Ever since the SPAC market exploded in late 2020 and early 2021, the SEC has sounded alarm bells through investor alerts, staff statements and public comments.  In March of 2021, it warned investors not to invest in SPACs just because of celebrity endorsements. In April, an SEC staff announcement said SPACs needed to account for warrants as liabilities, not equity, which led to many SPACs slamming on the IPO brakes and to post-combination companies restating their financials.  And when Gary Gensler took over as SEC Chairman in April, he promised further scrutiny of SPACs.

Greater scrutiny has arrived in the form of the SEC review process as reflected in comment letters over the last few months relating to SPACs.  The SEC selectively reviews filings made under the Securities Act of 1933 and the Securities Exchange Act of 1934 to monitor compliance with applicable disclosure and accounting requirements. After reviewing a filing, the SEC will send a comment letter to the issuer with detailed comments regarding critical disclosures that appear to conflict with SEC rules or accounting standards, as well as disclosure that appears to be deficient in explanation or clarity. The SEC doesn’t evaluate a transaction’s merits from an investment perspective.

Companies generally respond to each comment in a response letter back to the SEC and, where appropriate, in amendments to its filings.  Comment and response letters are kept confidential until the SEC has completed its review, at which point they become publicly accessible on the SEC’s EDGAR system.

The SEC could issue comment letters at two different junctures in a SPAC life cycle.  First, in connection with the S-1 filed to cover the shares to be issued in the IPO, and then, assuming the SPAC identifies a target, in connection with the S-4 registration statement relating to the business combination or “de-SPAC” transaction.  Because the SPAC is by definition a shell company at the time of its IPO, the far more interesting comment letters are the ones relating to the business combination S-4.

Recent comment letters sent to SPAC sponsors relating to proposed business combinations reveal the SEC’s enhanced focus on conflicts of interest inherent in most de-SPAC transactions.  For examples, see here, here and here.  The following are three conflict of interest comments that have appeared in several SPAC comment letters, followed by the ways in which sponsors have been responding.

Please revise to quantify to the extent known the interest of the SPAC officers and directors in the business combination. For instance, we note the reimbursement of out of pocket expenses, working capital loans, and the continuation of [SPAC director] as a director of the post-combination company.

In response to this comment, sponsors have added more detail into the right of SPAC board members to be reimbursed for out of pocket expenses in connection with identifying, investigating and consummating a business combination; conversion of working capital loans made by the sponsor and SPAC officers and directors to the SPAC; and the expected dollar amount of board compensation that will be paid to SPAC directors who continue as directors of the post-combination company.

We note your risk factor that the sponsor, certain members of the Board, and officers of [the SPAC] will benefit from the completion of a business combination. Please revise to highlight that these parties may be incentivized to complete an acquisition of a less favorable target company or on terms less favorable to shareholders rather than liquidate.

In response to this comment, sponsors are disclosing in tabular format the public shareholders’ and the SPAC’s initial shareholders’ (including the sponsor’s) investment per share and how these compare to the implied value of a share of post-combination company common stock upon completion of the business combination.  Often, the implied value of the post-combination company common stock represents a decrease from the initial public offering price of $10.00 per public share, but a significant increase in value for the sponsor and other insiders relative to the price they paid for their founder shares.

Sponsors are also adding language to the valuation information above to the effect that in light of the foregoing per share value analysis, the sponsor and insiders holding holding founder shares may be economically incentivized to complete an initial business combination with a riskier, weaker-performing or less-established target business, or on terms less favorable to the public shareholders, rather than liquidating the SPAC.

We note that your charter waived the corporate opportunities doctrine. Please address this potential conflict of interest and whether it impacted your search for an acquisition target.

Every SPAC following its IPO engages in the business of identifying and combining with one or more targets.  But the SPAC’s sponsor and officers and directors are typically affiliated with other entities (operating companies or investment vehicles) engaged in a similar business, including other SPACs.  Those officers and directors may become aware of business opportunities that may be appropriate for presentation to both the SPAC and the other entities to which they owe fiduciary or contractual duties.  It’s fairly common for a SPAC’s certificate of incorporation to renounce the SPAC’s interest in any corporate opportunity offered to any director or officer unless the opportunity is expressly offered to the individual solely in his or her capacity as a director or officer of the SPAC and the opportunity is one the SPAC is legally and contractually allowed to pursue and it would otherwise be reasonable for it to pursue, assuming the director or officer is permitted to refer that opportunity to the SPAC without violating any legal obligation.

The common rationale for the “corporate opportunity” waiver is that in the absence of the waiver, certain candidates would not be able to serve as an officer or director, and the inclusion of the waiver provides greater flexibility to attract and retain the best officers and directors.

In response to the comment, however, sponsors have been adding to the foregoing disclosure that the personal and financial interests of the directors and officers may influence their motivation in timely identifying and selecting a target business and completing a business combination. Further, the different timelines of competing business combinations could cause directors and officers to prioritize a different business combination over finding a suitable acquisition target for the SPAC. Consequently, directors’ and officers’ discretion in identifying and selecting a suitable target business may result in a conflict of interest when determining whether the terms, conditions and timing of a particular business combination are appropriate and in the public shareholders’ best interest, which could negatively impact the timing for a business combination. Sponsors then state whether they believe any such conflicts of interest impacted the SPAC’s search for an acquisition target.

Background: Crypto Catch 22

Followers of the SEC’s efforts to regulate digital tokens will recall former SEC Corp Fin Director William Hinman’s speech at the June 14, 2018 Yahoo Finance Conference in which he introduced the now generally accepted proposition that a digital asset could originally be deemed a security while its network is being developed but then evolve into a non-security where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, i.e., where the network is decentralized or functional.  See my blog post on this here.

Under the Howey test, digital tokens offered and sold before the underlying network is decentralized or functional would likely be deemed to be securities so long as purchasers reasonably expect the network’s developers to carry out the essential managerial or entrepreneurial efforts necessary to build value in the tokens.  But for a network to mature into a decentralized or functional network not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts, the tokens must be distributed to and freely tradeable by potential users, programmers and participants in the network. The problem with this crypto Catch 22 is that the application of the federal securities laws to the pre-“network maturity” distribution of tokens thwarts the network’s ability to achieve maturity and prevents tokens initially sold as a security from evolving into non-securities on the network.

