Conditional Relief For Persons Affected By Coronavirus

As the whole world faces unprecedented personal and business challenges, our duty to continue to run our businesses, meet regulatory filing obligations and support our capital markets continues unabated.  While we stay inside and practice social distancing, we also need to work each day navigating the new normal.  Thankfully many in the capital markets, including our firm, were already set up to continue without any interruption, working virtually in our homes relying on the same technology we have relied on for years.

We all need to remember that the panic selling frenzy will end.  Emotions with even out and the daily good news that comes with the bad (for example, the number of cases in China is falling dramatically; some drugs are working to help and the FDA is speeding up review times for others; early signs China’s economy is starting to recover already; scientists around the world are making breakthroughs on a vaccine; etc.) will begin to quell the fear.  No one knows what the economic damage will be but we do know that new opportunities will appear, the buying opportunity is already being hinted at for capital markets, and entrepreneurs will continue.

In the meantime, besides the economic stimulus packages that have already passed in some states and that are fighting their way through the federal partisan political system, regulators have provided some relief for our clients and the capital markets participants.

Extension in SEC Reporting Filing Deadlines

The SEC has issued an exemptive order providing public companies with an additional 45 days to file certain disclosure reports that would otherwise be due between March 1 and April 30, 2020.  The extension is only available under certain conditions.  In order to qualify for the extension a company must file a current report (Form 8-K or 6-K) explaining why the relief is needed in the company’s particular circumstances and the estimated date the report will be filed.  In addition, the 8-K or 6-K should include a risk factor explaining the material impact of Covid-19 on its business.   The Form 8-K or 6-K must be filed by the later of March 16 or the original reporting deadline.

Although the SEC will likely give significant leeway to companies, the general fact that the coronavirus has an impact on the world is not enough.  In order to qualify for the relief a company must be directly impacted in their ability to complete and file disclosure reports on a timely basis.  For instance, disruptions to transportation, and limited access to facilities, support staff and advisors could all impact the ability of a company to meet its filing deadlines

The current report disclosing the need for the extension must also provide investors and the market place with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments.  In other words, if a company is so impacted by the coronavirus that they must seek an extension to its filing obligation, it must also inform investors, to the best of its knowledge and ability, what that impact is and how it is being addressed.

If the reason the report cannot be timely filed relates to a third parties inability to furnish an opinion, report or certification, the Form 8-K or 6-K should attach an exhibit statement signed by such third party specifying the reason they cannot provide the opinion, report or certification.

For purposes of eligibility to use Form S-3, a company relying on the exemptive order will be considered current and timely in its Exchange Act filing requirements if it was current and timely as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.  For more on S-3 eligibility, see HERE.

Likewise, for purposes of the Form S-8 eligibility requirements and the current public information eligibility requirements of Rule 144, a company relying on the exemptive order will be considered current in its Exchange Act filing requirements if it was current as of the first day of the relief period and it files any report due during the relief period within 45 days of the filing deadline for the report.

The extension actually changes the due date for the filing of the report.  Accordingly, a company would be able to file a 12b-25 on the 45th day to gain an additional 5 day extension for a Form 10-Q and 15 day extension for a Form 10-K.

Disclosures Regarding Covid-19 Impact

The SEC press release regarding the exemptive Order reminds companies of the obligations to disclose information related to the impact of Covid-19 on their businesses.  SEC Chair Jay Clayton stated “[W]e also remind all companies to provide investors with insight regarding their assessment of, and plans for addressing, material risks to their business and operations resulting from the coronavirus to the fullest extent practicable to keep investors and markets informed of material developments.  How companies plan and respond to the events as they unfold can be material to an investment decision, and I urge companies to work with their audit committees and auditors to ensure that their financial reporting, auditing and review processes are as robust as practicable in light of the circumstances in meeting the applicable requirements. Companies providing forward-looking information in an effort to keep investors informed about material developments, including known trends or uncertainties regarding coronavirus, can take steps to avail themselves of the safe harbor in Section 21E of the Exchange Act for forward-looking statements.”

Furthermore, the combined effects of the impact of the virus and extensions in the filing of periodic reports creates an increased threat of the trading on material nonpublic information (insider trading).  The exemptive order reminds all companies of its obligations.  If a company is aware of risk related to the coronavirus it needs to refrain from engaging in securities transactions with the public (private and public offerings, buy-backs, etc.) and prevent directors and officers, and other corporate insiders who are aware of these matters, from initiating such transactions until investors have been appropriately informed about the risk.

Companies are reminded not to make selective disclosures and to take steps to ensure that information is publicly disseminated where accidental disclosure is made.  Depending on a company’s particular circumstances, it should consider whether it may need to revisit, refresh, or update previous disclosure to the extent that the information becomes materially inaccurate.  Where disclosures related to the coronavirus are forward looking, a company can avail itself of either the Exchange Act Section 21E or common law safe harbors (see HERE).

Furnishing of Proxy and Information Statements

The SEC has also granted relief where a company is required to comply with Exchange Act Sections 14(a) or 14(c) requiring the furnishing of proxy or information statements to shareholders, and mail delivery is not possible.  The order relieves a company of the requirement to furnish the proxy or information statement where the security holder has a mailing address located in an area where mail delivery service has been suspended due to Covid-19 and the company has made a good faith effort to furnish the materials to the shareholder.

Virtual Annual Meetings

Although the SEC regulates the proxy process for annual meetings of public companies, it does not regulate the place and format of the meeting itself, which remains subject to state law.  Although Delaware provides a great deal of flexibility for companies to hold virtual meetings, many states do not.  New York has historically been one of the states that does not have easy provisions for virtual meetings.  Accordingly, New York Governor Andrew Cuomo has issued an executive order temporarily permitting New York corporations to hold virtual annual meetings.  Although California is also not totally virtual meeting friendly, it has not yet issued exemptive relief.

Relief for Registered Transfer Agents

The SEC has issued an order providing transfer agents and certain other persons with conditional relief from certain obligations under the federal securities laws for persons affected by Covid-19 for the period from March 15, 2020 to May 30, 2020.  The SEC recognizes that transfer agents may have difficultly communicated with or conducting business with shareholders and others effected by the virus.

The exemptive order would provide relief for certain activities such as processing securities transfers and updating shareholder lists.  The exemptive order does not relieve the obligation to ensure that securities and funds are adequately safeguarded.

To qualify for the relief, the requesting person but make a written request to the SEC including a description of the obligation they are unable to comply with and the specific reasons for non-compliance.

Hester Peirce Proposal For Treatment Of Cryptocurrency

SEC Commissioner Hester M. Peirce, nicknamed “Crypto Mom,” has made a proposal for the temporary deregulation of digital assets to advance innovation and allow for unimpeded decentralization of blockchain networks.   Ms. Peirce made the proposal in a speech on February 6, 2020.

The world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector with the SEC’s announcement that a cryptocurrency is a security in its Section 21(a) Report on the DAO investigation. Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape.  Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised.  It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.

However, although capital raising seems clear, the breadth of the SEC’s jurisdiction and involvement are much less so.  Not all token issuances and digital assets are used for capital raising, but rather these digital assets are fundamental to the operations of decentralized applications.  Amazing new networks are being built and traditional applications are being disrupted at every turn.  However, the ability to publicly issue the digital tokens that drive these networks continues to challenge the best practitioners, with all avenues leading back to some form of registration.  The SEC’s temporary injunction against Telegram and its Grams digital token, the one token everyone firmly believed was a pure utility, together with the successful Regulation A offering of Blockstack’s token, has made Regulation A the clear choice for a public token issuance.

In theory, an S-1 would work as well, though to date no one has tried and likely will not do so in the short term.  The issue with an S-1 is testing the waters and gun jumping (see HERE).  Public communication in advance of an S-1 is strictly limited whereas most token offerings rely heavily on pre-marketing.  Regulation A broadly allows pre-offering marketing, offers and communications (see HERE).

Currently, those who operate in the digital asset space must carefully navigate rough, uncharted waters while doing everything possible to comply with federal regulations.  Although Regulation A+ works for the public issuance of a token, the issue of transitioning from a security to a utility a Hester Peirce Proposal For Treatment Oft this point requires a leap of faith.  The SEC has been clear that when a network becomes decentralized enough, a token can cease to be a security.  The question remains: how can a token that begins as a security, be utilized and traded freely in a network, in its utilitarian purpose, such to allow the network to grow in decentralization?

The SEC has also been clear that the secondary trading of securities, including digital assets, requires a broker-dealer license (see, for example, HERE).  Currently there is no active secondary trading market for digital asset securities in the U.S., though we are getting closer.  However, secondary trading is different than use in a network for a token’s intended purpose.

Although there is no written guidance or pronouncement from the SEC Division of Trading and Markets, it appears that the SEC will allow a token that is a security to be used in a network without compliance with the registration or exemption provisions of the federal securities laws.  The basis for this conclusion is the clearance of Blockstack’s Regulation A offering, which announces that the token can be used on the network and informal calls with FinHUB (see HERE) and digital asset legal practitioners.  This does not provide the sort of comfort that a business investing millions of dollars into technology wants to rely upon.

That is one huge gap in the digital asset regulatory framework, but many more exist, leading Commissioner Peirce to throw out the first of what will probably be several proposals that hopefully bring us to a working structure.

Commissioner Peirce’s Proposal

Ms. Peirce begins by pointing out what I and every other practitioner have pointed out while trying to traverse the law’s application to digital assets, and that is that compliance with the law while furthering the meritorious digital asset technology is an unwinnable struggle.  Ms. Peirce states, “[W]hether it is issuing tokens to be used in a network, launching an exchange-traded product based on bitcoin, providing custody for crypto assets, operating a broker-dealer that handles crypto transactions, or setting up an alternative trading system where people can trade crypto assets, our securities laws stand in the way of innovation.”

Although the issues are widespread, Ms. Peirce focuses on the issue of getting tokens into the hands of potential network users without violating securities laws.   Where a token is a security, the ability to grow a network and utilize a token within the network is unreasonably hampered.

Furthermore, although many tokens may be bundled in such a way as to create an investment contract under Howey, she thinks the SEC has gone too far in its analysis.  The mere fact that a token is marketed as potentially increasing in value should not make it a security.  If that were the case, quality handbags, designer sneakers, fine art and good wines would all be securities under the purview of the SEC.

The options available for digital asset technology innovators are limited.  A network could simply open source the code and allow mining to create the initial tokens.  A network could also take its chances and conclude that a token is not a security and proceed with the issuance, although that did not work out well for Telegram.  The option most networks have chosen is to either avoid the U.S. altogether or rely on Regulation D and/or Regulation S for token issuances, and recently Regulation A for a more public issuance.

The safe harbor proposed by Commissioner Peirce is designed for projects looking to build a decentralized network.  The safe harbor is admittedly in a draft form.  Commissioner Peirce hopes for active public input as well as involvement within the SEC to help take her draft and formulate a workable plan that is either a rule or a no-action position, but that the market can rely on in moving forward.

The safe harbor would provide network developers with a three-year grace period within which they could facilitate participation in and the development of a functional or decentralized network, exempt from the federal securities laws as long as certain conditions are satisfied.  In particular, (i) the offer and sale of tokens would be exempted from the provisions of the Securities Act of 1933 (“Securities Act”) other than the anti-fraud provisions; (ii) tokens would be exempt from registration under the Securities Exchange Act of 1934 (“Exchange Act”); and (iii) persons engaged in certain token transactions would be exempt from the definitions of “exchange,” “broker,” and “dealer” under the Exchange Act.

In order to qualify for the safe harbor, several conditions must be met including: (i) the development team must intend the network to reach maturity, either through full decentralization or token functionality, within three years of the date of the first token sale, and act in good faith to meet that goal.  I note that good faith is a hard standard to prove; (ii) the team must disclose key information on a freely accessible public website; (iii) the token must be offered and sold for the purpose of facilitating access to, participation on, or the development of the network; (iv) the team must take reasonable efforts to create liquidity for users; and (v) the team would have to file a notice of reliance on the safe harbor on EDGAR within 15 days of the first token sale.

Determining decentralization requires an analysis of whether the network is not controlled and is not reasonably likely to be controlled, or unilaterally changed, by any single person, group of persons, or entities under common control.  Functionality would be when holders can use the tokens for the transmission and storage of value or to participate in an application running on the network.

The key information that would need to be disclosed on a public website includes (i) the source code; (ii) transaction history; (iii) purpose and mechanics of the network (including the launch and supply process, number of tokens in initial allocation, total number of tokens to be created, release schedule for the tokens and total number of tokens outstanding); (iv) information about how tokens are generated or minted, the process for burning tokens, the process for validating transactions and the consensus mechanism; (v) the governance mechanisms for implementing changes to the protocol; (vi) the plan of development, including the current state and timeline for achieving maturity; (vii) financing plans, including prior token sales; (viii) the names and relevant experience, qualifications, attributes, or skills of each person that is a member of the team; (ix) the number of tokens owned by each member of the team, a description of any limitations or restrictions on the transferability of tokens held by such persons, and a description of the team members’ rights to receive tokens in the future; (x) the sale by any member of 5% or more of his or her originally held tokens; and (xi) any secondary markets on which the tokens trade. Disclosures would need to be updated to reflect any material changes.

