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The takeaway: security tokens are the future. They are the key to unlocking billions of dollars in value tied up in private markets, but a successful security token offering requires navigation through a complex set of existing regulations. While there is no magic bullet to solving the regulatory puzzle, there are a number of tools in the corporate finance toolkit issuers can use, each of which comes with its own set of benefits and drawbacks.

Last week was an interesting one to leave the relative monotony of high finance for the crypto world. My first week as COO of Futurism Markets (“FM”) coincided with Blockchain week and the accompanying panels, influencer events, cocktail hours, after parties, meet-and-greets, pitches and all the other craziness surrounding this frenzied environment. I’ve been blown away by the passion (or is it zealotry?), drive and sheer creative energy of all the people I’ve met so far, all of which has only served to strengthen my conviction that the token ecosystem will become the dominant form of asset ownership and serve as a bridge to help unlock billions of dollars in value by bringing liquidity to otherwise stagnant markets.

FM’s focus is on applying blockchain to the financial system, working within the existing rules and regulations to democratize access to high value assets and bring liquidity to an otherwise illiquid private market.

I believe the key to accomplishing these twin objectives of access and liquidity is the security token. My colleague and FM’s CEO, Tony Peccatiello, has written (extensively) about the shrinking divide between ownership and liquidity and how security tokens are the next logical, evolutionary step in the use of blockchain to facilitate corporate finance. Simply put, the security token is a superior financing product to the utility token, affording a more efficient way for companies to raise capital while offering investor protections and upside unavailable in the utility token world.

I have been thrilled to see the attention security tokens have been getting on the various panels and throughout the community, but I also want to clarify exactly where security tokens stand in our current regulatory environment and highlight the gray areas we need to navigate (and possibly revamp) in order to live up to the full potential security tokens promise. I plan to write a number of posts on this subject and will subsequently propose an ideal regulatory environment that simultaneously satisfies federal policy objectives while broadening the market of potential investors. This article will serve as a primer, highlighting certain securities laws relevant to the issuance of securities tokens and identifying some of the hurdles that still need to be overcome.

My initial training was as a securities lawyer (and then as an investment banker), so of course there’s a legal disclaimer…

The information contained in this article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should not act or refrain from acting on the basis of any content included in this article without seeking legal or other professional advice.

The Promise

The easiest place to begin is the dream. I cannot afford a Warhol painting and I don’t have the money to buy a building, even though I may think these would be good investments. I similarly lack the access and financial resources to invest in the privately held companies I love. Instead, like everyone else, I have to read about a killer idea, watch it grow exponentially, track its S-1 registration, wait for the investment bank-friendly funds who receive initial allocations to profit off the day-one pop…and only THEN do I gain the ability to invest in this killer company’s future. All the good meat is off the bone and the investing public is left with the scraps. Security tokens offer an alternative — fully digitized asset classes that may be bought and sold on liquid exchanges in any slice, large or small, an investor desires and can afford. This is the future proponents of security tokens often proclaim, and it is a pretty one. It is also, however, one that implicates a number of issues in the current regulatory regime and can be used to illustrate and educate.

The Playing Field

The two primary pieces of securities legislation in the United States are the Securities Act of 1933 (the “‘33 Act”) and the Securities Exchange Act of 1934 (the “‘34 Act”). These were enacted in the aftermath of the rampant speculation that characterized the Roaring Twenties with the subsequent crash and Great Depression that followed. The easiest way to think about these two acts is that the ’33 Act governs the primary issuance of securities (the initial sale of securities from a company to investors) and the ’34 Act governs company reporting and secondary sales (sales from one investor to the other). For purposes of this article, there are three primary takeaways necessary to understand the world in which security tokens will function:

Securities sold to investors must either be registered with the SEC or exempt from registration. The registration process is cumbersome and expensive (there may be changes coming here), so nearly all companies raise capital initially in exempt transactions that have historically only been available to institutional investors or the very wealthy. The primary goal of the securities laws is to protect retail investors. The agencies take a protectionist view that mom and pop investors are gullible, ignorant and easily taken advantage of by fast-talking businessmen and bankers. To the extent investors are wealthy or are otherwise capable of demonstrating financial sophistication (we’ll explore the term “accredited investor” below), the regulatory regime is less concerned with protection and permits securities issuances absent the full disclosure that would come with a registered offering via a series of exemptions. In addition, the securities laws recognize the limits of their own ability to regulate, meaning that smaller offerings with less potential for abuse are less heavily regulated than larger offerings that hit a broader cohort. This positive correlation between potential for harm to the “little guy” and increased regulation is a theme that will pop up repeatedly in our examination below. Fraud is always a crime — “exempt transactions” do not mean exempt from the anti-fraud provisions of the securities laws. Any material misstatement or omission in connection with an offering of securities subjects the issuer (and potentially others involved in the preparation of offering documentation and marketing of the offering) to civil and criminal penalties.

The Toolkit

The primary exemptions, policy justifications and various limitations are summarized below. Note that each of these exemptions is highly nuanced and the below is meant to provide a summary of the key takeaways as applied to potential uses for security tokens. In upcoming articles, I will explore certain of these exemptions in greater detail and provide more clarity on how these tools fit together to legitimize security token offerings as the most efficient financing tool available.

Regulation D

Anybody who has raised money is likely familiar with the private placement exemption from registration. Hedge funds, private equity firms and other investment vehicles all use Regulation D to fundraise while remaining exempt from SEC registration requirements. There are three separate exemptions under Regulation D, each of which provides a different avenue for raising capital and comes with different restrictions that align with the SEC’s policy objectives.

Rule 504 — permits capital raises of up to $5 million in any 12-month period.

Securities issued in reliance on Rule 504 are restricted securities, meaning the investors that receive securities are subject to a one-year holding period prior to being permitted to resell the securities into the market. The real kicker here is that an issuer may not solicit investments or advertise the offering (in layman’s terms, the company cannot market its raise), making it largely impossible to effectuate a broad distribution consistent with the goals of a security token offering.

Rule 506(b) — permits capital raises in an unlimited amount and without any time restrictions

Rule 506 has two subsections, 506(b) and 506(c). 506(b) contains the attractive feature that the dollar amount is not capped, but runs into the same problems as Rule 504 in that the issued securities are restricted and general solicitation or advertising is not permitted. In addition, Rule 506(b) introduces the idea of investor limits — 506(b) permits sales to an unlimited number of accredited investors but only up to 35 non-accredited investors.

Recall the regulatory policy objectives highlighted above. An accredited investor is one that either (1) earned income in excess of $200,000 individually (or $300,000 when including a spouse) in each of the prior two years or (2) has a net worth over $1 million. This rule follows directly from policy — if you’re rich, the SEC is less concerned about protecting your interests. They’re looking out for the little guy, limiting the number of mom and pop investors that can be harmed to 35.

Rule 506(c) — permits capital raises in an unlimited amount without any time restrictions and permits general solicitation and advertising

At last, we come to Rule 506(c), the most effective fundraising tool in the Regulation D arsenal. Rule 506(c) stemmed directly from the Jumpstart Our Business Startups (JOBS) Act signed into law in 2012. The final rules took effect in 2013 and are the logical extension of Rule 506(b). 506(c) essentially says that, so long as your investors are all accredited (i.e., the rich folks the SEC cares less about protecting), you are free to issue as many securities and raise as much money as you’d like.

This tool is great for raising capital, but does not provide a meaningful avenue for either early access for a broad base of investors or providing liquidity. The investor base is limited solely to the wealthy. The liquidity problem remains because, while accredited investors may trade amongst themselves after a brief holding period, the transaction costs of doing so are wildly expensive and inefficient. I shared a link to the Spotify registration document above (re-linked here) — check out the Sale Price History of Ordinary Shares section. The per share sale price fluctuated wildly on a monthly basis as investors struggled to find trading counterparties that fit into the registration exemptions. Compare those private market sales (ranging from $48.93 to $131.88 in the 14 days leading up to the direct listing) with the recent share price (currently fluctuating in the $150-$160 per share range). There you can see the illiquidity discount private investors demand.