Crypto Mom’s Safe Harbor

To address this problem, in March 2020 SEC Commissioner Hester Peirce (aka “Crypto Mom”) introduced a proposal (which I blogged about here), revised in April 2021 as Safe Harbor 2.0, to create a three-year safe harbor during which developers would be allowed to distribute tokens to facilitate participation in and development of a functional or decentralized network, exempt from the registration requirements of the federal securities laws, so long as certain disclosure and other conditions are met, including filing a notice of reliance on the safe harbor. Safe Harbor 2.0 proposed three changes to the original.  First, a requirement for semi-annual updates to the plan of development disclosure. Second, a mandatory exit report at the end of the three-year grace period containing either an analysis by outside counsel explaining why the network is decentralized or functional, or an announcement that the tokens will be registered under the Securities Exchange Act of 1934.  And third, guidance for outside counsel’s decentralization analysis in the form of facts and circumstances guideposts rather than a bright-line test.

The Clarity for Digital Tokens Act of 2021

Crypto Mom’s Safe Harbor 2.0 has not been adopted by the SEC, but it now has a powerful sponsor in Congress.  On October 5, 2021, Cong. Patrick McHenry, ranking member on the Financial Services Committee and leading capital markets reform advocate, introduced a bill called the Clarity for Digital Tokens Act of 2021 which would effectively codify Commissioner Peirce’s Safe Harbor 2.0 proposal.

The Clarity for Digital Tokens Act would create an exemption from registration under a new Section 4B to the Securities Act of 1933 (to be called “Token Safe Harbor”) for the offer and sale of a token if (i) the initial development team intends for the network on which the token functions to reach network maturity within three years after the first token sale, (ii) the token is offered and sold for the purpose of facilitating access to, participation on or the development of the network and (iii) the initial development team complies with certain disclosure and filing requirements.

Disclosure Requirements

The Act’s disclosure provisions would require developers to disclose on a freely accessible public website the source code; the steps necessary to independently access, search and verify the network’s transaction history; a description of the purpose of the network; the current state and timeline for the development of the network to show how and when the initial development team intends to achieve network maturity, with semi-annual updates; prior token sales; identities of the initial development team and certain token holders; trading platforms on which the token trades; related person transactions; and a warning that the purchase of tokens involves a high degree of risk and potential loss of money.

Filing Requirements

As is the case with Safe Harbor 2.0, the Act’s filing requirements would consist of a notice of reliance on the safe harbor and an exit report.  The notice of reliance on the safe harbor would need to be filed with the SEC prior to the date of the first token sold in reliance on the safe harbor.  If a development team has sold tokens prior to the effectiveness of the Act but wants to avail itself of the safe harbor, it may do so by filing the notice of reliance as soon as practicable.

The exit report would generally need to be filed on or before the expiration of the three year anniversary of the first token sale, the contents of which would depend on the development team’s determination at that point as to whether network maturity has been achieved, and if so whether for a decentralized or functional network.

If the dev team determines that network maturity has been reached for a decentralized network, the exit report would need to include a legal analysis that consists of a description of the extent to which decentralization has been reached as to voting power, development efforts and network participation, as well as an explanation of how the dev team’s pre-network maturity activities are distinguishable from the team’s ongoing involvement with the network.

If the dev team determines that network maturity has been reached for a functional network, the legal analysis would need to include a description of the holders’ use of tokens and an explanation of how the dev team’s pre-network maturity marketing efforts and the team’s ongoing efforts will continue to be focused on the token’s consumptive use, and not on token price appreciation.

If alternatively the initial dev team determines that network maturity has not been reached, the exit report would need to include a description of the status of the network and the next steps the dev team intends to take, and a statement acknowledging that the team will register the tokens as a class of securities under Section 12(g) of the Securities Exchange Act of 1934 within 120 days after filing the report.

Network Maturity

The Act defines “network maturity” as the status of a decentralized or functional network that is achieved by meeting the standard of either control or functionality.  Under the control standard, network maturity exists when the network is not economically or operationally controlled and not reasonably likely to be economically or operationally controlled or unilaterally changed by any single person, entity or group of persons or entities under common control.  Any network of which the initial development team owns more than 20% of the tokens or more than 20% of the means of determining network consensus would be not qualify for network maturity. A network would be determined to be “functional” if the tokens are used by token holders for transmission and storage of value on the network, for participation in an application running on the network, or otherwise in a manner consistent with the utility of the network.

Final Thoughts

The proposed Clarity for Digital Tokens Act of 2021 gives Congress an opportunity to bring greater clarity in a responsible manner to crypto developers seeking ways to finance the development of their network and achieve network maturity without unreasonable regulatory impediments.  As to the overarching determination of whether or not network maturity has been achieved, the Act takes a facts and circumstances approach rather than a bright line test, which is probably the sensible approach.  It remains to be seen whether the Act will gain traction on the Hill.

Lately I’ve been approached by clients and potential clients about series LLCs, so I thought it would be worth blogging about.  Basically, a series LLC is an LLC that may create one or more series, each generally having separate assets and liabilities, similar to having separate entities except without the expense and administrative burden of multiple entities. Although most commonly used for investment funds, series LLCs could be useful for any type of business with multiple assets where it would be advantageous to keep the respective liabilities of those assets separate.   Before organizing any investment or ownership structure through a series LLC, however, its practical uses and advantages should be understood and weighed against certain associated risks.

Benefits

For starters, a series LLC allows for the operation within a single legal entity of multiple separate business activities, each with its own separate assets and liabilities and each having its assets protected from the creditors of the other activities.  This in turn reduces expenses and administrative burdens as compared with the alternative of forming multiple LLCs.  Because Series LLC state filing fees and annual taxes are either the same (e.g., Delaware) or slightly higher than those imposed on a regular LLC, a Series LLC with two or more series is generally much more cost-effective than forming and operating multiple LLCs and operating a parent-sub structure.

Further, under applicable securities laws, a Series LLC may be the sole registrant and may register interests in all the series of the Series LLC. This can reduce the costs and burdens of filing multiple registration statements.