The requirement to make good-faith efforts to create liquidity for users could include a secondary trading market.  In that case, the team would be required to utilize a trading platform that can demonstrate compliance with all applicable federal and state law, as well as regulations relating to money transmission, anti-money laundering, and consumer protection.  Although I find this requirement perplexing, Commissioner Peirce believes it will help facilitate the distribution of the tokens such that they can flow back to a utility use on the network.

As mentioned, the safe harbor would not include the anti-fraud provisions of the securities laws.  In addition, the safe harbor would be subject to the bad actor rules, such that it could not be used if any member of a team fell within the bad actor provisions (see HERE).  The safe harbor would pre-empt state securities laws, but as with other pre-emptions, it would not include the state anti-fraud provisions.

The safe-harbor would be retroactive in that it would apply to tokens previously issued in registered or exempt offerings to allow for the free use of the token to build the network, and secondary sales.

Conclusion

Although as Commissioner Peirce notes, it has to start somewhere, it is a given in the industry that the proposal as written will not likely gain traction.  It is simply too anti-regulation for any regulator’s and perhaps even industry participant’s liking.  However, it does lay the framework to open the conversation and start towards a workable solution.  Certainly, the current plan to let tokens registered as securities, be used as utilities, until we say otherwise, is not any better. The industry needs a workable solution, and I am glad an SEC Commissioner is taking a step forward.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal’s op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.

For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HEREHERE and HERE.

For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.

For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.

For information on the SEC’s FinTech hub, see HERE.

For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.

For FinCEN’s most recent guidance related to cryptocurrency, see HERE.

For a discussion on the enforceability of smart contracts, see HERE.

For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.

For a review of the SEC, FinCEN and CFTC joint statement on digital assets, see HERE.

The SEC, FinCEN And CFTC Issue A Joint Statement On Digital Assets

On October 11, 2019 the SEC, FinCEN and CFTC issued a joint statement on activities involving digital assets.  Various agencies have been consistently working together, with overlapping jurisdiction, on matters involving digital assets and distributed ledger technology.  Earlier, in August, the SEC and FINRA issued a joint statement on the custody of digital assets, including as it relates to broker-dealers and investment advisors (see HERE).

The purpose of the joint statement is to remind persons engaged in activities involving digital assets of their anti-money laundering and countering the financing of terrorism (AML/CFT) obligations under the Bank Secrecy Act (BSA).  AML/CFT obligations apply to entities that the BSA defines as “financial institutions,” such as futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses (MSBs) as defined by FinCEN (for more information on MSBs see HERE), and broker-dealers and mutual funds obligated to register with the SEC.  The AML/CFT requirements under the BSA include establishing effective processes and procedures, recordkeeping and reporting and filing suspicious activity reports (SARs).

For purposes of the joint statement, “digital assets” include securities, commodities, and security- or commodity-based instruments such as futures or swaps.  The agencies point out that industry participants may use different terminology or assign different meanings to standard terminology.  As such, in determining whether an asset is a “digital asset” the agencies will look to the facts and circumstances, including its economic reality and use, whether intended, organically developed or repurposed.  As I’ve discussed in other blogs, the same analysis is used to determine whether an entity is a financial institution, including a BSA.

Furthermore, the nature of the activities of a person or institution determine what, if any, licenses are needed and regulations that must be complied with.  Some activities would require registration under the Commodity Exchange Act (CEA) and others may require registration as a broker-dealer under the Securities Exchange Act of 1934 (“Exchange Act”).  Although the joint statement only included three agencies, others also oversee digital assets and industry participants.  For example, the AML/CFT activities of a futures commission merchant will be overseen by the CFTC, FinCEN, and the National Futures Association (NFA); those of an MSB will be overseen by FinCEN; and those of a broker-dealer in securities will be overseen by the SEC, FinCEN and FINRA.

The CFTC added a specific statement that once an entity, such as an introducing broker or futures commission merchant, is licensed or required to be licensed under the CEA, all of their activities would require proper AML/CFT processes and procedures, not just those involving commodities.

FinCEN added a statement discussing its role as the administrator and lead regulator under the BSA.  FinCEN has supervisory and enforcement authority over U.S. financial institutions to ensure the effectiveness of the AML/CFT regime.  In general, entities that are subject to the BSA must: (i) register with FinCEN as a money services business (MSB) or with another agency such as the CFTC or the SEC; (ii) prepare a written AML compliance program that is designed to mitigate risks, including AML risks, and to ensure compliance with all BSA requirements including the filing of suspicious activity reports (SAR) and currency transaction reports; (iii) keep records for certain types of transactions at specific thresholds; and (iv) obtain customer identification information sufficient to comply with the AML program and recordkeeping requirements.  In its statement, FinCEN referenced the guidance it issued in May 2019 and encouraged entities to carefully review the guidance to determine if they qualify as a MSB.  For a review of the guidance, see HERE.

Like the other agencies, the SEC added a statement.  The SEC’s additional statement reminds SEC registered broker-dealers and mutual funds that they are considered financial institutions for purposes of the BSA.  A “broker-dealer” is defined in rules implementing the BSA as a person that is registered or required to register as a broker or dealer under the Securities Exchange Act, and a “mutual fund” is defined as an investment company that is an “open-end company” and that is registered or required to register under the Investment Company Act of 1940.  Both broker-dealers and mutual funds must enact and comply with AML/CFT policies and procedures for all activities, including as related to digital assets.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.

For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE and HERE.

For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.

For a review of SEC enforcement-driven guidance on digital asset issuances and trading, see HERE.

For information on the SEC’s FinTech hub, see HERE.

For the SEC’s most recent analysis matrix for digital assets and application of the Howey Test, see HERE.

For FinCEN’s most recent guidance related to cryptocurrency, see HERE.

For a discussion on the enforceability of smart contracts, see HERE.

For a summary of the SEC and FINRA’s joint statement related to the custody of digital assets, see HERE.

SEC Provides Enforcement Driven Guidance On Digital Asset Issuances And Trading

On November 16, 2018, the SEC settled two actions involving cryptocurrency offerings which settlement requires the registration of the digital assets. On the same day, the SEC issued a public statement stating, “[T]hese two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”

The two settled actions, CarrierEQ Inc., known as Airfox and Paragon Coin Inc., both involved an unregistered issuance of a cryptocurrency. In its statement the SEC highlighted three other recent settled actions involving digital assets and, in particular, the actions involving Crypto Asset Management, TokenLot and EtherDelta. The three additional cases involved investment vehicles investing in digital assets and the providing of investment advice, and secondary market trading of digital asset securities.

The SEC has developed a consistent mantra declaring both support for technological innovation while emphasizing the requirement to “adhere to [our] well-established and well-functioning federal securities law framework…” However, as Commissioner Hester Peirce has pointed out in her speeches, the current federal securities law may not be the best framework for the regulation of digital asset securities and their secondary trading. Although the overall purpose and structure of the Securities Act of 1933 (“Securities Act”) and its implementing rules, including the idea that the offer and sale of securities must either be registered or issued under an available exemption, and that investors are entitled to disclosure, may be appropriate, the granular requirements under the Act need to be updated to encompass new technology including blockchain and digital assets. Likewise, and maybe even more so, the broker-dealer, ATS and national exchange registration requirements, and the reporting requirement of issuers found in the Securities Exchange Act of 1934 (“Exchange Act”) and its implementing rules, need to be reviewed and updated.

Airfox and Paragon Coin Inc. – Offers and Sales of Digital Asset Securities

The SEC has brought many actions related to the offers and sales of digital assets – some before, and many after, the issuance of its Section 21(a) Report related to the offer and sale of tokens by the DAO. The Section 21(a) Report clearly laid out that a determination of whether a digital asset is a security requires an analysis using the Howey test as set out in the U.S. Supreme Court case SEC v. W. J. Howey Co. In various speeches and public statements following that Report, SEC officials, including Chair Jay Clayton, expressed their views that pretty well all ICOs to date involved the offer and sale of a security and, unfortunately, many had not complied with the federal securities laws.  A slew of enforcement proceedings followed and a shift in the ICO craze to a more compliant securities token offering (STO) resulted.

However, to date, STOs have relied on registration exemptions, such as Regulation D, in their offerings rather than registration under the Securities Act. When registering an issuance under the Securities Act, an issuer must comply with the full disclosure obligations under Regulations S-K and S-X. This has proven challenging for both issuers and the SEC when the security being registered is a digital asset.  Among the numerous issues to figure out have been providing a wallet to recipients, the custody of digital securities, the maintenance of a registrar and transfer agent duties, the lack of a licensed operational secondary market, cybersecurity issues, programming the digital security for the myriad of rights it may have (analogous to common stock, or completely different such that it could morph into a utility), selling and distribution methods, and the numerous issues with accepting other digital assets or cryptocurrencies as payment for the registered securities token.

If a placement agent or underwriter is involved, that placement agent or underwriter must not only resolve all of these matters, but additional issues such as escrow provisions, KYC and AML matters and even their own compensation, which typically involves not only cash, but payment in the security being sold either directly or through convertible instruments such as warrants.

These issues have not only added cost to a registration process, but time as well. The SEC has unapologetically informed registrants that the process would not follow the usual comment review timeline.  Yet time has been beneficial to the entire industry as the SEC has continued to make efforts to educate its staff and figure out how to help companies successfully register digital securities.  At the American Bar Association’s fall meeting in November, SEC Division of Corporation Finance (“Corp Fin”) Director, William Hinman, remarked that about half a dozen ICO S-1’s and a dozen ICO Regulation A+ filings are currently being reviewed by Corp Fin on a confidential basis.

Unlike a registration for the issuance and sale of specified securities, a registration statement under the Exchange Act registers a class of securities and thereafter makes the registrant subject to ongoing reporting requirements. Registration under the Exchange Act provides information about a company and its securities but does not involve an issuance of a security and therefore does not contain disclosures related to offers, sales, issuances, plans of distribution and the like. A registration under the Exchange Act (i.e., a Form 10) is slightly more robust than an annual report on Form 10-K and much less robust than a registration statement under the Securities Act.  Although subject to some comment and review, a Form 10 registration statement automatically goes effective 60 days following the date of filing.

In the AirFox and Paragon Coin settlements, the SEC is requiring both companies to file registration statements on Form 10 to register their class of tokens under the Exchange Act. Both companies will thereafter have to file periodic reports with the SEC, including quarterly Forms 10-Q with reviewed financial statements, an annual Form 10-K with audited financial statements and interim Forms 8-K upon certain triggering events. Furthermore, the companies will be subject to the proxy rules under Section 14 of the Exchange Act and insider filing and related requirements under Sections 13 and 16 of the Exchange Act. The settlement also included penalties and an agreement to compensate an investors who elect to make a claim. Interestingly, in its statement, the SEC indicates that “[T]he registration undertakings are designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act of 1933 (“Securities Act”) prior to the offer and sale of tokens in their respective ICOs.” As described above, I don’t really agree with the statement, but I do agree that the ongoing disclosure will provide information to investors in deciding whether to seek reimbursement or continue to hold their tokens.

Investment Vehicles Investing in Digital Assets

The Investment Company Act of 1940 (“Investment Company Act”) establishes a registration and regulatory framework for pooled vehicles that invest in securities. This framework applies to a pooled investment vehicle, and its service providers, even when the securities in which it invests are digital asset securities. There are several exemptions for private pooled investment funds with Section 3(c)(1) (a fund with less than 100 investors) and 3(c)(7) (a fund with only “qualified purchasers”) being the most commonly utilized.  Both exemptions prohibit the fund from making a public offering of its securities. In fact, there are no Investment Company Act exemptions where a company has engaged in a public offering.  Separately, the Investment Advisors Act of 1940 (“Advisors Act”) requires the registration of managers and advisors to investment companies.

On Sept. 11, 2018, the SEC issued a settlement Order in the case involving the Crypto Asset Management LP and its principal Timothy Enneking, finding that the manager of a hedge fund formed for the purpose of investing in digital assets had improperly failed to register the fund as an investment company. The Order found that the manager engaged in an unlawful, unregistered, non-exempt, public offering of the fund. The Order also found that the fund was an investment company, and that it had engaged in a public offering of interests in the fund and thus no exemption was available. The Order additionally found that the fund’s manager was an investment adviser, and that the manager had violated the antifraud provisions of the Advisers Act by making misleading statements to investors in the fund.

This case is interesting because it provided the SEC with an opportunity to make a public announcement and provide enforcement-related guidance under the Investment Company Act and Investment Advisors Act related to digital assets for the first time. Although the Investment Company Act does not allow for an exemption where there is a public offering of securities, it does allow exempted funds to utilize Regulation D, Rule 506(c) which, in turn, allows for general solicitation and advertising.  Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company.

In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited. Generally speaking, an offering that allows for general solicitation and advertising is considered a public offering (see HERE for more information). However, in a securities law nuance, the legislation implementing Rule 506(c) specifies that if all of the requirements of Rule 506(c) are satisfied, the offering will not be deemed a public offering under the Investment Company Act (see HERE).

The Crypto Asset Management LP made a mistake in that it engaged in general solicitation and advertising, but did not comply with Rule 506(c) by ensuring that all investors were accredited and verifying accredited status.  This mistake gave the SEC the opportunity to issue a statement that “[I]nvestment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act and the Advisers Act.”