Regulation Crowdfunding

Regulation Crowdfunding (“Reg CF”) was introduced in 2015, again at the direction of the JOBS Act, and represents a positive step towards reconciling fast-paced technological innovation with the strictures of decades old securities law.

Reg CF — permits capital raises up to $1.07 million in a twelve-month period to a broad-based investor group with very light limitations on solicitation and advertising

This tool addresses the accessibility problem head on — it is the first regulation we’ve explored that allows a company to reach out to the mom and pop investors in the earliest stages to allow everyday people to invest in ideas they love. There are limits on the amounts the everyday folks can put up, but equity in an early-stage entity has become an available avenue for all via this exemption.

Recall again the policy objectives of securities law — via Reg CF, the SEC is allowing a company to reach out to the general public, which means they’ll require heightened regulatory scrutiny to limit potential harm the investing public might be exposed to. Reg CF comes with additional disclosure requirements (annual reports and even audited financial statements depending on the offering size), restricted portals through which all Reg CF offerings must flow, limits around what advertising is permitted (only barebones notifications allowed outside of the funding portals) and severe limits on the amount of capital that may be raised and secondary trading of those securities. For all these restrictions, an interesting use case we’ll explore later is the potential use of Reg CF to perform airdrops of tokenized securities in an SEC-compliant offering.

Regulation A

Regulation A (“Reg A” and, colloquially, “Regulation A+” after its recent modifications) is the last exemption we’ll explore in this article. This is another exemption that was revamped in 2015 as part of the JOBS Act overhaul. Reg A divides offerings into two tiers:

Tier 1 — permits securities offerings of up to $20 million in a 12-month period to a broad base of investors without secondary market trading restrictions

This is huge. Reg A is the first exemption we’ve explored that allows an issuer to sell unrestricted securities. What’s more, these securities may be offered to all investors (rather than just the wealthy) AND issuers may advertise offerings to the investing public. We return to the regulatory curve — as companies tap broader investing markets and access higher dollar thresholds, the greater the regulatory burden the SEC will impose and the more disclosure they will require in order to utilize the exemption.

Tier 1 offerings require an offering statement that contains detailed public disclosure (think S-1-lite) and ongoing reporting. In addition, Tier 1 offerings require compliance with state blue sky laws. I’ll write more on this later, but a basic premise of federal securities law is that it preempts individual state requirements. In this way, if a company satisfies federal securities law requirements, in certain circumstances, it may avoid having to register (or find an exemption from registration) in each state in which it wishes to sell securities. This is an important preemption point as it helps streamline the securities sale process and is one that is not available in a Tier 1 Reg A offering.

Tier 2 — permits securities offerings of up to $50 million in a 12-month period to a broad base of investors (subject to certain investing limits) and absent secondary market trading restrictions

Tier 2 offerings are similar to Tier 1 in that a company may issue unrestricted securities to all investors and advertise while doing so. What’s more, a Tier 2 offering preempts state blue sky laws, removing substantial inefficiency in the offering process. With these enhancements comes increased financial reporting requirements (audited financial statements are required) and limitations on non-accredited investor participation (non-accredited investors are limited to the greater of 10% of annual income or net worth in their investment in a Tier 2 offering).

On its surface, the Reg A Tier 2 offering is the closest we’ve come to a panacea for successfully navigating the U.S. securities regime in issuing SEC-compliant security tokens without going through a formal registration process. It addresses the access problem by allowing all investors an opportunity to participate while simultaneously addressing the federal policy objective of protecting the mom and pop investors by limiting their potential loss to a percentage of annual income. What’s more, the issued securities are unrestricted, meaning holders may trade in or out of their position, creating a robust and liquid secondary market.

