On November 27, 2018, the United States District Court for the Southern District of California denied the Securities and Exchange Commission’s motion for a preliminary injunction to block an initial coin offering, finding the Commission did not meet its burden of showing the digital token in question was a security. Although this appears to be the first Federal decision against the Commission on the question of whether a token is a security under the Howey test, and may encourage some issuers with the resources to do so to resist SEC enforcement efforts, the order is extremely narrow in scope and is not likely to deter the Commission’s ICO enforcement efforts or shed much light on when if ever a token is not a security.

The issuer in this case, Blockvest LLC, is purportedly seeking to develop the “first licensed and regulated tokenized crypto currency exchange and index fund based in the U.S.” Earlier this year, it announced a plan to issue tokens in three stages: a private sale with a 50% bonus, followed by a “pre-sale” with a 20% bonus, and then a $100 million ICO to be launched on December 1, 2018.

In its original complaint filed on October 3, the Commission premised its fraud case on the notion that Blockvest’s token was a security without analyzing the facts under Howey, but rather by asserting that Blockvest itself conceded that its BLV token was a security by filing a Form D with the Commission and stating on its website that it was “Regulation A+ compliant and can offer [its] securities offering to Unaccredited Investors all over the globe” (emphasis added). See my last blog post regarding the Blockvest offering and its apparent offering exemption confusion.

In mid-October, U.S. District Judge Gonzalo Curiel, issued an ex parte (i.e., with only the Commission appearing before him) temporary restraining order in this case freezing Blockvest’s assets related to the ICO, based solely on the Commission’s version of the facts and largely because of multiple false claims made by Blockvest in its ICO promotional materials that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte.

As to the issue of whether Blockvest’s BLV token was a security, because the earlier TRO motion was made ex parte, the Court based its factual findings at that procedural stage entirely on what the Commission had asserted, namely that investors had invested more than $2.5 million in BLV tokens, which constituted 18% of the offering, and that the purchasers were interested primarily in the profit the BLVs were expected to generate given that Blockvest’s website promised that the BLVs would generate passive income.

But in Blockvest’s brief opposing the preliminary injunction motion and in a related written declaration by its founder Buddy Ringgold, the defendants offered a completely different factual narrative. They asserted that in fact no tokens were sold to the public and that Blockvest never received any money from their sale, and that Blockvest had only one investor (Rosegold Investment, in which Ringgold himself and friends and family were investors). Further, they asserted that BLV tokens were only used to test the platform by 32 “testers” who contributed less than $10,000 in the aggregate.  The BLV tokens were never released to the testers and the testers could not remove the tokens from the platform. Presumably, the testers could not resell them for profit.

The injunction rejection order states that “Ringgold recognizes that mistakes were made” but does not specify what those were. Presumably, it’s a reference to the various misrepresentations about regulatory endorsement. It may also refer to allowing eight of 17 investors in Rosegold (the investment vehicle) to write “Blockvest” and/or “coins” on their checks. It may also be a reference to Blockvest’s website temporarily featuring a credit card function with a “buy now” button. As to the SEC’s allegation that Blockvest had raised $2.5 million from investors, as Blockvest had boasted on social media, Blockvest explained it away as an “overly optimistic” statement and that in any event the funds were not intended to come from the public but rather from one investor, David Drake, and had fallen through anyway. Ringgold maintains the mistakes were made in the early stages of development when Blockvest’s chief compliance officer had not yet reviewed all the materials.

Unlike the TRO order, the injunction rejection order does invoke the Howey test, under which an instrument is deemed to be an investment contract and thus a security if it involves (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of earning a profit through the efforts of others. Judge Curiel addressed the first and third prongs of Howey, but not the second.  Under the first prong, “investment of money”, Judge Curiel examined not what the testers’ intent was in committing funds, but rather what Blockvest represented to the testers and what the testers relied on. Here, Judge Curiel found that the Commission and Blockvest provided “starkly different facts as to what the 32 test investors relied on, in terms of promotional materials, information, economic inducements or oral representations at the seminars, before they purchased the test BLV tokens”, and that consequently the court could not make a determination as to whether the test BLV tokens were “securities” under the first prong of Howey.  As to the second prong, “expectation of profits”, which Judge Curiel identified as either through capital appreciation or profit participation, he once again found that the Commission had not met its burden of proving expectation of profit.

So what are the key takeaways here? The competing factual narratives suggest this to be a narrow ruling. It must be kept in mind that this order comes without the benefit of full discovery; it’s basically “he said/she said”.  And without full discovery to address disputed issues of material facts, the court could not conclude that the Commission had met its burden in establishing that the BLV token offered to the 32 test investors was a security. Also, the Commission may have brought this case prematurely inasmuch as it was under the impression that the tokens had already been sold to the public; Blockvest in turn asserted facts indicating that no tokens had yet been issued (or offered) to the public and the tokens purchased by the testers were for testing purposes only and never released from the platform. It’s also unclear whether the Commission will pursue this case inasmuch as it has already secured Blockvest’s commitment to cease all efforts with respect to the ICO and to give the Commission 30 days’ notice of any resumption of efforts in this regard. Nevertheless, the order does serve as a reminder that the Commission, when seeking enforcement against an ICO in court, will have the burden of establishing that each of Howey’s prongs have been met, and suggests that future cases may be decided on the issuer’s actual marketing efforts and representations to purchasers and not on subjective perceptions of those purchasers’ expectations of profit.

If you were looking for a safe blockchain investment and had the chance to invest in the “first licensed and regulated tokenized cryptocurrency exchange and index fund based in the U.S.” and audited by a Big 4 accounting firm, you might do it, right? One problem: turns out it’s not licensed, regulated or audited.

On October 11, 2018, the Securities and Exchange Commission announced it had obtained an emergency court order halting Blockvest, LLC’s initial coin offering, whose sponsors falsely claimed that it was “registered” and “approved” by the SEC and other regulators, that its chief marketing officer was licensed by FINRA and that it was audited by Deloitte. None of that was true. The sponsors claimed they had already raised more than $2.5 million in pre-ICO sales of its digital token, BLV, and that it sought to raise an aggregate of $100 million in the ICO. The order also halts ongoing pre-ICO sales by Blockvest and its founder, Reginald Buddy Ringgold, III, a/k/a Rasool Abdul Rahim El.

The most brazen aspect of the alleged fraudulent scheme was the sponsors’ apparent creation of a fictitious blockchain regulatory agency which they call the “Blockchain Exchange Commission” or “BEC”, which they claim “regulates the blockchain digital asset space to protect digital asset investors”.  In May 2018, roughly one month after filing a Form D for the BLV offering (see below), Ringgold created the BEC, renaming a company that had been previously incorporated under various names including “Fartlife.” The BEC seems to plagiarize the SEC’s logo and mission statement, and gives itself the same address as SEC headquarters (100 F Street, NE, Washington, DC).  The BEC’s LinkedIn page includes a logo nearly identical to the SEC’s logo (see left), as well as the following mission statement, also uncannily similar to the SEC’s:

“The mission of the BEC is to protect investors; and assist in maintaining fair, orderly, and efficient markets within the Blockchain Digital Asset Space…The Blockchain Exchange Commission, or BEC, is dedicated to investor protection and market integrity.”