Trading of Digital Asset Securities

The SEC has brought multiple enforcement actions and has made public statements related to the secondary trading of digital assets, including the requirement to register as a national securities exchange or be exempt from such registration such as by operating as a broker-dealer ATS (see HERE).  To date, although several broker-dealers are registered as an ATS, there is no operational secondary securities digital asset market place.  In addition to SEC registration, broker-dealers must be members of FINRA, who regulates specific operations, including related to an ATS (see HERE and HERE).

The SEC’s recent enforcement action against the founder of EtherDelta, a platform facilitating the trading of digital assets securities, underscored the SEC’s Division of Trading and Markets’ ongoing concerns about the failure of platforms that facilitate trading in digital asset securities to register with the SEC or operate under a proper exemption from registration.  According to the SEC’s order, EtherDelta, which was not registered with the SEC in any capacity, provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain. EtherDelta’s smart contract was coded to, among other things, validate order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade. The SEC found that EtherDelta’s activities clearly fell within the definition of an exchange.

An analysis as to whether an entity is operating as an exchange requires a substance-over-form facts-and-circumstances review, regardless of terminology used by the operator.  For example, if a system “brings together orders of buyer and sellers” – if, for example, it displays, or otherwise represents, trading interest entered on a system to users or if the system receives users’ orders centrally for future processing and execution – it is likely an exchange.  Likewise, a system that uses non-discretionary methods to facilitate trades or bring together and execute orders, may fall within the definition of an exchange.

Even if an entity is not operating as an exchange, or would not require a full ATS license, it may be required to register as a broker-dealer.  Entities that facilitate the issuance of digital asset securities or their secondary trading may be required to register as a broker-dealer.  Section 15(a) of the Exchange Act provides that, absent an exception or exemption, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered in accordance with Section 15(b) of the Exchange Act.  Section 3(a)(4) of the Exchange Act generally defines a “broker” to mean any person engaged in the business of effecting transactions in securities for the account of others.  Section 3(a)(5) of the Exchange Act generally defines a “dealer” to mean any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise.  As with the “exchange” determination, a substance-over-form analysis must be applied to assess whether an entity meets the definition of a broker or dealer, regardless of how an entity may characterize either itself or the particular activities or technology used to provide the services.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE;

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journalop-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.

For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HEREHERE; and HERE.

For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the NasdaqNYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service.  The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offeringsRegulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.comCorporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

Follow Anthony L.G., PLLC on FacebookLinkedInYouTubePinterest and Twitter.

Listen toour podcast on iTunes Podcast channel.

law·cast

Noun

Lawcast is derived from the term podcast and specifically refers to a series of news segments that explain the technical aspects of corporate finance and securities law. The accepted interpretation of lawcast is most commonly used when referring to LawCast.comCorporate Finance in Focus. Example; “LawCast expounds on NASDAQ listing requirements.”

Anthony L.G., PLLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Anthony L.G., PLLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Anthony L.G., PLLC

The SEC’s Strategic Hub For Innovation And Financial Technology

Responding to the growing necessity, in mid-October the SEC launched a Strategic Hub for Innovation and Financial Technology (FinHub). The FinHub will serve as a resource for public engagement on the SEC’s FinTech-related issues and initiatives, such as distributed ledger technology (including digital assets), automated investment advice, digital marketplace financing, and artificial intelligence/machine learning. The FinHub also replaces and consolidates several SEC internal working groups that have been working on these matters.

According to the SEC press release on the matter, the FinHub will:

  • Provide a portal for the industry and the public to engage directly with SEC staff on innovative ideas and technological developments;
  • Publicize information regarding the SEC’s activities and initiatives involving FinTech on the FinHub web page;
  • Engage with the public through publications and events, including a FinTech Forum focusing on distributed ledger technology and digital assets planned for 2019;
  • Act as a platform and clearinghouse for SEC staff to acquire and disseminate information and FinTech-related knowledge within the agency; and
  • Serve as a liaison to other domestic and international regulators regarding emerging technologies in financial, regulatory, and supervisory systems.

Although I’m sure FinHub supports engagement in all FinTech areas, the website itself is broken into four categories: (i) blockchain/distributed ledger; (ii) digital marketplace financing; (iii) automated investment advice; and (iv) artificial intelligence/machine learning. Under each category the SEC has tabs with information such as regulations, speeches and presentations, opportunities for public input and empirical information.

                Blockchain/Distributed Ledger 

Blockchain and distributed ledger generally refer to databases that maintain information across a network of computers in a decentralized or distributed manner.  Blockchains are often used to issue and transfer ownership of digital assets that may be securities, depending on the facts and circumstances.

Clearly illustrating the need for regulatory initiatives, the “regulation, registration and related matters” tab under blockchain/distributed ledger is limited to public speeches, testimony and pronouncements, and enforcement actions, and not regulation (as none exists). Although certainly we in the community give public statements weight, they actually have no binding legal authority. The speeches, testimony and pronouncements that the SEC lists in this tab, and as such the ones that the SEC gives the most weight to, include (i) Chair Clayton’s testimony on virtual currencies to the Senate banking committee (see HERE); (ii) William Hinman’s speech on digital asset transactions (see HERE); (iii) statement on potentially unlawful online platforms for trading digital assets (see HERE); and (iv) remarks before the AICPA National Conference of Banks & Savings institutions (see HERE and HERE).

Providing more legal guidance are the enforcement proceedings. The SEC has provided a running list of all cyber enforcement actions broken down by category including digital asset/initial coin offerings; account intrusions; hacking/insider trading; market manipulation; safeguarding customer information; public company disclosure and controls; and trading suspensions.

Digital Marketplace Financing

Digital marketplace financing refers to fundraising using mass-marketed digital media – i.e., crowdfunding. In this category, the SEC includes traditional Title III Crowdfunding under Regulation CF and platforms for the marketing of Regulation D, Rule 506(c) offerings for the offering of debt or equity financing. Under the Regulation tab the SEC includes Regulation CF and the SEC’s Regulation CF homepage, including investor bulletins.

The SEC does not include a link to Rule 506(c) or Section 4(c) of the Securities Act, which provide an exemption for advertised offerings where all purchasers are accredited investors, and the platforms or web intermediaries that host such offerings, respectively. However, many securities token offerings are being completed relying on these exemptions from the registration provisions – in fact, more so than Regulation CF which is limited to $1,070,000 in any twelve-month period. In my opinion, this is a miss on the site layout.

This area of the FinHub website also provides a link to one of the first published SEC investor bulletins on initial coin offerings, including some high-level considerations to avoid a scam. Finally, this area provides a link to a Regulation CF empirical information page published by the SEC. Unfortunately I do not find the data to be user-friendly and could not determine how many, if any, Regulation CF offerings have included digitized assets or FinTech-related issuers.

Automated Investment Advice

Automated investment advisers or robo-advisers are investment advisers that typically provide asset management services through online algorithmic-based programs. Since their introduction, the SEC has been involved with regulating these market participants. Under this section, the SEC provides links to guidance related to robo-advisors.

Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Advisers Act. However, since robo-advisers rely on algorithms, provide advisory services over the internet, and may offer limited, if any, direct human interaction to their clients, their unique business models may raise certain considerations when seeking to comply with the Advisers Act. In particular, the Advisors Act requires that a client receive information that is critical to his or her ability to make informed decisions about engaging, and then managing the relationship with, the investment adviser. As a fiduciary, an investment adviser has a duty to make full and fair disclosure of all material facts to, and to employ reasonable care to avoid misleading, clients. The information provided must be sufficiently specific so that a client is able to understand the investment adviser’s business practices and conflicts of interests. Such information must be presented in a manner that clients are likely to read (if in writing) and understand.

Since robo-advisors provide information and disclosure over the internet without human interaction and the benefit of back-and-forth discussions, the disclosures must be extra robust and provide thorough material on the use of an algorithm. The SEC’s guidance on the subject contains a fairly thorough list of matters that should be included in the client information.

Artificial Intelligence/Machine Learning

Machine learning and artificial intelligence refer to methods of using computers to mine and analyze large data sets. The SEC includes links to a few speeches and presentations under this tab. The SEC uses machine learning and AI in numerous ways, including market risk assessment and helping identify risks that could result in enforcement proceedings such as the detection of potential investment adviser misconduct.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.

For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE; and HERE.

For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.

The Author
Laura Anthony, Esq.
Founding Partner
Anthony L.G., PLLC
A Corporate Law Firm
LAnthony@AnthonyPLLC.com

Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service.  The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.

Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.

Contact Anthony L.G., PLLC. Inquiries of a technical nature are always encouraged.

Follow Anthony L.G., PLLC on Facebook, LinkedIn, YouTube, Pinterest and Twitter.

Listen toour podcast on iTunes Podcast channel.

law·cast

Noun

Lawcast is derived from the term podcast and specifically refers to a series of news segments that explain the technical aspects of corporate finance and securities law. The accepted interpretation of lawcast is most commonly used when referring to LawCast.com, Corporate Finance in Focus. Example; “LawCast expounds on NASDAQ listing requirements.”

Anthony L.G., PLLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Anthony L.G., PLLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Anthony L.G., PLLC

Securities Token Or Not? A Case Study – Part III

This is the third part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. In Part 1 of the series, I examined a decentralized token that had been issued without any concurrent capital raise and was able to conclude such token was not a security. Part 1 can be read HERE. In Part 2 I examined a token that was issued with the intent of being a utility token, but as a result of the clear speculative motivation for purchasers, and the lack of decentralization, concluded it was a security. Part 2 can be read HERE.

In this Part 3 of the series, I examine the issuance of the Free Token as a dividend and its cousin the Bounty Token. Unlike the prior blogs in this series, which examined the question of whether a particular token is a security, this blog will analyze the definition of a “sale” under Section 2(a)(3) of the Securities Act of 1933, as amended (the “Securities Act”).  As part of this analysis, I will review the SEC action In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”).

The Free Token

Facts

Acme Insurance is building a blockchain-based community for the development of blockchain applications to revolutionize the insurance industry. Acme Insurance intends for the community to ultimately be decentralized and the code to be entirely open-source. Acme Insurance is a regional, top-tier insurance company that hopes to grow in the national marketplace and believes that if it can start and assist in the creation of a community that fosters technological developments in the industry, it will be able to capitalize on those developments to improve its market share. It also fundamentally believes in the improvement and advancement of the industry as a whole, which is defragmented and has a very large incidence of fraud. Prior to launching the Insurance Blockchain, Acme donated 2% of its net profits to educational projects which could benefit the insurance industry and has now committed to donating that 2% to the Insurance Blockchain community.

Acme is launching the Free Token to facilitate its plans. Acme is forming a Foundation to oversee the Insurance Blockchain project. An initial team of international developers is creating the platform. Acme has created 15 million Free Tokens, half of which it will distribute as a dividend to all Acme Insurance shareholders, on a pro rata basis. Acme has 900 shareholders. Acme will not receive any consideration for the issuance. Future Free Tokens will be issued through Proof of Work, and later Proof of Stake, mining efforts and as compensation for website maintenance, code updates, developing and other contributions to the project. All software developments will remain open-source, with no royalty or profit-sharing-type rights.

It is anticipated that the Free Token will trade on cryptocurrency exchanges, and Acme hopes they will increase in value to motivate efforts on the project.

Although Acme believes that ultimately the Free Token would not be considered a security, rather than test its analysis, it intends to sidestep the question and issue the token as a dividend by airdropping the token to all shareholders, without compliance with the registration and exemption requirements of the federal securities laws. Acme has asked me to confirm that it is able to do so.

Legal Analysis

As I’ve written about many times, Section 5 of the Securities Act stipulates that the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration.  Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the resale of a security by an existing security holder must either be registered or exempt from registration. The registration statement or offering circular is subject to review by the SEC before it can be used for the offer and sale of a security. The process can be both time-consuming and expensive.

Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

The registration requirements, or necessity to utilize an exemption, apply to the “offer” or “sale” of a security. Section 2(a)(3) of the Securities Act defines the terms “sale” and “offer” in pertinent part as:

The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security, for value. The term “offer to sell”, “offer for sale”, or “offer” shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value… Any security given or delivered with, or as a bonus on account of, any purchase of securities or any other thing, shall be conclusively presumed to constitute a part of the subject of such purchase and to have been offered and sold for value.

Section 2(a)(3), by its own terms, hinges on the receipt of value. The issuance of a dividend to all shareholders or the issuance of broad-based stock options to all employees has long been viewed as not involving the sale of securities.  This theory is often referred to as the “no sale” theory. In a Letter of General Counsel Discussing Question of Whether a Sale of a Security is Involved in the Payment of a Dividend, Securities Act Release No. 33-929, the SEC stated that the distribution of a cash or stock dividend to an issuer’s existing shareholders does not constitute a “sale” under Section 2(3)(a) of the Securities Act, and therefore such distribution does not require a Securities Act registration statement.  This guidance was issued in 1936 and has been reiterated on multiple occasions ever since.

Question 103.01 of the SEC Division of Corporation Finance’s Compliance and Disclosure Interpretations, published in November, 2008 confirmed the SEC’s long-standing position.  In particular:

Question 103.01

Question: If a company declares a dividend that is payable in either cash or securities at the election of the recipients, does the declaration of the dividend need to be registered under the Securities Act?

