Among the many challenges companies are facing during the COVID-19 pandemic is how to conduct their shareholder meetings. Current social distancing requirements are effectively forcing companies to choose between postponing meetings and conducting them virtually. This requires careful attention to state executive orders, the relevant corporate statute, the company’s certificate of incorporation and by-laws, as well as SEC rules and recent guidance in the case of public companies. Several states, including New York and Delaware, have issued executive orders designed to facilitate virtual meetings, and the SEC has issued virtual meeting proxy guidance, including for companies that mailed proxy materials to shareholders but wish to change to virtual meetings because of social distancing concerns.

State Corporate Law

State corporate statutes dictate how shareholder meetings are to be conducted, including whether and to what extent such meetings may be held virtually.

For corporations incorporated in New York, the Business Corporation Law (the “BCL”) requires that shareholder meetings be held at such place fixed by the company’s by-laws. Although the BCL allows remote shareholders to participate electronically (provided reasonable procedures are in place to enable participation and voting), the statute does not explicitly authorize virtual-only meetings and has generally been understood to require a physical location. On March 20, 2020, however, Governor Cuomo issued Executive Order No. 202.8, which among other COVID-19 emergency measures temporarily suspends the BCL’s meeting requirements “to the extent they require meetings of shareholders to be noticed and held at a physical location” through April 19, 2020, subsequently extended by further executive order to May 7, 2020. Essentially, the order temporarily permits New York corporations to hold annual and special shareholder meetings solely by means of remote communication.

For Delaware corporations, if the organizational documents do not require a physical location, the annual meeting may be held virtually (i.e., telephonically or online). However, Delaware law requires reasonable measures to ensure stockholders may meaningfully participate in the virtual meeting through a secure and verifiable process, which focuses on access to the meeting, voting and access to the stockholder list.

SEC Guidance and Delaware Clarification

On March 13, 2020 (updated as of April 7), the SEC’s Division of Corporation Finance issued guidance on holding virtual shareholders meetings, including guidance on transitioning from a previously noticed in-person meeting to a virtual or hybrid (i.e., in-person meeting that permits electronic shareholder participation) annual meeting format. The guidance requires companies planning to conduct a virtual or hybrid meeting to take the following steps:

  • Notify shareholders of such in a timely manner with information on the logistical details of the virtual or hybrid meeting, including how shareholders can remotely access, participate in and vote at the meeting.
  • Companies that haven’t yet filed definitive proxy materials should include the above disclosures in the definitive proxy statement and other soliciting materials.
  • Companies that have already filed and mailed proxy materials and seek to change to a virtual or hybrid meeting should issue a press release announcing the change, file the press release as definitive additional soliciting material on EDGAR and take all reasonable steps necessary to inform other intermediaries in the proxy process (e.g., proxy service providers) and other relevant market participants (e.g., the relevant national securities exchanges) of the change.

The guidance unintentionally gave rise to concern among Delaware corporations that a press release meeting the above SEC guidance would not necessarily qualify as effective notice under Delaware law. Consequently, Delaware Governor John Carney clarified the ambiguity by issuing an executive order on April 6 that a press release announcing a change from an in-person to a virtual or hybrid meeting due to COVID-19 issues and otherwise in compliance with the SEC’s guidance will constitute effective notice under Delaware law, provided it is promptly posted on the company’s website. The order also provides that if alternatively the meeting is adjourned, the company would not be required to call the meeting to order in order to adjourn, but would permit such adjournment to be announced solely by means of the SEC filing and press release.

Practical Considerations

There are some best practices emerging for conducting a virtual or hybrid annual meeting, including the following:

  • Engaging a remote communication service provider (such as Broadridge or Computershare) to host the virtual or hybrid meeting.
  • Ensuring the remote communication method allows shareholders to vote, make comments, ask questions, hear answers and otherwise exercise all of the rights shareholders have under state law for participation in shareholder meetings.
  • Ensuring the technology platform used to conduct the virtual meeting will accommodate all of the shareholders, board members, members of management, and other persons participating in the meeting.
  • Making shareholders aware of the procedures necessary to access and participate in the virtual meeting.

Venture-backed companies did not receive the relief they had hoped for this past Friday, April 3rd, when the Small Business Administration (“SBA”) issued affiliation rule guidance on the Paycheck Protection Program (“PPP”) created under the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”). The guidance largely affirms existing SBA regulations as they previously applied to SBA 7(a) loans and includes no affiliation rule waiver other than the limited waivers in the CARES Act. The absence of an applicable waiver means most venture-backed companies will need to include employees of other portfolio companies of their VC investors in determining whether they fall below the 500 employee limit for PPP eligibility. Without any further relief, PPP loans will not be extended to venture-backed companies, many of which are vital in the fight against the Coronavirus pandemic.


The CARES Act temporarily adds a new Paycheck Protection Program to the SBA’s 7(a) loan program providing guarantees for forgivable loans of up to $10 million (capped at $349 billion in the aggregate). The PPP is intended to provide economic relief to small businesses adversely impacted by COVID-19. An entity is generally eligible for the PPP if it, combined with its “affiliates”, has 500 or fewer employees whose principal place of residence is in the United States or is a business that operates in a certain industry and meets applicable SBA employee-based size standards for that industry. If two or more companies are deemed affiliates of each other, all employees of each of the affiliated entities are aggregated for the purpose of calculating the 500 employee threshold.

Without a waiver of the SBA affiliation rules, venture backed companies would be deemed affiliates of all other companies in their VC investor’s portfolio and would be required to aggregate employee numbers with those of the other portfolio companies.  Moreover, many venture backed companies have multiple VC investors.  Some receive investment from corporate VCs, where the related corporate entity single-handedly employs more than 500 persons.

On April 3, the SBA issued guidance on application of the SBA’s affiliation rules to the PPP in the form of an interim final rule and a summary of the applicable affiliation tests (together, the “PPP Affiliation Guidance”).  The day before the release of the PPP Affiliation Guidance, House minority leader Kevin McCarthy told the Axios Pro Rata Podcast the waiver would happen: “I just got off the phone with Treasury Secretary Mnuchin and this is going to be solved.” Speaker Nancy Pelosi also pushed for relief.  Nevertheless, the PPP Affiliation Guidance gave venture backed companies no satisfaction.

Determining Affiliate Status

Under the PPP Affiliation Guidance, any of the circumstances described below would be sufficient to establish affiliation for applicants for the Paycheck Protection Program.

  • Affiliation based on ownership. An entity is an affiliate of another entity that owns or has the power to control more than 50 percent of the first entity’s voting equity. If no individual or entity is found to control, the SBA will deem the board of directors or president or chief executive officer (or other officers, managing members, or partners who control the management of the entity) to be in control of the entity. The SBA will deem a minority shareholder to be in control, if that individual or entity has the ability, under the concern’s charter, by-laws or shareholder’s agreement, to prevent a quorum or otherwise block action by the board of directors or shareholders.
  • Affiliation arising under stock options and convertible securities. In determining size, the SBA considers stock options, convertible securities and agreements to merge (including agreements in principle), to have a present effect on the power to control an entity. The SBA treats such options, convertible securities and agreements as though the rights granted have been exercised. An individual or other entity that controls one or more other entities cannot use options, convertible securities or agreements to appear to terminate such control before actually doing so.  The SBA will not give present effect to an individual’s or entity’s ability to divest all or part of its ownership interest in order to avoid a finding of affiliation.
  • Affiliation based on management. Affiliation arises where the CEO or president (or other officers, managing members or partners who control management) also controls the management of one or more other concerns. Affiliation also arises where a single individual or entity that controls the board or management of one entity also controls the board or management of one of more other entities. It also arises where a single individual or entity controls the management of the applicant entity through a management agreement.
  • Affiliation based on “totality of the circumstances”.       The SBA may consider all connections between the borrower and a possible affiliate and, if no single factor is sufficient to constitute affiliation, the SBA may determine on a case-by-case basis that affiliation exists when there is “clear and convincing evidence” based on the totality of the circumstances.