Blockvest also appears to be confused about securities offering rules. It filed a Form D with the SEC on April 16, 2018, claiming an exemption under Rule 506(c), which requires that all purchasers be accredited investors and that the issuer use reasonable methods to verify status. The SEC’s complaint states that, on information and belief, Blockvest has not taken reasonable steps to ensure that BLV investors are accredited. Also, despite their Form D, Blockvest’s website invokes Regulation A. Never mind that Regulation A has an offering limit of $50 million (Blockvest is seeking $100 million in its ICO), and prohibits any sales until the issuer has filed an offering statement on Form 1-A and the SEC has issued a notice of qualification. The SEC’s complaint further states that Blockvest’s website stated falsely that its ICO was “Reg A+ compliant” and can offer its securities to unaccredited investors all over the globe. Blockvest’s website now states that the “Pre-IPO testing the waters phase has been halted.” Testing the waters is a Regulation A concept.  Blockvest hasn’t filed a Form 1-A offering statement, nor has any offering been qualified by the SEC under Regulation A.

The SEC complaint should serve as a warning to issuers conducting unregistered ICOs to exercise caution and avoid language implying that that their tokens have been registered with the SEC, or that the SEC has passed on the merits of the offered tokens. This is why exempt offerings include the following legend in their disclosure documents:

THE SECURITIES OFFERED HEREBY HAVE NOT BEEN APPROVED BY THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION, OR ANY STATE SECURITY AUTHORITY. ANY REPRESENTATION TO THE CONTRARY IS UNLAWFUL.

THE UNITED STATES SECURITIES AND EXCHANGE COMMISSION DOES NOT PASS UPON THE MERITS OF OR GIVE ITS APPROVAL TO ANY SECURITIES OFFERED OR THE TERMS OF THE OFFERING, NOR DOES IT PASS UPON THE ACCURACY OR COMPLETENESS OF ANY OFFERING CIRCULAR OR OTHER SOLICITATION MATERIALS. THESE SECURITIES ARE OFFERED PURSUANT TO AN EXEMPTION FROM REGISTRATION WITH THE COMMISSION; HOWEVER, THE COMMISSION HAS NOT MADE AN INDEPENDENT DETERMINATION THAT THE SECURITIES OFFERED HEREUNDER ARE EXEMPT FROM REGISTRATION.

 

Private companies in the gig economy like Uber and Airbnb would love to issue compensatory equity to their platform participants, just like they’re able to do with their employees. The problem is that the exemption from registration for compensatory issuances only covers issuances to employees and consultants of the issuer.  Last July, however, the Securities and Exchange Commission published a concept release seeking comment on whether the exemption should be extended to equity issued to participants in the gig economy.  This past Friday, Airbnb delivered a comment letter to the Commission advocating for an expansion of the exemption to cover sharing economy participants. This blog post will seek to explain some of the key issues involved here.

Background: Rule 701

Rule 701 of the Securities Act of 1933 provides a safe harbor exemption from registration for equity securities issued as compensation by non-reporting companies to employees, consultants, advisors or de facto employees providing services to the issuer. The purpose of the exemption is to facilitate securities-based compensation; it’s not available for capital-raising issuances or any other issuances for any purpose other than equity compensation.

The aggregate sales price or amount of securities that may be sold during any rolling 12-month period must not exceed the greatest of (i) 15% of the issuer’s total assets, (ii) 15% of the outstanding amount of the class of securities being offered and sold under Rule 701, or (iii) $1 million.

The issuer must give all participants a copy of the benefit plan or contract setting forth the incentive equity.  Beyond that, if the aggregate sales price or amount of securities sold under Rule 701 during any rolling 12-month period exceeds $10 million, the issuer must also provide additional mandated disclosure, including risk factors and specified financial statements.

Finally, under the amendments to Section 12(g) of the Securities Exchange Act of 1934 introduced by the JOBS Act (which increased the shareholder thresholds at which issuers must register a class of securities under the Exchange Act to 2,000 or 500 non-accredited investors), persons holding only securities received under an employee compensation plan in a transaction exempt from registration (including under Rule 701) are not considered to be holders of record for calculating record holders under Section 12(g).

Concept Release on Compensatory Securities Offerings and Sale

The Securities and Exchange Commission published its Concept Release on Compensatory Securities Offerings and Sales on July 18, 2018. In the introductory sections of the concept release, the Commission described the characteristics of the gig economy where service providers use a company’s Internet platform for a fee to provide peer-to-peer services such as ride-sharing, food delivery, household repairs, dog-sitting, tech support and lodging. These are not traditional employment relationships, and so the participants aren’t deemed to be “employees” — or consultants, advisors or de facto employees – and thus are ineligible to receive securities in compensatory arrangements under Rule 701. But the same compensatory and incentive motivations to include equity in employee compensation may exist with respect to gig economy participants, i.e., alignment of interests, recruitment, retention and enhanced compensation relative to what a company may be able to pay in cash or other benefits.

Accordingly, in light of the significant evolution in the composition of the workforce since Rule 701’s last meaningful amendment 20 years ago, the concept release sought comment on possible ways to modernize the exemption and expand it to cover securities issued to participants in the gig economy.  In seeking comment from the public to determine what attributes of gig economy relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption, the Commission posed several specific questions, including the following:

  • What activities should an individual need to engage in to be eligible?
  • Should the test identify Rule 701 eligible participants as individuals who use the issuer’s platform to secure work providing lawful services to end users?
  • Should there be a sufficient nexus between the individual and the issuer to justify application of the exemption for compensatory transactions?
  • Should it matter whether individuals provide services to the issuer, or instead to the issuer’s customers or end users?
  • Does it matter whether that business activity provides a service typically provided by an employee or is more of an entrepreneurial nature?
  • Whether a potential eligibility test should consider the individual’s level of dependence on the issuer, or, conversely, the issuer’s degree of dependence on the individuals?
  • Should it matter what percentage of the individual’s earned income is derived from using the issuer’s platform?

Recognizing that extending eligibility to individuals participating in the gig economy could significantly increase the volume of Rule 701 issuances, the Commission posed these additional questions:

  • Would revising the rule have an effect on a company’s decision to become a reporting company?
  • Would such revisions encourage companies to stay private longer?
  • To what extent do companies utilizing “gig economy” workers issue securities as compensation to those individuals?
  • What effect would the use of Rule 701 for “gig economy” companies have on competition among those companies and newer companies and more established companies vying for the same talent?
  • Should a gig economy participant receive the same disclosure as an employee?

The Airbnb Comment Letter

In a letter dated September 21, 2018, Airbnb responded to the concept release and offered a convincing rationale for reforming Rule 701 as well as several interesting specific proposals.