Formation

In Delaware, a series LLC is formed the same way as a general LLC, by filing a certificate of formation, although no individual series need exist at the time of formation.[i]  In Delaware, three requirements must be satisfied for the series LLC and each of its series to enjoy limited liability.

First, the certificate of formation must state that the LLC has or may form series, that the liabilities of each series will be enforceable against the assets of that series only and not against the assets of the series LLC generally or any other series and, unless otherwise provided in the LLC agreement, no liabilities of the series LLC generally or any other series will be enforceable against the assets of that series.

Second, the LLC agreement must provide for limitation on liability. That doesn’t mean that two or more series can’t share in certain assets or liabilities of the series LLC, but if there is any sharing, the LLC agreement should provide for how those assets and liabilities will be allocated among the different series of the Series LLC.

And third, separate records must be kept.  Specifically, the records for any series must account for the assets of that series separately from the assets of the series LLC itself and any other series.

Structure Flexibility

Similar to a regular LLC, series LLCs allow for a tremendous amount of management and ownership flexibility.  Series LLCs may have managers, members and assets of a particular series that are different from the managers, members and assets of the Series LLC itself and the other individual series.  Alternatively, you could have overlapping managers but different members and assets among the various series.  Profits and losses of a particular series could be attributed just to the members of that series or to the series LLC.  Although LLC agreements may provide for distribution provisions on a series-by-series basis, distributions by a particular series are typically limited under state law by the assets of that series.  For example, Delaware law prohibits a series LLC from making distributions to members of a particular series if the liabilities of the series post-distribution would exceed the fair value of that series’ assets.

Risks

Anyone considering the use of a series LLC should also consider certain risks.  Series LLCs are relatively novel and there just hasn’t been enough case law generated to test certain features and provide reliable guidance. Series LLCs aren’t recognized in every state, so there’s a risk that a series wouldn’t be recognized in a particular state and that creditors of one series may be allowed to reach the assets of another series in that state.   Series LLCs are not addressed by Federal and most states’ tax laws, so there’s some uncertainty surrounding the tax treatment of series LLCs.  Finally, series LLCs are relatively untested in the context of bankruptcy, and it’s unclear if a series may file for bankruptcy as to its assets and liabilities separate from those of other series in the group or the series LLC itself.

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[i] Delaware amended its series LLC law in August 2018 to provide for a second version of a series LLC called a “Registered Series”, which has essentially the same characteristics as a series LLC as well as others that could be helpful in secured lending transactions where a series is a borrower, except that a “certificate of registered series” must be filed with the Secretary of State in order to form a registered series of a Series LLC.

The Securities and Exchange Commission announced on July 13, 2021 that it settled fraud charges against a special purpose acquisition company, its sponsor, its sponsor’s CEO and its proposed merger target for making misleading statements about the target’s technology and national security concerns.  Charges against the target’s CEO are proceeding.  The settlement order imposes civil penalties on the target, the SPAC and the SPAC’s CEO of $7 million, $1 million and $40,000, respectively, and forfeiture by the sponsor of 250,000 shares it would have earned in the merger.  It also gives PIPE investors the right to terminate their subscription agreements prior to the shareholder vote on the merger.  The settlement order serves as a stark reminder to SPACs that they should not accept target company representations at face value and must conduct adequate due diligence on their proposed targets.

Background

Momentus Inc. was organized in 2017 to provide “last mile” launch services that place satellites into orbit. Stable Road Acquisition Company (“SRAC”) completed its initial public offering as a SPAC (special purpose acquisition company) in November 2019 with gross proceeds of $172.5 million, and secured PIPE (private investments in public equity) investor commitments for an additional $175 million when it entered into a merger agreement with Momentus.  As is typical for SPACs, it was required by the terms of its charter to complete an acquisition within two years or May 2021.

The Settlement Order

The settlement order states that Momentus and its CEO, Mikhail Kokorich, told investors on numerous occasions that Momentus had “successfully tested” its water propulsion technology in space. In fact, the testing failed to meet Momentus’ public and internal criteria for success. Momentus and Kokorich also misrepresented the extent to which national security concerns involving Kokorich as a “foreign person” jeopardized Momentus’ ability to secure governmental licenses, keep to its launch schedule and hit its revenue targets.

But the order also finds that SRAC’s due diligence of Momentus was inadequate because it was conducted in a compressed timeframe and failed to probe the basis of Momentus’ claims about its technology or follow up on red flags concerning national security and foreign ownership risks, resulting in the dissemination of false information to investors. The order further finds that SRAC’s CEO, Brian Kabot, participated in SRAC’s inadequate due diligence and inaccurate registration statements and proxy solicitations.

The order does state that SRAC engaged several firms to assist with due diligence, including a space technology consulting firm with the expertise to investigate the state of development of Momentus’ technology.  However, SRAC did not retain the firm and begin its substantive due diligence on Momentus’ technology until a little more than one month before the merger announcement.  SRAC did not specifically ask the consulting firm to review Momentus’ test mission results and, in response to the firm’s questions, Momentus suggested that the early-stage test launch was not relevant to their current work due to its development of the technology in the intervening sixteen months.  As a result, the firm did not evaluate the test results or review any related data or other information, and the report it provided to SRAC made no mention of the test mission.

Nevertheless, SRAC included Momentus’ false claims in its S-4 registration statement, stating that Momentus had “successfully tested” its technology in space. SRAC also included Momentus’ financial projections, which were based in part on the assumption that Momentus’ technology was approaching commercial viability and buttressed by misleading claims about the success of the test mission.  The Order finds that SRAC’s statements in its S-4 gave investors the misleading impression that its due diligence independently verified the claim that Momentus’ technology had been “successfully tested” in space.  The order states that investors had no way to know that SRAC was merely repeating what it had been told by Kokorich and Momentus, since the due diligence concerning Momentus’ technology solutions and testing progress never examined the results of the test mission. The order states further that although Kokorich and Momentus never shared with SRAC and Kabot internal analyses about the mission’s failure, SRAC nevertheless acted unreasonably in adopting and repeating Momentus’s claim that it had successfully tested its technology in space when SRAC had not conducted any specific due diligence to evaluate and verify the accuracy of that material assertion.