Who’s in Control?

VC funds typically own less than 50% of the voting securities of their portfolio companies, primarily to preserve proper management incentives, and compensate for its minority position by negotiating for certain control rights. In the VC context, affiliation typically comes down to an analysis of those control rights. Because SBA affiliation rules do not specify the exact control rights that will or will not trigger affiliate status, determinations must be made on a case-by-case analysis of relevant administrative case law guidance to determine loan eligibility.

Based on a review of SBA Office of Hearings and Appeals (the “OHA”) case law, the National Venture Capital Association put together a handy list of block rights which would constitute the type of control sufficient to trigger affiliate status.

In Control

The existence of a block right by a VC fund, exercisable either by the fund itself at the stockholder level or by its designee(s) at the board level, over any of the following actions would likely constitute the type of control that triggers affiliate status for PPP eligibility purposes:

  • Making, declaring, or paying distributions or dividends other than tax distributions.
  • Establishing a quorum at a meeting of stockholders (and likely, by extension, at a meeting of the board).
  • Approving or making changes to the company’s budget or approving capital expenditures outside the budget.
  • Determining employee compensation.
  • Hiring and firing officers and executives.
  • Changes in the company’s strategic direction.
  • Establishing or amending an incentive or employee stock ownership plan.
  • Incurring or guaranteeing debts or obligations.
  • Initiating or defending a lawsuit.
  • Entering into contracts or joint ventures.
  • Amending or terminating leases.

Out of Control

By contrast, the NVCA’s review of OHA case law shows that VC funds may have block rights over the following extraordinary decisions without triggering affiliate status:

  • Selling all or substantially all of the company’s assets.
  • Placing an encumbrance or lien on all or substantially all of the company’s assets.
  • Engaging in any action that could result in a change in the amount or character of a company’s capital contributions.
  • Changing the company’s line of business.
  • Engaging in a merger transaction.
  • Issuing additional stock/equity.
  • Amending the organizational documents of a company.
  • Filing for bankruptcy.
  • Amending the governing documents to materially alter the rights of the existing owners.
  • Dissolving the company.
  • Increasing, decreasing, or reclassifying the authorized capital of the company.
  • Increasing or decreasing the size of the board.
  • Entering into a confession of judgment.
  • Disposing of the goodwill of the company.
  • Committing to take any action that would make it impossible for the company to carry on its ordinary course of business.


As of now, many of the companies that would be excluded from PPP loan eligibility by a strict read of the SBA’s affiliation rules are precisely the innovative emerging companies vital to the fight against the new Coronavirus, namely biotechs developing vaccines and therapies, technology companies developing testing solutions, medical device companies and PPE companies. For that reason, it is expected that there will be continuing pressure for a regulatory or legislative fix for the affiliation rule problem as it would impact venture-backed companies. Whether the fix arrives in time is anyone’s guess. The PPP will be open only until the earlier of either June 30, 2020 or when the $349 billion cap in funding is exhausted.

Public companies stressing over how to meet filing deadlines during the COVID-19 crisis and what to say about the pandemic’s impact just received a filing reprieve and disclosure guidance from the SEC. The Securities and Exchange Commission issued an order on March 25, 2020 conditionally extending the deadlines for certain public company filings under the federal securities laws. On the same day, the staff of the SEC’s Division of Corporation Finance issued guidance on disclosure considerations and other securities law matters related to COVID-19.

Filing Extensions

Subject to certain conditions summarized below, SEC filers will have a 45-day extension to file certain disclosure reports that would otherwise have been due between March 1 and July 1, 2020. For example, a smaller reporting company with a normal filing deadline of March 30, 2020 for its Annual Report on Form 10-K will now have an extended deadline of May 14, 2020.

To qualify for the filing extension under the order, a filer must (i) be unable to meet a filing deadline due to circumstances related to COVID-19 and (ii) file a Current Report on Form 8-K (or Form 6-K) for each delayed filing by the later of March 16, 2020 or the original filing deadline of the report stating:

  • that it is relying on the order;
  • a brief description of the reasons why it could not file the report, schedule or form on a timely basis;
  • the estimated date by which the report, schedule, or form is expected to be filed; and
  • company-specific risk factors explaining the impact, if material, of COVID-19 on its business, which may be subject to the protections of the statutory safe harbor for forward-looking statements.

If the reason the report cannot be filed timely relates to the inability of any person, other than the company, to furnish any required opinion, report or certification, the Form 8-K (or Form 6-K) must attach as an exhibit a statement signed by that person stating the specific reasons why that person is unable to furnish the required opinion, report or certification on or before the date the report must be filed.

A registrant relying on the order would not need to file a Form 12b-25 so long as the report, schedule or form is filed within the time period prescribed by the order. The SEC order does not apply to Schedule 13D filings or amendments to a previously-filed Schedule 13D. Finally, the SEC order also does not apply to Section 16 beneficial ownership reports on Forms 3, 4 and 5.

COVID-19 Disclosure Guidance

Also on March 25, 2020, the staff of the SEC’s Division of Corporation Finance provided guidance on disclosure and other securities law obligations relating to COVID-19. The guidance provides a series of factors for companies to consider when drafting COVID-19 disclosure, including the following:

  • COVID-19’s impact on financial condition and results of operations, future operating results and near-and-long-term financial condition.
  • COVID-19’s impact on capital and financial resources, including overall liquidity position and outlook, cost of or access to capital and funding sources.
  • Material uncertainty about ongoing ability to meet credit agreements covenants because of the impact.
  • Course of action taken or proposed to be taken to remedy any material liquidity deficiency.
  • COVID-19’s effect on the company’s balance sheet and the company’s ability to account timely for those assets.
  • Anticipation for any material impairments (e.g., with respect to goodwill, intangible assets, long-lived assets, right of use assets, investment securities), increases in allowances for credit losses, restructuring charges, other expenses, or changes in accounting judgments that have had or are reasonably likely to have a material impact on the financial statements.
  • Adverse impact of any COVID-19-related circumstances such as remote work arrangements on the company’s ability to maintain operations, including financial reporting systems, internal control over financial reporting and disclosure controls and procedures.
  • Any expectation that COVID-19 will materially affect the demand for the company’s products or services.
  • Whether the company anticipates a material adverse impact of COVID-19 on supply chain or methods used to distribute products or services.
  • Whether operations will be materially impacted by any constraints or other impacts on human capital resources and productivity.
  • Whether travel restrictions and border closures are expected to have a material impact on ability to operate and achieve business goals.

The guidance also confirmed the need for companies and insiders to refrain from trading in the company’s securities prior to dissemination of material non-public information. For example, where COVID-19 has affected a company in a way that would be material to investors or where a company has become aware of a risk related to COVID-19 that would be material to investors, the company, its directors and officers, and other corporate insiders who are aware of these matters should refrain from trading in the company’s securities until such information is disclosed to the public.

