Regulation A+: A Path to Market for Crypto Companies?

Most companies considering an Initial Coin Offering to U.S. purchasers have resigned themselves to the fact that their proposed token or coin offering is likely to be considered an offering of securities by the Securities and Exchange Commission (“SEC”) and must be made in compliance with U.S. securities laws. The logical next question then becomes – “what are my options?”

Traditional IPO

A traditional initial public offering (“IPO”) of equity securities usually requires extensive meetings with underwriters, accountants and lawyers, the preparation of audited financial statements and the filing of voluminous and detailed documents with the SEC.  In addition, once a company has completed an initial public offering, it must comply with extensive ongoing SEC disclosure requirements.

Reg. D Private Placements

The sale of securities (including securities tokens) may also be conducted as a private placement under Regulation D of the Securities Act, particularly Rules 506(b) and (c).  Rules 506(b) and (c) of Regulation D allow issuers to raise an unlimited amount of funds from “accredited” investors.[1]

Issuers conducting their offering under Rule 506(b) may allow, in addition to the accredited investors, up to 35 sophisticated but non-accredited investors to participate in their offering, but there are heightened disclosure requirements that apply; there are no exceptions for Rule 506(c) offerings, which may be made only to accredited investors.

Aside from the unlimited offering potential, one other big advantage for many issuers using the Rule 506 exemptions is that the securities issued do not have to be registered with the SEC and therefore there is no SEC review process.  Aside from a short Form D that must be filed with the SEC within 15 days of the first sale of securities with basic details of the offering (i.e., maximum dollar amount of securities being offered, number of investors, industry group, etc.), there are no other SEC filing requirements and no ongoing disclosure requirements.

Issuers using one of the Rule 506 exemptions will typically provide prospective investors with offering documents such as a private placement memorandum (which is subject to antifraud liability), but the costs, both financial and timewise, associated with Rule 506 offerings are significantly less than a traditional public offering.  Of course, there also are drawbacks to conducting an offering under Rule 506.  For example, we mention above that under Rule 506, securities may only be sold to accredited investors (barring the limited exception provided under Rule 506(b)). But perhaps the most significant drawback of Rule 506 offerings is that the securities offered and sold in a Rule 506 offering are deemed to be “restricted” securities under U.S. securities laws and must generally be held by the purchaser for one year before they may be resold.  In addition, while Rule 506(c) offerings permit general solicitation and advertising, issuers conducting 506(b) offerings may not participate in any general solicitation or advertising.

Reg A+ Offerings

There is an alternative path that has been gaining a lot of attention in crypto circles recently, and that is the exemption provided by Regulation A+ of the Securities Act, deemed by some the “mini-IPO.”

Regulation A+ was passed under the JOBS Act as an improvement to the predecessor Regulation A exemption and provides for a more streamlined process than the typical IPO.  Like an IPO, Regulation A+ permits eligible issuers to offer securities to the general public, not just to accredited investors. Issuers relying on Regulation A+ are required to file a Form 1-A with the SEC, which is subject to SEC review and approval (unlike Regulation D offerings, which are not reviewed and issuers do not need to wait for approval prior to issuance).

The crux of the Form 1-A is the offering circular, which must contain financial statements and other information similar to but less extensive than what would be required in a registration statement (albeit significantly more extensive than what is typically included in an ICO white paper).

Aside from the ability of the issuer to offer securities to the general public under Regulation A+ (subject to the non-accredited investor caps imposed by Tier 2), one of the most significant advantages of Regulation A+, as compared to Regulation D, is that securities issued in a Regulation A+ offering are not “restricted” securities and are freely tradable. However, we note that the potential for a trading market actually developing, and the potential for real liquidity, particularly for tokens and coins, should be evaluated.  Another benefit to Regulation A+ is that it allows issuers to “test the waters” or solicit interest in a potential offering either before or after the filing of the Form 1-A, subject to certain conditions.  However, Regulation A+ offerings are subject to offering caps, unlike Rule 506 offerings, as described below.

