USA and Switzerland became the first countries to initiate the legitimization of tokens. It is up to them that today we know the difference between security and utility tokens. Despite the fact that no law defines these concepts, each jurisdiction already has its own rules regarding security tokens’ issuance. Experts from consulting company Platinum have examined the American legislation and share their insights on SEC regulation, common pitfalls and secret paths.
2018 can be considered as the year when crypto industry matured. The US Securities Exchange Commission (SEC) started investigating crypto companies on the nature of their tokens. As a result, more and more companies started filing the SEC’s Form D to conduct an STO, considering this type of fundraising as a reliable and convenient substitution to traditional IPO and ICO.
According to the SEC’s EDGAR database, a total of 40 crypto and 18 blockchain related ventures with the words “crypto” and “blockchain” in their titles have filed notices with the SEC since 2014. In the crypto boom period (from July 2017 and especially in 2018) the tendency intensified: while in April 2017 only one company filed a notice, then a year later their number amounted to 36. The chart by Elementus clearly demonstrates the trend.
And now, when regulatory authorities became stricter towards new coins emission, the number of SEC filings only grows.
Fundraising via STO is compliant with the US laws, thus it allows crypto companies to sell security tokens to big institutional players. It is something that startups were not able to do before.
Hedera Hashgraph, the blockchain platform seeking to provide a new form of distributed consensus, is a perfect example of the potential this method of fundraising has. After filing the Reg D 506c with SEC, they have conducted an STO, raising $104,467,509 from over 900 different investors.
Why Form D? Because this type of offering is exempt from full SEC registration requirement. It permits issuers to broadly solicit and generally advertise an offering, provided that:
- All purchasers in the offering are accredited investors.
- The issuer takes reasonable steps to verify purchasers’ accredited investor status and certain other conditions in Regulation D are satisfied.
According to the law, businesses do not have to file the Form D before STO. There are 15 days to do that after the first sale of securities in the offering takes place. However, the most revolutionary thing is that the security nature of tokens allows institutional investors to form part in the STO, it includes pension funds, ETFs, banks, insurance companies, pensions, hedge funds, REITs, investment advisors, endowments, and mutual funds.
Review of SEC regulations and their pitfalls
The SEC, being a federal government agency, is responsible for protecting investors, maintaining fair and orderly functioning of securities markets and facilitating capital formation.
According to the Federal Securities Law, none company can issue or sell security tokens without the previous registration in the SEC, unless the offering falls under another exemption from registration.
SEC has several documents regulating financial instruments, including tokens and securities.The most fundamental is the Securities Act of 1933, under which not all offerings of securities must be registered with the SEC. The most common exemptions from the registration requirements include:
- Private offerings to a limited number of persons or institutions;
- Offerings of limited size;
- Intrastate offerings;
- Securities of municipal, state, and federal governments.
Regulation D of the Securities Act. Currently, Regulation D is comprised of three rules: Rule 504, Rule 506(b) and Rule 506(c) – all of them allow a company to raise capital by accessing the private capital markets through an unregistered (“private”) offering, without having to pass through whole process of registration.
According to the SEC report, this path reduces an issuer’s regulatory obligations, thereby decreasing issuance costs and the time required to raise new capital. This particularly benefits smaller firms, for whom accessing public capital markets may generally be too costly.
Under Rule 506(b), a company:
- Can raise an unlimited amount of money;
- May sell its securities to an unlimited number of "accredited investors" and up to 35 other purchasers;
- Cannot use general solicitation or advertising to market the securities;
- Must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws;
- Must be available to answer questions by prospective purchasers.
Under Rule 506(c), a company:
- Can broadly solicit and generally advertise the offering only to accredited investors;
- Takes reasonable steps to verify that the investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Rule 504 of Regulation D provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $5,000,000 of their securities in any 12-month period. Investors in such offerings should be informed that they may not be able to sell the securities for at least a year unless the issuer registers the resale transaction with the Commission.
The following companies are not eligible to use the Rule 504 exemption:
- Companies that already are Exchange Act reporting companies;
- Investment companies;
- Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies;
- Companies that are disqualified under Rule 504’s “bad actor” disqualification provisions.
It is important to keep in mind that each US state has its own securities act, known colloquially as the “blue sky law”, which regulates both the offer and sale of securities as well as the registration and reporting requirements for broker-dealers and individual stock brokers doing business (both directly and indirectly) in the state, as well as investment advisers seeking to offer their investment advisory services in the state.
Regulation A of the Securities Act. As the Securities Act states there are two offering tiers: Tier 1, for offerings of up to $20 million in a 12-month period; and Tier 2, for offerings of up to $50 million in a 12-month period. For offerings of up to $20 million, companies can elect to proceed under the requirements for either Tier 1 or Tier 2.
There are certain basic requirements applicable to both Tier 1 and Tier 2 offerings, including:
- Company eligibility requirements;
- Bad actor disqualification provisions;
- Disclosure, and other matters.
Additional requirements apply to Tier 2 offerings, including:
- Limitations on the amount of money a non-accredited investor may invest in a Tier 2 offering;
- Requirements for audited financial statements and the filing of ongoing reports;
- Issuers in Tier 2 offerings are not required to register or qualify their offerings with state securities regulators.
Regulation S of the Securities Act. It is an additional mechanism that provides an SEC compliant way for US and non-US companies to raise capital outside the U.S. It is not necessary to have a company in the USA to use Reg S.
When a foreign issuer is making an unregistered offshore Internet offer and does not plan to sell securities in the United States as part of the offering, it should implement the general measures outlined in Section III.B. to avoid targeting the United States. Assuming that the offering is made pursuant to Regulation S, the offering must comply with all of the applicable requirements under that regulation, including the requirement that all offers and sales be made in "offshore transactions."
Regulation S advantages are:
- U.S. issuers can sell securities offshore without regard to the sophistication or number of purchasers in the offering or the size of the offering.
- It does not contain specific information requirements.
- It permits issuers and distributors to advertise an offering offshore (consistent with the prohibition against directed selling efforts and the offshore transaction requirements) in a manner that would not be consistent with the prohibition against general solicitation in a private placement in the United States.
- It will continue to afford U.S. issuers a means to sell securities without the potential delay and "market overhang" caused by registering equity securities under the Securities Act.
- Purchasers will continue to have several sources of liquidity.
- It is possible that purchasers in Regulation S offerings could insist upon registration rights as do purchasers in private placements.
Particularly in the case of reporting companies, a Regulation S offering coupled with on demand registration rights provides an issuer with ready access to foreign capital while according purchasers access to U.S. markets for liquidity.
Regulation S disadvantages are:
- Purchasers of domestic equity securities sold pursuant to Regulation S may have to wait a longer period of time before they can publicly resell the securities into the United States.
- In addition, these purchasers will have to provide certification that they are not U.S. persons that may result in additional recordkeeping burdens on issuers and distributors who must maintain records of this compliance.
There are different regulations that a company can choose to follow, however neither of them is perfect, as Platinum legal team admits. There are some pitfalls that must be weighed before coming to a final decision.
Head of legal department in Platinum