Implications of the Order

The Order sends a strong message to SPACs, SPAC sponsors and SPAC management teams that they cannot take target business representations at face value, must conduct adequate due diligence to verify such representations independently and will be held accountable for a failure to do so.  SPACs and their sponsors will be deemed to have acted unreasonably by repeating claims made by target companies if they fail to conduct specific due diligence to evaluate and verify the accuracy of such claims.  To underscore the message, SEC Chairman Gary Gensler took the unusual step of making a statement in the order press release about the inherent conflicts in de-SPAC transactions and the due diligence obligations of SPACs.  According to Chairman Gensler, “[t]his case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors.”  Further, “[t]he fact that Momentus lied to Stable Road does not absolve Stable Road of its failure to undertake adequate due diligence to protect shareholders. Today’s actions will prevent the wrongdoers from benefitting at the expense of investors and help to better align the incentives of parties to a SPAC transaction with those of investors relying on truthful information to make investment decisions.”

On May 3, 2021, blockchain-based trading platform operator INX Ltd. announced it had completed its initial public offering of digital tokens, raising approximately $85 million in the IPO from over 7,200 institutional and retail investors.  The INX IPO is the first SEC registered offering of digital tokens, and represents another major milestone for blockchain asset markets.  At least two digital token offerings under Regulation A+ have previously been completed after being qualified by the SEC.  And just three weeks before the INX digital token IPO, cryptocurrency exchange operator Coinbase Global, Inc. completed a direct listing, albeit of its common stock[1], not digital tokens.

In its prospectus included in its F-1 registration statement, INX stated it is focusing its business operations on two emerging blockchain asset classes: cryptocurrencies and security tokens.

A “cryptocurrency” is a digital representation of value that functions as a medium of exchange, a unit of account or a store of value. Cryptocurrencies are generally used a substitute for fiat currencies as a means of paying for goods or services or transferring value. Bitcoin and ether are examples of well-known cryptocurrencies.  In its prospectus, INX stated emphatically that a cryptocurrency is not a “security” as that term is defined under the federal securities laws.

The INX prospectus defined a “security token” (a term not used by the SEC) as a blockchain asset that falls within the definition of a security under the federal securities laws.  The SEC staff has acknowledged that determining whether a blockchain asset is a security can require a careful analysis of the nature of the blockchain asset and how it is offered and sold. Further, the SEC staff acknowledged that a blockchain asset that is initially sold as a security may, at a later point, no longer meet the characteristics of a security.

INX’s stated business objective is to establish two trading platforms and a security token that provide regulatory clarity to the blockchain asset industry. It plans to achieve that goal by differentiating between security and non-security blockchain asset classes and providing trading opportunities for each class.

U.S. persons may only trade INX tokens on either a registered securities exchange or an alternative trading system, in each case that has accepted the INX tokens for trading or quotation. To date, no registered securities exchange or alternative trading system has done so.

The INX token has both security and utility attributes.  The security features are twofold: a right to receive an annual pro rata distribution of 40% of INX’s cumulative adjusted net operating cash flow, and a right to a liquidation preference equal to the ratable portion of a cash fund equal to 75% of the net proceeds from the IPO in excess of $25 million, triggered upon a failure to launch cryptocurrency trading or a liquidation event.

The utility features of the INX token consist of a discount of at least 10% on transaction fees on the INX securities trading platform when INX tokens are used to pay fees, and a passive tiered trading fee discount program on the INX digital trading platform based upon the number of INX tokens held in customers’ private wallets.

To the extent the INX tokens are securities, they are not voting securities and the token holders are not stockholders.  No INX token holder will have the right to vote, or otherwise participate in INX’s general meeting of stockholders. An INX token holder will possess none of the rights that a common stockholder would ordinarily be entitled to.  INX token holders will not participate in, or benefit from, significant corporate transactions in which INX is a party, such as a merger, sale of INX or sale of its assets.  Furthermore, directors are nominated and elected by INX’s stockholders, and INX’s directors have no fiduciary obligations to act in the interests of token holders.

The road to completion of the INX IPO was anything but smooth.  After filing its initial draft registration statement confidentially with the SEC in January 2018, INX filed a total of sixteen amendments (five of which related to the confidential filing) during a two plus year SEC review process as it sought to respond to a bevy of comments from the SEC staff. But in going through that review process, the INX IPO could help bring much needed clarity to the market for blockchain asset markets, help issuers and regulators better distinguish between security tokens and cryptocurrencies and lead to clearer rules for the offer and sale of each.

[1] “Satoshi Nakamoto” is identified on the facing page of Coinbase’s S-1 as among those who should receive copies of any SEC correspondence, along with the blockchain address “1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa”, the genesis address for bitcoin.  Satoshi Nakamoto is the name used by the presumed pseudonymous person or persons who developed bitcoin, authored the bitcoin white paper and devised the first blockchain database.

A new reality streaming television series called Unicorn Hunters debuts May 10 in which startups will pitch to a panel that includes Apple co-founder Steve Wozniak, and the panelists after grilling the entrepreneurs will make decisions on whether or not to invest, similar to Shark Tank.  But unlike the couch potato viewers of Shark Tank, viewers of Unicorn Hunters will also be given the opportunity to invest in the presenting companies, which raises some pretty interesting securities law issues.

The securities offered on Unicorn Hunters will not be registered with the Securities and Exchange Commission, which means the companies, show sponsors and intermediaries will need to make sure the offerings satisfy the requirements of an exemption from registration and refrain from engaging in any activities prohibited thereby.  In fact, Unicorn HuntersFact Sheet states that all presenting companies will be engaging in side-by-side offerings under two different equity crowdfunding exemptions: Regulation Crowdfunding, which limits issuers to an aggregate offering amount of $5 million, and Rule 506(c) under Regulation D, in which only accredited investors may participate.

Regulation Crowdfunding

As for Regulation CF, the companies on Unicorn Hunters will benefit from recently promulgated significant reforms, which include an increase in the aggregate offering amount from $1.07 million to $5 million, change in the calculation of the investor cap from the lesser of to the greater of income and net worth, permission to test-the waters and self-certification for previously verified accredited investors.