Answer: No, as there is no sale of the dividend shares under the Securities Act. [Nov. 26, 2008]

The analysis is based in part on the lack of investment decision by the recipient of the dividend.  If the recipient is not bargaining for the dividend and is not giving up anything of value, there is no risk, and therefore no sale of securities has occurred.

Accordingly, without more, even if the Free Token is a security, Acme Insurance can issue it as a dividend without compliance with the registration or exemption requirements under the federal securities laws.

The Bounty Token

Facts

To increase distribution of the Free Token, Acme will create a bounty program whereby initial users receive Free Tokens for (i) signing up to the Insurance Blockchain project; (ii) sharing certain white papers and other information documents on the project; or (iii) writing and creating educational and informational documents on the project.

Bounty programs are also often referred to as airdrop programs, though an airdrop can be used for a dividend release as well. An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. Generally the goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Bounty programs are a means of advertising and have gained in popularity in ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as registering at a website, reading and sharing materials, or marketing and making improvements to aspects of the cryptocurrency framework. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements.  In a bounty program, however, individuals must execute assigned tasks before receiving the tokens.

Legal Analysis

Tokens issued in a bounty program generally involve the sale of securities that must either be registered or exempt from registration. The concept behind a bounty token program is not new. In the Internet bubble of the ’90s, companies were issuing free stock to gain website traffic and the SEC took notice. In a series of no-action letters, the SEC shut down the practice.

In Vanderkam & Sanders (January 27, 1999), an unnamed operator of an Internet-based auto referral service proposed to issue free stock to anyone who registered at the company’s website or who referred others to it. Visitors would complete a simple registration form and would not be required to provide cash, property or services for their shares. The SEC ruled that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale” and would be unlawful unless “the subject of a registration statement or a valid exemption from registration.”

In Simplystocks.com (February 4, 1999), a web-based provider of financial information proposed to distribute free stock from a pool of entrants who logged in to the company’s website and provided their name, address, Social Security number, phone number and email address and then chose a log-in name and password. Visitors would receive one entry in the stock pool for each day they logged in to the website. After 180 days, the stock would be randomly allocated among the entrants in the stock pool. The SEC stated that the Simplystocks.com stock giveaway would be unlawful unless registered or exempt from registration.

In Andrew Jones (June 8, 1999), the promoter proposed to issue free stock to the first one million people who signed up or referred others to sign up. Shares would be claimed either by sending a self-addressed stamped envelope to the company along with the person’s name, address and email address, or by visiting the company’s website and providing the same information. The company said the information provided by shareholders would be used solely for corporate purposes and would not be sold or given to others or used for advertising purposes. The SEC ruled that “the issuance of securities in consideration of a person’s registration with the issuer, whether or not through the issuer’s Internet site, would be an event of sale” and would be unlawful unless registered or exempt from registration.

                In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”)

On August 14, 2018 the SEC obtained a judgment against Tomahawk Exploration LLC and its principal for engaging in a fraudulent ICO.  According to the SEC, Tomahawk attempted to complete an ICO using fraudulent and misleading sales materials. However, the ICO failed to raise any money and so Tomahawk “gave away” its tokens as part of a bounty program involving online promotional services.

The bounty program, like the ICO sales materials, were misleading on their face and clearly an effort to promote the token.  Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 tokens for activities such as making requests to list TOM on token trading platforms, promoting tokens on blogs and other online forums, and creating professional picture file designs, YouTube videos or other promotional materials.

The SEC Order found that Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the company provided tokens to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities. In other words, the services required in the bounty program were a valid consideration. It has long been established that value for securities can be in the form of services, cash, property, or anything that a board of directors reasonably determines as valuable. Tomahawk received value in the form of online marketing and promotion, and by the creation of a secondary public trading market for its token.  In the case of SEC vs. Sierra Brokerage Servs, Inc., the court specifically found that “where a ‘gift’ disperses corporate ownership and thereby helps to create a public trading market it is treated as a sale.”

Although the Insurance Blockchain bounty program does not require outright promotional activity, at this point, I would still recommend that the bounty program be discontinued or comply with the registration or exemption requirements of the federal securities laws.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

Copy of Logo

Securities Token Or Not? A Case Study – Part II

This is the second part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. Although the first and easy answer is that if a digital asset is being issued today, it is most assuredly a security upon issuance that needs to comply with the federal securities laws, the answer is not always that straightforward for digital assets that have been in the marketplace for a period of time, such as Bitcoin and Ether, or for new digital assets that are carefully being constructed to fall outside the purview of a securitized token.

In the first part of this series, we examined the Oldie Token and, under the fact pattern presented, was able to determine that the Oldie Token was not a security. Part 1 can be read HERE. In this part we will examine the Functional Token, which has not yet been issued. In our fictional fact pattern, Freight Blockchain, Inc. has created what they believe to be a true utility token, the Functional Token that would not need to comply with the federal securities laws. Based on the analysis below, I concluded that Functional Token does indeed need to comply with the federal securities laws.

Sources Applicable to an Analysis of all Digital Assets

In determining whether a digital asset is a security and/or needs to comply with the U.S. federal securities laws in its issuance and distribution, at least the following sources should be reviewed and considered by securities counsel. This is not a comprehensive list as facts and circumstances, and the evolving state of the U.S. and international laws, must also be considered, but it covers the basics.

  1. The Securities Act;
  2. The Exchange Act;
  3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”);
  4. Reves v. Ernst & Young, 494 U.S. 56 (1990) (“Reves”);
  5. Report of Investigation Pursuant to Section 21(a) of the Exchange Act: The DAO (July 25, 2017)(the “DAO Report”);
  6. In the Matter of Munchee Inc. (“Munchee Order”);
  7. Statement on Cryptocurrencies and Initial Coin Offerings (SEC Chairman Jay Clayton) (December 11, 2017) (“SEC Cryptocurrency Statement”);
  8. Speech by William Hinman, the Director of the SEC Division of Corporation Finance at Yahoo Finance’s All Markets Summit on June 14, 2018;
  9. SEC v. PlexCorps et al., Civil Action No. 17-cv-07007 (E.D. N.Y., filed December 1, 2017) (“PlexCorp Litigation”);
  10. In the Matter of Tomahawk Exploration LLC et al. (“Tomahawk Matter”);
  11. The Bitcoin White Paper;
  12. The Ethereum White Paper;
  13. The MUN Coin White Paper;
  14. The PlexCoin White Paper; and
  15. The White Paper and all relevant documents associated with the particular Digital Asset.

Like the first, this blog and case study is limited to an analysis of the U.S. federal securities laws and does not include any state or international securities laws nor the applicability of any regulations promulgated under or enforced by any other U.S. regulators such as the CFTC, FinCEN or the IRS.

The Functional Token

Facts

Freight Blockchain, Inc. is a software company focused in the logistics and transportation business. They have built a blockchain software application whereby the defragmented small trucking company can have access to the freight and transport needs of customers such as warehouses, stockrooms and shipping and receiving stations, without the use of a freight agent or broker. In addition to allowing for direct communication between trucking companies and potential customers, the Freight Blockchain allows for pre-screened qualified businesses in the logistics industry to advertise their goods and services on its platform. Freight Blockchain’s revenue model is based on transaction fees for the use of the Freight Blockchain.

Freight Blockchain’s idea was well received in the trucking industry and, as a result, they were able to raise funds in traditional debt and equity offerings and through venture capital investors. The Freight Blockchain is fully built out and operational, though as with any application, it is expected that it will need consistent development modifications and improvements as it gains users.

Partially as a result of the marketing angle and to attract users, and partially to encourage developers and the crowd to collaborate on maintenance and improvements to the Freight Blockchain, the company has decided to issue a Functional Token. Freight Blockchain created 10 million Functional Tokens for release with an upper limit of 15 million tokens. The management team of Freight Blockchain each received 100,000 Functional Tokens for deferred compensation, and the company removed the deferred compensation liability from its financial statements.

Freight Blockchain sold the Functional Token to users of the Freight Blockchain in its initial release at $2.00 per token with the Functional Tokens to be used as currency on the Freight Blockchain. Freight Blockchain accounted for the sales as advance transaction fees and purchasers were given a transaction fee credit for the purchase. Freight Blockchain sold 5 million Functional Tokens in its initial launch, all to individuals or entities that they thought to be customers or prospective customers of the Freight Blockchain based on a check-the-box response from purchasers.  Freight Blockchain did not separately advertise the Functional Token, but rather included the offer to prepay transaction fees via the purchase of a Functional Token in its regular Freight Blockchain ads and on its website.

Transaction fees equate to 6% of the transaction value and could vary widely depending on the customer and whether a haul is local or long-range. However, Freight Blockchain did not include either a minimum or maximum on the ability to purchase the Functional Token. A review of purchase records show that the minimum purchase was $500 and the maximum was $50,000. Although it is possible that a large customer could pay $50,000 in transaction fees in a year, it does not appear that the particular purchaser would do so and thus in hindsight, it is likely that person purchased for speculative value.

Users of the Freight Blockchain can opt to be paid in Bitcoin, Ethereum, Functional Token or fiat currency.  Transaction fees are paid to Freight Blockchain in the same currency that the users complete their transaction with.  Following the initial release Freight Blockchain launched the Functional Token open source code on Github and began trading on several cryptocurrency exchanges. Tokens can be earned by miners and are issued as compensation for website maintenance, code updates and other contributions to the Freight Blockchain. The Functional Token works as Proof-of-Stake. Freight Blockchain did not and does not market the Functional Token as an investment opportunity.

All changes to the Freight Blockchain platform must be approved by the Freight Blockchain management team, who maintains ultimate control over the software. No Foundation has been formed.

Functional Token holders do not have rights generally associated with security holders.  In particular, Functional Token holders (i) have no ownership rights in Freight Blockchain; (ii) have no right to share in profits and/or losses of Freight Blockchain; (iii) claims in bankruptcy or similar proceedings with a status of an equity holder; (iv) right to convert or exchange the Functional Token for a security token or other security; or (v) right to purchase a security token.

Legal Analysis

As I’ve written about many times, the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration. Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the re-sale of a security by an existing security holder must either be registered or exempt from registration.

Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

The registration requirements, or necessity to utilize an exemption, only apply to securities and accordingly, if Functional Token is not a security, it could be issued or resold on a cryptocurrency exchange without compliance with the federal securities laws.

The Securities Act defines the term “security” broadly to include “investment contracts.” Several tests have been used by the SEC and the courts to determine whether an offering involves an investment contract and thus a security, with the most commonly used test being the “Howey test.”  The SEC relied on the Howey test in its DAO Report in determining that certain offerings of tokens may be deemed securities. Another common test is the “Reves Test,” which I will discuss further in this analysis.

As set forth below, I conclude that the Functional Token is a security requiring compliance with the federal securities laws. However, my conclusion is weighed by the lack of legal clarity on tokens in general and my belief that when in doubt, it is a security. Furthermore, I find an analysis of a token with the features of the Functional Token to be more difficult than a decentralized token such as the Oldie Token from Part 1 of this series.

The Howey Test

The US Supreme Court case of SEC v Howey, 328 U.S. 293 (1946) established the test for whether an arrangement involves an investment contract.  An investment contract is a type of security.  In Howey, the Supreme Court noted that the term “investment contract” has been used to classify those instruments that are of a “more variable character” that may be considered a form of “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” The Howey test can be expressed as three independent elements.  All three elements must be met in order for a token or cryptocurrency to be a security, including (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits predominantly from the efforts of others. For more on the Howey test, see HERE.

(i) Investment of Money. Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. Given the broad definition of investment, Functional Token distributed to developers for mining or other services to the Functional Token project may satisfy this part of the test, but it is also possible that a court might view the individual efforts of the miners or developers differently and conclude that no investment of money has occurred. Furthermore, it is possible that the courts would interpret the initial sale of the Functional Token, even though it was characterized as advance payment for transaction fees, as an investment of money. As part of this analysis, I consider the fact that it is unlikely that a customer would advance any fees associated with the use of the Freight Blockchain but for the potential for receiving value from such advancement in excess of the amount expended.

(ii) Common Enterprise. Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: (a) horizontal; (b) narrow vertical; and (c) broad vertical.

  1. Under the horizontal test, a common enterprise is deemed to exist where multiple investors pool funds into an investment and the profits of each investor equal a prorated portion of the total profits of the pool; see, e.g., Curran v. Merrill Lynch, 622 F.2nd 216 (6th Cir. 1980). Whether funds are pooled appears to be the key question, and thus in cases where there is no sharing of profits or pooling of funds, a common enterprise may not be deemed to exist. For example, a court has found that a discretionary trading account was not an investment contract because there was no pooling of funds.

Under the horizontal test, the Functional Token may be considered a common enterprise — notwithstanding the absence of a pooling of funds — where the reward for work, through mining or the contribution of other services, correlates to the reward received by the miners, developers or other members of the Functional Token platform receiving Functional Token. However, since Freight Blockchain retains control over the platform and there is no sharing of profits or pooling of funds, it is also likely that there is not a common enterprise under the horizontal test.

  1. Under the narrow vertical test, the key is whether the profits of an investor are tied to the promoter. For example, a court has found that the imposition of profit limitations on investors through requiring a promoter to receive an excess return rate tied to the investors return, satisfied this test. This test generally relates to income earned by a promoter from profits derived from participants.
  2. Under the broad vertical test, the critical fact is whether the success of the investor depends on the promoter’s expertise. If there is such a reliance, then a common enterprise is deemed to exist.

