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Securities Re-Sale Restrictions: The Achilles Heel of ICOs

Jim Verdonik founder of Innovate Capital Law


COINS and Tokens are creating a new capital raising world.

For the past year, the Securities and Exchange Commission has been focused bringing law and order to that new world.

Much of the focus has been on:

Complying with securities laws at the time you first offer and sell securities is certainly important.  Criminals have taken advantage of investor greed.  In other cases, many ICOs failed to provide even basic disclosures, because the sponsors believed they were not selling securities.

Fraudsters will continue to prey upon investors who don’t know that there is no such thing as a “sure bet,” but the days of businesses routinely ignoring securities disclosure and registration rules are over.

New ICOs in the U. S. are making good faith efforts to comply with securities rules about exemptions from registration and disclosure requirements. That’s the easy part of securities law compliance for ICO sponsors.  Exemption and disclosure issues are fairly routine – the tricky part is whether the resale of the Token or COIN complies with securities laws.

The securities law compliance debate is moving to what happens after the offering is over. Issuers who focus only on holding their offering outside the U. S. or only on conducting a compliant U. S. offering should also focus on developing post-offering securities law compliance strategies.

In this article, we will focus on why the nature of COINs and Utility Tokens makes it difficult to comply with routine post-offering resale restrictions and still achieve your business purpose and why blockchain transfer systems pose securities compliance difficulties. Our focus will include:

SAFTS and Utility Tokens Post-Offering Issues

SAFTS (Simple Agreements for Future Tokens) were introduced in mid-2017 about the time the SEC announced that many ICOs were unregistered securities offerings. Everyone agrees SAFTS are securities that need an exemption from registration and full disclosure. The only debate is whether the Token that is issued when the software development project produces a viable product is a security. This “utility token” may be issued months or even years after the SAFTS are sold depending on how complex the software development project that creates utility is.

The basic premise of the SAFT is that, because the software development risk is eliminated or reduced before the Token is issued, other market forces that are unrelated to the efforts of the Token sponsor become the predominant factor in determining the value of the Token.

The analogy is that investing in a gold mining business is a security, but after the gold comes out of the ground the gold itself is not a security, because the value of gold or other commodities is determined by the laws of supply and demand, which no single person or business controls.

Investors in gold try to determine when the market will rise and fall and buy and sell based on their opinions. If market forces control the value of Utility Tokens, then the holders of the Utility Token controls how much profit they make by deciding whether and when to spend or resell their Utility Tokens just like the buy/sell decisions commodities traders make determines their profits.

In this scenario, Utility Tokens would not be the type of security known as an “investment contract” under the Supreme Court’s test in SEC vs. Howey because the amount of profit depends on the investor’s decisions and not on the efforts of others.

The SEC, however, has vehemently denounced this premise. Essentially, the SEC is asserting that the usefulness of a Token always depends on the efforts of persons other than the Token owner.  While some SAFT proponents may underestimate the continued influence of the efforts of the Token sponsor on the Token’s value, the SEC is taking a very broad approach in saying that the efforts of the Token sponsor almost always continues to determine the Token’s value and therefore, the profits of Token investors.

Since the Howey investment contract test is a facts and circumstances test, it is reasonable to conclude that having utility does not always mean that a Token is not a security and does not always mean that a Token is a security.

Who cares?

One might say: Who cares whether the Utility Token is a security or not if you complied with securities laws when you issued your SAFT?

You don’t need to comply with securities laws a second time when people decide to convert convertible preferred stock to common stock or convertible debt securities to equity securities. That’s because the offering exemption and the disclosure that covered the original offer and sale of the convertible security also covered the securities issuable upon conversion. The same rule applies for exercising warrants.

The convertible security or warrant is a continuous offer to sell the underlying securities. If the issuer is seeking to induce the holders to convert or exercise, the issuer should make updated disclosures. For example, if the issuer offers to change the conversion terms or exercise price to induce conversion or exercise, the SEC deems the changed terms to constitute the offer of a new security.

Why would SAFTs and Utility Tokens be different from convertible securities? 

Transfer is the Primary Purpose of COINS and Utility Tokens

One difference is that a traditional security represents ownership of some type of economic right that exists independently of whether you can transfer the securities. The value of traditional securities comes from a debt being repaid or a dividend or a liquidity event, such as an IPO or merger.  Currently, most traditional securities of private businesses are never resold or actively traded.  Transferability is a nice additional feature for traditional private securities, not the whole value.

COINS and Utility Tokens on the other hand have no purpose if you cannot transfer them easily. Imagine the chaos if you imposed complex transfer restrictions on U. S. Dollars or Euros.

Unlike traditional securities, the primary purpose of COINS and Utility Tokens is to serve as a type of transferable currency that is used to purchase technology, products and services. Therefore, traditional securities resale restrictions will probably substantially impede the usefulness of Utility Tokens, if they are securities.

This means that even issuers who fully comply with SEC rules when they offer and sell Coins or Tokens will have problems dealing with resale questions, if Utility Tokens are considered securities. What good is Token that supposedly enables you to purchase something, if securities laws impose expensive time consuming barriers to spending the Tokens?