But Reg CF also has strict rules governing how issuers may “advertise” the offering.  A Reg CF offering must be conducted through one (and only one) online intermediary, either a registered broker-dealer or a platform satisfying the requirements of a “funding portal”.  An issuer may communicate with investors and potential investors about the terms of the offering only through communication channels provided by the intermediary on the intermediary’s platform, provided that an issuer identifies itself as the issuer in all communications.

But what about communications outside the funding portal, such as what will take place on Unicorn Hunters? Under Reg CF, issuers are prohibited from advertising any of the terms of the offering outside the intermediary’s portal.  Rather, communications outside the portal may only include a brief description of the business of the issuer, as well as the name of and link to the platform.  This strict limitation on advertising outside the funding portal could be a significant regulatory risk for Unicorn Hunters’ presenting companies.  If companies on Unicorn Hunters mention the terms of the offering on the show, they may be blowing their exemption under Reg CF.  This probably explains why, unlike Shark Tank, there will be no negotiation of terms between the Unicorn Hunters panelists and the presenting companies.  It remains to be seen whether the companies will say anything on air about the terms of their offering.

There is another potential trap in the Reg CF side of the Unicorn Hunter investment program, but this additional trap is one that will impact NetCapital, the registered funding portal through which all Reg CF Unicorn Hunters investments will be made.  The potential trap is the individual investor cap.  Each investor is limited as to how much he or she may invest in all Reg CF deals in any rolling 12-month period based on a formula that depends on an individual’s annual income and net worth.  If either annual income or net worth are below $107,000, the investor’s aggregate investment in all Reg CF deals in any rolling 12-month period may not exceed the greater of $2,000 or five percent of the greater of annual income and net worth.  If both annual income and net worth exceed $107,000, the cap is the greater of 10% or the greater of annual income and net worth with a hard cap of $100,000.  The risk here is how to monitor individual investment caps on potentially thousands of investors, and that burden will fall on NetCapital because under Reg CF, it is the intermediary that is responsible for monitoring individual cap compliance.  Thankfully, intermediaries are judged by a reasonableness standard: the intermediary must have a reasonable basis for believing that the investor satisfies the investment limitations, and in this regard an intermediary may rely on an investor’s representations concerning the investor’s annual income, net worth and the amount of the investor’s other investments made pursuant to Reg CF, unless the intermediary has reason to question the reliability of the representation.  For example, the intermediary may be expected to be able to track all other Reg CF investments made by an individual on that intermediary’s platform, and if an investor has exceeded the cap just on that platform, it presumably would not be reasonable for the intermediary to rely on the individual’s representation that his aggregate Reg CF investments fall below the cap.

One last point here on Reg CF is that, ironically, among the recent crowdfunding reforms was that accredited investors are no longer subject to the Reg CF individual cap, yet Unicorn Hunters will steer accredited investors into the Rule 506(c) side of the offering and to the extent that occurs, companies won’t be able to benefit from that reform.

Rule 506(c)

Recognizing that companies are capped at $5 million under Regulation CF, Unicorn Hunters is set up so that all companies are also conducting a simultaneous or side-by-side Rule 506(c) offering.  Rule 506(c) allows issuers to use general solicitation to raise an unlimited amount, provided sales are made only to accredited investors and issuers use reasonable verification methods to determine accredited investor status.  Unlike Reg CF, Rule 506(c) has no limitation on how investors are solicited or the content of any advertising.  To maximize proceeds, companies appearing on Unicorn Hunters will try to include all investments from accredited investors in the Rule 506(c) side of the offering, which has no cap on the dollar amount raised.  Furthermore, once a presenting company on the show reaches the $5 million limit from Reg CF investors, the company will only accept further investment from accredited investors and only under Rule 506(c).  Nevertheless, not all accredited investors will be willing to provide the additional information or third-party certifications needed for verification as required under Rule 506(c).  The Unicorn Hunters Fact Sheet states that its broker/dealer partners will be responsible for determining if proper validation of accredited investor status has been completed.  Interestingly, Unicorn Hunters’ designated broker dealer for investments under Rule 506(c) is Livingston Securities, controlled by Scott Livingston, a Uniform Hunters panelist.

Key Takeaway

Self-styled as a new genre of “enrichtainment”, Unicorn Hunters will aim to combine entertainment with the drama of millions of viewing investors being given the opportunity to invest in growth companies with the chance, however remote, that one or more of these companies will become a unicorn.  This is equity crowdfunding, and reality television is its newest frontier.  But lurking beneath the entertainment aspect of the show are the complex rules that govern how unregistered securities may be offered to the public.  Presenting companies will need to be mindful of the prohibition under Reg CF on discussing the terms of the offering on air (i.e., outside the permissible confines of the funding portal), and the intermediary will have a tall task monitoring individual investment limitations.  I’m excited to see how this goes, and what exactly companies will be saying on air about their offering terms.  All I can say at this point is: stay tuned!

 

 

Perhaps the most vexing threshold issue faced by any company considering a capital raise is which securities exemption to pursue.  The chosen exemption largely depends on the targeted amount of the raise, as well as the manner in which potential investors will be solicited and the type of disclosure to be provided.  But this presents a capital-raising Catch 22 for issuers:  you can’t know for sure how much can be raised and from whom without first soliciting interest, but until recently soliciting interest would generally constitute a general solicitation which could blow the ultimate exemption used.  The SEC has attempted to rectify this Catch 22 by adopting new Rule 241 which allows issuers to “test the waters” by making a generic solicitation of interest in an offering prior to deciding on which exemption to pursue.

New Rule 241, adopted as part of the SEC’s significant exempt offering reforms which became effective March 15, provides that, prior to selecting an exemption for a particular offering, an issuer may solicit investors to determine the extent of investor interest.  Communications under the Rule would be deemed securities offers for fraud liability purposes, and Rule 241 will not preempt applicable blue sky registration or qualification.  No solicitation or acceptance of money is allowed, nor is any investor commitment permitted until the issuer commences an offering meeting the requirements of a particular exemption.

To protect prospective investors, Rule 241 communications must state that (i) the issuer is considering an exempt offering but has not determined the specific exemption, (ii) no money or other consideration is being solicited, and none will be accepted, (iii) no offer to buy the securities can be accepted and no part of the purchase price can be received until the issuer determines what the exemption will be and any applicable filing, disclosure and qualification requirements are met, and (iv) a prospective investor’s indication of interest involves no obligation or commitment of any kind.  Such communications may include the means by which a person may indicate his interest, and may require the person’s name, address, telephone number and/or email address in any response form.

