Can Security Tokens Survive the Exchange Act’s Section 12(g)?
Security tokens offer a new way for companies to raise capital from a wide pool of investors in full regulatory compliance. The Securities Exchange Act of 1934 includes a provision (section 12(g)) that would mandate that companies must report to the SEC as public companies if their investor base grows larger than 2,000 holders of record. This would seriously hinder those companies’ potential adoption of security tokens and/or their ability to realize the benefits of tokenization. To combat this, the security token industry can utilize a precedent set in traditional finance in which the number of holders of record only includes broker-dealers, not all of the broker-dealers’ clients. This would enable tokenizing companies to comply with section 12(g) while also allowing the number of investors to reach full market potential.
Taking on Traditional Finance and Legitimizing Cryptoassets
Over the course of this year, the promise of security tokens has gained increasing attention in the cryptoasset community, though perhaps too little has been paid to the technical and legal aspects. In contrast to utility tokens, which essentially provide access to a company’s product or service, security tokens represent actual ownership of a real-world asset, such as equity, rights to dividends, debt, etc. But while the function of these cryptoassets differ, their functionality and value propositions from a financial perspective remain similar as they each provide increasingly democratized access, high liquidity, and 24/7 markets.
In addition to the general benefits of tokens, security tokens have specific advantages in comparison to utility tokens and to traditional financial securities. In contrast to the precedent set by ICOs and utility tokens which operate in a regulatory gray area as potentially unregulated securities, security tokens are fully compliant with SEC regulations. This will increase investor confidence and draw institutional players to support the market. For a great overview on the regulatory landscape of equity financing, check out Nick Goss’s article “Welcome to the Jungle: STOs and the Regulatory State,” it’s the best I’ve seen.
When comparing security tokens to their traditional financial counterparts, we see a number of benefits, which should come as no surprise to those familiar with cryptoassets and/or our current financial system. These benefits include lower operational costs, automated compliance, rapid settlement, fractional ownership, and future increased design space in how financial assets function. For a comprehensive review of the potential benefits of security tokens, Stephen McKeon’s “The Security Token Thesis” provides a fantastic overview.
While many of the benefits mentioned above will be utilized most by those in the financial industry who regularly deal with complex financial asset structures, there are two applications of security tokens that will directly influence individual investors and asset owners, including businesses and individuals. The first is the tokenization of tangible real-world assets, such as fine art (notably by Maecenas) and real estate (notably by Brickblock), which would democratize access to assets that are traditionally unavailable to individuals without a high net worth.
The second application is the tokenization of private company equity, an asset class typically reserved to angel investors, venture capitalists, and institutions. These actors have the ability to invest in early stage growth-oriented companies as well as later stage, highly developed private businesses like Uber and Stripe — companies that in a prior era would likely have already undergone an IPO. An IPO is the moment when the average investor gains access to successful, growth-oriented companies, and we have seen companies, particularly high-growth tech start-ups, waiting longer and longer to undergo the IPO process. This delay is due to two primary reasons: the high cost of an IPO, including recurring costs as a reporting company, and the comparative ease of funding through venture capital.
Security tokens have a huge opportunity to disrupt what has emerged as the traditional venture capital route. Typically, funding happens in rounds with liquidity opportunities for investors often delayed years down the road and additional funding opportunities for companies requiring significant time and resources. Security tokens have the ability to increase the liquidity of investors, which can be one of the risks of private equity investment, while also allowing for greatly increased flexibility in capital financing for companies, including both raising additional funds and buying back equity.
While we see the potential for companies of all sizes to realize significant benefits through capital financing by tokenizing, small to medium sized enterprises have perhaps the most to gain. In contrast to the current structure, young companies will have an exponentially increased number of investors to pitch, as opposed to the typical friends, family, and gate-keeper venture capital firms.
So where does Section 12(g) of the Exchange Act come in?
Section 12(g) states that a company raising funds through exemptions like Reg CF, Reg D, or Reg A+, will become a reporting company (meaning annual and quarterly reports identical to those that public companies provide) if either of the following apply:
- It has more than $10 million in total assets and a class of equity securities, like common stock, that is held of record by either (1) 2,000 or more persons or (2) 500 or more persons who are not accredited investors or
- It lists the securities on a U.S. exchange
In other words, if a tokenizing company crosses the threshold of 2,000 investors, it will incur many of the costly requirements of a public company, which would be impossible for a young company working to build a successful and scalable business. This is a major threat to the adoption of tokenization, but in and of itself, not unpreventable.