In this case, I believe a common enterprise exists in applying the vertical test.  Although miners depend on their own efforts to receive Functional Tokens, the ultimate secondary trading value of the Functional Token is inextricably tied to the success of the Freight Blockchain. Moreover, management of Freight Blockchain has maintained control over the platform and it is their expertise that will drive the success of the enterprise as a whole. If the Freight Blockchain does not gain customers and users, it is unlikely that the Functional Token will have any value to miners or those receiving the Functional Token in exchange for services.  Furthermore, I don’t believe a reasonable argument could be made that the initial purchasers of the Functional Token were purchasing for the purpose of pre-paying transaction fees, but rather were purchasing with the hope of an increased value on secondary markets, which would depend on the success of the Freight Blockchain under the control of its management.

An alternative test, sometimes called the “risk capital test,” focuses on whether the holder of an investment may be deemed passive, and in being passive, relying on the efforts of others.  This test has four parts: (i) are any funds raised for use by a venture or enterprise; (ii) who is the target investor (i.e., is it the public generally, or a group comprised only of those with specialized interest or expertise in the area relating to the investment); (iii) how much influence do investors have on the success of the enterprise; and (iv) is the investor’s investment substantially at risk?  Under the risk capital test, I believe the Functional Token would be a security.  If Freight Blockchain is not successful, then the Functional Tokens will have no value either on a secondary market or to be used against future transaction fees.

(iii) Expectation of Profit from the Efforts of Others.  Under this element of the test, profit refers to the type of return or income an investor seeks on their investment.   This could refer to any type of return or income earned from being the owner of a Functional Token, but for purpose of the Howey test and a securities law analysis would only include profits earned passively from the efforts of others.  In other words, it is the essentially passive nature of the return, utilizing the efforts of others, that results in an “investment contract” and determination of the existence of a security, rather than a simple contract which in itself would not be a security.

As discussed above, the success of the Freight Blockchain and therefore value of the Functional Token depends on the efforts of the Freight Blockchain management and as such, I believe that this part of the Howey test is satisfied.

As with the Oldie Token, the appreciation in the value of the Functional Token after issuance, due to secondary trading, should not affect the analysis of whether a Functional Token is an investment contract and thus a security.  Other rights that are not investment contracts or securities, such as loyalty points, airline points, licenses and franchise rights, can increase in value over time due to the secondary market for those assets.

Reves and the Family Resemblance Test

An analysis of Reves and the “family resemblance test” as formulated by the Supreme Court in Reves v. Ernst & Young, is only appropriate when determining whether a loan is a security under the Securities Laws.  Reves focused on the term “note” rather than the term “investment contract” as such terms are included in the definition of a security under the Securities Laws.  For more on the Reves test, see HERE.

The Functional Token as sold as pre-paid transaction fees and recorded as same on the books and records of the company. Each purchaser received a credit on their account. Accordingly, the funds received from the Functional Token sales are a liability on the books of Freight Blockchain and each purchaser is a creditor. In the event that Freight Blockchain were to fail, the purchasers of the Functional Token with remaining transaction fee credits would be creditors of the company entitled to a distribution of assets, if any.

The first part of an analysis as to whether the Functional Tokens could be a debt security would be to consider the time in which repayment is likely. The Exchange Act and SEC specifically exclude notes with a term of less than nine months, the proceeds of which are used for a current transaction, from the definition of a “security.”  The transaction fee credit associated with Functional Tokens does not have an expiration date and based on the amounts purchased, although some will be used up in nine months, many will take much longer.

A Reves analysis involves four tests: (i) the motivation of the seller and buyer; (ii) the plan of distribution of the instrument; (iii) the reasonable expectations of the investment public; and (iv) the presence of an alternative regulatory regime.

(i) Motivation of the seller and buyer. The first factor is described as the motivation that prompts “a reasonable seller and buyer to enter into” the transaction.  If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, the courts can determine that indeed a security has been sold.  Furthermore, Reves specifically states that if the purpose is, for example, to “facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash flow difficulties, or to advance some other commercial or consumer purpose,” it is unlikely to be deemed a security.

Although the Freight Blockchain management was attempting to motivate users and build the commercial enterprise of the Freight Blockchain by issuing the Functional Token, I think it would be difficult to establish that the motivation of the purchaser was to pre-pay transaction fees.  Transaction fees do not fluctuate and therefore there would be no motivation to pre-pay this expense.  However, the immediate secondary trading of the Functional Token created a motivation to expend risk capital with the hope of a return on such investment.  Moreover, the Freight Blockchain transaction fees could be paid in fiat currency, and thus it would not be necessary to purchase the Functional Token to conduct business on the platform.

(ii) Plan of distribution.  The second factor determines whether the instrument is being distributed for investment or speculation.  If the debt instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.  Although the Functional Blockchain was not marketed as an investment, advertisements related to the Freight Blockchain and the availability of the Functional Token were widely disseminated.  Moreover, a Telegram group quickly formed regarding the Functional Token, which appeared to increase sales dramatically.

(iii) Reasonable expectation of investing public.  An instrument will be deemed a security where the reasonable expectation of the investing public is that the securities laws (and accompanying anti-fraud provisions) apply to the investment.  Although the investing public did not believe they were purchasing a security, as described herein, it is likely that the purchase of the Functional Token was motivated by a potential return on investment as opposed to purely commercial uses.

(iv) The presence of alternative regulatory regime.  The fourth factor is a determination whether another regulatory scheme “significantly reduces the risk of the instrument, thereby rendering the application of the Securities Act unnecessary.”  A “utility token” or cryptocurrency remains largely unregulated in the U.S. unless such token is found to be a security under the federal securities laws, or a commodity subject to the Commodity Exchange Act.  The lack of alternative regulatory regime supports the need for protection under the federal securities laws in the issuance and sale of the Functional Token.

Speech by William Hinman

On June 14, 2018, William Hinman, the Director of the SEC Division of Corporation Finance, gave a speech at Yahoo Finance’s All Markets Summit in which he expressed his views on when a cryptocurrency would most assuredly be a security, and laid out some factors to consider in completing an analysis under the securities laws.  An important factor in determining that a token is not, or no longer, a security is the decentralization of the underlying platform.  If a platform is decentralized, purchasers of the token would not reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the result of which would increase the value of the token.

When the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.  It is this information asymmetry that I find is key to the analysis of the Functional Token, and why using both Howey’s based-on-the-efforts-of-others test and Reves’ motivation test, the Functional Token is a security.

The Freight Blockchain management team is uniquely positioned to know whether the Freight Blockchain platform is meeting its milestones, successful, and profitable, all of which are necessary for the Functional Token to have value.  To the extent that initial purchasers hold credits for future transaction fees, those credits become worthless if the Freight Blockchain fails.  Furthermore, it is likely that the trading value of the Functional Token is inextricably tied into the success of the Freight Blockchain.  Without meaningful disclosures, such as can be found in a registration statements or proper private placement offering document, the only information that purchasers receive is found on the Freight Blockchain website, press releases and on social media such as the Telegram group.

Moreover, a review of the social media sites, such as Telegram, clearly indicates that some are promoting the Freight Blockchain for the purpose of increasing the value of the Functional Token, presumably because they hold tokens and hope to sell at a profit.  The Functional Token was sold to anyone who sought to purchase which would include those that may not understand the risks associated with the investment, and even those that did, were not provided with any meaningful information on which to assess such risks.

Hinman provided some guidance in determining whether a particular sale involves the sale of a security.  The primary consideration is whether a third party, such as a person, entity, or coordinated group, drives the expectation of a return on investment.  Questions to consider include:

  1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
  2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
  3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
  4. Are purchasers “investing,” i.e., seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
  5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
  6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

Other than that the Freight Blockchain was built and operational at the time of the issuance of the Functional Token, the answer to all of these questions supports the conclusion that the Functional Token is a security.

License/Contract Right Considerations

Providing access to the open-source Functional Token blockchain can be analogized to the grant of a license.  Because software licenses are typically governed by contract law, one possible analysis would be to focus on the rights associated with the license that are granted by the licensor to the licensee. For example, the licensor’s rights would include the ability to grant or distribute all, some or none of the rights attached to the use of the software code (originally the licensor’s intellectual property), as well as the right to exclude certain parties from using any of those rights.  Thus, the licensee would receive all of these rights, or a portion of these rights depending on what the licensor grants.

In the context of a license of the Functional Token blockchain, if any, Freight Blockchain would act as the licensor of the system, which includes the right to use the Functional Token platform and earn fees for accepted developments, but which does not include most other proprietary rights, including the right to assign or sublicense the Functional Token blockchain or transfer any rights.  There are no voting rights inherent in the Functional Token or provided other members of the Functional Token community.  Of the bundle of rights, the only right is to use the Functional Token blockchain, with the hope that innovations will be rewarded.  This limitation could be used to argue that the right is more analogous to a limited contract right rather than a security.

The DAO Report

The SEC has advised that tokens may be securities in certain circumstances, generally when involving raising capital for the issuer or seller of the tokens.  On July 25, 2017, the SEC issued the DAO Report detailing its investigation into whether the DAO (an unincorporated “decentralized autonomous organization”), Slock.iotUG (“Slock.it”), its co-founders, and intermediaries violated the federal securities laws.  Utilizing the Howey test, the SEC determined that the tokens issued by the DAO are securities under the Securities Laws and advised that those who would use distributed ledger or blockchain-enabled means for capital raising must take appropriate steps to comply with the Securities Laws (e.g., register the offering or qualify for an exemption from registration).

The DAO Report emphasized that whether a particular investment transaction involves the offer or sale of security is not dependent on the terminology used, but rather on the facts and circumstances, including the economic realities of the transaction. For more on the DAO Report, see HERE.

As detailed in the DAO Report, the concept of the DAO was memorialized in a white paper (the “DAO White Paper”) authored by the Chief Technology Officer of Slock.it.  In the DAO White Paper Slock.it proposed an entity (a DAO entity) that would use smart contracts to attempt to solve governance issues it describes as inherent in traditional corporations. Slock.it organized a DAO as a crowdfunding contract to raise funds to grow a company in the crypto space. The DAO was a for-profit entity where participants would send ETH to the DAO to purchase DAO tokens, which would permit the participant to vote and entitle the participant to “rewards.” The White Paper described this as similar to “buying shares in a company and getting . . . dividends.”  The DAO was to be “decentralized” in that it would allow for voting by investors holding DAO tokens.  All funds raised were to be held at an Ethereum blockchain “address” associated with the DAO, and the DAO token holders were to vote on contract proposals, including proposals to the DAO to fund projects. Based on the vote of the DAO token holders, the DAO would use any “rewards” from the projects it funded to either fund new projects or distribute them to the DAO token holders. The DAO was intended to be “autonomous” in that project proposals were in the form of smart contracts that exist on the Ethereum blockchain and the votes were administered by the code of the DAO.

In applying the Howey test, the SEC found that the DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it, its co-founders, and the DAO’s curators to manage the DAO and generate profits.

The Freight Blockchain project is an actual for-profit corporation under the control of a standard board of directors and officers.   Under this analysis the Freight Blockchain management acted as promoters of the Functional Token, and continue to be motivated to increase its value, as each received Functional Tokens as compensation. Moreover, although the Functional Token can be used as currency on the Freight Blockchain, its real value is in the secondary trading market, which depends on the success of the underlying platform. Applying the Howey test and principles in the DAO Report, it is difficult to argue that the Functional Token is not a security.

The Munchee Order

On December 11, 2017, the SEC issued a cease-and-desist order against Munchee, Inc. (“Munchee”) to stop Munchee’s ICO and require it to return to investors the funds it collected through the sale of its MUN token. The SEC found that Munchee’s token sale constituted an offering of securities in violation of the Securities Laws.

In applying the Howey test to the offering of the MUN token, the SEC gave little weight to the fact that Munchee characterized the MUN token as a “utility” token because of their functional use in connection with the business model of Munchee.  Instead, the SEC focused on the manner in which the offering of the MUN token was marketed.  In connection with the ICO, Munchee described how MUN tokens were expected to increase in value, especially as the result of Munchee’s future efforts. The SEC noted that Munchee made statements in its White Paper, on blogs, podcast and Facebook posts that suggested that investors would profit from purchasing MUN tokens.  In addition, Munchee endorsed statements made by other commentators that highlighted the opportunity for profit through the purchase of MUN tokens, including, for example, by linking their public post on their Facebook page about the offering (“199% GAINS on MUN token at ICO price!”) to a YouTube video in which the person featured claimed that if investors got in early enough on ICOs, they would make a profit.  Munchee also stated in a blog post that investors could count on the burning of MUN tokens by Munchee from time to time to increase value.

In the Munchee Order, the SEC noted that in its White Paper, Munchee said that they would work to cause MUN tokens to be listed on various exchanges to ensure that a secondary trading market would exist for MUN tokens. The SEC viewed such statements as priming “purchasers’ reasonable expectations of profit” and that “[p]urchasers would reasonably believe that they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUM ‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and other materials.”

In addition to concluding that purchasers of MUN tokens would have a reasonable expectation of profits based on Munchee’s states, the SEC concluded that those profits would be based primarily on the future efforts of Munchee.  In the Munchee Order, the SEC said:

The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable. Munchee was to revise the Munchee App so that people could buy and sell services using MUN tokens and was to recruit “partners” such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of the MUN tokens created by the revised Munchee App and by Munchee’s ability to create an “ecosystem” – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens.