The new test-the-waters exemption under rule 241 is similar to the one available in connection with registered public offerings.  Rule 241 is broader in scope, however, in that it allows generic solicitations of interest to anyone, whereas those for registered offerings may only target qualified institutional buyers and institutional accredited investors.

One trap for the unwary here is that a Rule 241 test-the-waters communication may be deemed to be a general solicitation, depending on facts and circumstances.  An issuer would not be able to engage in a solicitation of interest constituting general solicitation and then pursue an offering exemption that prohibits general solicitation, such as under Rule 506(b) or Section 4(a)(2).  The SEC provided in its final rules release that an issuer may reasonably conclude, depending on the facts and circumstances, that a test-the-waters communication targeted only to qualified institutional buyers and/or institutional accredited investors would not constitute general solicitation. Accordingly, issuers contemplating an exemption that prohibits general solicitation may decide to solicit interest only from qualified institutional buyers and/or institutional accredited investors.

If an offering is launched under Regulation Crowdfunding or Regulation A within 30 days following a Rule 241 communication, the issuer must file the written communication or broadcast script (as applicable) as an exhibit to the Form C or Form 1-A, as applicable, which is filed with the SEC. If a Rule 241 communication is followed within 30 days by a Rule 506(b) offering in which any securities are sold to a non-accredited investor, the written communication or broadcast script must be provided to such non-accredited investor a reasonable period of time before the sale.

For Regulation Crowdfunding issuers, Rule 241 will serve to complement new Rule 206 and Rule 204.  Rule 206 allows test-the-waters communications after an issuer decides to rely on Regulation CF but before it files a Form C.  Rule 204 was amended in connection with these new rules explicitly in order to permit oral communications after filing Form C, clarify that an issuer may include a description of the planned use of proceeds and progress information and permit issuers to provide information about the offering in a concurrent offering (e.g., under Regulation A). The combination of these test-the-water rules should be enormously helpful to companies contemplating Regulation CF campaigns as it will allow them to gauge investor interest before committing significant resources.

On December 2, the Securities and Exchange Commission filed a lawsuit against Ripple Labs, Inc. and two of its executives alleging they offered and sold over $1.38 billion of digital asset XRP without registration or exemption in violation of Section 5 of the Securities Act of 1933, seeking disgorgement of ill-gotten gains.  Ripple filed an answer on January 29 denying that XRP is a security or that it violated the securities laws.  At the heart of this case is the issue that’s been central to just about every other enforcement action brought by the SEC in the digital asset space: whether XRP is an “investment contract” and thus a security.  The court in Ripple may have a unique opportunity to fill a regulatory vacuum and provide needed guidance to cryptocurrency network developers about how to launch digital currencies without triggering the securities laws.  The decision in the Ripple case may indeed make waves throughout digital asset markets.

Ripple and XRP

Ripple operates a network that allows cross-border payments using the cryptocurrency XRP to facilitate currency transfers over the XRP network.  XRP differs from Bitcoin or Ether, two cryptocurrencies acknowledged by the SEC to be non-securities, in that Bitcoin and Ether are minted through the mining process, whereas XRP’s supply was capped at 100 billion XRP when it was created in 2012, 20 billion of which was transferred to Ripple’s three co-founders and the remaining 80 billion was left in reserve for future issuances.

Regulatory Landscape

SEC enforcement actions in the digital asset space tend to focus on the last two prongs of Howey, namely whether purchasers had a reasonable expectation of profit, and if so whether the profit expectation was dependent on the efforts of others.  Key factors relevant to the profit expectation prong include whether the promoter marketed the digital assets to prospective users for their functionality or alternatively to investors for the tokens’ speculative value.  Important elements in determining the efforts of others prong have included whether the network was decentralized or fully functional.

For the past several years, crypto network developers have faced a regulatory Catch-22.  Distributing tokens to people may violate the securities laws if the network isn’t functional or decentralized.  But it can’t mature into a functional, decentralized network that isn’t dependent on the managerial and entrepreneurial efforts of a single group unless the tokens are distributed to and freely transferable among potential users and developers on the network.

This is where the Ripple case can provide much needed clarity.  Prior cases have focused on whether the developer suggested the tokens will increase in value and whether it tried to support a secondary market.  But a meaningful facts and circumstances analysis should really dig deeper.  A developer’s touting of a token’s potential to increase in value certainly makes the token look like an investment contract, but it could also be explained more innocently as an expression of a desire that the network succeed and be used by lots of people.  Some crypto network developers have proceeded with digital token offerings in the hope of being able to convince the SEC that its token is sufficiently functional and avoid being branded an investment contract, but this approach is risky because it’s difficult to prove that a token is functional before distributing it to lots of people for use on the network.

One alternative for a crypto network developer would be to bite the bullet, concede the securities issue and sell the tokens to investors under an exemption from registration.  Several blockchain network developers have done so under Rule 506 of Regulation D, but that approach has severe limitations inasmuch as the issuer is limited to selling only to accredited investors.  Further, if the offering is under Rule 506(c), which is expected because the offering would likely involve general solicitation efforts, the seller would need to use enhanced methods of verification of accredited investor status, which isn’t practical.  Another exemption pathway would be a mini-public offering under Regulation A+.  But that is a more expensive process that involves intermediaries, which would undercut one of the primary advantages of a blockchain network, namely that it is decentralized with people transacting directly with each other without the need for intermediaries.

Another alternative would be to distribute the tokens only outside the U.S. in jurisdictions that would allow it.  The risk here is that the tokens could easily find their way back to the U.S.  And from a public policy perspective, a regulatory regime that incentivizes entrepreneurs to operate outside the U.S. denies Americans and U.S. markets the opportunity to participate in an innovative opportunity.

Last year, SEC Commissioner Hester Peirce proposed a safe harbor for blockchain network developers that would entail a three-year grace period during which they could develop a functional or decentralized network exempt from registration, so long as certain disclosure, intended functionality, liquidity and notice conditions are met.  I blogged about the proposal here.  It represents a sensible, practical solution to the blockchain developers’ regulatory Catch 22, although it hasn’t been formally proposed by the SEC.