As to rationale, Arbnb’s comment letter argues that expanding the category of persons eligible to receive securities under the Rule is consistent with the goals of the JOBS Act to facilitate entrepreneurship and growth startups. Doing so would further democratize share ownership and enable many ordinary individuals who have been effectively excluded from early stage investing to benefit from the potential growth of startups. It would align the interests of sharing economy companies with the service providers who use their platforms to the benefit of both. (Note that Airbnb is careful to use the term “sharing economy” rather than “gig economy”; for a good, concise explanation of the distinction, see here.) Extending the exemption to issuances to sharing economy participants would also incentivize individuals to leverage their assets to participate in the sharing economy and supplement their income. Finally, it would help younger and smaller companies compete with older and larger competitors yielding better outcomes for end users.

Because of the magnitude of Airbnb’s and other sharing economy companies’ participants, Airbnb asserts that the extension of Rule 701 to sharing economy participants would only be useful to those companies if they were allowed to exclude the recipients from the number of record holders under Section 12(g), as is the case with recipients under the current Rule; otherwise, such issuers would easily exceed either or both the 2,000 holder or 500 non-accredited investor holder threshold forcing those companies to register with the Commission and be saddled prematurely with its regulatory and reporting regime.

But shouldn’t sharing economy participants receive adequate disclosure when receiving securities? Airbnb asserts that most Rule 701 recipients are not making an investment decision when they receive their shares (which is why there’s no mandated disclosure obligation under the current Rule unless a dollar threshold is exceeded). Moreover, sharing economy participants would be expected to know much more about the issuer than typical investors, thus minimizing the need for disclosure. Finally, the primary motivation for issuing equity to participants would not be to raise capital but rather to align interests.

Airbnb advocates for the creation of a new subcategory of eligible recipients under Rule 701, which would be more restrictive than for recipients under the current Rule. The focus of any amendment to Rule 701 to create what Airbnb calls the Sharing Economy Award Exemption should be on the nature of eligible companies, nature of securities awarded to participants and transferability of the securities.

Eligible companies would need to satisfy the following criteria to ensure they are bona fide sharing economy companies and not just seeking to sell securities:

  • Provide a platform to allow third parties to provide goods and/or services to end users;
  • Derive a significant portion of its revenue from fees paid by platform participants;
  • Control the platform by either having the right to exclude a listing or participant for violating terms, or by determining amount of user fees and terms and conditions for receiving payment for goods and services sold on the platform.

Airbnb believes the securities permissible under the Sharing Economy Award Exemption should be more limited than currently allowed. Recipients should not be permitted to choose between securities or cash, so that they aren’t making an investment decision. Not more than 50% of the value received by the recipient from the issuer for goods and services sold on the platform over a 24 month period should be in the form of equity. And any equity award should not be made contingent on making a capital contribution, to ensure the absence of a capital raising motive.

Finally, Airbnb believes the restrictions on transferability of securities issued in the Sharing Economy Award Exemption should be more restrictive than under current Rule 701, even suggesting that it would be appropriate to provide that such securities be non-transferable prior to an IPO or a change in control. If such serious transfer restrictions are imposed and no cash is contributed in connection with the issuance, Airbnb believes any disclosure obligation should be minimal.

If you’re thinking of airdropping free tokens or implementing a cryptocurrency bounty program, be careful. The Securities and Exchange Commission just issued a cease and desist order (the “Order”) with respect to an initial coin offering, finding the issuance of “free” tokens through a related bounty program in exchange for online promotional services constituted an unregistered sale of securities and thus a violation of the registration provisions of the federal securities laws. Although courts and the Commission have traditionally held that the transfer of “free” shares of stock is a “sale” of securities where the issuer derives some benefit from the transfer, the Order is the first treatment of the issue in the context of cryptocurrency bounty programs.

Airdrops and Bounty Programs

An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. The main goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Like airdrops, bounty progrms are a means of advertising and have become a useful part of many ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as marketing and making improvements to aspects of the cryptocurrency framework. Airdrops and bounties are similar in that both involve issuing seemingly free tokens. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements. But in a bounty program, individuals must execute assigned tasks before receiving the tokens.

The Facts

According to the Order, Tomahawk Exploration LLC and its founder attempted to raise money through the sale of blockchain-based digital tokens called “Tomahawkcoins” or TOM to fund oil exploration in California. Although Tomahawk failed to raise money through the ICO, it issued approximately 80,000 TOM to approximately 40 wallet holders on a decentralized platform as part of a bounty program in exchange for online promotional and marketing services to promote the ICO. Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 TOM for activities such as making requests to list TOM on token trading platforms, promoting TOM on blogs and other online forums like Twitter or Facebook, and creating professional picture file designs, YouTube videos or other promotional materials.

Legal Background

Section 5 of the Securities Act of 1933 makes it unlawful to offer or sell any security unless a registration statement is in effect as to that security or there is an available exemption from registration. The terms “offer” and “sale” are defined very broadly in the Securities Act. Section 2(a)(3) of the Securities Act defines an “offer” of securities as any “attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value”. Similarly, Section 2(a)(3) defines a “sale” of securities” under Section 2(a)(3) of the Securities Act as “every disposition of a security or interest in a security, for value.”

The Order

The Order found that the bounty program constituted an offer of securities under Section 2(a)(3) of the Securities Act because it involved an offer to dispose of a security for value. The Order states that the lack of monetary consideration for the shares doesn’t mean there wasn’t a sale or offer for sale for purposes of Section 5, asserting that a “gift” of a security is a “sale” within the meaning of the Securities Act when the donor receives some real benefit. According to the Order, the value or real benefit that Tomahawk received in exchange for the token distributions under the bounty program was in the form of promotion of the ICO on blogs and other online forums and in the creation of a public trading market for its securities. The decentralized platform on which Tomahawk issued the TOM tokens was publicly accessible to U.S. persons and others throughout the offering period, and bounty recipients subsequently traded their TOM tokens on a platform for digital assets.

Bounty program and airdrop enthusiasts would probably point to the Howey test, identified by the Commission as the relevant standard for determining whether a token is an investment contract and thus a security, to support the proposition that tokens issued in airdrops and bounty programs should not be securities. Howey states that for an instrument to be a security, there must be an investment of “money” (in a common enterprise with a reasonable expectation of earning a profit through the efforts of others); since no money is exchanged, the argument is that there is no security. But the Order makes it clear that the Commission continues to interpret the Howey test’s reference to “money” very broadly. That interpretation was made clear in the 2017 DAO Report:

“In determining whether an investment contract exists, the investment of “money” need not take the form of cash. See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (“[I]n spite of Howey’s reference to an ‘investment of money,’ it is well established that cash is not the only form of contribution or investment that will create an investment contract.”).