The SEC focused on the ongoing efforts by Munchee after the token sale. However, in most cases token issuers intend to use at least a portion of the proceeds from the sale to further develop the token ecosystem. In the Functional Token context, the work done by developers, miners and other contributors to the Functional Token project is rewarded with Functional Tokens.

The Freight Blockchain management team believed that because the Freight Blockchain was built and operational at the time of issuance of the Functional Token, and because they did not tout the potential increase in value, it would not be a security. However, I believe that, because the Functional Token immediately began to trade in a secondary market, despite how it was marketed, its purchase would logically be to realize an increase in value and because the Functional Token is not a requirement to use the Freight Blockchain, it is a security.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a Bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC’s and NASAA’s statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal’s op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and need for even further guidance in this space, see HERE.

For a discussion of William Hinman’s speech related to Ether and Bitcoin and guidance on cryptocurrencies in general, see HERE.

For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.

For a review of Wyoming’s blockchain legislation, see HERE.

For a review of FINRA’s Special Notice seeking public comments on how FINRA can support fintech developments including those related to data aggregation services, supervisory processes, including with the use of artificial intelligence, and the development of a taxonomy-based, machine-readable rulebook and FINRA regulatory Notice 18-20 related to member firms’ digital asset activities, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

Copy of Logo

Security or Utility Token? A Case Study – Part I

Is it a security or is it a utility, currency, commodity or some other digital asset? That question has been continuously raised by those working with digital assets such as cryptocurrencies, virtual coins and tokens, including by digital asset issuers and companies that run platforms for the issuance or trading of such digital assets. Although the first and easy answer is that if a digital asset is being issued today, it is most assuredly a security upon issuance that needs to comply with the federal securities laws, the answer is not always that straightforward for digital assets that have been in the marketplace for a period of time, such as bitcoin and ether, or for new digital assets that are carefully being constructed to fall outside the purview of a securitized token.

The “STO” standing for security token offering has quickly gained favor alongside “ICO” with an industry-understood distinction. An STO is designed to be a security or financial instrument offering usually backed by stock, assets, revenues or profits in a company. An ICO may or may not be designed to be a security or financial instrument upon issuance, has utility or commodity attributes, and often involves a token offering entirely outside of the United States precluding US investors (some doing so more successfully than others, but that is another topic).

In this three-part blog, I will lay out fact patterns and analyze whether a digital asset is a security including (i) the issued- and trading-for-years Oldie Token; (ii) the about-to-be-issued Functional Token; and (iii) the newly-issued-as-a-dividend Free Token including a discussion of the definition of a “sale” under the Securities Act and its cousin, the Bounty Token.

Sources Applicable to an Analysis of all Digital Assets

In determining whether a digital asset is a security and/or needs to comply with the U.S. federal securities laws in its issuance and distribution, at least the following sources should be reviewed and considered by securities counsel. This is not a comprehensive list of facts and circumstances, and the evolving state of the U.S. and international laws must also be considered, but it covers the basics.

  1. The Securities Act;
  2. The Exchange Act;
  3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”);
  4. Reves v. Ernst & Young, 494 U.S. 56 (1990) (“Reves”);
  5. Report of Investigation Pursuant to Section 21(a) of the Exchange Act: The DAO (July 25, 2017)(the “DAO Report”);
  6. In the Matter of Munchee Inc. (“Munchee Order”);
  7. Statement on Cryptocurrencies and Initial Coin Offerings (SEC Chairman Jay Clayton) (December 11, 2017) (“SEC Cryptocurrency Statement”);
  8. Speech by William Hinman, the Director of the SEC Division of Corporation Finance at Yahoo Finance’s All Markets Summit on June 14, 2018;
  9. SEC v. PlexCorps et al., Civil Action No. 17-cv-07007 (E.D. N.Y., filed December 1, 2017) (“PlexCorp Litigation”);
  10. In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”);
  11. The Bitcoin White Paper;
  12. The Ethereum White Paper;
  13. The MUN Coin White Paper;
  14. The PlexCoin White Paper;
  15. Any and all recent statements, speeches or enforcement proceedings by the SEC; and
  16. The White Paper and all relevant documents associated with the particular Digital Asset.

This blog and case study is limited to an analysis of the U.S. federal securities laws and does not include any state or international securities laws nor the applicability of any regulations promulgated under or enforced by any other U.S. regulators such as the CFTC, FinCEN or the IRS.

The Oldie Token

Facts

The Oldie Token was a fair launch without any presale, ICO, pre-mine or distribution to the Oldie Token Team. No central company or entity was in charge of the initial launch. An international group of developers, building on the idea of John Doe, the founder of the idea on which Oldie Token is based (the “Initial Founders”), created the core code for the Oldie Token. Members of the developer community donated bitcoin, fiat currencies, coin and their time in a collaborative effort to launch, develop and maintain the Oldie Token.

The Oldie Token Team released 10 million coins during its Proof-of-Work phase and has a total upper limit of 15 million coins. Following the initial release, a team of developers and hundreds of contributors launched the Oldie Token open-source code on Github, the Oldie Token switched from Proof-of-Work to Proof-of-Stake and began trading on several cryptocurrency exchanges. Tokens continue to be issued via mining and as compensation for on initial graphical works, website maintenance, code updates and other contributions to the Oldie Token project.

A few years after the initial issuance of the Oldie Token, the Initial Founders formed a Foundation to direct the continued development of the Oldie Token on open source blockchain. Over time developers have made changes and upgrades to the Oldie Token code including to the wallet, programming which enables user to register names on a server linked to the blockchain and send and receive Oldie Token, data storage and messaging. The Foundation also solicits donations to spend on further development on the open sourced Oldie Token blockchain. The Foundation is based in Switzerland.

Legal Analysis

As I’ve written about many times, the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration. Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the resale of a security by an existing security holder must either be registered or exempt from registration. The registration statement or offering circular is subject to review by the SEC before it can be used for the offer and sale of a security. The process can be both time-consuming and expensive.

Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

The registration requirements, or necessity to utilize an exemption, only apply to securities and accordingly, if Oldie Token is not a security, it could be issued or resold without compliance with the federal securities laws.

The Securities Act defines the term “security” broadly to include “investment contracts.” Several tests have been used by the SEC and the courts to determine whether an offering involves an investment contract and thus a security, with the most commonly used test being the “Howey test.” The SEC relied on the Howey test in its DAO Report in determining that certain offerings of tokens may be deemed securities.

As set forth below, I conclude that the Oldie Token is not a security requiring compliance with the federal securities laws.

The Howey Test

The US Supreme Court case of SEC v Howey, 328 U.S. 293 (1946) established the test for whether an arrangement involves an investment contract. An investment contract is a type of security. In Howey, the Supreme Court noted that the term “investment contract” has been used to classify those instruments that are of a “more variable character” that may be considered a form of “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” The Howey test can be expressed as three independent elements (the third element encompasses both the third and fourth prongs of the traditional Howey test). All three elements must be met in order for a token or cryptocurrency to be a security, including (i) An investment of money, (ii) in a common enterprise, (iii) with an expectation of profits predominantly from the efforts of others. For more on the Howey test, see HERE.

(i) Investment of Money. Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. Given the broad definition of investment, Oldie Token distributed to developers for mining or other services to the Oldie Token Project may satisfy this part of the test, but it is also possible that a court might view the individual efforts of the miners or developers differently and conclude that no investment of money has occurred.

(ii) Common Enterprise. Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: (a) horizontal; (b) narrow vertical; and (c) broad vertical.

  1. Under the horizontal test, a common enterprise is deemed to exist where multiple investors pool funds into an investment and the profits of each investor equal a prorated portion of the total profits of the pool. See, e.g., Curran v. Merrill Lynch, 622 F.2nd 216 (6th Cir. 1980). Whether funds are pooled appears to be the key question, and thus in cases where there is no sharing of profits or pooling of funds, a common enterprise may not be deemed to exist. For example, a court has found that a discretionary trading account was not an investment contract because there was no pooling of funds.

Under the horizontal test, the Oldie Token may be considered a common enterprise — notwithstanding the absence of a pooling of funds — where the reward for work, through mining or the contribution of other services, correlates to the reward received by the miners, developers or other members of the Oldie Token community receiving Oldie Token. Thus, although the Foundation has some control over the protocol, the rewards in the form of Oldie Token would likely be correlated.

  1. Under the narrow vertical test, the key is whether the profits of an investor are tied to the promoter. For example, a court has found that the imposition of profit limitations on investors through requiring a promoter to receive an excess return rate tied to the investors return, satisfied this test. This test generally relates to income earned by a promoter from profits derived from participants.
  2. Under the broad vertical test, the critical fact is whether the success of the investor depends on the promoter’s expertise. If there is such a reliance, then a common enterprise is deemed to exist.

Under either of the vertical approaches, however, a common enterprise may not exist given the decentralized nature of the Oldie Token blockchain framework. This is because those who receive Oldie Tokens depend on their own efforts (mining or otherwise), rather than on any expertise of the Foundation or the Oldie Token Team (even though the Foundation may in some cases control or influence technical permission or changes to the protocol). The key is the degree of control exerted by the Foundation; where there is less reliance on the Foundation’s expertise, there is less likelihood that the Oldie Token blockchain would be viewed as being part of a common enterprise.

The law on what constitutes a “common enterprise” is unclear and a definitive conclusion is not possible. Nevertheless, given that at no time has the Oldie Project received any funds from the issuance of the Oldie Token, and instead relies on donations, including donations made to the Foundation, to create, support and maintain the Oldie Token blockchain, a court would not be likely to find that the common enterprise element is satisfied. This is all the more the case since there was no presale of the Oldie Token or distribution to members of the Oldie Team.

An alternative test, sometimes called the “risk capital test,” focuses on whether the holder of an investment may be deemed passive, and in being passive, relying on the efforts of others. This test has four parts: (i) are any funds raised for use by a venture or enterprise; (ii) who is the target investor (i.e., is it the public generally, or a group comprised only of those with specialized interest or expertise in the area relating to the investment); (iii) how much influence do investors have on the success of the enterprise; and (iv) is the investor’s investment substantially at risk? The risk capital test does not seem applicable to the facts and circumstances of the Oldie Token distribution since it generally applies only in a limited number of jurisdictions, and typically is applied only in the context of “startup” capitalization for a business. Cases relating to the risk capital test generally relate to memberships in a club-like organization that does not allow commercial exploitation for profit, but only create a right of personal use.  To the contrary, our fictional Oldie Token blockchain is an open-source system which allows for exploitation of the system by the Oldie Token owner. The Oldie Token Project does not receive funds from the issuance of Oldie Token.  Moreover, the target investor in Oldie Token is the Oldie Token developer community, rather than the general investor class.

(iii) Expectation of Profit from the Efforts of Others. Under this element of the test, profit refers to the type of return or income an investor seeks on their investment (rather than the profits that might be earned from using the Oldie Token blockchain). This could refer to any type of return or income earned from being the owner of an Oldie Token, but for purpose of the Howey test and a securities law analysis would only include profits earned passively from the efforts of others. In other words, it is the essentially passive nature of the return, utilizing the efforts of others, that results in an “investment contract” and determination of the existence of a security, rather than a simple contract which in itself would not be a security.

In determining whether profits arise from the efforts of others, courts have been flexible including situations where there is significant or essential managerial or other efforts necessary to the success of the investment. An expectation of profits resulting from receipt of an Oldie Token primarily relates to whether the holder receives (i) rights or (ii) investment interests. While the holder of an Oldie Token may receive some form of financial incentive inherent in the Oldie Token’s current and potential value, these incentives are primarily derived through the efforts of the holder of the Oldie Token, whether obtained by mining or by providing other services, or whether developed outside of the open-source blockchain protocol.

That is, owners of an Oldie Token can utilize, contribute to or even license their own contribution to the Oldie Token blockchain in various ways, none of which would be considered a passive investment. Owners of Oldie Token received by mining or for services would be better viewed as active participants, like franchisees or licensees. Although the Foundation may have some managerial oversight over the Oldie Token blockchain, including the distribution of the Oldie Token, the Foundation seeks the consensus of the Oldie Token community to make changes to the protocol, again making the owners active participants.

The appreciation in the value of the Oldie Token after issuance, due to secondary trading, should not affect the analysis of whether an Oldie Token is an investment contract and thus a security. Other rights that are not investment contracts or securities, such as loyalty points, airline points, licenses and franchise rights, can increase in value over time due to the secondary market for those assets.

The manner in which the Oldie Token is distributed to developers and miners, particularly the promotion and marketing, likely affects the “expectation of profits” analysis.  For example, we assume that since the Oldie Project’s public statements do not include words like “returns” or “profits” derived from the Oldie Token.

Reves and the Family Resemblance Test

An analysis of Reves and the “family resemblance test” as formulated by the Supreme Court in Reves v. Ernst & Young is only appropriate when determining whether a loan is a security under the Securities Laws. Reves focused on the term “note” rather than the term “investment contract” as such terms are included in the definition of a security under the Securities Laws. There is nothing about the Oldie Token that suggests it could be a debt obligation or that any party has an obligation of repayment. That is also generally the case with any token or coin.  For more on the Reves test, see HERE.

