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.

Bloomberg reported on October 16 that over $3 billion dollars have been raised in over 200 initial coin offerings so far this year. It remains to be seen whether the pace of ICOs will slow down in the face of regulatory headwinds such as the outright ICO bans in China and South Korea. Here in the United States, the Securities and Exchange Commission has been sounding alarm bells. On July 25, the SEC’s Division of Enforcement issued a Report of Investigation finding that tokens offered and sold by a virtual organization known as “The DAO” were securities and therefore subject to the federal securities laws. I blogged about it here. On the same day the SEC issued the report, its Office of Investor Education and Advocacy issued an investor bulletin to make investors aware of potential risks of participating in ICOs.  Then on September 29, it charged a businessman and two companies with defrauding investors in a pair of ICOs purportedly backed by investments in real estate and diamonds. And on November 1, it issued a “Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others”, warning that any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

Needless to say, the days of ICOs flying below the SEC’s radar are over, and developers conducting token sales to fund the development of a network need to be aware of the securities law implications of the sale.  In its Report of Investigation, the SEC made clear (what most of us suspected all along) that the traditional Howey test for determining whether a funding mechanism is an ”investment contract” and thus a “security” applies to blockchain based tokens. I won’t go into a deep dive here. For those wanting to jump into the weeds, Debevoise has done a pretty good job on this. But the basic test under Howey is that an agreement constitutes an investment contract that meets the definition of a “security” if there is (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) solely from the efforts of others.

It’s useful to consider that blockchain tokens fall generally into two broad categories. “Securities tokens” are basically like shares in a corporation or membership interests in a limited liability company where the purchaser receives an economic right to a proportional share of distributions from profits or a sale of the company. On the other hand, “utility tokens” don’t purport to offer purchasers an interest or share in the seller entity itself but rather access to the product or service the seller is developing or has developed. Unfortunately, there exists virtually no SEC or case law guidance on securities law aspects of utility tokens. The token at issue in the SEC’s investigative report on The DAO was a securities token. The DAO was a smart contract on the Ethereum blockchain that operated like a virtual venture fund. Purchasers would share in profits from the DAO’s investments and so the tokens were like limited partnership interests.

The question of whether utility tokens are securities may turn on whether the blockchain network for which the tokens will function is fully functional or still in development, and an interesting debate has emerged as to whether there should be a bright line test on that basis.

One side of the debate, advanced by Cooley (Marco Santori) and Protocol Labs (Juan Batiz-Benet and Jesse Clayburgh), is that purchasers of utility tokens prior to network launch and before genuine utility necessarily rely on the managerial and technical efforts of the developers to realize value from their tokens. Accordingly, agreements for the sale of pre-functional tokens meet the “expectation of profit” and “through the efforts of others” prongs of Howey and should be characterized as securities. On the other hand, fully functional utility tokens should not be considered securities because they fail the “through the efforts of others” prong of Howey and maybe even the “expectation of profit” prong.  Purchasers of fully functional tokens are likely to be people seeking access to the seller’s network as consumers or app developers with any expectation of profit from appreciation of the tokens being a secondary motivation, so the expectation of profit prong of Howey fails as to those purchasers. The same conclusion should apply even as to the other type of purchaser who is motivated primarily by the prospect of a token resale for profit because the profit that is hoped for is not expected to come through the managerial or entrepreneurial efforts of the developers, but rather through the many different independent forces that drive supply and demand for the tokens. There is a line of cases involving contracts for the purchase of commodities holding that they are not securities because the expectation of profit was solely from fluctuations in the secondary market, and not from any efforts on the part of the producer. Fully functional tokens are analogous to commodities in that the token developers have completed development of the network, and so there should not be any expectation that profit will result from any further efforts by the seller.

On the other side of the debate is Debevoise, which advocates for a facts and circumstances approach, rejects the bright line test of whether or not a utility token is fully functional and offers several arguments. The determination of whether an agreement is an investment contract and thus a security has long been based upon a facts and circumstances analysis. A blockchain token is not a homogenous asset class; a token could be a digital representation of an equity or debt security but it could also represent things like hospital records or a person’s identity, and that particular character of the token is unaffected by whether the network is or is not fully functional. Also, there is an implicit recognition in the JOBS Act that pre-order sales on non-equity crowdfunding sites like Kickstarter and Indiegogo are not sales of securities, and that pre-functional utility token sales should be analyzed the same way.  It also questions whether agreements by a mature company to presell a new product in development would automatically be deemed an investment contract. Finally, there’s the difficulty of determining when exactly a token is fully-functional given the complexity of software and network development.

Seems to me that the arguments on both sides of the utility token debate have merit.  I do think there’s a distinction, though, between pre-order sales of product by a mature company and a sale of pre-functional tokens, in that the tokens most likely can be sold on a secondary market, with any profit likely resulting from the entrepreneurial efforts of the developer.  I also think that until we have guidance from the SEC and/or judicial opinions on the issue, the better approach is to treat clearly pre-functional tokens as investment contracts and conduct their sale under an exemption from registration.