Possible Exemption: Rule 701

Just because a token is deemed to be a “security” or its issuance a “sale” of securities doesn’t mean it’s illegal. It just means the issuer needs either to register the offering with the SEC (not happening) or satisfy the requirements for an exemption from registration. One possible exemption that token issuers should consider when pondering a bounty program is Rule 701, which is the primary exemption used by non-reporting companies to issue equity incentive awards without registration to employees and certain consultants. There are three key elements here. First, the issuer would need to have a written instrument evidencing the recipients’ right to receive tokens as compensation for services. Second, the bounty program cannot be related to raising money, so the announcement regarding the bounty program should promote the product or service as opposed to fundraising. Finally, the recipients of the tokens in the bounty program may not be engaged in any securities promotion on behalf of the issuer.

It’s not often that the House of Representatives votes nearly unanimously on anything noteworthy these days, but that’s exactly what the House did on July 17 in voting 406-4 for the “JOBS and Investor Confidence Act of 2018”, also known on the street as “JOBS Act 3.0”, which is the latest iteration of the effort to improve on the capital markets reform initiative started in the original JOBS Act of 2012. JOBS Act 3.0 consists of 32 individual pieces of legislation that have passed the Financial Services Committee or the House, the substance of several of which I have blogged about previously. If passed by the Senate in some form or another and signed by the President, the reforms included in JOBS Act 3.0 will continue the process of removing unreasonable impediments to capital formation by early stage companies and address perceived problems with the original JOBS Act.

The highlights of JOBS Act 3.0 passed by the House are as follows:

Demo Days: Helping Angels Lead Our Startups Act” or the “HALOS Act”

The bill would direct the SEC to amend Regulation D to make clear that activities associated with demo day or pitch night events satisfying certain criteria would not constitute prohibited “general solicitation” under Regulation D. Specifically, the new exemption would cover events with specified types of sponsors, such as “angel investor groups”, venture forums and venture capital associations, so long as the event advertising doesn’t refer to any specific offering of securities by the issuer, the sponsor doesn’t provide investment advice to attendees or engage in investment negotiations with attendees, charge certain fees, or receive certain compensation, and no specific information regarding a securities offering is communicated at the event beyond the type and amount of securities being offered, the amount of securities already subscribed for and the intended use of proceeds from the offering.

I previously blogged about the issue of demo days and the ban on general solicitation here.

Private Company M&A Brokers: Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2017

The bill would exempt from SEC broker-dealer registration mergers-and-acquisitions brokers that facilitate transfers of ownership in privately held companies with earnings or revenues under a specified threshold. The exemption would not apply to any broker who takes custody of funds or securities, participates in a public offering of registered securities, engages in a transaction involving certain shell companies, provides or facilitates financing related to the transfer of ownership, represents both buyer and seller without disclosure and consent, assists in the formation of a group of buyers, engages in transferring ownership to a passive buyer, binds a party to a transfer of ownership or is a “bad actor”.

Since 2014, private company M&A brokers could at best be guided by an SEC no-action letter, although there had been previous Congressional efforts to codify the protection, which I had blogged about here.

Accredited Investor Definition: Fair Investment Opportunities for Professional Experts Act

The bill would direct the SEC to expand the definition of “accredited investor” under Regulation D beyond the net worth and income test to include individuals licensed as a broker or investment advisor and individuals determined by the SEC to have demonstrable education or job experience to qualify as having professional knowledge of a subject related to a particular investment.

Venture Exchanges: Main Street Growth Act

Although the JOBS Act created an IPO on-ramp for emerging growth companies, it did comparatively little to address secondary market trading in these companies. This portion of the bill seeks to remedy that shortcoming by providing a tailored trading platform for EGCs and stocks with distressed liquidity. Companies that choose to list on a venture exchange would have their shares traded on a single venue, thereby concentrating liquidity and exempting their shares from rules that are more appropriate for deeply liquid and highly valued stocks. Venture exchanges would also be afforded the flexibility to develop appropriate “tick sizes” that could help incentivize market makers to trade in the shares of companies listed on the exchange.

VC Fund Exemption – Investment Advisor Registration: Developing and Empowering our Aspiring Leaders Act

Dodd-Frank requires private equity and hedge fund managers to register with the SEC under the Investment Advisors Act but allows venture capital fund managers to become “exempt reporting advisors” and be relieved from the regulatory requirements encountered by registered investment advisors. Currently, to qualify under the venture capital fund definition and register with the SEC as an exempt reporting advisor, VCs must ensure that more than 80% of their activities are in qualifying investments, which are defined only as direct investments in private companies.

The bill would require the SEC to revise the definitions of a qualifying portfolio company and a qualifying investment to include an emerging growth company and the equity securities of an emerging growth company, “whether acquired directly from the company or in a secondary acquisition”, for purposes of the exemption from registration for venture capital fund advisers under the Investment Advisers Act.  A company qualifies as an emerging growth company if it has total annual gross revenues of less than $1.07 billion during its most recently completed fiscal year and continues to be an emerging growth company for the first five fiscal years after it completes an IPO unless its total annual gross revenues are $1.07 billion or more, it has issued more than $1 billion in non-convertible debt in the past three years or it becomes a “large accelerated filer”.

Founders often leave startups, voluntarily or involuntarily, and it may be in everyone’s interest to have their shares purchased by other existing shareholders rather than sold to an outsider or held by a disgruntled founder.  VC funds should have the flexibility to be able to buy those shares.  Similarly, the inclusion of emerging growth companies in the category of qualifying portfolio company will benefit the innovation ecosystem by encouraging VC funds to invest further in their portfolio companies post-IPO.

Special Purpose Crowdfunding Vehicles: Crowdfunding Amendments Act

One of the perceived defects of the rules governing equity crowdfunding under Regulation CF is the ineligibility of investment vehicles. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors under Regulation D to invest in a special purpose vehicle whose only purpose is to invest in an operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field. The additional benefit to the portfolio company from this model is that the company ends up with only one additional investor on its cap table, instead of the hundreds that can result under current rules.  Due to the fear of having to collect thousands of signatures every time shareholder consent is required for a transaction, higher-quality issuers with other financing options are less likely to crowdfund without a single-purpose-vehicle. I suspect that many companies are shying away from Reg CF or not reaching potential raise targets because of this reason alone.

The bill would allow equity crowdfunding offerings under Reg CF through special purpose vehicles that issue only one class of securities, receive no compensation in connection with the offering and are advised by a registered investment adviser.  Special-purpose-vehicles allow small investors to invest alongside a sophisticated lead investor with a fiduciary duty to advocate for their interests. The lead investor may negotiate better terms and represent small investors on the board.  Retail investors don’t enjoy these benefits under Reg CF.

