Proceeds from blockchain token sales (popularly known as initial coin offerings or “ICOs”) reportedly topped $5 billion in 2017, with approximately $1 billion of such offerings originating in the United States (EY research: initial coin offerings [ICOs] [Dec. 2017]). Blockchain technology has a variety of potential applications, and blockchain tokens may have a variety of characteristics. 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.” Depending on the characteristics of the token and the manner in which the token is sold, the US securities laws may be applicable.
Under the Securities Act of 1933 (the Securities Act) and the Securities Exchange Act of 1934 (the Exchange Act), the definition of a security 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. As first noted in the DAO Token Report, and recently reiterated by the US Securities and Exchange Commission’s (the SEC’s) Director of the Division of Corporation Finance, the Howey test is often applied to determine whether a blockchain 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. The surge in ICOs 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.
This article discusses potential options for structuring sales of tokens that constitute securities offerings in compliance with US securities laws.
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 may 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 even broadly solicit and generally advertise an offering and still be deemed 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. However, both of these routes have their own shortcomings. 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 in the types 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, both of these may be disqualifying limitations.
One potential alternative is for issuers to sell securities pursuant to Regulation A under the Securities Act by filing a Form 1-A for review and qualification with the SEC. Prior to July 2015, Regulation A was a rarely used exemption from registration, as it limited sales to $5 million in a 12 month period. However, following the implementation of the Jumpstart Our Business Startups (JOBS) Act-mandated amendments to Regulation A on July 19, 2015 (frequently referred to as Regulation A+), Regulation A has become a much more attractive option for issuers. Because of the limitations inherent in utilizing the Regulation D and S exemptions, issuers should consider Regulation A. Several companies have filed Forms 1-A for token offerings, though to our knowledge, none has yet 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. This is similar to filing a registration statement in a registered offering. 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 conduct a Tier 2 offering must provide up to two years of audited financial statements. Like Tier 1 companies, Tier 2 companies must file exit reports on Form 1-Z; however, 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 (i.e., state blue sky laws), a major change from the old Regulation A regime. 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.
Regardless of the offering tier, 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.
Although all offerings and issuers are different, the basic process of “going public” is relatively consistent. In addition to putting in place corporate governance structures and policies and processes that comply with securities laws, an issuer conducting a registered offering must file a registration statement with the SEC containing a prospectus with financial statements and detailed disclosures about the issuer, the issuer’s business and the offering. Most issuers undertaking a registered offering will need to file a registration statement on Form S-1 or, in the case of foreign private issuers, on Form F-1. Typically, within 30 days after an initial or amended registration statement is filed, the SEC will review and provide comments on it (though with a coin offering, the initial response may take longer). Then, an issuer attempts to resolve the issues raised in the SEC comments by responding to the SEC in writing and amending the registration statement. Once an issuer has satisfactorily resolved all of the SEC’s comments, the SEC will declare a registration statement effective, and only then may the issuer commence the registered offering.
The benefit 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. Compared to conducting an exempt offering however, a registered offering involves extensive regulatory requirements and is significantly more expensive due to increased filing, legal and accounting fees. Additionally, an issuer will become a full reporting company, and therefore 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. Notwithstanding the technological development represented by blockchain tokens, the test enunciated more than 70 years ago in SEC v. W.J. Howey Co. remains the standard for gauging whether the sale of a blockchain token represents an investment contract subject to the US securities laws. Issuers contemplating 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.
The authors would like to acknowledge and thank Daniel Engoren, Verity Van Tassel Richards, Joseph Williams and former McDermott associate Robert Stelton-Swan for their contributions to this article.