The SEC’s Claims

The SEC alleges that from at least 2013 through the present, Ripple, its Chairman and its CEO sold over 14.6 billion XRP in return for nearly $1.4 billion in cash or other consideration to fund Ripple’s operations and enrich themselves.  They did so despite two memos from Ripple’s lawyers telling the company in 2012 that XRP may be considered an investment contract, that XRP differed from Bitcoin because Ripple had identified itself as responsible for the distribution, promotion and marketing of the network XRP traded on and that it should seek guidance from the SEC on how to distribute XRP without triggering the securities laws.  Further, Ripple promised during the offering that it would engage in efforts to increase the value of XRP, and then engaged in extensive entrepreneurial and managerial efforts with proceeds from the offering.  It also touted the potential future use of XRP by certain specialized institutions while simultaneously selling XRP widely into the market.

The SEC asserts that XRP is an investment contract and thus a security under the Howey Test, which is met when there’s an investment of money in a common enterprise with a reasonable expectation of earning profit through the efforts of others.  Ripple promised to undertake significant efforts to develop, monitor and maintain a secondary market for XRP with a goal of increasing trading volume and resale opportunities. It made repeated public statements highlighting its business development effort that will drive demand, adoption and liquidity of XRP, and held itself out as the primary source of information regarding XRP. The SEC alleges these factors led investors reasonably to expect that Ripple’s entrepreneurial and managerial efforts would drive the success or failure of Ripple’s XRP network.

Ripple’s Response

Ripple’s response to the SEC’s lawsuit is multifaceted.  In its answer to the complaint, it notes the SEC’s action comes five years after the DOJ and FinCen determined in a separate proceeding that XRP is a virtual currency.  It states that inasmuch as the SEC has previously deemed Bitcoin and Ether not to be securities, this action would amount to the SEC picking virtual currency winners and losers.  It asserts the mere filing of the lawsuit has caused immense harm to XRP holders, with an estimated $15 billion in damage to those the SEC purports to protect.

Ripple asserts it never conducted an initial coin offering, never offered or contracted to sell future tokens as a way to raise money to build an ecosystem, has no explicit or implicit obligation to any counterparty to expend efforts on their behalf and never explicitly or implicitly promised profits to any XRP holder.  For these reasons, Ripple concludes XRP holders cannot objectively rely on Ripple’s efforts.  Further, Ripple has its own equity shareholders who purchased shares in traditional venture capital funding rounds and who, unlike purchasers of XRP, did contribute capital to fund Ripple’s operations, do have a claim on its future profits and obtained their shares through a lawful (and unchallenged) exempt private offering.

Ripple seems to be signaling it knows it’s in trouble as it appears to be going above and beyond in asserting it is being treated differently than other cryptocurrency initiatives which have not been targeted with an SEC enforcement action.  Ripple filed a Freedom of Information Act request seeking all SEC communications regarding other cryptocurrencies, and its legal team includes such heavyweights as former SEC Chairwoman Mary Jo White and the former Director of Enforcement at the SEC, Andrew Ceresney, both now of Debevoise & Plimpton.

Why Ripple is Potentially Significant

Whether or not cryptocurrencies are investment contracts and thus securities remains an unresolved issue vexing crypto network entrepreneurs, and there could be some meaningful case law to emerge from Ripple on this. Although Commissioner Peirce’s safe harbor recommendation seems like a good way to promote innovation in this space without hammering entrepreneurs right off the bat with onerous securities regulatory requirements, there’s no reason to believe it will be formally proposed by the SEC given the new administration’s paternalistic emphasis on investor protection.  Cryptocurrencies cannot be launched in a decentralized manner.  Like network effects in economics, cryptocurrency networks need to hit a critical mass of participants for the network to be economically viable.  Most cryptocurrencies are considered decentralized with no central authority governing the blockchain.  Whether or not Ripple has that kind of central authority is what this case seems to be hinging on.

Right now we’re in a regulatory vacuum in which the SEC has not provided enough formal guidance to cryptocurrency developers and their lawyers about how to launch digital currencies without triggering the securities laws.  If it doesn’t settle, Ripple could be a seminal case in the cryptocurrency arena and an opportunity to set forth clear, objective standards which could hopefully be followed by well-intentioned crypto network developers.  If that happens, Ripple could make waves in the digital asset space.

For the second time in nine days, I recently drove ten hours round-trip to drop my son off at school for spring semester.  The first time around, he ended up returning home with me the next day for unexpected oral surgery to remove his wisdom teeth after completing his mandatory one-day COVID quarantine at school.  But on his second return to school several days later, he was required by the university to undergo another round of COVID testing and isolation protocols all over again.

It’s pretty common for issuers in follow-on offerings to solicit investors from previous rounds first.  Indeed, doing so is often mandatory when early investors have preemptive rights.  If the particular offering exemption relied upon by the issuer includes an investor qualification requirement, the investor may need to endure the hassle of re-establishing his qualifications all over again in each subsequent round, sort of like my son’s repeat COVID testing and quarantining.  And if the verification method required by a particular offering exemption is time consuming, expensive and invasive, the issuer may decide it’s not worth the trouble and instead opt for another exemption, or the investor may choose to invest in another company.

Such has been the case with the offering exemption under Rule 506(c) of Regulation D.  As part of the Jumpstart Our Business Startups Act of 2012, Congress and the Securities and Exchange Commission created a new variation on the old private offering exemption to allow issuers to solicit investors by means of general solicitation (e.g., the internet), provided they sold only to accredited investors and used “reasonable methods” to verify qualification.  Rule 506(c) is principles-based (requiring an objective determination as to whether a proposed verification method is reasonable in light of the particular facts and circumstances of each investor and transaction) with a few non-exclusive safe harbor methods, such as reviewing tax returns, brokerage statements, appraisal reports and credit reports, and obtaining written confirmation from the investor’s broker-dealer, investment advisor, lawyer or certified public accountant that the investor is accredited. But despite the great promise of the new rule to allow issuers to use the internet to find investors, the vast majority of private offerings are not being conducted under Rule 506(c) but rather old Rule 506(b), notwithstanding the restrictive prohibition on general solicitation.  The overall consensus is that Rule 506(c) is significantly underutilized because the verification requirement is still perceived by many individual investors and issuers (deservedly or not) as an invasion of privacy, needlessly expensive and time consuming, despite the emergence of third party verification firms.