On June 28, 2018, the Securities and Exchange Commission issued a release amending the definition of “smaller reporting company” (“SRC”) to expand the number of reporting companies eligible for relaxed or scaled disclosure. The change is estimated to benefit nearly 1,000 additional small public companies currently outside the SRC definition. But equally noteworthy in the SRC release is that the Commission staff has been directed, and has begun, to formulate recommendations to the Commission for possible changes to another definition, that of “accelerated filer”, to reduce the number of companies that qualify as accelerated filers in order to further reduce compliance costs. That change would likely be more significant than expanding the SRC definition because “accelerated filer” status triggers the expensive requirement to obtain auditor attestation for management’s assessment of internal control over financial reporting.

Background

Smaller Reporting Company

The Commission established the SRC category in 2008 in an effort to provide general regulatory relief for smaller companies. SRCs are allowed to provide scaled disclosures under Regulation S-K and Regulation S-X. Under the previous SRC definition, SRCs generally were companies with less than $75 million in public float (i.e., aggregate market capitalization of a company’s shares held by non-affiliates). Companies with no public float − because they have no public equity outstanding or no market price for their public equity − were considered SRCs if they had less than $50 million in annual revenues.

Examples of scaled disclosure available to SRCs are two year management discussion and analysis comparisons rather than three years, no compensation discussion and analysis and no risk factor disclosure in Exchange Act filings. A table summarizing the scaled disclosure accommodations for SRCs can be found in the Annex at the bottom of this post.

Under previous rules, SRCs were also automatically excluded from being categorized as “accelerated filers” or “large accelerated filers”, the requirements of which are discussed below. As a result, existing public float thresholds in the accelerated filer definition aligned with the public float threshold in the SRC definition.

Accelerated Filer

In December 2005, the SEC voted to adopt amendments that redefined “accelerated filers” as companies that have at least $75 million, but less than $700 million, in public float, and created a new category of “large accelerated filers” that includes companies with a public float of $700 million or more. In addition to the requirement to file periodic reports on an accelerated basis, accelerated filers must also have their auditor provide an attestation report on management’s assessment of internal control over financial reporting under Section 404(b) of Sarbanes-Oxley.

The determinations of public float thresholds for SRC and accelerated filer status are both made as of the last business day of a registrant’s most recently completed second fiscal quarter for purposes of the following fiscal year.

Amendments to Smaller Reporting Company and Accelerated Filer Definitions

The new rules define SRCs as companies with less than $250 million of public float, as compared with the $75 million threshold under the previous definition. The final rules also expand the definition to include companies with less than $100 million in annual revenues if they have either no public float or a public float of less than $700 million. This reflects a change from the revenue test in the prior definition, under which a company would be categorized as an SRC only if it had no public float and less than $50 million in annual revenues.

The final rules will become effective September 10, 2018.

The amended SRC thresholds are summarized in the following chart:

Criterion

Current Definition

Revised Definition

Public Float Public float of less than $75 million Public float of less than $250 million
Revenue Less than $50 million of annual revenue and no public float Less than $100 million of annual revenues and:

  • no public float, or
  • public float of less than $700 million

The increase in SRC public float thresholds will lead to a dramatic expansion in companies eligible for scaled disclosure. The Commission estimates that 966 additional registrants will be eligible for SRC status in the first year under the new definition. These registrants estimated to be eligible in the first year comprise 779 registrants with a public float of $75 million or more and less than $250 million, 26 registrants with no public float and revenues of $50 million or more and less than $100 million, and 161 registrants with revenues below $100 million and a public float of $250 million or more and less than $700 million.

The SRC amendments also eliminate the automatic exclusion of SRCs from accelerated filer status. The definitions of accelerated filer and large accelerated filer are based on public float, but previously contained a provision excluding SRCs from accelerated filer status. As a result, raising the SRC public float threshold without eliminating that provision effectively would raise the accelerated filer public float threshold as well.

Accordingly, the Commission had also considered increasing the public float thresholds in the accelerated filer definition, consistent with the changes to the SRC definition, to reduce compliance costs and maintain uniformity across relevant rules. Opponents viewed a parallel increase in the accelerated filer thresholds as a weakening of investor protections. Some cited a 2011 Staff Section 404(b) Study finding that accelerated filers subject to Section 404(b)’s attestation requirement had a lower restatement rate compared to non-accelerated filers not subject to Section 404(b). But supporters argued that the attestation requirement is particularly costly for SRCs and that audit costs associated with Section 404(b) divert capital from core business needs. One maintained that a Section 404(b) audit represents over $1 million of capital diversion. Another cited the same 2011 Staff Section 404(b) Study which estimated that companies with a public float between $75 million and $250 million spend, on average, $840,276 to comply with Section 404(b). Interestingly, one commenter that stated that its public float was more than $75 million but less than $250 million estimated that relief from Section 404(b) would result in a 35% reduction in compliance costs whereas there would be no material change in such costs from the SRC amendments qualifying him for scaled disclosure as an SRC.

In the final rules release, the Commission determined to eliminate the exclusion of SRCs from accelerated filer status, effectively deciding not to increase the accelerated filer thresholds.

As indicated in the chart below, the increase in the SRC thresholds coupled with the elimination of the automatic exclusion of SRCs from accelerated filer status (i.e., no increase in the accelerated filer threshold) means good news/bad news for companies with a public float between $75 million and $250 million: they benefit from scaled disclosure (unlike under previous rules), but must continue to provide auditor attestations to management’s assessment of the effectiveness of internal control over financial reporting, an enormously expensive proposition.

 

But as I mentioned at the top of this post, auditor attestation relief may be on the way.  SEC Chairman Clayton has directed the Commission staff to formulate recommendations for possible changes to the accelerated filer definition to reduce the number of companies that fall under its requirements, including the auditor attestation requirement. Perhaps, the staff will recommend to increase the accelerated filer public float threshold to $250 million from its current $75 million. That would appear to bring far more practical regulatory relief than the expansion of the SRC definition.

 

Annex

Smaller Reporting Company Scaled Disclosure

 

Regulation S-K

Item Scaled Disclosure Accommodation
101 − Description of Business May satisfy disclosure obligations by describing the development of the registrant’s business during the last three years rather than five years. Business development description requirements are less detailed than disclosure requirements for non-SRCs.
201 − Market Price of and Dividends on the Registrant’s Common Equity and Related Stock performance graph not required.
301 – Selected Financial Data Not required.
302 – Supplementary Financial Information Not required.
303 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”)

Two-year MD&A comparison rather than three-year comparison.

Two year discussion of impact of inflation and changes in prices rather than three years.

Tabular disclosure of contractual obligations not required.

305 – Quantitative and Qualitative Disclosures About Market Risk Not required.
402 – Executive Compensation

Three named executive officers rather than five.

Two years of summary compensation table information rather than three. Not required:

·      Compensation discussion and analysis.

·      Grants of plan-based awards table.

·      Option exercises and stock vested table.

·      Pension benefits table.

·      Nonqualified deferred compensation table.

·      Disclosure of compensation policies and practices related to risk management.

·      Pay ratio disclosure.

404 – Transactions With Related Persons, Promoters and Certain Control Persons Description of policies/procedures for the review, approval or ratification of related party transactions not required.
407 – Corporate Governance

Audit committee financial expert disclosure not required in first annual report

Compensation committee interlocks and insider participation disclosure not required.

