regulation A+).
The nature of STOs, including the desire for liquidity, increases the likelihood that companies will trigger one of the maximum ownership thresholds for having reporting obligations. To avoid undesired reporting obligations, companies selling smart securities should consider whether to implement appropriate protocols to gain control over the number of persons holding their securities when they begin trading.
In conclusion, undertaking an STO subject to U.S. laws results in a mosaic of exemptions and regulations. We hope this article is both encouraging to companies looking for ways to sell smart securities and compliant network tokens, as well as a cautionary outline of the lengthy and costly processes to which an STO could be subject.
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