Regulation A+ consists of two offering categories – Tier 1 for offerings up to $20 million and Tier 2 for offerings up to $50 million. Aside from the price differential, the other significant differences between the two offering tiers are that Tier 2 offerings require audited financial statements, ongoing SEC disclosure requirements (albeit to a lesser extent than those required in connection with an IPO) and an investment cap for non-accredited investors.  Tier 2 offerings, but not Tier 1 offerings, also preempt state securities regulatory review (similar to Rule 506 offerings), a significant improvement over the predecessor Regulation A.

So, is Regulation A+ the answer for crypto companies?  Maybe, maybe not.  To date, only six issuers have filed a publicly available Form 1-A for a token offering, and none of these filings has been qualified by the SEC.

As noted above, perhaps the most significant advantage to Regulation A+ is that investors receive unrestricted securities that are freely tradable.  But how soon will a truly robust secondary trading market develop for the tokens and coins being offered by most crypto companies?  And why would a crypto company subject itself to the filing requirements and ongoing disclosure requirements of a Regulation A+ offering, when it could instead offer unlimited securities (albeit to accredited investors only) under Rule 506 with limited filing requirements, not to mention no SEC review, and no ongoing SEC reporting obligations?  The best alternative will, of course, be issuer specific, which is why it is critical for issuers to weigh the pros and cons with experienced legal counsel.

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[1] An “accredited investor,” in the context of a natural person, includes anyone who: (i) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or (ii) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence.  Entities such as banks, partnerships, corporations, nonprofits and trusts with total assets in excess of $5 million also qualify as accredited investors.

Reed Smith partner applies AI techniques to develop new type of contract – a Data Contract

Click here to see a demonstration of a simplified “AI and the Law: Data Contract”: https://lnkd.in/gRNDBk2  and the Companion Software Application.  This demo shows how we can access contract information stored as fields of data on the Microsoft Azure cloud.  (I use a credit agreement as an example, but the same principles work for any contract.)  With the increased focus on digitization of contracts in financial services, healthcare, shipping, energy, entertainment, and other industries, efforts are underway to create a new form of contract in a data format (a “Data Contract”) – the next step in the evolution of contracts.  The essence of the Data Contract is that the terms of the contract are stored in a database at both the Clause Level and the Idea Level.  This gives the parties complete control over the information in the contract for purposes of origination, amendment, reporting, compliance, and other operational issues, as well as transfer, securitization, and other forms of monetization.  We can always print to paper or pdf, so there is no downside or risk to experimenting with a Data Contract.  See, past and future posts for more information about the “New Logic of the Law,” which is the math and logic system underlying Data Contracts. – William S. Veatch https://www.linkedin.com/in/william-veatch-9666371b/

Ohio Enacts Blockchain Legislation

Governor John Kasich signed a bill into law on Friday, August 3, 2018, adding Ohio to the list of U.S. states enacting blockchain legislation.  Introduced last October and passed by the House at the end of June, SB 220 legally recognizes records or contracts and signatures secured through blockchain technology.  Specifically, the bill amends Section 1306.01 of Ohio’s Uniform Electronic Transactions Act, reflecting a “record or contract that is secured through blockchain technology is considered to be in an electronic form and to be an electronic record,” and a “signature that is secured through blockchain technology is considered to be in an electronic form and to be an electronic signature.”  This language was incorporated from an earlier bill introduced in May, SB 300, although language legally recognizing smart contracts was cut.

Ohio’s recent statutory adoption follows a growing state-by-state trend.  For example, Nevada, Delaware, Tennessee, and Wyoming, among others, have already enacted similar laws relating to authorizing blockchain-based records, and states continue to lead blockchain-friendly legislative initiatives in other contexts, such as establishing regulatory sandboxes and clarifying money transmission laws.

While generally welcomed by the industry, there also is some concern that the state-level legislation makes too many distinctions between technologies and may have additional harmful domino effects.  For example, the Electronic Signatures and Records Association (“ESRA”) and the Chamber of Digital Commerce issued a joint statement in April 2018, warning that while state legislation may be well-intentioned, it can lead to redundancies, inconsistencies, and issues with federal preemption.