Compensation committee report not required.

503 – Prospectus Summary, Risk Factors and Ratio of Earnings to Fixed Charges No ratio of earnings to fixed charges disclosure required. No risk factors required in Exchange Act filings.
601 – Exhibits Statements regarding computation of ratios not required.

Regulation S-X

Rule Scaled Disclosure
8-02 – Annual Financial Statements

Two years of income statements rather than three years. Two years of cash flow statements rather than three years.

Two years of changes in stockholders’ equity statements rather than three years.

8-03 – Interim Financial Statements Permits certain historical financial data in lieu of separate historical financial statements of equity investees.
8-04 – Financial Statements of Businesses Acquired or to Be Acquired Maximum of two years of acquiree financial statements rather than three years.
8-05 – Pro forma Financial Information Fewer circumstances under which pro forma financial statements are required.
8-06 – Real Estate Operations Acquired or to Be Acquired Maximum of two years of financial statements for acquisition of properties from related parties rather than three years.
8-08 – Age of Financial Statements Less stringent age of financial statements requirements.

 

 

 

 

“Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”

Such was the question posed by William Hinman, Director of the Securities and Exchange Commission’s Division of Corporation Finance, in his speech at the Yahoo Finance All Markets Summit: Crypto event in San Francisco on June 14. Hinman’s answer: a qualified “yes” 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. This may be the most positive guidance yet from the SEC on when a digital asset might be deemed not to be a security under the Howey test. It may help create a pathway for blockchain startups to sell without registration or exemption digital tokens that had previously been sold in securities offerings, and should provide a measure of comfort to past and future issuers of SAFT-based ICOs.

After making his overarching point that a digital asset originally offered in a securities offering could be later sold in a manner that does not constitute an offering of a security when 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, Hinman went on to describe the circumstances under which he believes that could occur. In doing so, Hinman concentrated primarily on the last prong of the Howey test, namely whether an expectation of profit derived through the efforts of others, and suggested that the inquiry should focus on two areas: (i) who are the participants, and (ii) how is the digital asset structured?

Who are the Participants?

When determining whether a digital asset should be deemed to be an investment contract, Hinman stated that one should “consider whether a third party – be it a person, entity or coordinated group of actors – drives the expectation of a return.”

He suggested that this question will always depend on the particular facts and circumstances of a transaction, and offered the following non-exhaustive list of factors:

  • Promoter’s efforts play a significant role in the development and maintenance of the digital asset and its potential increase in value.
  • Promoter retains a stake or other interest in the digital asset such that he would be motivated to expend efforts to cause an increase in its value, particularly where purchasers are made to reasonably believe such efforts will be undertaken.
  • Amount raised in the ICO exceeds amount needed to establish a functional network and use of proceeds includes supporting the token’s value or increasing enterprise’s value
  • Promoter continues to expend funds from proceeds or operations to enhance functionality and/or value of system within which the tokens operate.
  • No persons or entities other than the promoter exercise governance rights or meaningful influence.

How is the digital asset structured?

Hinman then pointed to the existence of contractual or technical methods to structure digital assets so they function more like consumer items and less like a security, including the following:

  • Is token creation commensurate with meeting the needs of users or, rather, with feeding speculation?
  • Are independent actors setting the price or is the promoter supporting the secondary market for the asset or otherwise influencing trading?
  • Is it clear that the primary motivation for purchasing the digital asset is for personal use or consumption, as compared to investment? Have purchasers made representations as to their consumptive, as opposed to their investment, intent? Are the tokens available in increments that correlate with a consumptive versus investment intent?
  • Are the tokens distributed in ways to meet users’ needs? For example, can the tokens be held or transferred only in amounts that correspond to a purchaser’s expected use? Are there built-in incentives that compel using the tokens promptly on the network, such as having the tokens degrade in value over time, or can the tokens be held for extended periods for investment?
  • Is the asset marketed and distributed to potential users or the general public?
  • Are the assets dispersed across a diverse user base or concentrated in the hands of a few that can exert influence over the application?
  • Is the application fully functioning or in early stages of development?

Information Asymmetry

Director Hinman also pointed out that one of the rationales for the securities laws is to remove the information asymmetry between promoters and investors by mandating adequate disclosure to address that asymmetry. That disclosure regime is needed when a token purchaser relies on a token seller’s efforts to develop a network and generate a potential return on investment for the token purchaser.

Conversely, when the promoter’s efforts are no longer an important factor in determining the enterprise’s success, “material information asymmetries recede” and the protections of the securities laws may no longer be necessary. Moreover, as a practical matter, when a network becomes decentralized, the ability to identify a promoter to make the mandated disclosures “becomes difficult, and less meaningful.”

Implication for SAFTs

The Simple Agreement for Future Tokens or SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price. In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

In a SAFT-based ICO, the SAFT itself is generally acknowledged to be an investment contract and thus a security, and sold to accredited investors under Rule 506(c) of Regulation D. A quick search on EDGAR reveals there have been 37 Form D filings identifying the type of security offered as a SAFT. No court or regulator has interpreted the SAFT framework and whether or not the tokens to be ultimately issued are securities.

Director Hinman’s view that certain tokens initially issued by blockchain startups as securities may have the potential to become part of a decentralized network and no longer bear the attributes of securities may give legitimacy to SAFT-based ICOs. Interestingly, the only place where the word SAFT appears in the speech is in footnote 15 of the written version. In that footnote, Hinman states that although nothing in his remarks should be construed as opining on the legality of a SAFT (because the analysis of a particular SAFT must turn on the economic realities of the particular case), “it is clear from [his speech that he believes] that a token once offered in a security offering can, depending on the circumstances, later be offered in a non-securities transaction.”

Buried in new legislation mainly intended to ease Dodd-Frank restrictions on small banks is an expansion of Regulation A eligibility to include SEC reporting companies. Previously, such companies were not eligible. The new access to Regulation A will create a viable mini-public offering pathway for SEC reporting companies, particularly those not eligible for registering securities on the streamlined Form S-3 registration statement.

Regulation A is an exemption from registration requirements for offerings of up to $50 million in any 12-month period, subject to eligibility, disclosure and reporting requirements.  The exemption, often referred to as Regulation A+, provides for two tiers of offerings: Tier 1 for offerings of up to $20 million and Tier 2 for offerings of up to $50 million, in each case during any 12-month period. Tier 2 offerings are subject to additional disclosure and ongoing reporting requirements, but consequently benefit from preemption of state securities law registration and qualification requirements. As originally adopted, SEC reporting companies were not eligible to use Regulation A+.