One of the primary benefits issuers of SAFTS (Simple Agreements for Future Tokens) would gain, if the Utility Tokens issued to owners of SAFTS are not deemed to be securities, is that the Token owners could freely spend their Tokens without securities law restrictions.

The SEC’s pronouncements that all Utility Tokens that are issuable to SAFT owners will be securities, therefore, go far beyond simply wanting to ensure that purchasers of SAFTs receive adequate disclosure.

This raises the question: Is the SEC intentionally undermining the usefulness of COINS and Tokens?

Governments around the world fear COINS and Tokens that break government monopolies over currency. Is the SEC joining China in seeking to ban COINs and Tokens?

What effect will this have on how blockchain develops in America?

COINS and Tokens are not absolutely necessary for all blockchains, but the reality is that many blockchain creators and users find COINS and Tokens useful instruments. Therefore, the SEC’s campaign against COINS and Tokens could substantially change the direction of blockchain development.

This raises the question: Do we want securities laws steering technology development?

Affiliates of Sponsors Foreign ICOs

It is common practice in many ICOs to reserve Tokens for later sale by the sponsor and its affiliates of issuers. Restrictions on re-sale by affiliates are even more onerous than for re-sales by non-affiliate investors.  Therefore, Utility Tokens owned by affiliates would be even less useful as a currency than Utility Tokens owned by non-affiliates.

Foreign ICOs

So far, we have focused on issuers who conducted U. S. SAFT offerings.  There are many complex issues associated with U. S. based companies trying to do an offering that is completely outside the U. S.,  but issuers who successfully conduct ICOs outside the U. S. without selling to U. S. investors should also consider what will happen after their ICOs.

If their Utility Tokens are securities under U. S. securities laws, then resales by investors of Tokens into the U. S. would constitute the resale of a security in the SEC’s view. Spending the Utility Tokens in the U. S. would probably be considered reselling them in the U. S. for securities law purposes, because the SEC has long taken the position that exchanging anything of value for a security constitutes a sale of that security.

That will not matter if the sponsor creates a resale market that is totally outside the U. S., but many U. S. issuers have conducted offerings outside the U. S. on the assumption that the Tokens will later be used to purchase technology, products and services in the U. S. Keeping Tokens offshore may substantially decrease demand for such Tokens and decrease their value.

Broker-Dealer Issue: Revenue Model of Utility Token Sponsors

We have focused on the usefulness of Tokens when they are issued.   Let’s turn our attention to how Token sponsors intend to generate revenue.

Some Token sponsors intend to create marketplaces where Tokens are the medium of exchange.  If the sponsor’s revenue model is to collect transaction fees each time someone uses a Token to purchases something, this raises the question whether the sponsor is acting as an unregistered broker-dealer.

If the Token is a security, is the transaction fee a commission for selling the security? Maybe not. Maybe the commission is on the sale of the technology, products or services that the Token buys. However, the SEC has questioned whether Token sponsors need to register as broker-dealers.

The SEC has a long history of protecting broker-dealers from competition. Is this another in a long series of actions by the SEC to protect Wall Street?

Tokenized Securities

On the other hand, some Tokens are meant to represent securities. These “tokenized” securities may be stock, debt, warrants, or contracts like SAFES and KISSES that issuers want to be tokenized to create efficient stock transfer systems where sellers can make automated transfers to buyers.

I describe 2017 changes to Delaware’s General Corporation Law to permit such automated stock transfer systems in my article of February 16, 2018.

Whether the instrument is a traditional stock certificate, a tokenized security or a COIN or Token that the SEC deems to be a security, restricted stock transfer restrictions following an unregistered offering are essentially the same. They must satisfy their obligations to avoid conducting a distribution through statutory “underwriters.”

The new wrinkle for issuers of tokenized securities is that blockchain powered stock transfer systems require careful planning to comply with restricted stock transfer rules. My next article will discuss how to design blockchain stock transfer systems to comply with restricted stock rules.

The cost efficiency and convenience of automated blockchain stock transfer systems will be impeded, however, unless the SEC clarifies how broker-dealer and securities exchange regulations under the Securities Exchange Act of 1934 impact the blockchain and smart contract stock transfer systems issuers would like to implement.

Regulatory Clarification Needed

No one disputes that investors need adequate disclosures when businesses sell securities to raise capital. Some ICO issuers turned a blind eye to securities laws.  Action should be taken to restore the principle that investors deserve full disclosure.  But the SEC’s rush to classify all COINS and Tokens as securities raises a host of other questions for which the answers are much less clear:

There is no need to make this a winner-takes-all game.

Why not create a system where disclosures are required when issuers raise capital, but exempt COINS and tokens from all the other restrictions that automatically follow the determination that something is a security?

If the SEC does not show restraint, it would be useful for Congress and the Courts to act to place reasonable boundaries over the extent to which the banner of investor protection should be used to regulate commerce and technology.


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