License/Contract Right Considerations

Providing access to the open-source Oldie Token blockchain can be analogized to the grant of a license. Because software licenses are typically governed by contract law, one possible analysis would be to focus on the rights associated with the license that are granted by the licensor to the licensee. For example, the licensor’s rights would include the ability to grant or distribute all, some or none of the rights attached to the use of the software code (originally the licensor’s intellectual property), as well as the right to exclude certain parties from using any of those rights. Thus, the licensee would receive all of these rights, or a portion of these rights depending on what the licensor grants.

In the context of a license of the Oldie Token blockchain, if any, the Foundation would act as the licensor of the system, which includes the right to use the Oldie Token blockchain, but which does not include most other proprietary rights, including the right to assign or sublicense the Oldie Token blockchain or transfer any rights, other than those created by the developer/miner (licensee) by its independent contribution to a side blockchain, albeit one which builds on the public open-source Oldie Token blockchain. There are no voting rights inherent in the Oldie Token or provided to donors or other members of the Oldie Token community (other than, of course, the Board of the Foundation); at best there is an expectation that decisions will be made by consensus, and that users may use the Oldie Token blockchain for their own purposes, independent of the Foundation. Thus, of the bundle of rights, the only right is to use the Oldie Token blockchain, like any other open-source code. This limitation could be used to argue that the right is more analogous to a limited contract right rather than a security.

The DAO Report

The SEC has advised that tokens may be securities in certain circumstances, generally when involving raising capital for the issuer or seller of the tokens. On July 25, 2017, the SEC issued the DAO Report detailing its investigation into whether the DAO (an unincorporated “decentralized autonomous organization”), Slock.iotUG (“Slock.it”), its co-founders, and intermediaries violated the federal securities laws. Utilizing the Howey test, the SEC determined that the tokens issued by the DAO are securities under the Securities Laws and advised that those who would use distributed ledger or blockchain-enabled means for capital raising must take appropriate steps to comply with the Securities Laws (e.g., register the offering or qualify for an exemption from registration).

The DAO Report emphasized that whether a particular investment transaction involves the offer or sale of security is not dependent on the terminology used, but rather on the facts and circumstances, including the economic realities of the transaction. For more on the DAO Report, see HERE.

As detailed in the DAO Report, the concept of the DAO was memorialized in a white paper (the “DAO White Paper”) authored by the Chief Technology Officer of Slock.it.  In the DAO White Paper Slock.it proposed an entity (a DAO entity) that would use smart contracts to attempt to solve governance issues it describes as inherent in traditional corporations. Slock.it organized a DAO as a crowdfunding contract to raise funds to grow a company in the crypto space. The DAO was a for-profit entity where participants would send ETH to the DAO to purchase DAO tokens, which would permit the participant to vote and entitle the participant to “rewards.” The White Paper described this as similar to “buying shares in a company and getting . . . dividends.”  The DAO was to be “decentralized” in that it would allow for voting by investors holding DAO tokens. All funds raised were to be held at an Ethereum Blockchain “address” associated with the DAO and the DAO token holders were to vote on contract proposals, including proposals to the DAO to fund projects. Based on the vote of the DAO token holders, the DAO would use any “rewards” from the projects it funded to either fund new projects or distribute them to the DAO token holders. The DAO was intended to be “autonomous” in that project proposals were in the form of smart contracts that exist on the Ethereum blockchain and the votes were administered by the code of the DAO.

As described in the DAO Report, Slock.it was the promoter of the DAO and its tokens because it launched a website to describe and facilitate the DAO token sale, solicited media attention by posting updates on websites and online forums, communicated to the public about how to participate in the DAO token sale and retained the right to choose the “curators” that would determine what proposals to put to a vote by DAO token holders.

In applying the Howey test, the SEC found that the DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it, its co-founders, and the DAO’s curators to manage the DAO and generate profits.

Generally, the Oldie Project has a substantially different focus than that of the DAO. The DAO was focused on providing incentives for investment and promoting sales of the DAO token. Slock.it did this by emphasizing the DAO token’s potential for profits by distributions/dividends and appreciation in value. Oldie Tokens are not sold for other currency, fiat or virtual, but are issued for the contributions made by the miners/developers to the Oldie Token blockchain from which they benefit themselves. Moreover, the role of the Oldie Team and the Foundation is different from that of Slock.it, primarily in that, unlike Slock.it, neither the Oldie Team or the Foundation receive payment for their role and neither actively promotes the Oldie Token as an investment.

The Munchee Order

On December 11, 2017, the SEC issued a cease-and-desist order against Munchee, Inc. (“Munchee”) to stop Munchee’s ICO and require it to return to investors the funds it collected through the sale of its MUN token.  The SEC found that Munchee’s token sale constituted an offering of securities in violation of the Securities Laws.

In applying the Howey test to the offering of the MUN token, the SEC gave little weight to the fact that Munchee characterized the MUN token as a “utility” token because of their functional use in connection with the business model of Munchee.  Instead, the SEC focused on the manner in which the offering of the MUN token was marketed. In connection with the ICO, Munchee described how MUN tokens were expected to increase in value, especially as the result of Munchee’s future efforts. The SEC noted that Munchee made statements in its White Paper, on blogs, podcast and Facebook posts that suggested that investors would profit from purchasing MUN tokens. In addition, Munchee endorsed statements made by other commentators that highlighted the opportunity for profit through the purchase of MUN tokens, including, for example, by linking their public post on their Facebook page about the offering (“199% GAINS on MUN token at ICO price!”) to a YouTube video in which the person featured claimed that if investors got in early enough on ICOs they would make a profit. Munchee also stated in a blog post that investors could count on the burning of MUN tokens by Munchee from time to time to increase value.

In the Munchee Order the SEC noted that in its White Paper, Munchee said that they would work to cause MUN tokens to be listed on various exchanges to ensure that a secondary trading market would exist for MUN tokens.  The SEC viewed such statements as priming “purchasers’ reasonable expectations of profit” and that “[p]urchasers would reasonably believe that they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUM ‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and other materials.”

In addition to concluding that purchasers of MUN tokens would have a reasonable expectation of profits based on Munchee’s states, the SEC concluded that those profits would be based primarily on the future efforts of Munchee.  In the Munchee Order, the SEC said:

The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable.  Munchee was to revise the Munchee App so that people could buy and sell services using MUN tokens and was to recruit “partners” such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of the MUN tokens created by the revised Munchee App and by Munchee’s ability to create an “ecosystem” – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens.

The SEC focused on the ongoing efforts by Munchee after the token sale.  However, in most cases token issuers intend to use at least a portion of the proceeds from the sale to further develop the token ecosystem. In the Oldie Token context, the work done by developers and miners, and other contributors to the Oldie Token project is rewarded with Oldie Tokens. I do not think that the SEC intended by its statements in the Munchee Order to require an issuer of cryptocurrencies to refrain from any ongoing development and promotional activities for its blockchain once it issues a cryptocurrency coin.

I believe that had the Munchee ecosystem been built and usable at the time of sale and had Munchee not marketed and promoted the MUN tokens in a manner that focused on the future profit and investment potential of MUN tokens and had instead focused on how the MUN token would be used in Munchee’s ecosystem and why the token was an important component of using and accessing the ecosystem, the SEC may not have found the token to be a security.

The SEC noted that Munchee focused on people interested in investing and making profits, not current users of the Munchee app or “people who, for example, might have wanted MUN tokens to buy advertising or increase their ‘tier’ as a reviewer on the Munchee App.” This is different from the Oldie Team and Foundation’s focus on miners/developers and members of the Oldie Token community who can contribute to the development of the Oldie Project (ecosystem) and not on the profits that may be derived from holding and investing in Oldie Token.

Realistically, in most cases, the developers and team involved in the creation of the cryptocurrency coin, such as is the case  for the Oldie Team, will continue to play some form of role in supporting and developing the blockchain. This, in and of itself, is not a fatal fact. However, if the cryptocurrency has little or no functionality at the time of sale, as was the case with Munchee, the SEC may view this as indicative that the initial purchasers are passive investors hoping to make a profit as opposed to those desiring to participate in the development of the blockchain or to gain access to the products or services that will ultimately be provided through the blockchain’s ecosystem.

SEC Cryptocurrency Statement

Concurrently with the release of the Munchee Order, the SEC’s Chairman, Jay Clayton, released a statement on cryptocurrencies and ICOs that provides some additional insights into the SEC’s mindset in reviewing cryptocurrencies. He stated that “I believe that initial coin offerings – whether they represent offerings of securities or not – can be effective ways for entrepreneurs and others to raise funding, including for innovative projects.” He also reemphasized in his statement that “replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a block chain entry on a distributed ledger may change the form of the transaction, but it does not change the substance.”

            SEC v. PlexCorps

On December 1, 2017, the SEC’s newly created Cyber Unit filed a civil enforcement action in federal court against PlexCorps in connection with its ICO or the cryptocurrency “PlexCoin.” On December 4, 2017, the court granted the SEC’s request for an emergency freeze on PlexCorps assets. The PlexCoin White Paper written by PlexCorp characterizes PlexCoin as “the new Bitcoin.” It states that it is comparable to bitcoin but with faster confirmation speeds. However, in the PlexCorps White Paper, PlexCoin promised an investment return of 1,354% for presale purchasers. The SEC viewed these as fraudulent misrepresentations designed to promote the purchase of over $15 million in PlexCoins.

Although the PlexCorp litigation and the facts of the case have some similarities with that of the Oldie Token Project, there are significant differences, most notably the manner in which Oldie Token has been promoted, as a tool for the developer community and those who use the Oldie Token blockchain for their own business purposes, apart from the Oldie Team and the Foundation. I do not think this changes the analysis or warrants the finding that the Oldie Token blockchain as directed by the Oldie Team and the Foundation would be deemed a security.

Conclusion

Based on this analysis, I would be comfortable concluding that the Oldie Token is not a security requiring compliance with the federal securities laws. In the next chapter in this three-part blog series, I will set forth facts and analyze how a new token could be created and issued without being a security, and facts and circumstances which sway the argument in the other direction.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

Copy of Logo

FINRA Examines Fintech Including Blockchain

On July 30, 2018, the Financial Industry Regulatory Authority (FINRA) published a Special Notice seeking public comments on how FINRA can support fintech developments including those related to data aggregation services, supervisory processes, including with the use of artificial intelligence, and the development of a taxonomy-based, machine-readable rulebook. The Special Notice, and fintech in general, necessarily includes blockchain technology, a topic FINRA has been examining for a few years now. Last July, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, and earlier in January 2017 FINRA issued a report entitled “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry” on the topic (see HERE).

Also, on July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens. FINRA informs members that it is monitoring the digital asset marketplace and as part of its efforts and wants all firms to notify FINRA if it or its associated persons engage in any activities related to digital assets. FINRA has requested that it be kept updated on firms’ digital asset matters through July 31, 2019.

FINRA Special Notice on Financial Technology Innovation

Clearly financial technology innovation (“fintech”) offers benefits to investors and the financial marketplace as a whole, but also creates challenges for regulators to adapt rules and supervision that support the innovations while continuing to satisfy their goals of investor protection. In addition to blockchain, technological advances have been affecting how financial service providers conduct their business and interact with clients for years. For example, fintech applications related to digital advice including robo-advisors and algorithmic trading platforms, and the use of social media in wealth management, have been hot topics of several years now. Furthermore, the use of artificial intelligence, natural language processing and social media have impacted market research and analytical coverage on a wide scale.

FINRA’s special notice provides a succinct summary of the actions FINRA has taken to date involving fintech developments, including:

  • Created an external website dedicated to fintech-related matters (see HERE).
  • Formed Fintech Industry Committee with large and small member firms, non-member fintech service providers and SEC and NASAA representation. Topics of focus for the committee include: (i) the potential impact of innovation on FINRA’s investor protection and market integrity objectives; (ii) challenges to the adoption of fintech-based products or services; (iii) opportunities to improve interactions with FINRA; and (iv) FINRA fintech-related initiatives.
  • Have held 4 blockchain and/or fintech symposiums;
  • Fintech representation at the annual FINRA conference;
  • Issued reports and investor alerts related to blockchain, cryptocurrencies digital investment advice and other fintech matters;
  • Working with other domestic and foreign regulators to share insights and address fintech-related issues.

The special report generally seeks comments that can help identify FINRA rules or administrative processes that could be modified or improved to support fintech innovation while still protecting investors and market integrity. In addition to the general request for comments, FINRA specifically requests comments on (i) the provision of data aggregation services through compiling information from different financial accounts into a single place for investors; (ii) supervisory processes concerning the use of artificial intelligence; and (iii) the development of a taxonomy-based, machine-readable rulebook.

Data Aggregation

Many investors have started using data aggregation services that compile their financial data from different financial institutions, including broker-dealers, into one place, often using a dashboard on an Internet-based platform, in order to offer a variety of services such as financial planning, portfolio analysis, budgeting, and other types of financial analysis or advice. In order to compile the data, personal information, including passwords, must be provided to these service providers. Generally, the system is automated such that a program or computer code utilizes the passwords to access various financial institutions and obtain data that is then presented to the investor. In this case the aggregation service provider and financial institution to not have a contractual relationship.