On May 24, 2018, President Trump signed into law the Economic Growth, Regulatory Relief, and Consumer Protection Act, which primarily is intended to ease the burdens on smaller banks under Dodd-Frank. Buried in the Act is Section 508, entitled “Improving Access to Capital”, which expands the availability of Regulation A+ by requiring the SEC to remove the requirement that the issuer not be an SEC reporting company. Section 508 also requires the SEC to amend Regulation A+ so that any company subject to Section 13 or 15(d) of the Exchange Act will be deemed to have met the periodic and current reporting requirements of Regulation A+ if it satisfies the Section 13 reporting requirements.

Currently, public companies seeking to conduct small public offerings in the range of up to $50 million would likely register such offering with the SEC through a streamlined registration statement on Form S-3, which has certain significant benefits. Form S-3 is a short-form registration statement which allows the issuer to update the registration statement’s disclosure prospectively through incorporation by reference of the issuer’s subsequently filed current reports on Form 8-K and periodic reports on Form 10-Q and Form 10-K. This “evergreen” feature means that a company generally will not need to file any post-effective amendments to the registration statement, a time and cost saving advantage.

The process of completing a registered offering on Form S-3 is generally quicker and cheaper than even a Reg A+ offering. So as a practical matter, it’s unlikely that S-3 eligible issuers will opt to do a Reg A+ offering over S-3.

But use of Form S-3 is subject to several stringent issuer and transaction eligibility requirements, including that the issuer be organized and have its principal business operations in the United States and that it have a public float, i.e., aggregate market value of common equity held by non-affiliates, of at least $75 million (unless it’s a listed company, limits the offering amount to not more than one-third of the company’s public float during any 12-month period and is not a shell company).

So issuers that are not S-3 eligible may decide that a Reg A+ offering is an attractive alternative for raising up to $50 million. The benefits of Reg A+, even to an SEC reporting company, could be significant: freedom to “test the waters” with investors prior to launch, faster SEC review relative to registered offerings and preemption of state blue sky registration in Tier 2 offerings.

Initial coin offerings so far have gone through two major phases in their brief lifespan. The initial phase flew under the regulatory radar in an explosion of deals that raised billions of dollars seemingly overnight and without either registering the offerings with the SEC or complying with an exemption from registration. The ICO atmosphere changed drastically when the SEC issued its now famous DAO report in July 2017, which together with subsequent speecheswritten statements and enforcement actions took the position that tokens will generally be considered securities whose offering would need either to be registered with the SEC or qualify for a registration exemption such as Regulation D. That led to a second phase of issuers launching bifurcated ICOs consisting first of a sale of SAFTs to accredited investors under Regulation D, followed by the public sale of fully function tokens that sponsors would argue are not securities.

During the Senate’s February 6, 2018 committee hearing on cryptocurrencies, SEC Chairman Jay Clayton stressed the importance of disclosure for making informed decisions, but warned investors that no ICO had been registered with the SEC yet. That all seemed to change a month later when a group calling itself The Praetorian Group filed with the SEC a registration statement on Form S-1 to publicly offer and sell its cryptocurrency called PAX. With that S-1 filing, might we be entering a third phase of SEC-registered ICOs? For the reasons covered in this post, probably not.

The Registrant

The S-1 registration statement was filed by a company calling itself The Praetorian Group, and describes a dual business plan to be carried out in two phases. In the first phase, Praetorian will operate as a self-styled cryptocurrency real estate investment vehicle, or CREIV, through which it will purchase and upgrade residential and commercial real estate properties in lower income areas in New York, and then fund “outreach programs” to enrich the quality of life for the residents living in those properties. The second phase is projected to begin 12 months after the commencement of the first, and would involve the creation of a digital wallet that will convert cryptocurrencies (e.g., BTC, ETH, LTC, NEO, XLM) into local fiat currency and enable users to earn a reward in the form of PAX tokens for every purchase they make, which they can then spend, hold or sell.

What’s Wrong with this S-1?

The Praetorian S-1 is so deficient from a disclosure standpoint and so sloppy in its drafting that if the SEC bothered to review it, it may set some sort of record for number of comments in a comment letter.

Not to get overly picky, but the sloppiness starts right on the facing page. For starters, the registrant designates “The Praetorian Group” as its “exact name … as specified in its charter”, leaving out the “Inc.” It provides that the approximate date of commencement of the proposed sale to the public is “upon SEC registration as a ‘security’”. Technically, issuers may only proceed with a public offering after their registration statement is declared effective by the SEC. Also, it appears Praetorian may have marked up the facing page from an old S-1 filing, as Praetorian’s facing page form is missing a reference to emerging growth companies (EGCs).

The EGC facing page omission leads me to a more substantive observation, which is that a registrant more serious about its offering would arguably have availed itself of a JOBS Act feature that allows EGCs to submit an S-1 confidentially and undergo an initial review off the EDGAR radar screen. Why not file confidentially and clear up any disclosure and accounting issues before having to file publicly? On that score, it’s entirely possible that Praetorian isn’t even the first ICO to file an S-1, and may have been beaten in a race to the SEC by a confidential EGC filer we don’t even know about yet.

One of the sections in the S-1 that really jumped out at me is a rather bizarre liability disclaimer, which reads as follows:

To the maximum extent permitted by the applicable laws, regulations and rules the Company and/or the Distributor shall not be liable for any indirect, special, incidental, consequential, or other losses of any kind, in tort, contract, tax or otherwise (including but not limited to loss of revenue, income or profits, and loss of use or data), arising out of or in connection with any acceptance of or reliance on this Prospectus or any part thereof by you.”

Talk about an exercise in wishful thinking. Suffice it to say that I have never seen an issuer in a Securities Act registration statement attempt to disclaim liability for losses of any kind resulting from reliance on a prospectus. Federal securities law clearly allows a private plaintiff to recover damages for economic loss sustained as a result of an issuer’s material misstatements, omissions or fraud.

Pretty interesting given that Praetorian actually states that it’s “mindful of the uncertainties associated with the [SEC]’s view as to whether or not an [ICO] would constitute a ‘security’ under applicable federal securities laws” and consequently that they “believe it is more prudent to register the offering with the SEC to avoid any unanticipated regulatory issues”. It’s as if Praetorian is under the view that a registration statement is a notice filing, rather than a disclosure document to be vetted in great detail in a review process involving typically multiple rounds of comments followed by responses and registration statement amendments, and where issuers may not proceed with selling until the SEC is satisfied that all mandated disclosures have been made and accounting and other issues resolved and the SEC has declared the registration statement effective.

Another bizarre aspect of the S-1 is that Praetorian appears to be confused over whom it may sell to, or that it’s forgotten that it has filed a registration statement (which, if declared effective, would allow it to sell to anyone) and is not seeking to sell within the purchaser requirements of a given exemption:

We strongly encourage each “accredited investor” to access the various SEC websites to gain a deeper and more knowledgeable understanding of this new form of digital currency prior to investing in the PAX token.”

Either Praetorian believes it may only sell in the public offering to accredited investors (as is the case in a private offering exemption under Rule 506(c)), or it strangely thinks that only accredited investors (which by definition must have a minimum net worth or annual income) need to be encouraged to inform themselves of the risks associated with ICOs.

