(This is the first of what will be a series of blogs addressing ICO offerings made in compliance with securities laws. Click here to view our memo that will cover the topic more extensively.)
CrowdCheck is working on a Regulation A ICO. That means we are in effect trying to push a five-dimensional square peg into a two-dimensional hole that was dug in the 1930s (please refrain from trying to find me better analogies). There are a lot of issues that have to be addressed. One we are looking at at the moment is Section 12(g) of the Securities Exchange Act. Section 12(g) says that if you have assets of $10 million and a certain number of “holders of record” of a class of equity securities (2,000 holders, or 500 non-accredited holders), you have to register that class of securities with the SEC, becoming a fully-reporting company. Not something most ICO issuers are ready for.
We’ve all heard about the SEC’s view that many coins or tokens in ICOs are securities. We haven’t seen so much discussion of whether the securities are debt or equity. That’s another thing we are working out, but for now let’s imagine that the tokens either represent a share in the profits of the issuer or include some aspect of profit share, such that they get treated as equity. Let’s also imagine that the ICO raises at least $10 million, so that asset test is met.
We’re assuming that the tokens will trade using blockchain technology and be transferred through smart contracts. (Whether that really works for the securities of corporations required to keep stock ledgers is another topic for another time, but for now let’s keep the focus on Section 12(g).)
Blockchain technology is anonymous by its nature; issuers will know how many transactions there are and how many “addresses” on a chain hold tokens. They will never know how many investors are behind those addresses. One address could be a wallet that holds the tokens of dozens of widows and orphans. Or one person could have many addresses; one that she uses for her own investments, one for holding the tokens she is managing for the local orphanage and one for her money-laundering business. We believe the only way of counting the “number of investors” that trigger the 12(g) registration requirement is to treat each address as if it were one holder of record, in the same way you would treat a broker holding in street name. And we think you have to assume that each “holder” is non-accredited, unless you build some accreditation-verification process into your smart contract.
So where does that leave the issuer? Depends on which type of securities offering it is making. If the issuer is making a Regulation A offering, a conditional exemption from Section 12(g) MAY be of some help. The exemption applies if the issuer has revenues of less than $50 million, makes its required ongoing filings and engages a registered transfer agent. But where in the process does the transfer agent sit?* Our clients suggested that one solution might be to “tokenize the tokens”: issue a token to an address owned by the issuer (and that’s what the transfer agent will keep track of), then chop up the tokens and transfer them via blockchain technology. This begs the question as to whether the captive address or the addresses holding the tokenized tokens should be treated as the “holders of record”; there’s an argument to be made either way. But at least this way you manage to engage a transfer agent and can stay within the conditional exemption until you have revenues of $50 million.
Issuers making offerings under Regulation D are going to experience this problem sooner. There’s no conditional exemption from 12(g) for them. In that case, they are left with maybe three alternatives: build an algorithm into the smart contract that prohibits transfers except to existing token-holders once there are 500 token-holding addresses, take the approach that a captive address that tokenizes the tokens is the sole holder of record, or register with the SEC.
Our clients told us that our securities laws interfered with the “beauty of the blockchain.” Yeah, kinda.
*For the moment assume this discussion doesn’t apply to Delaware corporations; Delaware law’s particular reflection of blockchain technology has caused a whole different set of issues.