It’s not often that an SEC Commissioner quotes Bruce Springsteen – not once, but twice – in a speech on securities regulation. But SEC Commissioner Hester Peirce did just that in a February 6, 2020 speech in which she unveiled her novel proposal for a digital asset safe harbor. The proposal would create a three-year securities regulatory grace period during which digital network developers could distribute digital tokens while building a decentralized or functional network, provided they engage in good faith efforts to achieve decentralization or functionality within three years, fulfill disclosure obligations, sell the tokens with a purpose of facilitating network access, participation or development, undertake reasonable efforts to create token liquidity and file a reliance notice with the SEC.

Commissioner Pierce’s proposal may be the most significant since Commissioner William Hinman’s speech at the June 14, 2018 Yahoo Finance Conference in which he set forth the now generally accepted proposition that a digital asset originally offered in a securities offering could later be sold in a manner that does not constitute an offering of a security, where there is no longer any central enterprise being invested in or where the digital asset is sold only to be used to purchase a good or service available through the network on which it was created, i.e., where the network is either decentralized or functional.

Commissioner Peirce opened her speech (after quoting the Boss) by describing what she referred to as a regulatory Catch 22. Digital token network developers fear distributing tokens until the network is either decentralized or fully functional because doing so would violate the Securities Act. But they can’t develop a centralized or fully functional network unless they widely distribute the tokens to many people. Developers’ enforcement concerns are well founded given the Commission’s digital token offering enforcement campaign over the last two years, and I’ve blogged about it extensively. See, for example, here, here, here and here for my most recent posts on digital token sale enforcement.

Commissioner Peirce’s proposal seeks to resolve the regulatory Catch 22 by bridging the gap between a blockchain network’s initial centralized phase (when the tokens would be deemed to be securities) and its hoped-for decentralized or fully functional stage. The safe harbor would provide network developers a three-year grace period to facilitate development of and participation in a decentralized network by exempting (i) the offer and sale of tokens from the provisions of the Securities Act of 1933, (ii) the tokens from registration under the Securities Exchange Act of 1934 (the “Exchange Act”), and (iii) persons engaged in certain token transactions from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.

To qualify for the proposed safe harbor, digital token network developers would have to meet the following five conditions:

  1. Reasonable Development Efforts: The development team must intend for the network to reach network maturity, defined as either decentralization or token functionality, within three years of the date of the first token sale and undertake good faith and reasonable efforts to achieve that goal.
  2. Disclosure. Disclosure of material information on a freely accessible public website, including source code and transaction history, description of the purpose, protocol and operations of the network, plan of development, prior token sales, initial development team and certain token holders, any secondary trading platforms on which the token trades and any member token sales of five percent or more.
  3. Purpose of Token Sales. The tokens must be offered and sold for the purpose of facilitating access to, participation on or the development of the network. This condition is intended to clarify that the safe harbor is not appropriate for debt or equity securities masquerading as tokens.
  4. Token Liquidity. The development team must undertake good faith and reasonable efforts to create liquidity for token holders.
  5. Notice of Reliance. The development team must file a notice of reliance on EDGAR within 15 days following the date of the first token sale in reliance on the safe harbor.

The safe harbor is not intended to provide immunity from fraud and is subject to bad actor disqualification under the securities laws.

Previously, compliant token offerings have been conducted pursuant to offering exemptions under Rule 506(c) of Regulation D or under Regulation A+. As Commissioner Peirce notes, however, because Rule 506(c) requires that sales be made only to accredited investors and there aren’t enough accredited investors to go around, this poses a built-in impediment to building a decentralized network. As to the alternative, Regulation A+, Commissioner Peirce observes the costs of conducting such a “mini-IPO” can be prohibitive. And even if a development team has the financial resources to do so, once the token is a security it must trade as a security while a core benefit of a token network is its non-reliance on intermediaries — people transact directly with one another. Having to buy or sell tokens through a registered broker-dealer or on a registered exchange would impede the development of a thriving, decentralized crypto network.

Finally, the condition that the development team promote liquidity in the tokens may seem antithetical to the securities offering law doctrine that generally holds that attempts to facilitate secondary trading is one indicator of a securities offering. Commissioner Peirce recognizes this, but seeks to reconcile the apparent contradiction by positing that in the context of the safe harbor, secondary trading is necessary both to get tokens into the hands of people who will use them and to offer developers and network service providers a way to exchange their tokens for fiat or crypto currency.

The Securities and Exchange Commission is proposing to expand the definition of “accredited investor” to include additional entities that could bear the economic risks of investment and certain financially sophisticated persons irrespective of income or wealth. The Commission’s main objective is to identify more effectively institutional and individual investors that have the knowledge and expertise to participate in private capital markets and thus do not need the protections of registration.  If adopted, the proposed expansion would significantly benefit issuers and investors alike.

Regulation D and Current Accredited Investor Definition

Private offerings conducted under Rule 506 of Regulation D play a significant role in capital formation in the United States. In 2018, an estimated $1.7 trillion was raised in Rule 506 offerings, as compared with $1.4 trillion raised in registered offerings. Of the $1.7 trillion raised in private offerings, $1.5 trillion went to investment funds and $228 billion to operating issuers.

Rule 506 allows an issuer to sell shares to an unlimited number of “accredited investors” and up to 35 non-accredited investors. As a practical matter, however, the vast majority of issuers in Rule 506 offerings offer and sell the offered securities only to accredited investors. The reason for this is a built-in disclosure bias in favor of accredited investor-only offerings: if you sell only to accredited investors, you do not have to satisfy the specific, mandated and rather onerous disclosure requirements set forth in Regulation D. Instead, an issuer selling only to accredited investors may determine for itself what is material and what is not, and satisfy its disclosure obligation through the concept of “access”, whereby the investors are given access to information offered to or requested by the investors and an opportunity to ask questions directly. The theory here is that an accredited investor is able to fend for himself and has the leverage to extract information.

Currently, the term “accredited investor” means anyone who fits any of the following categories:

  • banks, registered broker-dealers, certain insurance companies and certain employee benefit plans with more than $5 million in assets;
  • private business development companies;
  • 501(c)(3) companies, corporations, business trusts and partnerships, in each case exceeding $5 million in assets and not formed to acquire the offered securities;
  • directors, executive officers and general partners of the issuer of the securities, or any director, executive officer or general partner of a general partner of that issuer;
  • individuals with net worth, or joint net worth with spouse, exceeding $1 million;
  • individuals with income of over $200,000 (or $300,000 with spouse) in each of two most recent years, with reasonable expectation of earning at least same in current year;
  • trusts with assets exceeding $5 million not formed to acquire the offered securities, whose purchase is directed by a sophisticated person; or
  • entities in which all of the equity owners are accredited investors.

In June 2019, the Commission issued a concept release that solicited public comment on ways to simplify and improve the exempt offering framework to promote capital formation and expand investment opportunities while still maintaining appropriate investor protections. In the concept release, the Commission requested comments on possible approaches to amending the definition of “accredited investor” in Rule 501(a) of Regulation D.

Historically, the accredited investor definition used income level and wealth as a proxy for both capacity to sustain investment loss and for financial sophistication. The problem with the old approach is that it excluded investors who are financially sophisticated but do not meet the income and wealth criteria. In this regard, the concept release requested comment on the use of sophistication measures other than income and net worth to expand the universe of accredited investors.

Proposal to Expand Accredited Investor Definition

The Commission’s current proposal to expand the accredited investor definition was presented in its release dated December 18, 2019 entitled Amending the “Accredited Investor” Definition (the “Release”). The Release is premised on the Commission’s stated belief that wealth and income should not be the sole means of establishing financial sophistication for purposes of the accredited investor definition. Accordingly, it seeks to create new categories of individuals who would qualify as accredited investors irrespective of wealth and income on the basis that such investors have the requisite financial sophistication to assess an investment opportunity. It also seeks to add new categories and add to existing categories of entities that can fend for themselves as a result of asset ownership or investment in securities.