Another glaring deficiency is the lack of risk factor disclosure. The only risk included in the section entitled “Risks and Uncertainties” is the risk that it may not be successful in achieving secondary market listings of the PAX token. Otherwise, the section simply consists of a conclusory statement that prospective purchasers of tokens should evaluate all risks and uncertainties associated with the company, the tokens, the token sale and the business plan prior to any purchase of tokens.

Finally, Praetorian’s S-1 omits in totality all of the information required in Part II of S-1. This includes expenses of issuance and distribution, indemnification of directors and officers, recent sales of unregistered securities, exhibits, financial statement schedules and certain required undertakings.

Conclusion

The Praetorian Guard was an elite unit of the Imperial Roman Army whose members served as personal bodyguards to the Roman emperors, sort of like the Roman equivalent of today’s Secret Service that protects the President. Although the ancient Praetorians continued to serve in that capacity for roughly three centuries, they became notable for their intrigue and interference in Roman politics, including overthrowing emperors and proclaiming successors. In the year 312, the Praetorian Guard was disbanded by Constantine the Great. Like its namesake, The Praetorian Group has generated a fair amount of intrigue with its S-1 filing, but I can only imagine that the great examiners of the SEC will take a page out of Constantine’s playbook and disband this Praetorian Group’s S-1 registration statement.

The Wall Street Journal ominously reported on February 28 that the Securities and Exchange Commission recently issued dozens of subpoenas to initial coin offering issuers and their advisors demanding information about the structure of their ICOs. Although the Commission has yet to officially acknowledge them, the subpoenas are consistent with a series of SEC enforcement actions alleging fraud or illegal sale of securities (see, e.g., here and here) and public speeches and statements warning ICO participants about regulatory compliance and promising greater scrutiny and enforcement (see, e.g., here, here and here).  Nevertheless, the enforcement actions and speeches don’t appear to have had much success in slowing down the pace of the ICO market.  Coinschedule reports that ICOs have raised over $3.3 billion in 88 deals already in 2018 through March 16, and is on pace to exceed the estimated $5.6 billion raised in 2017. The latest SEC subpoena campaign coupled with the accelerating pace of deals suggests the Commission believes its message is not resonating in the ICO market.

Although I’m grateful I didn’t find one of the subpoenas in my mailbox, I’m definitely curious about their contents.  Coindesk quotes industry sources who have seen several of the ICO subpoenas as saying that the requested information includes investor lists, emails, marketing materials, organizational structures, amounts raised, location of funds and people involved and their locations. It also cites an anonymous industry lawyer saying that the 25-page subpoena received by his client was “hyper-detailed” and that it asked for “every bit of communication around the token launch.”

So what exactly is the Commission focusing on?  Many naturally believe the Commission is primarily targeting fraud.  But the Journal, Coindesk and others suggest a different focus: Simple Agreements for Future Tokens or SAFTs.

The SAFT is modeled after Y Combinator’s Simple Agreement for Future Equity, or SAFE, which has been a popular mechanism for funding startups. With both the SAFE and the SAFT, the investor receives a right to something of value in the future in exchange for the current investment. With a SAFE, the investor gets the right to receive the security issued in the issuer’s next major funding round, typically preferred stock and usually at a discount to the next round’s price.  In a SAFT, the investor is given the right to receive tokens, also at a discount, typically once the network is created and the tokens are fully functional.

My first observation is that there may be some confusion in the media regarding SAFTs and Federal securities law, with some seeming to suggest that there may be a conflict of opinion about whether the SAFT itself is a security or whether the contract itself is illegal or non-compliant.  I’ve seen statements such as “what will happen to those who invested time and money if SAFTs don’t satisfy securities law?” and “what happens if the SEC comes out and says SAFTs are illegal”? Crowdfund Insider ran a piece with this provocative title: “Bad News: SAFTs May Not Be ‘Compliant’ After All”.

There should be no controversy regarding the SAFT itself (as opposed to the tokens that ultimately get issued). Protocol Labs and Cooley’s SAFT White Paper states in no uncertain terms that the SAFT is a security and must satisfy an exemption from registration, and contemplates compliance with Rule 506(c) under Regulation D.  I haven’t seen or heard anyone suggesting otherwise.  In fact, each SAFT investor is required to represent in the SAFT that it “has no intent to use or consume any or all Tokens on the corresponding blockchain network for the Tokens after Network Launch” and “enters into this security instrument purely to realize profits that accrue from purchasing Tokens at the Discount Price”. Accordingly, there should be no Federal securities law issue with the issuance of the SAFT itself, assuming of course that the issuer complies with Rule 506(c)’s requirements, i.e., disclosure obligations, selling only to accredited investors, using reasonable methods to verify accredited investor status and filing Form D.

The real issue is whether the eventual tokens, assuming they are issued to investors only when the network is created and the tokens fully functional, are necessarily not securities because of their full functionality.  SAFT proponents argue that fully functional tokens fail the “expectation of profits” and/or the “through the efforts of others” prongs of the Howey test, and thus should not be deemed to be securities. The SAFT White Paper analyzes these two prongs of the test from the perspective of the two likely categories of purchasers of tokens: actual token users and investors.  In the case of actual users, their bona fide desire to make direct use of the relevant consumptive aspect of a token on a blockchain-based platform predominates their profit-seeking motives, so arguably they fail the “expectation of profit” prong of Howey.  Investors, on the other hand, clearly expect a profit from resale of the tokens on a secondary market; that profit expectation, however, is usually not predominantly “through the efforts of others” (because management has already brought the tokens to full functionality) but rather from the myriad of factors that cause the price of assets to increase or decrease on an open market.

Opponents of the SAFT approach (see, e.g., Cardozo Blockchain Project’s Not So Fast—Risks Related to the Use of a “SAFT” for Token Sales) reject the concept of a bright-line test, i.e., they reject the notion that the question of whether a utility token will be deemed a security solely turns on whether the token is “fully functional”.  They maintain that courts and the SEC have repeatedly, and unambiguously, stated that the question of whether or not an instrument is a security is not subject to a bright-line test but rather an examination of the facts, circumstances and economic realities of the transaction.  Opponents also assert that the SAFT approach actually runs the risk of increasing regulatory scrutiny of utility token issuers because of the emphasis on the speculative, profit-generating aspects of the utility tokens (e.g., the investor reps referred to above), which could ironically transform an inherently consumptive digital good (the token itself) into an investment contract subject to federal securities laws.  Others have suggested that reliance on the efforts of management doesn’t end with full functionality of the tokens, and that ultimately the success of the network and hence the investment will turn on whether management is successful in overcoming competition.

If anything, the Commission’s subpoena campaign suggests that the SAFT opponents correctly predicted the increased regulatory scrutiny.  And the increased regulatory scrutiny through the subpoena campaign is a stark warning to ICO issuers and counsel that SAFTs may not be completely safe after all.