Smart contracts within the security tokens can allow for caps in the number of investors allowed — at 1,999 for instance. This would narrow the pool of investors and cripple many of the benefits of security tokens. In addition to running counter to the democratic principles at the core of the crypto community, such a cap would severely limit market depth, and therefor liquidity. This is detrimental to the businesses and owners for whom liquidity was a key benefits of security tokens, but it also negatively impacts ATSs (Alternative Trading Systems) that operate on the fees of high transaction volume.
While there is still value for a company to tokenize its equity under a smart contract investor cap structure, it is an extremely watered-down version of how tokenized equity could improve how capital financing operates.
A Traditional Finance Solution
While it would be fantastic if the SEC simply revised their regulatory protectionism, this seems highly unlikely given the reactive precedent they have set regarding the cryptoasset space. They have been largely focused on finding and persecuting instances of fraud, much to their credit.
It is tempting to believe that the SEC would take a similar stance in the security token realm, merely rooting out true fraud as opposed to proactively enforcing regulatory compliance, but so much of the security token value proposition rests on regulatory compliance — to pick and choose where we are compliant negates the purpose. In the absence of new, pro-market regulation, we must find a solution to the 12(g) problem within the existing market and regulatory structures.
To understand the existing market and regulatory structures, I again direct you to Nick Goss’s work, specifically “The Rube Goldberg Machine: Security Tokens and the Indirect Holding System,” for an elucidating description of how ownership of securities currently operates with a contextual focus on security tokens (spoiler: it is bonkers.)
Here’s an extremely brief overview, as there are plenty of resources that go into the convoluted depth. In most cases, anytime you buy a stock, you are not the full owner of that stock — you are the beneficial owner, but not the physical owner. The physical owner is typically a company called Cede & Co., which is the registered holder of all securities controlled by the Depository Trust Company. You place an order with your broker, who logs the order in their books and modifies their total position with the Depository Trust Company, who then logs the change of beneficial ownership in their books.
It starts to become easy to see why settlement time is t+2. One of the most interesting notes that Goss points out in his article, however, is that when it is time for reporting companies to fill out their 10-Q’s, they don’t actually have to list every beneficial owner. Instead, they list the “street name” owners, aka the broker-dealers. This drastically lowers the number of holders of record a major company has from the millions to the thousands. This basically comes down to the fairly arbitrary way in which the SEC has decided to monitor “holders of record,” deciding that:
securities held in street name by a broker-dealer are held of record under the rule only by the broker-dealer. The Commission originally proposed a version of the rule that would have looked through to the beneficial owners of the street-name securities, but adopted the rule in a form that does not produce this result. (Source)
Put plainly, the SEC does not require a company to report the total number of shareholders, only the holders of record, which stop at broker-dealers.
The solution to the 12(g) problem may then exist in this old-world finance inefficiency. Rather than fully granting ownership to the purchasers of security tokens, broker-dealers may need to give only beneficial ownership such that the number of holders of record in tokenized companies does not exceed 2,000 but the number of investors can rise to market levels. Additionally, the smart contract can implement a whitelist of addresses which would be able to hold full ownership, combating possible honeypot security risks to which centralized exchanges are exposed.
While this is certainly not a perfect solution, as it adds an element of centralization and lowers individual autonomy, it is not as bad as it at first seems. Transactions and ownership rights can still be recorded on the blockchain, so the investor’s record of ownership will remain immutable. It follows the precedent currently established by the SEC, which they will happily continue to follow. Most importantly, it allows security tokens to provide their full potential benefit to businesses, investors, and the trading platforms.
At the core of the SEC’s mission and subsequent regulation is the need to protect investors. While, like many in the space, I don’t typically appreciate centralized authority, I do agree with the SEC’s prescription for protection: transparency.
Transparency is in so many ways the backbone of the blockchain revolution — it’s what allows for decentralization and immutability to occur. When information is democratized and accessible, we no longer need a centralized institution to tell us the “truth,” we are able to go discover it ourselves.
The cryptoasset space has been stricken with scams and fraud executed by bad actors and enabled by those lacking the knowledge and information to discern the risk. Frankly, players at that end of the spectrum should stay home.
But the SEC instituted 12(g) for a reason: insufficient knowledge and information can afflict us all. When that many actors are investing in a high-risk, early stage enterprise, there needs to be information that allows them to evaluate their investment. The solution should not be high-cost mandated reporting, but should rather be market-based and designed to support and grow the businesses, investors, and exchanges that are contributing to the cryptoasset ecosystem.
I am not a lawyer and do not purport to have a comprehensive knowledge of the US financial legal system. I welcome further clarity around these issues, as well as thoughts and opinions that further this important discussion. For more cryptoasset commentary, follow on Medium and Twitter.
Once again, go read Nick Goss’s thoughts on these issues — extremely clear, thoughtful, and well researched pieces:
General Security Token Readings:
SEC Key References: