Blockchain Security Token Offering under US Securities Laws
In this article, we discuss United States rules and regulations around security token issued and managed via blockchain technology. The key question is how do we know whether a token is a security token? To answer this question, we need to have an overview of the US securities laws and know what will be covered under such laws. We start off reviewing Security Token Offering or STO, followed by comprehensive coverage of federal and state regulations around security token.
If you are not familiar with blockchain technology, its history or use cases, reading the following articles in advance is highly recommended:
- Overview of Blockchain Technology and Blockchain Development Platforms
- History and Evolution of Blockchain Technology from Bitcoin
- Comprehensive overview and analysis of blockchain use cases in many industries
- Overview of Blockchain evolution and phases from Ethereum to Hyperledger
- Decentralized App Use Case for Healthcare Data Sharing
Also, reading Initial Public Offerings versus Blockchain Initial Coin Offerings Crowdfunding article is highly recommended as it reviews the differences between traditional Initial Public Offering investments and blockchain Initial Coin Offering or ICO. Furthermore, it discusses the causes of the ICO bubble that led to its downfall. Another related article is Blockchain Crowdfunding via Security Token or Initial Coin Offerings which discusses differences between security token investments and ICO.
What is an STO?
A security, in a general sense (but not according to the legal definition), is described as a financial instrument secured by a certain type of valuable asset. Securities can also be backed by revenues or profits in a company. Historically, a security is issued and purchased by signing the transaction documents on paper, such as share-purchase
agreements or subscription agreements. The offer and sale of any security by any issuer in the US is subject to the federal and state securities laws and regulations.
A security token (a token classified as a security) performs a similar function as a traditional security, except that it confirms ownership through blockchain transactions rather than paper documents. Security tokens provide some key financial rights to the investors that include shares of revenue, shares of profit, equity, dividends, rights to vote, and some other financial stakes.
When an issuer issues a token that is backed by stocks, bonds, and managed real-estate trusts to purchasers with a potential return or increase in values of such tokens based on the ownership of the digital tokens, it would likely be considered as an offer or sale of securities that is subject to the US federal and state securities laws and regulations.
For an issuance of a digital token to be considered an STO, first we need to categorize it as an offer and sale of security. Hence, the question is what kind of digital token is considered as a security and hence subject to the US federal and state securities laws and regulations?
According to CoinMarketCap, there are more than 2,000 (to be specific, 2,092) different cryptocurrencies on the market. The total market cap is $130,024,960,166 (around $130 billion—last updated: February 27, 2019 5:40 am, UTC). There are also many other types of digital tokens that are not listed on the website.
Some possible categorizations of a digital token are as follows:
- Utility token (for example, FunFair, Timicoin)
- Virtual currency cryptocurrencies (for example, virtual coins) Commodity (for example, Bitcoin)
With all these different features of digital tokens, how do we know whether a token is a security token? To answer this question, we need to have an overview of the US securities laws and know what will be covered under such laws. This will be the focus of this article.
Overview of US securities laws
Before getting into the analysis of how an STO would be subject to the US securities regulations under the Securities and Exchange Commission’s (SEC’s) radar, first let’s look at an overview of the US securities laws that govern securities offered or sold in the US.
The first issue is jurisdiction—whether the offer and sale of security is subject to regulation in the US.
For an issuance of security to be subject to US federal and state securities, such issuance should be targeted toward potential US purchasers. Hence, for an STO to be regulated under US securities laws, the STO should be exposed to public or targeted purchasers in the US.
The offer and sale of securities in the US are regulated under both federal and state laws. In some types of offerings, the federal laws will preempt the state laws. For other types of offerings, the issuers have to satisfy both federal and state laws.
In this section, we will cover some important federal regulations in the blockchain space.
Section 5 of the Securities Act of 1933
The federal securities law governing the offer and sale of a security is covered under the Securities Act of 1933, (the Securities Act). The purpose of the Securities Act is to protect the general public from making investments in fraudulent schemes. The Securities Act requires the disclosure of information that will be significant for the investors to make investment decisions. This is the main reason that the SEC requires issuers that offer and sell securities in the US to file registrations of such offerings.
Under Section 5 of the Securities Act, generally, an offer or sale of a security in the United States needs to be either registered with the SEC or exempted under one of the exemptions. However, registration of the securities offerings with the SEC is time-consuming and expensive; hence, many issuers seek ways to offer securities without the need to register.
There are several ways for the offer and sale of securities in the US to be exempt from the registration requirements.
Section 3(b)(1) and (2) / Regulation A/A+ offerings (Mini IPOs)
For an STO, where the token is considered as a security and the STO does not fall squarely into any of the exemptions under the Securities Act, the issuer may consider issuing such a digital token under a Regulation A/A+ offering, which is usually referred to as a mini IPO.
The Jumpstart Our Business Startups Act (JOBS Act) in 2012 modified the original Regulation A (the so-called Regulation A+) and modified the Securities Act by adding Section 3(b) (2) to the Securities Act.
Like the former Regulation A, the amended Regulation A (Regulation A+) provides for mini IPOs, which are exempt from SEC registration; however, the amended Regulation A covers public offerings, where general solicitation and advertising are allowed. To offer securities under the amended Regulation A, an issuer must file an offering statement on Form 1-A with the SEC, with an offering circular (OC) for distribution to investors and all required exhibits.
Form 1-A filings are subject to SEC review and comment. Before sales of securities tokens can be made, this filing and review process must evaluate the qualification of Form 1-A. This is similar to a registration statement for a registered offering to become effective. Subject to certain conditions, an issuer is allowed to test the waters or communicate with potential investors to see whether they might be interested in an offering before filing in Form 1-A; however, certain issuers under Regulation A+ are subject to ongoing reporting.
Securities sold in Regulation A+ offerings are not restricted securities, which means that they generally can be freely resold by nonaffiliates of the issuer. Certain Regulation A+ offerings benefit from federal preemption of the registration and qualification requirements of state securities laws.
Under Regulation A+, there are two tiers of offers, as described in the following list:
- Tier-1 offer requirements: This is an exemption for offerings of up to an aggregate total amount of $20 million in a 12-month period, which includes up to $6 million of secondary sales by the issuer’s affiliates. Tier-1 securities offerings are not securities that are covered under preemptive federal exemption, but they are generally subject to state bluesky registration and qualification requirements. Tier-1 issuers are subject to minimal continuous reporting requirements.
- Tier-2 offer requirements: This is an exemption for offerings of up to an aggregate total amount of $50 million in a 12-month period, which includes up to $15 million of secondary sales by the issuer’s affiliates. Investors in Tier-2 offerings that are not accredited investors are subject to limits on the amount they may invest in a Regulation A offering. Tier-2 offerings are exempt from state bluesky registration and qualification requirements. Tier-2 issuers are subject to ongoing periodic reporting requirements.
Exemptions to Section 5 of Securities Act of 1933
The Securities Act protects the general public against fraud when they make investments in securities; however, the law carves out certain offerings from the registration requirements if such offerings are targeted at certain types of investors who the SEC considers to have the ability to appreciate the risks in the investment market and have sufficient assets to bear the risks.
Section 4(a)(2) / Reg D – Rule 506(b) and (c) –private placement exemption
Section 4(a)(2) provides a private placement exemption that mainly states that if the offering for the sale of securities is not made toward the general public, but is targeted toward some specific type of investors, mainly sophisticated investors who have the assets and maturity to comprehend the complicated structure and risks in connection to the securities offerings, then the Securities Act should put such sophisticated investors into a group, namely, the accredited investors.
Section 2(a) of the Securities Act/Reg D-Rule 501(a) defines the term accredited investors as follows:
- Individuals with:
- Net worth of over 1,000,000 USD (excluding residential home)
- Annual income of more than 200,000 USD (or 300,000 USD as a couple) in the last two years
- Entities with total assets in excess of 5,000,000 USD
- Directors, executive officers, and general partners of the issuer
The most popular way to offer a sale of securities is under Regulation D, Rules 506(b) and 506(c), which are generally considered as the safe harbor under Section 4(a)(2). Offerings made under the rule 506 safe harbor will preempt the state securities requirements, which means that if the offering of securities satisfies the exemption requirements under Rule 506, it will be exempted under the states’ securities laws.
Rule 506(b) states the following:
- Under Rule 506(b), the issuer cannot make general solicitations and general advertising. But it allows the issuer to offer the securities to a maximum of 35 non-accredited investors provided that such non-accredited investors are so called sophisticated investors or such non-accredited investors making the investment decision as advised by a purchaser representative. In addition, any non-accredited investor must receive a substantive disclosure document that includes financial statements.
- Under Rule 506(b), as long as the issuer has a reasonable belief that the investor is an accredited investor for example if the issuer provides the investor a questionnaire in which the investor shows that they are an accredited investor it will satisfy the requirement under Rule 506(b).
Rule 506(c) states the following:
- The JOBS Act in 2015 also provides a new type of exemption that allows the issuer to use general solicitation and general advertising for its offerings, but with a stricter scrutiny of the qualifications of the investors.
- First, under Rule 506(c), all investors must be accredited creditors. Second, the issuer is required to take reasonable steps to verify that all investors are in fact accredited investors. The SEC provided some nonexclusive methods to verify the status of the accredited investor of individuals, such as asking for W-2 or bank statements of such individual investors.
However, some issuers consider such verification methods as intrusive, so this exemption is not as popular as the Rule 506(b) exemption.
Section 3(b)(1)/ Rule 504 – small issuance
The less popular exemption for a securities offering under Regulation D is Rule 504. Under Rule 504, the issuer can only offer an aggregate total amount of securities up to 5,000,000 USD in a 12-month period. This is considered as a small issuance exemption and is sort of overlapped by Tier 1 under Regulation A+.
Limitation of Rule 504 and 506 – bad actor disqualifications
Both offerings under Rule 504 and Rule 506 under Regulation D are subject to limitation under Rule 506(d), which is known as the bad actor disqualification.
As a result of Rule 506(d), bad actor the disqualification, an offering is disqualified from relying on Rules 506(b) and 506(c) of the Regulation D exemption if the issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order, or other disqualifying event that occurred on or after September 23, 2013, the effective date of the rule amendments. Under Rule 506(e), for disqualifying events that occurred before September 23, 2013, issuers may still rely on Rule 506, but will have to comply with the disclosure provisions of Rule 506(e).
A disqualifying event is usually one of the following:
- Certain criminal convictions
- Certain court injunctions and restraining orders
- Final orders of certain state and federal regulators
- Certain SEC disciplinary orders
- Certain SEC cease-and-desist orders
- SEC stop orders and orders suspending the Regulation A exemption Suspension or expulsion from the membership of a self-regulatory organization, for example, the Financial Industry Regulatory Authority (FINRA)
- US Postal Service false representation orders
However, actions taken outside of the US will not trigger the disqualification under Rule 506(d).
The bad actors are defined as the following:
- Issuer, predecessor of issuer, or any affiliated issuer
- Any director, executive officer, other officer participating in the offering, general partner, or managing member of the issuer
- Beneficial owner of 20% or more of the issuer’s outstanding voting equity securities
- Any promoter connected to the issuer in any capacity at the time of the sale of securities
- Any investment manager of an issuer that is a pooled investment fund
- Any person who has been or will be paid remuneration directly or indirectly for the solicitation of purchasers in connection with the sale of securities
- Any general partner or managing member of any such investment manager or solicitor
- Any director, executive officer, or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor
Section 4(a)(5) – accredited investor exemption
Section 4(a)(5) is a very limited exemption, as it only allows the offerings of securities with a total amount of more than USD 5,000,000 to one or more accredited investor(s) without using general solicitation and public advertising; however, this exemption is not limited by the bad actor disqualification. Hence, for offerings that involve a bad actor disqualification, this is a useful tool.
Section 4(a)(6) / Regulation Crowdfunding – crowdfunding exemption
The JOBS Act of 2012 added Section 4(a)(6) to the Securities Act, which provides an exemption from registration for certain crowdfunding transactions. In 2015, the SEC adopted Regulation Crowdfunding to implement the requirements under the JOBS Act. Under the rules, eligible companies will be allowed to raise capital using Regulation Crowdfunding, starting May 16, 2016.
Offerings under Section 4(a)(6) and Regulation Crowdfunding preempts the state law requirements. The aggregated total amount of securities offerings under crowdfunding by each issuer and its affiliates (note: not each offering) cannot exceed 1,070,000 USD with the following additional requirements:
- The crowdfunding cannot be offered by a non-US issuer, reporting company, investment company, and private fund.
- Investment limits for individuals:
- Individuals with either an annual income or a net worth of less than 107,00 USD can only invest the greater of 2,200 USD and 5% of the lesser of investors’ net worth or annual income.
- Individuals with both an annual income and a net worth greater than 107,000 USD may invest 10% of the lesser of the investors’ annual income and net worth (not to exceed 107,000 USD per individual investor).
- The issuer needs to file Form C with the SEC prior to offering and after completion of offering the Form C file with the SEC annually.
- Registration of Funding Portal—the issuer who collects crowdfunding must register with the SEC as an intermediary (other than the broker).
As is the case with the exemptions under Regulation D, exemption under Regulation Crowdfunding is also subject to bad actor disqualification.
Section 3(a)(11) / Rule 147 (added by JOBS Act 2012) – intrastate offering
Under Section 3(a)(11) and Rule 147, there is a very limited exemption if the issuer offers and sells its securities only in one specific state.
Regulatory issues with respect to exemptions under the Securities Act
For all the securities offerings conducted under exemptions under the Securities Act, there are several legal issues the issuers need to be reminded of:
Notice filing requirements: First, though the offerings of securities are exempt under Section 5 of the Securities Act, the issuers still must file a notice.
For an offerings exemption under Section 4(a)(2), Regulation D and (that is, Rule 504 506) Section 4(a)(5), the issuers need to file Form D which contains the basic information of the securities offerings with the SEC within 15 days after the first sale, which is the date on which the first investor becomes irrevocably contractually committed to invest. Depending on the terms of the contract between the issuer and the investor, this could be the date on which the issuer receives the investor’s signed subscription agreement or payment for the securities.
- For crowdfunding offerings, the issuers need to file Form C, which should include the information in a brief business overview containing the target- offering amount, selected offering details, intermediary information, and financial and other information about the issuer. The issuer needs to file Form C online through the SEC’s filing website.
- Transaction-specific exemptions: Second, the issuer should note that each of the preceding exemptions covers only a specific transaction that is, the offerings made at a specific time. If subsequent offerings of the same type of securities are made, such offerings have to satisfy the requirements under any of the exemptions.
- Integration doctrine: Third, even if the offerings satisfy each of the exemptions at each time that the offerings are made, there is an integration rule that the SEC will consider any offerings made within a six-month period as one big transaction, and this means that each transaction may taint the other transaction(s) and hence disqualify the other transactions under the relevant exemptions.
- Securities offered under exemptions are restricted securities: Fourth, the securities offered under an exemption under the section of the Securities Act are considered restricted securities, which should not be available for sale or be tradable in a public secondary market. Resale of restricted securities must satisfy separate exemption requirements.
- Fifth, the issuers must know that even though the initial offerings of securities are exempted under the registration requirements, a subsequent sale of such securities must separately satisfy the exemption under the Securities Act.
Other related regulatory regimes
In this section, we will cover primary regulatory regimes, as well as other related regulatory regimes as shown in the following list:
Security fraud Rule 10b-5: The offering materials for STC/ICO may be subject to Rule 10b-5, which is an important rule targeting securities fraud promulgated by the US SEC, pursuant to its authority granted under § 10(b) of the Securities Exchange Act of 1934. The rule prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.
- Securities trading platform – Securities Exchange Act of 1934: The entity that trades and provides trading platforms of securities tokens may also be subject to the Securities Exchange Act of 1934.
- Section 15(a) of the Exchange Act states that, without qualifying for an exception or exemption, it is unlawful for any broker or dealer to make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale, of any security if such broker or dealer is not registered in accordance with Section 15(b) of the Exchange Act.
- Section 3(a)(4) of the Exchange Act generally defines a broker as any person, including a company, 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 as any person, including a company, engaged in the business of buying and selling securities for that person’s own account through a broker or otherwise.
- Issuers – Investment Company Act of 1940: If an investment entity, such as a fund or issuer of tokens, is considered a pooled investment vehicle formed by the founder for the purpose of investing in certain digital tokens issued by others, it may be subject to registration as an investment company under the Investment Company Act of 1940, unless the applicable exemptions apply to it.
- A fund investing in security tokens may fall under the definitions of an investment company if either of the following applies:
- Under the operation test, the issuer is or holds itself out as being engaged primarily or proposes to engage primarily in the business of investing in securities.
- Under the balance sheet test, the issuer is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and holds or proposes to hold more than 40% of its assets in securities
- There are two types of exemptions, the so-called private investment company exemptions that are applicable to such investment funds in crypto tokens:
- Section 3(c)(1) exempts those issuers with fewer than 100 individual beneficial owners and does not make any public offering of their securities.
- Section 3(c)(7) exempts those issuers whose outstanding securities are owned exclusively by qualified purchasers who are basically investors with more than USD 5 million (for individuals, trusts, and closely held family offices) and USD 25 million (for companies and investment managers). But there is no limit to the number of investors of the issuer.
- An investment company that neither registers nor falls under any applicable exemption will basically render any contracts previously entered unenforceable.
- Investment Advisers Act of 1940: Under the Investment Advisers Act of 1940, an investment adviser is defined as any person or group that makes investment recommendations or conducts securities analysis in return for a fee, whether through the direct management of client assets or via written publications. An investment adviser who has sufficient assets to be registered with the SEC is known as a registered investment adviser.
As federal agencies, regulators are responsible for regulating and overseeing the financial system in the following ways:
- The SEC protects investors, maintains fair, orderly, and efficient markets, and facilitates capital formation by promulgating securities regulations, enforcing these regulatory rules. The SEC oversees the key participants in the securities market, including securities exchanges, securities brokers and dealers, investment advisers, and mutual funds. The SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud.
- The Financial Crimes Enforcement Network (FinCEN) safeguards the financial system from illicit use, combats money laundering, and promotes national security through the strategic use of financial authorities and the collection, analysis, and dissemination of financial intelligence. FinCEN supplements the SEC’s works.
- The Department of Justice (DOJ) starts investigations into US securities violations and prosecute violators under criminal charges.
The following cryptocurrency regulations were issued in US states:
- The New York State Department of Financial Services (NYSDFS) issued the requirements to acquire a BitLicense in order to trade virtual currencies, including bitcoin, in the state of New York.
- The Uniform Regulation of Virtual Currency Business Act (URVCBA). In July 2017, the Uniform Law Commission completed a uniform model state law, known as the Uniform Regulation of the Virtual Currency Businesses Act (URVCBA or the Act).
Each state has its own securities laws and regulations, as well as its security registration requirements.
Resale of securities Rule 144/144A/Section 4(a)(1½ ) / Section 4(a)(7)
Securities issued in an unregistered offering under the exemptions mentioned previously are restricted securities. In order to transfer or resell the restricted security by the holder, it has to be either registered or exempt from the registration requirement, which is a separate requirement from its initial offering.
The secondary sale of such restricted securities in the US is governed under these rules.
Rule 144 exemption
The Rule 144 exemption is a safe harbor provision. This allows nonaffiliate public resales of a private company’s restricted securities after a one-year holding period by the security holder.
Rule 144A exemption
Rule 144A allows the resale of restricted securities only to qualified institutional buyers (QIBs) who are institutions that own or invest on a discretionary basis at least US $100 million of securities and are considered the most sophisticated investors.
Section 4(a)(1½) exemption
The so-called Section 4(a)(1½) resale is not formally established by any written rule or regulation. It has just been developed over time by securities professionals. It was used as a basis to allow for the resale of restricted securities among sophisticated investors who could buy securities at a private resale of restricted securities without much protection of the Securities Act registration and offering materials delivery requirements.
Section 4(a)(7) exemption
This is a new resale exemption added in 2015. It requires that the resales can only be made to each purchaser who is an accredited investor without using general solicitation or general advertising and with certain information requirements for nonreporting issuers.
Securities laws development in blockchain and digital cryptocurrencies
After an overview of the US securities laws and regulations, we now turn to how the SEC gradually became involved in regulating digital tokens offerings and trading. We will review the SEC’s analysis of how the current securities regulations apply to this regime as new issues emerge.
At DC Web Makers Company, we consult small to large companies on how to navigate through blockchain technology. Specifically, we assess your industry and company business processes and needs and determine whether your business will benefit from blockchain technology.
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