The proposed revised definition would add the following categories of individuals and entities as “accredited investors”:

  • individuals with a license as a general securities representative (Series 7), investment adviser representative (Series 65) or private securities offerings representative (Series 82);
  • “knowledgeable employees” of a private fund, as to investments in that fund;
  • registered investment advisers (but not “exempt reporting advisers” relying on the venture capital adviser exemption or private funds adviser exemption);
  • “family offices” with at least $5 million in assets under management, directed by a sophisticated person and not formed to invest in the offered securities, as well as their “family clients”;
  • entities owning “investments” of more than $5 million, so long as the “investments” fall within Rule 2a51-1(b) of the Investment Company Act and so long as the entity was not formed for the specific purpose of investing in the offered securities;
  • limited liability companies exceeding $5 million in assets not formed to acquire the offered securities; and
  • rural business investment companies.

Benefit to Issuers and Investors

The proposed amendment to the accredited investor definition could prove enormously advantageous to issuers and investors beyond the obvious expansion of the universe of accredited investors who supply the vast majority of private capital in the U.S.  The benefit of an expanded accredited investor definition to Regulation A issuers is that accredited investors are not subject to the Tier 2 investment cap.  In Regulation Crowdfunding offerings, the expanded definition would mean enhanced resale opportunities inasmuch as securities purchased in a Regulation CF offering may not be resold for a one year period other than to accredited investors, the issuer or family members (or in a registered sale).  The reasonable verification requirement has been identified as an impediment to Rule 506(c) offerings, and the expansion of the definition to include those with professional certifications would provide issuers with more palatable methods to verify status. For holders of restricted securities, an expanded accredited investor pool would make it easier to conduct a private resale under Rule 4(a)(7) which requires that the purchaser be an accredited investor.  If the proposed rules indeed make it easier to conduct private resales of restricted securities, this could lead to lower liquidity discounts and thus higher prices.

Finally, the Release also proposes to amend the definition of “qualified institutional buyer” for purposes of the resale exemption under Rule 144A to include additional entity types that meet the $100 million threshold to avoid inconsistencies between the types of entities that are eligible for accredited investor status and those that are eligible for qualified institutional buyer status under Rule 144A.

The Commission is seeking input on its proposed amendments to the accredited investor definition, and comments may be communicated using the Commission’s internet comment form, by email to or by mail to Vanessa A. Countryman, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090. Published comment letters, including your humble blogger’s January 13, 2020 comment letter regarding inclusion as accredited investors limited liability companies with more than $5 million in assets not formed to invest in the offering, as well as managers of manager-managed LLCs, could be found here. Comments need to be received by the Commission not later than March 15, 2020 (60 days after the Release’s January 15, 2020 publication in the Federal Register).

On September 30, 2019, the Securities and Exchange Commission announced that blockchain developer had agreed to pay a $24 million fine to settle charges that it had engaged in an unregistered offering of securities in violation of Section 5 of the Securities Act.  The announcement set off a mini-firestorm of criticism in the crypto community because the $24 million penalty seemed disproportionately small relative to the $4 billion it raised in its ICO and relative to the penalties imposed on other ICO issuers targeted by the Commission in similar cases not involving fraud.  Moreover, was not hit with any of the non-monetary sanctions imposed in the other cases, namely rescission, registration and bad actor disqualification. The apparent enforcement disconnect has resulted in confusion among ICO issuers, exchanges, lawyers and other players in the space, along with demands for an explanation from the Commission and predictions that the case signals a relaxation of enforcement policy. A closer look at the circumstances of’s ICO, however, suggests another possibility.

Rescission, Registration and Bad-Actor Disqualification

Before, Commission sanctions in unregistered offering cases not involving fraud allegations such as Airfox and ParagonCoin included rescission, registration and bad-actor disqualification.

Rescission refers to the process of remedying a securities violation by offering investors the right to rescind their purchase of securities and receive a repayment of their investment. Purchasers who reject the offer lose the right to bring a private action under state securities law, but it is unclear whether federal claims are barred as well. The Commission has taken the position through no-action letters that rescission offers don’t eliminate Federal securities liability to those rejecting the offer, but Federal courts have held the opposite.

The mechanics of the rescission obligation under previous settlement orders begin with the requirement to issue a press release within a certain number of days following the settlement order.  The press release notifies the public of the order and links to the rescission claim form, which also must be posted on the issuer’s website.  The claim form along with a notice is then delivered to all potential claimants informing them of their rescission rights and the deadline for filing the claim form. The issuer then is required to make payments to all claimants properly delivering claim forms, and to provide updates to the Commission to enable the Commission to monitor the rescission process.

A rescission offer is deemed a separate offer of securities which must either be registered or qualify for an offering exemption. This is to ensure that those receiving the offer have sufficient meaningful information on which to base a decision on whether or not to accept the offer. Consequently, the aforementioned settlement cases also obligate the issuer to register the ICO tokens with the Commission. Specifically, the issuers in the subject settlements were required to register the tokens on Form 10 under the Securities Exchange Act of 1934. See for example ParagonCoin’s Form 10 here. The filing of a Form 10 also triggers the periodic reporting requirements of the Exchange Act, obligating the issuer to file annual reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K.

Finally, the settlements also include bad actor disqualification from future utilization of the exemptions provided in Regulation A, Regulation CF (crowdfunding) and Regulation D.  Although the settlement orders don’t explicitly provide as much, the disqualification applies because the order requires the issuer to cease and desist from committing or causing any future violations of Section 5 of the Securities Act, and a Commission order to cease and desist from future violations of Section 5 of the Securities Act is one of the disqualifying events under the Commission’s bad actor rules.

Why the Enforcement Disparity?

So what explains the apparent enforcement disparity between, which involved only a relatively insignificant monetary penalty, and previous non-fraud unregistered offering cases which included rescission, registration, bad-actor disqualification and relatively more significant penalties relative to offering proceeds? Some have suggested that the settlement order signals a relaxation of enforcement in these cases. Others have justifiably called for the Commission to provide more detail and explain the disparate treatment.

It would certainly be helpful to ICO issuers, exchanges, lawyers and other market participants for the Commission to provide further detail explaining the apparent disparity. In the meantime, some of the details of how the ICO was conducted may suggest an explanation. The order states that implemented certain measures to prohibit U.S. persons from participating in the ICO.  First,’s offering website included certain measures intended to block U.S.-based purchasers from buying the offered digital tokens, including by blocking U.S.-based IP addresses from accessing the website token sale page. Second, required all token purchasers to sign a token purchase agreement which provided that U.S. persons were prohibited from purchasing the tokens and that any purchase by a U.S. person was unlawful and rendered the token purchase agreement null and void.

So if took steps to ensure offers and sales were not made to U.S. persons, why was the ICO of any concern to the Commission? Despite the aforementioned efforts to exclude U.S. persons from purchasing tokens in the ICO, the settlement order implies that some portion of the multi-billion dollar proceeds was raised from U.S. persons. The Commission also implies in the order that whatever U.S. sales did occur may not have been purely accidental. The order states that did not ascertain from purchasers whether they were in fact U.S.-based persons. Also, a number of U.S. based persons apparently purchased tokens directly through’s offering website, and received information through that site and various social media and forum posts. Further, the order states that undertook efforts for the purpose of, or that could reasonably be expected to have the effect of, conditioning the market in the U.S. for the tokens, including by engaging in directed selling efforts. Among other things, was said to have participated in blockchain conferences in the U.S. where it promoted its ICO.  Its offering website, white paper and other promotional statements were accessible to potential U.S. purchasers. Finally, the order states that the tokens were traded and widely available for purchase on numerous online trading platforms open to U.S.-based purchasers throughout the duration of the ICO, and that didn’t take any steps to prevent the tokens from being immediately resold to U.S.-based purchasers in secondary market trades.