CFPB Picks Paul Watkins to Lead Office of Innovation

On July 18, 2018, Acting Director Mick Mulvaney of the Consumer Financial Protection Bureau (“CFPB”) announced that Paul Watkins will head the CFPB’s new Office of Innovation. According to the press release, the office, which Mulvaney created to focus on consumer-friendly innovation, “will focus on creating policies to facilitate innovation, engaging with entrepreneurs and regulators, and reviewing outdated or unnecessary regulations.” Watkins previously managed the first state fintech regulatory sandbox in the United States out of the the Arizona Office of the Attorney General, which we have previously reported on here. He is expected to take charge of a sandbox initiative that the CFPB is working on in coordination with the Commodity Futures Trading Commission (“CFTC”). A sandbox program aims to provide relief from various regulatory requirements and regulatory guidance to start-ups, while providing insight into fintech startups and technology innovation to regulators.

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Bank of England Governor backs FinTech

In a speech delivered at Mansion House on 21 June 2018, Mark Carney, the Governor of the Bank of England (BofE), made the case for a modernised financial services sector, which would be underpinned by a thriving FinTech sector, especially in the area of payments.

The remarks reinforce the BofE’s plan for FinTech in central banking, which started last year when it partnered with a range of firms to look into the functionality the BofE would need to offer to support the sector.  The result came when the BofE announced that a new generation of non-bank payment service providers would be eligible to apply for a settlement account under its real-time gross settlement system (RTGS).  Those proposed changes were also focused on widening access to UK payment systems, supporting financial stability through greater diversity and risk-reduction technologies, and creating a more level playing field for non-banks wishing to compete with banks.

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Digital Tokens and Coins Advisories and Regulatory Proposals – CFTC and Financial Stability Board Pronouncements

CFTC Customer Advisory

On Monday, the Commodity Futures Trading Commission (“CFTC” or “Commission”) issued its fourth virtual currency customer advisory, Customer Advisory 7756-18, as part of its outreach effort to educate market participants.  Titled, Use Caution When Buying Digital Coins or Tokens, the advisory warns customers of the risks of speculation of future value and fraud; it ultimately advises that the best protection is to exercise caution and to extensively research digital tokens and coins—and those who offer them for sale—prior to purchase.

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Applying Howey, Court Concludes that Centra Token Likely a Security:

While the SEC continues to target fraudulent crypto-projects, we’ve seen a marked increase in the number of class actions targeting a wider-range of ICOs.[1] The crypto-industry is watching these cases intently; awaiting the judiciary’s play in the on-going game of “Are Crypto-Tokens Securities?”. Earlier this week, United States Magistrate Judge Andrea M. Simonton (Southern District of Florida) laid an early card in Rensel v. Centra Tech, Inc.[2] Although the Report and Recommendation[3] is not the in-depth analysis of a functional, utility-heavy token the industry desperately needs, it nonetheless offers some food for thought.

Analyzing the plaintiffs’ motion for a temporary restraining order, the court asked whether the plaintiffs had a likelihood of succeeding on the merits of their securities fraud claims. Part of that analysis involved applying the Howey Test[4] to determine whether Centra Token (“CTR”), the token powering Centra Tech’s purported “crypto-debit card” is a security. Judge Simonton had little trouble concluding that the token-purchasers met the first two Howey-prongs because the plaintiffs invested USD, Ether, and Bitcoin in an operation they had little control over. Moreover, “because the success of Centra Tech and the Centra Debit Card, CTR Tokens, and cBay that it purported to develop was entirely dependent on the efforts and actions of the Defendants,” the court also concluded that CTR satisfied the remaining Howey prong (that there be an expectation of profits derived solely from the efforts of others). Ultimately, Judge Simonton concluded that CTR meets the requirements of an investment contract and, thus, for now, the unregistered Centra Tech ICO could have violated the Securities Act of 1933.