As an alternative, some financial institutions now offer services called “application programming interface” (API) in which there is a direct transfer of data from the financial institution to the aggregator. The consumer client sets the access authorization and level. In this case there is a contract between the aggregator and the financial institution including provisions related to responsibilities and technical requirements to safeguard data and privacy.

Broker-dealers can be on both sides of these transactions. That is, the broker-dealer may be one of the financial institutions from which data is being aggregated and broker-dealers can act as the aggregation service provider as well. FINRA is exploring ways to address this increasing consumer option including through the development of standards and protocols. FINRA has provided a notice to members with some guidance on data aggregation services, including that consolidated reports are communications with the public subject to anti-fraud parameters. FINRA also provided some guidance on supervisory and internal control systems; however, with the increase use of these services, more robust rules and guidance may be necessary. Blockchain, including the use of smart contracts, could be utilized in data aggregation services.

Supervision Related to Artificial Intelligence

There is a growing interest in applying artificial intelligence, including machine learning and natural language processing, to financial markets and broker-dealer processes and services. Artificial intelligence is used in areas such as anti-money laundering/know-your-customer compliance, trading, data management and customer service.

With the growth of artificial intelligence comes concerns about how the processes fit within existing FINRA regulations, and the need for new regulations. For example, FINRA is examining how a firm can adequately supervise algorithmic trading, including suitability requirements for specific customer transactions. However, more information is needed and the Special Report indicates that FINRA needs to develop a better understanding of artificial intelligence applications in the industry.  Smart contracts built on the blockchain are a form of artificial intelligence.

FINRA specifically requests comments on the following:

  • For what purposes are members using, or considering, artificial intelligence tools—including chat bots and robotic process automation (RPA) tools—in their brokerage businesses and what benefits will it serve?
  • Do firms’ governance practices for the development and ongoing operation of artificial intelligence tools differ from those used for tools or processes that use more conventional operational techniques?
  • What forms of quality assurance do firms use in developing artificial intelligence?
  • What are the greatest regulatory challenges in adapting artificial intelligence, including those related to supervision?
  • Are there specific regulatory issues that the use of artificial intelligence tools in the context of algorithmic trading strategies raises?

Development of Taxonomy-based, Machine-readable Rulebook

The UK Financial Conduct Authority (FCA) and the Bank of England (BoE) have launched an initiative to examine how to simplify regulatory compliance through the digitization of rulebooks, making them “machine-readable” – in other words, the creation of a rulebook that is structured in such a way as to make it more easily processed by a computer such as a rulebook built on the blockchain using smart contracts. FINRA is reviewing the possibility of machine-readable rulebooks for compliance policies, procedures and transaction databases.

According to the FCA and BoE, such efforts have the potential to “fundamentally change how the financial services industry understands, interprets, and then reports regulatory information,” through the mapping of regulatory obligations. The reduction of compliance costs and elimination of human error would benefit both firms and regulators.

Obviously, such a dramatic change in the industry will not happen overnight, but as FINRA indicates, it has to start with a first step. As such, FINRA is considering the feasibility and desirability of developing a type of machine-readable rulebook through the creation of an embedded taxonomy (i.e., a method for classification and categorization) within its rules.

FINRA specifically seeks comments on:

  • Who will benefit the most and who will utilize a machine-readable rulebook?
  • In what way will it make compliance more efficient and effective?
  • Is there a risk of “over-reliance”?
  • What are the benefits of developing machine-readable rulebooks that interact with other US-based and foreign regulators’ machine-readable rulebooks?
  • What role should vendors and regulated firms play in the adoption, development and ongoing taxonomy maintenance?

Regulatory Notice 18-20

The market for digital assets such as cryptocurrencies, tokens and coins continues to grow significantly and as such, fraud in their issuance and secondary trading continues to be a focus for regulators including FINRA. On July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens and to continue to update FINRA on such activities through July 31, 2019. FINRA informed members that it is monitoring the digital asset marketplace and, as part of its efforts, wants all firms to advise FINRA if it or its associated persons engage in any activities related to digital assets.

Member firms are specifically requested to notify FINRA of any of the following activities:

  • Purchases, sales or execution of transactions in digital assets;
  • Purchases, sales or execution of transactions in a pooled fund investing in digital assets;
  • The creation of, management of, or provision of advisory services for a pooled fund investing in digital assets;
  • Purchases, sales or execution of transaction in derivatives tied to digital assets;
  • Participation in an initial or secondary offering of digital assets including ICOs and pre-ICOs;
  • Creation or management of a platform for the secondary trading of digital assets;
  • Custody or similar arrangement involving digital assets;
  • Acceptance of cryptocurrencies from a customer;
  • Mining of cryptocurrencies;
  • Recommending, soliciting or accepting orders in cryptocurrencies or any digital assets;
  • Displaying indications of interest or quotations in cryptocurrencies or any digital assets;
  • Providing or facilitating clearance and settlement services for cryptocurrencies or any digital assets;
  • Recording cryptocurrencies or any digital assets using distributed ledger technology; or
  • Any use of blockchain technology.

The Regulatory Notice also explicitly reminds member firms to be cognizant of all applicable federal and state laws, rules and regulations, including FINRA and SEC rules and regulations. Furthermore, any material change in the business operations of a member firm requires the submittal of a CMA.  Involvement in cryptocurrencies, digital assets or blockchain would be considered a material change.

FinCEN and the SEC Weigh In

In a speech at a blockchain conference on August 9, 2018, FinCEN director Kenneth A. Blanco was less than positive on the state of compliance of money transmitter businesses such as cryptocurrency exchanges. For more information on FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.  In particular, Blanco states that the industry lacks adequate anti-money laundering (AML) controls and that most businesses do not even attempt to put better measures into place until after they are reviewed or investigated by a regulatory authority. Furthermore, the victims of improper AML procedures are not investors with money to lose, but rather families who lose loved ones to opioid addictions or terrorist acts, as both of these utilize cryptocurrencies in their operations.

Mr. Blanco’s remarks follow similar comments by SEC assistant director Amy Hartman, who also advised companies planning on an ICO to engage competent securities counsel.

 

Wyoming’s Blockchain Legislation

Wyoming continues to position itself as a business-friendly state most recently by passing groundbreaking blockchain legislation defining cryptocurrency coins or tokens as a whole new asset class separate from securities and commodities.  While it is unlikely that Wyoming’s new statutes will impact the SEC’s view that most, if not all, cryptocurrencies, or at least those issued to investors or used for capital raising, are securities, or the CFTC’s view that cryptocurrencies that are used as a medium of exchange, are a commodity, Wyoming has done what federal lawmakers have not yet endeavored – created comprehensive blockchain legislation.

In March 2018, Wyoming passed five separate bills addressing securities, corporate, banking and tax matters which could entice cryptocurrency and blockchain businesses to locate within the state. The statutes are part of an initiative in Wyoming called ENDOW – Economically Needed Diversity Options for Wyoming.

HB 19

Wyoming House Bill 19 provides an exemption for virtual currency, including bitcoin and ethereum, used within Wyoming from money transmitter laws and regulations subject to providing certain specified verification authority to the Wyoming Secretary of State and Wyoming Banking Commissioner.  The specified verification authority includes representations, warranties and undertakings by the issuer of “utility tokens” to confirm beneficial ownership of the token and to prevent unauthorized or fraudulent duplication of the token by third parties.

HB 19 defines a “virtual currency” as “any type of digital representation of value that: (i) is used as a medium of exchange, unit of account or store of value; and (ii) is not recognized as legal tender by the United States government.”

As a reminder, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies and has oversight to pursue claims of fraud or manipulation involving a virtual currency traded in interstate commerce.  Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing.  Rather, these “exchanges” are regulated as payment processors or money transmitters under state law.

However, despite the Wyoming state law exemption, businesses which issue or exchange these tokens would still be subject to FinCEN’s regulations and the requirements to comply with the Bank Secrecy Act (BSA).  The BSA requires virtual currency exchangers and administrators, including those businesses that issue a virtual currency in exchange for other virtual currencies, fiat currency or types of value, to complete anti-money laundering (AML), know your customer (KYC) and other procedures to combat the financing of terrorism and prevent or detect the abuse of virtual currency to facilitate cyber-crime, money laundering, terrorist financing, black market sales of illegal or illicit products and services and other high-tech crimes. For more on FinCEN and the BSA, see HERE.

HB 70

Wyoming House Bill 70 removes utility tokens from specified securities and money transmission laws.  In particular, any person that develops, sells or facilitates the exchange of an open blockchain utility token would not be required to comply with specified securities and money transmission laws subject to providing specified verification authority.  The purpose of the statute is to make clear that utility tokens issued for non-investment purposes, are exempt from the Wyoming securities laws including registration and exemption provisions and broker-dealer registration requirements.

HB 70 defines an “open blockchain token” as a digital unit which is: (i) created (a) in response to the verification or collection of a specified number of transactions relating to a digital ledger or database, (b) by deploying computer code to a blockchain network that allows for the creation of digital tokens or other units, or (c) using any combination of (a) and (b); (ii) recorded in a digital ledger or database that is chronological, consensus-based, decentralized and mathematically verified, especially related to the supply of units and their distributions; and (iii) capable of being traded or transferred between persons without an intermediary or custodian of value.

HB 70 provides that the purpose of the token must be for “a consumptive purpose, which shall only be exchangeable for, or provided for the receipt of, goods, services or content, including rights of access to goods, services or content.”

Furthermore, HB 70 would not apply where the developer or seller of the token sold the token to the initial buyer as a financial investment.  The requirement that the token not be an investment can only be satisfied if: (i) the developer or seller does not market the token as a financial investment; and (ii) at least one of the following is true: (a) the developer or seller reasonably believed that it sold the token for a consumptive purpose; (b) the token has a consumptive purpose that is available at the time of sale and can be used at or near the time of sale; (c) if the token does not have a consumptive purpose at the time of sale, the token is prevented from being resold until the consumptive purpose is available; or (d) the developer or seller takes other reasonable precautions to prevent the buyers from purchasing the token as a financial investment.

The SEC has been clear in numerous statements that it believes that tokens that are issued for the purpose of capital raising and an increase in value, are securities offerings that must comply with the federal securities laws.  The SEC’s position relates to factors such as the method of issuance and sale of the tokens, use of proceeds, investment intent and expectation of profit, ability to increase value, whether the “utility” has been built out or established, and ability for secondary trading.  The SEC has specifically not taken into account the ultimate utility value of the token, nor directly answered the oft asked question of whether a token that is issued in a securities offering, can then morph into a commodity or other asset class, not subject to the securities laws.  It is my view, and the general view of the marketplace, that “utility tokens” can be sold in a “securities offering.”

Although the Wyoming statute attempts to address the investment intent, and even appears to attempt to address the SEC main criteria, I would suggest that issuers of any tokens should continue to comply with the federal securities laws until there is further guidance and certainty at the federal level.

SF 111

SF 111 provides that virtual currency is not subject to taxation as “property” in Wyoming.  That is, virtual currency would be treated as personal property, not subject to Wyoming property taxes.  SF 111 amends a prior statute that exempted money and cash on hand, currency, gold, silver and related items by adding virtual currencies.  Like HB 19, SF 111 defines a “virtual currency” as “any type of digital representation of value that: (i) is used as a medium of exchange, unit of account or store of value; and (ii) is not recognized as legal tender by the United States government.”

HB 101

HB 101 allows for the maintenance of corporate records of Wyoming entities via blockchain that utilizes electronic keys, network signatures and digital receipts.  In particular, the Act authorizes the use of electronic networks or databases for the creation or maintenance of corporate records, authorizes the use of a data address to identify shareholders, authorizes the acceptance of shareholder votes if signed by a network signature that corresponds to a data address and specifies the requirements for the use of electronic networks and databases.  In addition, the Act requires the secretary of state to review and update its rules for consistency.

HB 126

HB 126 allows the creation and use of “series LLC’s.”  Delaware is well known for its series LLC statute.  Series LLC have become popular in the blockchain space and accordingly it is thought that this will attract blockchain-based businesses.

Further Reading on DLT/Blockchain and ICOs

For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE.

For an update on state-distributed ledger technology and blockchain regulations, see HERE.

For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.

For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.

For a review of the CFTC’s role and position on cryptocurrencies, see HERE.

For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.

To learn about SAFTs and the issues with the SAFT investment structure, see HERE.

To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.

For more information on platforms that trade cryptocurrencies and more on the continued regulatory confusion in the space, see HERE.

For information on FinCEN’s role and requirements related to the cryptocurrency marketplace, including requirements for issuers of ICOs, see HERE.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

Follow me on Facebook, LinkedIn, YouTube, Google+, Pinterest and Twitter.

Legal & Compliance, LLC makes this general information available for educational purposes only. The information is general in nature and does not constitute legal advice. Furthermore, the use of this information, and the sending or receipt of this information, does not create or constitute an attorney-client relationship between us. Therefore, your communication with us via this information in any form will not be considered as privileged or confidential.

This information is not intended to be advertising, and Legal & Compliance, LLC does not desire to represent anyone desiring representation based upon viewing this information in a jurisdiction where this information fails to comply with all laws and ethical rules of that jurisdiction. This information may only be reproduced in its entirety (without modification) for the individual reader’s personal and/or educational use and must include this notice.

© Legal & Compliance, LLC 2018

Copy of Logo