So in the final analysis, the Commission may have been worried about’s selling efforts in the U.S. despite the tangible and seemingly reasonable safeguards implemented by it to ensure no sales were made to U.S. persons. But perhaps because the Commission was not ultimately able to prove how much of the offering proceeds were in fact generated in the U.S., and because of the difficulty of ever being able to make such a determination, the Commission may have tried to split the baby by settling with under terms more relaxed than in previous enforcement actions.

Key Takeaway

The key takeaway here is that ICO issuers that believe they can conduct a successful offering outside the U.S. should implement the safeguards employed by while avoiding the offering pitfalls that may have undercut its efforts to exclude U.S. persons.  That means blocking U.S.-based IP addresses from accessing the offering website, requiring that all token purchasers sign token purchase agreements prohibiting U.S. persons from purchasing tokens and providing that any purchase by a U.S. person is unlawful and renders the token purchase agreement null and void.  It also means obtaining written representations from purchasers that they are not U.S.-based persons.  It also means refraining from any efforts that could reasonably be expected to have the effect of conditioning the market in the U.S. for tokens, including by engaging in directed selling efforts such as promoting the ICO in U.S. blockchain conferences. Issuers should ensure that their offering website, white paper and other promotional statements are not accessible to potential U.S. purchasers, and that their digital tokens are not available for purchase on online trading platforms open to U.S.-based purchasers.

On October 11, 2019, the Securities and Exchange Commission (the “Commission”) announced it filed a complaint and obtained a temporary restraining order against Telegram Group Inc. and its wholly-owned subsidiary TON Issuer Inc. (collectively, “Telegram”) relating to Telegram’s offering of tokens without registration in violation of the Federal securities laws. The action sends a strong signal that the Commission is paying close attention to SAFT-based digital token offerings and is willing to go to court to stop the subsequent public launch of underlying tokens if it appears that the tokens are not yet fully developed and where the expectation of profit necessarily still derives from the efforts of the issuer.


In late 2013, Telegram launched an encrypted messaging application called “Messenger” which today may have as many as 300 million monthly users worldwide and has become a ubiquitous messaging application for the cryptocurrency community. Telegram, however, doesn’t make money from Messenger; the app is free to users and Telegram has pledged not to sell ads or introduce subscription fees and never to give third parties access to user data. Although Messenger incorporates ad hoc functionality that lets users exchange goods and services for both fiat and digital currency, Telegram envisioned integrating the ability to exchange digital assets directly into Messenger. It concluded, though, that existing networks like the Bitcoin and Ethereum blockchains don’t have the capability to replace high-volume transaction mechanisms like credit cards and fiat currency. So in late 2017, Telegram announced its intention to develop “next-generation multi-blockchain” systems designed to host a new generation of cryptocurrencies and decentralized applications at a massive scale, calling it “Telegram Open Network” or “TON”.

Telegram began funding the development of the TON blockchain network in January 2018 with the sale to investors of Purchase Agreements for Cryptocurrency, a form of simple agreement for future tokens, or SAFT. Under the Purchase Agreements, each purchaser made an investment in exchange for a promise by Telegram to issue the investor a certain number of its new cryptocurrency token “Grams” following the development and launch of the TON network. Importantly, the Purchase Agreements also provided that if the Network Launch had not occurred by October 31, 2019, Telegram would be obligated to return the investment amounts to the investors.

SAFTs Under the Howey Test

A typical SAFT based ICO consists of two stages. First, the issuer developing the blockchain network seeks to fund its network development through the sale of SAFTs to investors, in which the issuer promises to issue network tokens to the investors upon completion of the development and when the tokens are functional and offered to the public, usually at a discount to the public offering price. The prevailing securities law approach to a SAFT is that the SAFT itself and the tokens issuable thereunder are generally considered to be an investment contract and thus a security, meaning that their offering must either be registered with the Commission or qualify for an exemption from registration such as under Rule 506 of Regulation D. However, the status of the tokens issuable to the public after the network launch requires a thorough analysis under the Howey test. The key issue in the Howey analysis is the last prong of Howey, namely whether the purchaser of the token following the network launch is expecting a profit through the efforts of others. If he is, it’s a security; if he isn’t, it’s not. Whether there is an expectation of profit through the efforts of others in turn depends on whether the network is fully developed and the token fully functional. If it is, it’s a utility token and any expectation of profit derives not from the efforts of the developers (who have completed their development) but rather on the myriad of factors that cause assets to increase or decrease in value in a free market.

Complaint and TRO

Not much attention in the Commission’s complaint against Telegram was given to the securities law compliance of the early 2018 offer and sale of Telegram’s Purchase Agreements. Those were offered and sold under the exemption provided under Rule 506(c) of Regulation D, and Telegram filed with the Commission the required Notice of Exempt Offering of Securities on Form D in February 2018 with respect to $850 million in proceeds and filed another Form D in March 2018 with respect to an additional $850 million in proceeds. By filing the Forms D, Telegram was effectively conceding that the Purchase Agreements and the Gram tokens issuable to the original investors thereunder were securities. Although Rule 506(c) requires that the issuer sell only to accredited investors and use reasonable methods to verify accredited investor status, there is no direct assertion in the Commission’s complaint that Telegram violated either of these requirements or any other aspect of Rule 506(c) in connection with the Purchase Agreements. The complaint does allege, however, that the Purchase Agreements did not contain proper disclosure, as required under Regulation D. But if the Purchase Agreements were offered only to accredited investors (as is required by Rule 506(c), Regulation D would allow Telegram to avoid providing the investors the specifically mandated disclosure otherwise set forth in Regulation D. Instead, Telegram would be allowed to determine for itself what information is material and how to deliver that disclosure (including by providing its investors “access” to information).

What is at issue, however, is whether the planned issuance of the Gram tokens to the public prior to October 31, 2019 is an offering and sale of securities. The complaint states that Telegram took the position that the Gram tokens were currency and not securities. Public purchasers of Gram tokens were not restricted from reselling them. There was no restrictive legend associated with the to-be-publicly-issued tokens, and no warning was communicated that the publicly issued tokens may not be resold without registration or exemption therefrom. This contrasts with the Purchase Agreements, which contained legends stating that “this security” (presumably the Purchase Agreements and the Gram tokens issuable thereunder) is not registered with the Commission and may not be resold without registration or exemption therefrom, which restrictions on reselling were enforced through smart contract-based lockups.

The Commission rejects Telegrams position that the publicly issuable Gram tokens were not securities. In its complaint, the Commission points out that the October 31 deadline was not tied to whether the Gram tokens could be used to buy any products or services, but solely to whether Telegram was able to launch the TON blockchain network. If Telegram launched the network and sold the tokens publicly before they were fully functional, the tokens would be deemed to be securities because the public investors’ expectation of profit would necessarily depend on Telegram’s ability to complete the development of the tokens, i.e., the profit expectation would be “through the efforts of others”. Because Telegram planned to “flood the U.S. capital markets with billions of Grams by October 31”, the SEC jumped in to stop it.