Recognizing that the burden of Rule 506(c)’s investor verification rule is exacerbated by the current requirement to repeat the intense scrutiny with each follow-on offering, the SEC, as part of the new exempt offering rules it adopted last November, relaxed the requirement as it would apply to previously verified investors.  Specifically, an issuer may establish that a previously verified investor remains an accredited investor at the time of a subsequent sale under Rule 506(c) merely by having the investor provide a written representation that he continues to qualify, so long as the issuer is not aware of information to the contrary and the previous verification occurred within five years prior to the subsequent sale.

The five year window was added to the final rule to address concerns that permitting reliance on a prior verification over an unlimited period of time may not appropriately account for changes in financial circumstances and could result in issuers raising money from non-accredited investors.  The SEC believes the five-year period is not so remote that the initial verification is no longer meaningful, and together with the preexisting relationship between the issuer and such investor, will appropriately balance cost and burden reduction with risk mitigation.

The relaxation of the verification rule for previously verified investors should make it easier for issuers to conduct, and encourage investors to be more willing to participate in, multiple offering rounds utilizing the internet or other general solicitation techniques under Rule 506(c).

The new exempt offering reform rules were published in the Federal Register on January 14, meaning that they would ordinarily become effective March 15 (60 days after publication).  But as per my last blog post, there exists some uncertainty regarding whether any of the reforms will become effective, or at least when.  That’s because President Biden ordered a “Regulatory Freeze Pending Review”, which provides, as to regulations that have already been published in the Federal Register but have not taken effect, that the heads of executive departments and agencies are instructed to consider postponing the rules’ effective dates for 60 days for the purpose of reviewing any questions of fact, law and policy the rules may raise.  Consequently, issuers should sit tight until further confirmation from the SEC or the new administration as to the effectiveness of the accredited investor verification rule or any other aspect of the exempt offering reforms adopted by the SEC in November.

A freeze on government regulation is generally perceived by most people as being a positive development for private enterprise.  Not necessarily so, however, when the regulation being frozen is itself a reform of preexisting regulatory burdens.

Among the many Presidential Actions taken by President Biden on his first day in office was one entitled Regulatory Freeze Pending Review, in which he ordered that all final regulations that have not yet become effective (because they haven’t completed the standard process of publication in the Federal Register followed by a waiting period) be frozen pending further review.  Specifically, regulations that have been sent to the Office of the Federal Register but not yet published in the Federal Register are to be immediately withdrawn for review and approval.  As to regulations that have already been published in the Federal Register but have not taken effect, the heads of executive departments and agencies are instructed to consider postponing the rules’ effective dates for 60 days for the purpose of reviewing any questions of fact, law and policy (emphasis added) the rules may raise.

Among the regulatory developments potentially impacted by the regulatory freeze are the November 2020 reforms on the exempt offering framework, which include rules specifically relating to crowdfunding under Regulation CF and Regulation A.  I previously blogged on these important reforms here, here, here and here, and indicated that the new rules would not be effective until 60 days after publication in the Federal Register.

As of my last blog post dated January 10, the exempt offering rules had not yet been published in the Federal Register.  The rules finally did get published on January 14.  Although the delay from November 2 to January 14 seemed strange inasmuch as final rules typically make their way over to the Federal Register within days following SEC adoption, to paraphrase Samuel Jackson in Pulp Fiction: “I didn’t give a lot of thought to what it meant”.  Until now.

The new exempt offering rules passed by the SEC in November were intended to be common sense reforms to facilitate capital formation, increase opportunities for investors and simplify and harmonize certain aspects of the exempt offering framework while preserving or enhancing important investor protections.  Seems pretty non-controversial, something everyone should be able to agree on.  But not everyone agrees that the new exempt offering rules preserve investor protections.

On December 4, 2020, the Chairwoman of the House Financial Services Committee Maxine Waters, on behalf of the Democratic members of the Committee, sent a letter to then President-elect Biden highlighting several areas where his administration “should immediately reverse the actions of [his] predecessors”.  Among the predecessors’ actions targeted by Cong. Waters are several taken by the SEC “that have … stripped away fundamental investor protections, including safeguards around private markets, where investors have few protections”.

Cong. Waters is not alone in her hostility to capital markets reform efforts by the SEC because of investor protection concerns.  In her dissent to the SEC’s exempt offering framework amendments, Commissioner (now Acting Chair) Allison Herren Lee did not mince words, asserting that the new rules on integration, test the waters and demo days, among others, exacerbate concerns over investor protections by encouraging a surge in general solicitation and offers to non-accredited investors in the private markets without a reliable method for regulators to determine if an exemption is available.  Commissioner Lee argued the best opportunities for retail investors are in the public markets where we should be encouraging investment, not in the private markets which have fewer investor safeguards.

Also at risk in the regulatory freeze are the proposed reforms of the rules that require private capital markets finders to be registered with the SEC as broker dealers.  On October 7, the SEC issued proposed rules for a limited, conditional exemption from broker-dealer registration for individual finders who engage in limited activities on behalf of issuers.  I blogged about that here.  Investor protection hawks have argued against the finder reform proposals, including Cong. Waters in her December 4 letter to the SEC and Commissioner Lee in her dissent to the proposed finder rules which she entitled “Regulating in the Dark: What We Don’t Know About Finders Can Hurt Us”.

Technically, the Presidential Action calling for a regulatory freeze may just mean an inconvenient delay in recently promulgated capital markets reforms becoming effective.  But that assumes no philosophical difference in policy. President Biden’s nominee for SEC Chair, Gary Gensler, has not yet been confirmed by the Senate and it’s anyone’s guess as to where he stands in the debate on private capital markets reform.  But there’s no guessing required as to where Acting SEC Chair Allison Herren Lee stands, and accordingly the risk of reform rollback is real, which if realized will impede crowdfunding markets from achieving their full potential.