The Fly in the Ointment

Unfortunately, our analysis cannot stop with the Reg A Tier 2 offering. The securities laws must be looked at holistically and issuers must comply with all aspects of those laws in order to conduct a compliant offering. Here, I introduce what I’ll call the “12(g) problem.” Prior to the JOBS Act, Section 12(g) required companies with assets exceeding $10 million and a class of equity securities held of record by 500 or more persons to register with the SEC. This was the reason Facebook went public. While the JOBS Act increased the shareholder threshold to 500 unaccredited investors and 2,000 total investors, these restrictions remain impediments to both access and liquidity in the private market. The existing regulations provide two workarounds to this investor threshold limitation, one under Reg CF and one under Reg A.

Reg CF — holders of record in equity securities issued pursuant to Reg CF are conditionally exempted from the 12(g) record holder count so long as: 1) the issuer is current in its required filings, 2) the issuer’s total assets as of its fiscal year end remain under $25 million and 3) the issuer engages the services of an SEC-registered transfer agent.

Example: BlockCo does an initial $5 million dollar raise to 20 accredited investors and funds in a private placement in reliance on 506(c). To achieve a wide distribution of its token, BlockCo then uses Reg CF to distribute security tokens representing equity to 50,000 participants at $1 per token. These 50,000 participants do not count towards the 12(g) record holder count for purposes of determining whether BlockCo must register with the SEC. BlockCo continues to grow, exceeding $25 million in total assets two years later as of its fiscal year end. The holders of these airdropped tokens will all count towards the investor threshold and a two-year clock begins running for BlockCo to register with the SEC.

Reg A Tier 2 — holders of record of equity securities issued pursuant to a compliant Reg A Tier 2 offering are conditionally exempted from the 12(g) record holder count so long as: 1) the issuer is subject to and current with its reporting obligations, 2) the issuer engages the services of an SEC-registered transfer agent and 3) the issuer maintains a public float of less than $75 million, determined as of the last business day of its most recently completed fiscal quarter (in the absence of a public float, annual revenues of less than $50 million for its most recently completed year becomes the threshold).

Example: BlockCo issues 50 million security tokens representing 20% of its total equity at $1 per token to 25,000 investors. The tokens immediately trade up to $1.05, resulting in a public float of $50.5 million. The holders of the securities token issued in the Reg A Tier 2 offering do not count towards the investor thresholds in 12(g). BlockCo signs a large customer contract one year later that is well-received by the market — its security token pops to $2 per token, resulting in a public float of $100 million as of the last day of its fiscal quarter. The holders now count towards the 12(g) threshold and a two-year clock begins running for BlockCo to register with the SEC.

Putting it All Together and Conclusion

What does this all mean? I think the easiest way to think about these regulations is to analyze them in light of the dream scenario that kicked off this discussion — think of the fully democratized financial ecosystem with easy accessibility for all and highly liquid secondary markets. It is a libertarian’s dreamworld and a world that could one day be realized through the adoption of security tokens, but it is not one that squares with the current regulatory environment. Instead, what exists today is a toolkit of devices that allow companies and investors to access portions of this aspired to state. This current state of affairs is one of the primary reasons I am so optimistic around the efficacy of the security token as the proper and most efficient tool for navigating this complex regime. Through security tokens, we can ensure all SEC mandates around substance and form of securities offerings are followed precisely, building this functionality into the tokens themselves, and helping to reduce uncertainty as companies raise capital in an efficient and compliant manner.

Looking ahead, the potential for tokenized securities reaches much further than simple KYC/AML compliance and equity markets at small- to medium-sized companies. Security tokens can, ought to and will be used to enhance efficiency in shareholder voting, dividend payments, interest payments, amortization payments, covenant compliance and a whole host of other use cases currently outsourced to specialized third parties. What’s more, this tokenized security technology ought to be embraced not only by the entrepreneurs and end users that form the community today, but by the regulatory bodies themselves who will see it as a more effective means of implementing their own policy objectives. We have a real opportunity to shape this environment going forward, and I look forward to doing just that.

Coming soon on this channel: Potential Solutions to the 12(g) Problem, SAFTs v. SAFETs, Considering a New Regulatory Framework, Tokenized Airdrops and much more…