The complaint further alleges the Gram tokens are not a currency because they currently have no realistic currency uses. It asserts that Telegram sold Grams in amounts that far exceed any anticipated “use” on the TON Blockchain. Telegram also didn’t restrict sales to individuals who would actually “use” Grams. The complaint further alleges that Telegram led investors to reasonably expect that Telegram’s and others’ entrepreneurial and managerial efforts would drive the success or failure of Gram tokens and the TON network. Telegram’s offering documents made clear that Telegram’s work would continue for some years after delivery of Gram tokens on the new TON Blockchain and would remain critical for the foreseeable future. The offering documents also spoke of potential future uses for the Gram tokens, specifically as a medium of exchange for goods and services (or “cryptocurrency”), to purchase not-yet-developed tools on the TON network (e.g., network storage, blockchain-based domain names, identity-hiding services) and as a token for future unspecified uses that Telegram and other third parties may eventually develop. But none of these uses of Gram tokens existed at any time. There are not now and have never been any products or services that can be purchased with Gram tokens. Finally, the principal means by which investors would reasonably expect to profit is through their resale of the tokens.


The Commission’s TRO and complaint against Telegram should serve as a stark warning to SAFT-based digital token issuers that the Commission is paying close attention to the unique characteristics of post-network launch tokens and will not hesitate to go to court to seek enforcement if the publicly launched tokens are not fully functional. The Commission in the past has at least informally acknowledged the viability of SAFT-based offerings by allowing that a class of digital tokens originally sold in a securities offering could be later sold in a manner that does not constitute an offering of a security where there is no longer any central enterprise being invested in or where the token is sold only to be used to purchase a good or service available through the network on which it was created. See the Division of Corporation Finance William Hinman’s June 14, 2018 speech on this issue here and my blog post on that speech here . Whether a post-network launch token is deemed to be an investment contract and thus a security will require a facts and circumstances inquiry, and will focus largely on whether a third party drives the expectation of a return and whether the digital token is structured through contractual or technical methods so that it functions more like consumer items and less like a security. Issuers would do well to try to structure enough flexibility into their SAFTs so that they are not forced to launch prematurely by an arbitrarily chosen deadline, and instead try to negotiate into the SAFT the right to postpone the launch for a reasonable period of time without having to return funds, perhaps conditioned on the consent of the SAFT investors, if the token is not fully functional by the deadline date. In the Telegram complaint, the Commission emphasized that the Purchase Agreement deadline is not tied to any promise or guarantee that the Gram tokens could actually be used to buy goods and services and instead depends solely on Telegram’s ability to create and launch the TON blockchain network. Clearly, Telegram’s public statements that it intended to launch the public release of the Gram tokens prior to October 31 was motivated by its determination to avoid returning investment proceeds to the original purchasers. In addition or as an alternative to a deadline postponement mechanism, issuers should focus on avoiding unrealistic network launch deadlines. Finally, it appears that Telegram had refused to accept service of an administrative subpoena, and the TRO mentions this as one of the reasons for its necessity. Lesson here is that issuers fail to cooperate with SEC investigations at their own peril.

The corporate spectacle better known as The We Company IPO officially and mercifully came to an end September 30 when The We Company (“We Co.”), the corporate parent of WeWork, requested that the Securities and Exchange Commission consent to the withdrawal of We Co.’s registration statement because it “no longer wishes to conduct a public offering of securities at this time”.  The filing of the withdrawal request was no shocker, following six weeks of intense scrutiny by prospective IPO investors and the media over WeWork’s business model, $1.6 billion in losses in 2018, related party transactions, questionable corporate governance and CEO Adam Neumann’s bizarre behavior, all of which prompted the company’s board last week to fire Neumann, put ancillary businesses up for sale and slash the company’s implied IPO valuation from $47 billion down to as low as $10 billion.

Much focus has been placed on We Co.’s largest investor, SoftBank, which directly or indirectly through its Vision Fund invested more than $10 billion in the company, with its latest investment earlier this year valuing the We Co. at $47 billion. Softbank clearly was not happy about the prospect of an IPO price based on a $10 billion valuation. But a feature in We Co.’s amended and restated certificate of incorporation will help cushion the blow when the company completes its next offering: dilution protection, or anti-dilution rights.

Without any desire whatsoever to pile on and kick We Co. when it’s down, I thought this was a good occasion to delve into the concept of dilution and the mechanics of anti-dilution.

There are two types of dilution experienced by investors: percentage dilution and economic dilution. Percentage dilution is not necessarily a problem; economic dilution always is.

Percentage Dilution

Percentage dilution is simply the mathematical result of one’s share in the whole declining as a result of the whole expanding. This automatically occurs when a company sells shares to new investors. For example, if a company with 1,000 outstanding shares completes the sale of 500 new shares to a new investor, the incumbent shareholders will experience percentage dilution in that their percentage of the outstanding shares drops as a result of the new issuance from 100% to 67% (1,000/1,500). Percentage dilution may be an issue if the dilution causes the holder to fall below a percentage threshold needed to maintain certain rights, such as board representation or veto rights. Otherwise, percentage dilution is not a cause for concern; it certainly was not for Softbank in WeWork.

Economic Dilution

Economic dilution, on the other hand, is always a problem for an incumbent investor. Economic dilution is experienced by an investor when the company issues new shares at a lower price per share than the price paid by that previous investor, a so-called down round. For example, a Series A investor purchases one million Series A shares at $1 per share. After failing to hit one or more milestones, the company burns through the Series A proceeds and must raise another round. But to attract investors in its Series B round after the economic hiccups, the company must agree to a lower valuation and sells shares at $0.50 per share. As a result, the value of the Series A investor’s shares has decreased from $1 million to $500,000. That’s economic dilution, and the Series A investor is not happy.

Anti-Dilution Protection

As a measure of protection against economic dilution, venture investors typically negotiate at the time of their investment for anti-dilution rights, which get baked into the company’s amended certificate of incorporation. In plain English, it means that if the company subsequently issues stock for consideration per share lower than what the investor paid, the company will be obligated to issue additional shares to the investor upon conversion of the preferred.

Preferred stock is almost always convertible into common, which is what allows the preferred to benefit from any upside on a sale of the company. In a disappointing exit with low proceeds, the preferred holder would just get his liquidation preference, expressed as an amount per share (usually equal to the amount per share paid by the investor). If the company sells for an amount that exceeds the aggregate liquidation preference, the preferred converts into common to share in the excess proceeds.

In a conversion, the number of shares of common that each share of preferred is convertible into is equal to the original price per share paid by the investor divided by the conversion price, which is initially equal to the price per share paid by the investor (resulting in a one-for-one conversion rate). The anti-dilution section triggers a downward adjustment in the conversion price resulting in additional shares issuable upon conversion. The magnitude of the adjustment depends on the extent to which the formula is investor friendly (full ratchet) or company friendly (weighted average), as explained below.

It’s important to understand that anti-dilution does not trigger issuance of additional (preferred) shares at the time of the down round, but rather additional (common) upon conversion which would occur on a sale of the company. That’s because anti-dilution is intended to protect the upside, not the downside. Otherwise, the issuance of additional preferred shares would result in unfairly increasing the liquidation preference amount, which would not be intended. If the pre-down round investor were to receive additional preferred shares for no additional consideration, the investor would receive an increase in his down side protection, an unintended windfall.

There are two general methods of calculating the anti-dilution adjustment: full ratchet and weighted average.