However limited, Judge Simonton’s analysis is interesting for several reasons. First, the court focused on how the defendants’ efforts impacted the success of not just the CTR token, but also the products and applications operating around CTR, namely the cBay marketplace and the Centra Debit Cart.  Second, rather than inquiring whether the defendants themselves created an expectation of profits, the court was satisfied that such an expectation existed, regardless of its origin. Ultimately, the precedential value of this opinion is limited because the defendants conceded for the purposes of the motion that CTR are securities. In an industry searching for clarity, however, interested parties in all corners will undoubtedly rely on Rensel to make their respective points. With time and repetition, the contours of the Howey test as it applies to crypto-tokens will begin to take shape; whether other courts should follow the path laid in Rensel remains to be seen.

The parties have the opportunity to lodge objections to Judge Simonton’s Report and Recommendation before it is ultimately considered by United States District Judge James Lawrence King.

[1] See e.g., Jacob Zowie Thomas Rensel v. Centra Tech, Inc., No. 17-CV-24500 (S.D. Fla.); Coffey v. Ripple Labs Inc. et al., No. 3:18-cv-03286 (N.D.C.A.); GGCC LLC v. Dynamic Ledger Solutions Inc. et al., No. 5:17-cv-06779, (N.D. Cal.).

[2] Rensel, v. Centra Tech, Inc., No. 17-CV-24500, 2018 BL 227097 (S.D. Fla. June 25, 2018).

[3] A magistrate’s report and recommendation is subject to objections by both parties. After the parties object, the report and recommendation goes to the assigned district court judge who will make the final decision whether to reject, adopt, or adopt in-part the magistrate’s decision.

[4] Under the so-called Howey Test, a particular scheme is considered a security if it qualifies as an investment contract whereby a person [1] invests money in [2] a common enterprise and [3] is led to expect profits [4] solely from the efforts of the promoter or a third party.  SEC v. W.J. Howey, 328 U.S. 293 (1946). Although some courts apply this as a three-prong test, the same essential elements are required.

CFTC Issues Guidance on Listing Virtual Currency Derivatives

Last week, the Market Oversight and Clearing and Risk Divisions of the Commodity Futures Trading Commission (“CFTC” or “Commission”) issued Staff Advisory No. 18-14 regarding virtual currency derivative product listings. The advisory serves as guidance to exchanges and clearinghouses in the context of listing derivative contracts based on virtual currency under Commission Regulations 40.2 (self-certification) or 40.3 (voluntary submission for Commission review and approval) in order to promote effectiveness and efficiency in the emerging area virtual currency derivatives.

Specifically, the advisory clarifies CFTC priorities and expectations for virtual currency derivatives listed on a designated contract market (“DCM”) or swap execution facility (“SEF”) or cleared by a derivatives clearing organization (“DCO”­) with regard to enhanced market surveillance, coordination with CFTC staff, large trader reporting, stakeholder outreach, and DCO risk management. The Commission notes that this latest effort at providing regulatory clarity is not a “compliance checklist,” and the extent of its relevance depends on the terms and conditions of each virtual currency contract.

Enhanced Market Surveillance: DCMs and SEFs are responsible for having an oversight program designed to ensure listed contracts are not readily susceptible to manipulation and to detect and prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process. To increase visibility into underlying spot markets and manage risks related to the trading of listed virtual currency derivatives, the Commission advises having an information sharing arrangement in place with the underlying spot markets that may contribute to the cash-settlement price in order to provide the derivatives exchanges access to a broader range of trade data, including trader identity, prices, volumes, times, and quotes.

The Commission also advises a heightened level of real-time monitoring that involves continuous monitoring of relevant data feeds (particularly around settlement) and making inquiries where appropriate in the event of identified anomalies or disproportionate moves in spot markets.

Coordination with CFTC Staff: The Commission expects exchanges to regularly discuss virtual currency derivatives contracts surveillance issues with CFTC staff and to provide information upon request, including data related to the settlement process referenced by the derivatives contract.

Large Trader Reporting: The Commission may raise or lower reporting levels in specific markets under the Commission’s Large Trader Reporting System. Exchanges can set the reporting level of contracts in a particular commodity at a lower level than specified in CFTC regulations, but the Commission recommends setting the large trader reporting threshold for any virtual currency derivative contract at five bitcoin (or the equivalent) to facilitate surveillance.

Stakeholder Outreach: The Commission expects exchanges to take extra care to engage meaningfully with stakeholders due to the novel and evolving nature of virtual currency contracts and concerns related to price volatility and lack of transparency. The effort should include soliciting comments on a broad array of topics related to the listing that go beyond the terms and conditions and manipulation susceptibility from members as well as other relevant stakeholders that go beyond those interested in trading the contract (e.g., clearing members and futures commission merchants (“FCMs”). When submitting a virtual currency derivative contract listing, an exchange should provide as much information as possible, including explanations of substantive opposing views and how the exchange has addressed them.

DCO Risk Management: CFTC staff will request and review from the identified DCO: (1) proposed initial margin requirements to assess whether they are commensurate with the risks; (2) ability of proposed margin requirements to adequately cover potential future exposures to clearing members based on an appropriate historic time period (and may require adjustments); (3) information related to the governance process for approving the proposed contract(s), including explanation of views of approving clearing members and the response to dissenting reviews; (4) adherence to internal governance procedures for new contract approval; and (5) any other information relevant to the clearing of the proposed contract.

Exchanges and clearinghouses are currently evaluating new crypto products, and these guidelines setting forth the Commission’s expectations with regard to that process will help streamline the new contract listing procedures. It also emphasizes a current priority for the CFTC, which is to obtain more information regarding the crypto spot markets, which they hope to accomplish via the registered platforms. Market participants are looking forward to seeing a wider variety of crypto derivative products, and hopefully this guidance will speed that process.

The Chain Gang – FTC’s New Blockchain Working Group May be Good News for Marketers

One of the greatest developments for marketers in 2018 is likely to be the proliferation of new and innovative applications on the blockchain in the context of marketing and promotion, particularly in connection with loyalty programs, ad fraud mitigation, and ongoing CRM activities that combine brand affinity and peer-to-peer influencing.  The potential magnitude of the changes that the promotion marketing industry could see in the next 12 months, especially in the loyalty area, is simultaneously thrilling and daunting.  The technological challenges of simply understanding the blockchain is hard enough.  In addition, cryptocurrency fraud and money laundering concerns have delayed public acceptance of blockchain-based promotional activities.

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Massachusetts Enforces While Arizona Provides Flexibility to Fintech

This week, the Massachusetts Secretary of State ordered five companies, 18Moons, Across Platforms, Mattervest, Pink Ribbon, and Sparko, to cease and desist from engaging in initial coin offering (“ICO) campaigns as part of an ongoing government investigation of token sales.  The companies allegedly offered and sold unregistered securities in violation of the Massachusetts Uniform Securities Act (Chapter 110A of Massachusetts’ General Laws) and corresponding regulations.  The orders, among other things, (1) prohibit the companies from selling unregistered or non-exempt securities in Massachusetts until they are in compliance, including filing a Form U-2 Consent to Service of Process; (2) require the companies to provide the Enforcement Section with written notice of securities offerings prior to making future offers or sales; and (3) mandate rescission of sales to investors that purchased the tokens at issue prior to the order date, pursuant to specified terms.  The Enforcement Section may take further actions if the companies fail to comply, including re-instituting investigations.

The announcement of the Massachusetts enforcement actions was announced five days after Arizona announced becoming the first U.S. state to enact a fintech regulatory “sandbox.” The Arizona Governor signed House Bill 2434 into law on March 23, which aims to foster innovation by allowing companies to launch and test innovative products under limited conditions in the Arizona market outside of the scope of potentially burdensome and costly regulatory requirements.  The Office of the Arizona Attorney General will administer the sandbox program and will likely begin accepting applications for entry in late 2018, which will require detailed descriptions of the product or service and a to-be-determined fee.  Approved participants will have one year to test their product or service on Arizona residents, with the possibility of a year-long extension before July 2028, when the program ends.  Other limits include caps on the numbers of individuals who may participate in each agreement, the amount of loans that may be issued, and those related to financial transactions under Arizona law.  The sandbox participants also will be subject to the Arizona Consumer Fraud Act.  Notably, a reciprocity provision allows the Attorney General to provide sandbox participants the opportunity to participate in similar programs that other jurisdictions may develop in time.

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