Full Ratchet Anti-Dilution

Full ratchet anti-dilution is the most investor friendly, and extremely rare. In plain English, it provides that the conversion price gets adjusted all the way down to the lower down round price, irrespective of the number of shares that were issued in the down round. Basically, a do-over in the earlier round that would result in the earlier round investor receiving for the same dollar amount of his investment, on conversion, a number of shares calculated based on a price per share equal to the lower down round price. As an absurd example for illustration, if a Series A investor invested $1 million and received one million shares constituting 20% of the outstanding, and the company then issued just one Series B share for one penny, the post-full ratchet cap table would indicate that the Series A holder would then have 100 million as-converted shares ($1,000,000/$0.01) constituting 96% of the fully-diluted, as-converted outstanding shares (100,000,000/104,000,001). The real victims? The founders. In my absurd example, the founders dropped from 80% post-Series A to just 3.99% post-Series B.

Weighted Average Anti-Dilution

Weighted average anti-dilution is far more common and considered more reasonable because it takes into account, in addition to price, the number of additional shares issued in the down round relative to the pre-money shares outstanding. The actual formula is as follows:

CP2 = CP1 x ((A + B) ÷ (A + C))

  • “CP2” is the new (post-down round) conversion price;
  • “CP1” is the conversion price in effect immediately before the down round;
  • “A” is the number of shares of common stock (including all shares issuable upon exercise of outstanding options or upon conversion of convertible securities) outstanding immediately prior to the down round;
  • “B” is the number of shares that would have been issued in the down round if price per share were equal to CP1 (determined by dividing the aggregate consideration received in the down round by CP1); and
  • “C” is the number of shares issued in the down round.

There’s an important wrinkle to weighted average anti-dilution protection. Weighted average anti-dilution could be either broad based or narrow based, depending on the extent of options and convertible securities that are included in shares outstanding. The formula that appears above is broad based because the number of shares outstanding includes all shares issuable on exercise of options and on conversion of convertible securities. The broader the formula (i.e., the more securities that are included in the outstanding), the less of an adjustment to conversion price.

Under narrow based weighted average anti-dilution, the only securities that would be included in shares outstanding (in addition to actually outstanding common shares) would be the number of shares outstanding of the particular series of preferred whose conversion price is being adjusted.

SoftBank’s Anti-Dilution Protection in We Co.

Page F-115 of We Co.’s S-1 Registration Statement  states that all preferred stock (including preferred held by SoftBank) is subject to “broad weighted-average anti-dilution protection”. For companies that have issued multiple series of preferred, each series has a separate conversion price (which typically starts out being equal to the purchase price per share). The beneficial ownership table in We Co’s S-1 indicates that SoftBank directly or indirectly is the beneficial owner of shares in 11 different series of We Co. preferred stock. SoftBank’s last investment in We Co. was $5 million at a $47 billion valuation, with a per share purchase price of $112 per share.

At this point, it remains to be seen when (if at all) We Co. will resume its efforts to go public. But what’s clear from the S-1 and many media reports, We Co. needs to raise cash. Before it withdrew its IPO, We Co. and its underwriters were rumored to be prepared to drop the valuation to as low as $10 billion. So whether the next round is a public or private offering, it almost certainly will be a down round.

Given the eleven different series invested in by SoftBank, each with its own price and conversion price, the amount of time it would take to calculate all the anti-dilution adjustments would be a multiple of what it has taken me to write this blog post. In fact, the conjecture is that the complicated calculations needed to figure out the anti-dilution adjustments to SoftBank’s various conversion prices in its multiple funding rounds weighed heavily on SoftBank’s decision to cause We Co. to pull the IPO plug for now. Ultimately, We Co. couldn’t proceed with the IPO without SoftBank’s, part of a package of vetos over major decisions usually negotiated by investors.

So how impactful will the anti-dilution adjustment be with respect to SoftBank?  Even under the more relaxed weighted average method of anti-dilution protection, because of the magnitude of the drop in valuation from SoftBank’s previous investment, coupled with the enormous number of shares that would be issued in We Co.’s IPO (if it does happen) at that lower valuation, the additional number of common shares issuable to SoftBank on conversion will be dramatic.  So much so that Renaissance Capital estimates the anti-dilution adjustments here could result in the largest IPO anti-dilution adjustment ever, as large as $200 million to $500 million worth of additional shares issuable on conversion to preferred stockholders, mostly going to SoftBank.  Moreover, it was disclosed in the S-1 that upon payment of the final $1.5 billion installment of SoftBank’s most recent Series G-1 round investment, We Co. will issue it a warrant to purchase a large but undisclosed number of additional shares at a very low but undisclosed price per share.

In the final analysis, anti-dilution softens the economic dilution blow of the down round to the preferred stockholders, resulting in massive disproportionate percentage and economic dilution to the common stockholders.

On July 10, 2019, the Securities and Exchange Commission declared Blockstack PBC’s offering statement “qualified”, thus allowing Blockstack to commence the distribution and sale of its Stacks Tokens under Regulation A. This is the first offering of digital tokens to be qualified by the Commission under Regulation A, a significant milestone for the blockchain industry which raised billions of dollars in 2016-2018 in unregistered non-exempt initial coin offerings before the Commission threw down the gauntlet in the form of lawsuits and enforcement actions alleging illegal unregistered offerings, most recently against Kik Interactive Inc.  Yet given recent Regulation A headwinds, it’s unclear to what extent other blockchain developers will follow Blockstack’s lead and look to raise capital under Regulation A.

State of Regulation A

Regulation A was reformed under the JOBS Act of 2012 to allow issuers to raise up to $50 million in any rolling 12-month period with scaled down disclosure relative to full-blown registration, freedom to test-the-waters and no qualification at the state level. Referred to as a mini-IPO, Regulation A also provides a streamlined pathway to Securities Exchange Act registration (for those issuers choosing to be SEC reporting companies) and for listing on a national securities exchange. Shares issued in a Regulation A offering are unrestricted; they can be freely resold without a holding period or other restriction.

Issuers’ and securities professionals’ hopes were high that Regulation A could be a viable alternative to registered public offerings or other existing exemptions. Initial signs were encouraging. Since Regulation A went live in 2016, over 100 transactions have been consummated averaging $10 million per deal, including ten issuers that got listed on Nasdaq or the NYSE.

Unfortunately, however, Regulation A has experienced some hiccups lately. The shares of the ten listed Regulation A issuers have fared poorly, and the Commission recently approved Nasdaq’s proposed rule to require Regulation A funded companies seeking Nasdaq listing to have a minimum two year operating history. One Regulation A issuer, Longfin Corp., terminated operations less than one year after closing its Regulation A offering and is now the subject of a fraud lawsuit by the Commission.

Blockstack Offering of Stacks Tokens

Blockstack is developing an open-source peer-to-peer network using blockchain technologies to ultimately build a new network for decentralized applications. Blockstack is offering up to $40 million of its Stacks Tokens, consisting of a combination of full-priced tokens to “qualified purchasers” as defined in Regulation A, discounted tokens to holders of certain purchase vouchers and non-cash consideration tokens under Blockstack’s “app mining” program in exchange for the development of well-reviewed applications on its decentralized application network.  Blockstack previously raised over $50 million in VC rounds and under Rule 506(c); among those investing were big-time early stage investors Union Square Ventures, Y Combinator, Lux Capital and Naval Ravikant.

The Evolving Token

In a June 2018 speech, SEC Division of Corporate Finance Director William Hinman broke new ground when he stated that a digital asset originally sold in a securities offering could later be 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. I blogged about the speech here.

Consistent with the guidance from Hinman’s speech and with the Commission’s recent guidance in its “Framework for ‘Investment Contract’ Analysis of Digital Assets”, Blockstack asserts its Stacks Token is a security now but may not be so in the future. In its offering statement, Blockstack states that, for the foreseeable future, it anticipates treating the Stacks Token as a security based on its view that the token is an “investment contract” under the application of the Howey test to digital assets: an investment of money, in a common enterprise, with a reasonable expectation of earning a profit, through the efforts of others. With investment of money in a common enterprise and a reasonable expectation of earning a profit assumed, the real issue is whether that profit expectation is through the efforts of others.

Under the Framework and the Howey Test, a profit expectation is considered to be through the efforts of others if the network is still being developed and the token is not fully functional, because the success of the network is considered to be dependent on the efforts of management. Once the network is sufficiently decentralized, that success can no longer be said to be dependent on the efforts of management. Blockstack maintains that, currently, it employs all core developers of the Blockstack network. But as the network becomes increasingly decentralized, core developers other than those employed by Blockstack may become primarily responsible for the development and future success of the network. Blockstack also maintains it may transfer governance and control of the Blockstack network to other parties, such as network users and developers.

Whether Stacks Tokens lose their status as investment contracts will ultimately depend on whether purchasers of the tokens no longer expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack no longer retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants.  Arguably, purchasers will no longer have that expectation and Blockstack will no longer have that power when the network becomes truly decentralized, at which point Blockstack asserts the Stacks Tokens will no longer constitute a security.

Precedent Setting?

Blockstack’s Regulation A journey has been an expensive and long one, purportedly costing it $2 million over the ten months of engaging in the process. Blockstack’s co-founder Muneeb Ali joked about what he calls Blockstack’s “$2 million donation to the crypto industry”, but he also made these interesting comments on his blog about the precedent setting potential of the offering:

“[the offering could] set a precedent for others in the industry…Recently, U.S. markets have been closed to crypto projects given regulatory uncertainty, and we believe in opening the U.S. markets to innovation in this area. We’ve been working with securities lawyers to create a legal framework that can enable blockchain protocols to comply with SEC regulations…Following a regulated path and proactively working with the regulators was a decision we made with the understanding that it’ll require a lot of work and time…This can potentially set a precedent for others in the industry, not just for public offerings, but also as a path to launch new public blockchains and establish a path to bootstrapping decentralized ecosystems.”

Whether Blockstack’s Regulation A offering will indeed set a capital raising precedent for others in the blockchain industry remains to be seen, and will depend on several factors including whether Regulation A can rehabilitate its brand and whether Blockstack’s “$2 million contribution to the crypto industry”, presumably through multiple versions of its offering circular and responses to voluminous SEC comment letters, will have created a practical, workable model from which others can follow Blockstack’s lead in a more cost-effective manner.

Non-accredited investors are estimated to constitute approximately 92% of the U.S. population. Yet restrictive rules governing exempt offerings have significantly limited their freedom to invest in private offerings and prevented or discouraged issuers from selling them privately offered securities. But in a recently issued concept release, the Securities and Exchange Commission has signaled a willingness to approach the issue in a much more creative way, suggesting the possibility of expanded opportunities for companies to include non-accredited investors in exempt offerings without unduly compromising their protection.

The SEC’s June 18, 2019 concept release seeks public comment on ways to simplify, harmonize and improve exempt offerings by removing some of the existing complexity, thereby promoting capital formation without unduly compromising investor protections and expanding opportunities for investors. In its press release issued the same day, SEC Chairman Jay Clayton noted that “input from startups, entrepreneurs and investors who have first-hand experience with [the SEC’s] exempt offering framework will be key to its efforts to analyze and improve the complex system we have today.”

Significant changes over the past few years to the rules governing exempt offerings (most notably through the Jumpstart Our Business Startups Act of 2012, the Fixing America’s Surface Transportation Act of 2015 and the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018) have resulted in a complex framework of differing requirements and conditions, which may be difficult for issuers to navigate, particularly startups and emerging companies with more limited resources.

Interestingly, the amount raised in exempt offerings has been trending higher in both absolute terms and relative to registered offerings, and now is twice the amount raised in registered public offerings. The concept release estimates that in 2018, registered offerings accounted for $1.4 trillion of new capital compared to approximately $2.9 trillion raised through exempt offerings.

Given the dominance of exempt offerings, the focus of the release is to seek input on whether the current regulatory framework provides adequate access to capital for a variety of issuers, particularly smaller issuers, and adequate access to investment opportunities for non-accredited investors while maintaining investor protections. Non-accredited investors’ primary investment opportunities have historically been in registered markets because of the restrictions on their participation in private offerings. Non-accredited investors have not had the same level of access to investment opportunities in exempt markets as an accredited investor would, and the upward trend in exempt offerings only exacerbates the problem.

Consequently, the SEC is seeking comment on whether it would be consistent with capital formation and investor protection for it to consider steps to make a broader range of investment opportunities available to non-accredited investors. In particular, the SEC is seeking comment on the following specific questions (among others):

Accredited Investor Definition. To be considered an accredited investor, an entity would need to fall under one of the designated categories of financial institutions, have more than $5 million in assets or have only accredited investor owners, while an individual must pass either a net worth or income test. The SEC is seeking comment on:

  • Whether the $5 million asset test for entities should be replaced with a $5 million investments test that includes all entities rather than specifically enumerated types of entities?
  • Whether individuals should be allowed to qualify based on other measures of sophistication, such as minimum amount of investments, certain professional credentials, experience investing in exempt offerings, knowledgeable employees of private funds for investments in their employer’s funds, individuals who pass an accredited investor examination?
  • Currently, a natural person just above the income or net worth thresholds would be able to invest without limits, but a person just below the thresholds cannot invest at all as an accredited investor. Should that be changed?

Rule 506 of Regulation D. Currently, Rule 506(b) allows sales to up to 35 non-accredited investors (and an unlimited number of accredited investors), but the exemption from the specific, mandated disclosure obligations of Regulation D for offerings sold only to accredited investors serves as a significant incentive to exclude non-accredited investors.   Accordingly the SEC seeks comment on:

  • Whether it is important to continue to allow non-accredited investors to participate in Rule 506(b) offerings, and if so are the information requirements having an impact on the willingness of issuers to allow non-accredited investors to participate?
  • Whether the SEC should consider eliminating or scaling the information requirements depending on the characteristics of the non-accredited investors participating in the offering, such as if all non-accredited investors are advised by a financial professional or a purchaser representative?
  • Whether information requirements should vary if non-accredited investors can only invest a limited amount or if they invest alongside a lead accredited investor on the same terms as the lead investor?
  • Should non-accredited investors be allowed to purchase securities in an offering that involves general solicitation? If so, what types of investor protection conditions should apply? For example, only if: (i) such non-accredited investors had a pre-existing substantive relationship with the issuer or were not made aware of the offering through the general solicitation; (ii) the offering is done through a registered intermediary; or (iii) a minimum percentage of the offering is sold to institutional accredited investors that have experience in exempt offerings and the terms of the securities are the same as those sold to the non-accredited investors?

Regulation A. In a Tier 2 offering by an issuer of securities that are not going to be listed on a national securities exchange upon qualification, non-accredited individual investors are limited in how much they can invest to no more than 10% of the greater of their annual income or net worth, alone or together with a spouse and excluding the value of their primary residence and any loans secured by the residence (up to the value of the residence). The SEC seeks comment on:

  • Whether the individual investment limits for non-accredited investors in Tier 2 offerings should be changed or eliminated?
  • If the investment limits are changed, what limits would be appropriate?

Responses to the foregoing or any other requests for comment set forth in the concept release may be submitted to the SEC here prior to the deadline of September 24, 2019.