Jim Verdonik founder of Innovate Capital Law
In my last article, we discussed why securities law resale limitations for “restricted securities” pose serious problems for both issuers of COINS and Utility Tokens that the SEC deems to be securities and for issuers that want to use blockchain technology to create automated efficient stock transfer systems.
Most of the public discussion about ICOs has focused on how issuers can make offerings that comply with securities laws. There has been relatively little discussion about how investors can resell COINS and Tokens that are securities.
As we point out in our prior article, what good is a COIN or Token if you can’t spend it or resell it?
Let’s begin developing our detailed plan for COIN and Token re-sales by discussing the opportunities and challenges offered by blockchain securities transfer systems.
Blockchain Smart Contracts the Perfect Automated Stock Transfer Systems
In mid – 2017, the State of Delaware amended its General Corporation Law to allow Delaware corporations to use blockchain and other digital stock transfer and corporate records. See my article of February 16, 2018 for discussion of these amendments to the Delaware General Corporation Law. Coincidentally, this change occurred at approximately the same time the SEC declared that most Coins/Tokens are securities. https://gatewaycapitalx.com/2018/02/16/delaware-law-on-blockchain-and-other-automated-stock-transfer-and-records-systems/
What’s so startling about that you might say? Businesses have been maintaining massive amounts of digital records for many years.
But blockchain software is capable of doing a lot more than simply storing records. Blockchain and smart contracts also enable peer to peer transactions to occur without an intermediary. Blockchain software actually transfers the ownership from one account to another account. That means that sellers who own anything in digital form can transfer what they own to buyers in return for payment of a COIN or Token.
This new technology will make stock transfers more efficient by removing middlemen and their annoying fees. Who will be replaced?
- Stock transfer agents
But most issuers typically want to spend as little time thinking about stock transfer issues as possible. When was the last time you heard a CEO say: “At our annual strategy planning retreat, we decided to make stock transfer our highest priority.”
Of course, that never happens. Stock transfer issues are the sleepy backwater of the securities world.
The danger is businesses will make a quick decision to automate an annoying process without fully thinking through how their new stock transfer system will comply with securities laws. That would be a big mistake. If you normally drive a four cylinder car that requires you to push the pedal to the floor and keep it there to accelerate from 0 to 60, you might not be able to handle a high powered V- 8 engine without some practice. Blockchain’s power can easily cause you to accelerate yourself right off the road.
So, in this article, we’ll talk about:
- SEC rules you should consider when you design you automated securities transfer system.
- Some smart contract features you can use to manage your securities transfer system.
Let’s start by reviewing some securities transfer basics, because some people who purchase and sell COINS and Tokens are not familiar with the SEC rules that govern re-sales after securities are sold in an offering that is exempt from registration.
What are “Restricted Securities”?
When issuers sell securities under an exemption from registration instead of registering the offer and sale are issuing “restricted securities.” SEC Rule 144 (a) (3) provides:
The term restricted securities means:
(i) Securities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a transaction or chain of transactions not involving any public offering;
(ii) Securities acquired from the issuer that are subject to the resale limitations of §230.502(d) under Regulation D or §230.701(c);
Now, let’s talk about the rules that govern “restricted securities.”
Ignoring these rules can create big SEC problems.
Statutory Underwriters and Coming to Rest
The reason the SEC limits an investor’s ability to resell “restricted securities” is to ensure that that the issuer’s sale to the investor is not just the first step of a plan to evade the requirements of offering exemptions from registration. For example, if the exemption from registration requires the issuer to only sell securities to “accredited investors,” it would be easy to avoid that requirement by selling to an accredited investor who then re-sells to unaccredited investors.
To prevent such circumvention of exemption rules, the “restricted securities” sold in exempt offerings have to “come to rest.” Until the securities “come to rest,” any resale of the securities will be deemed to be a continuation of the offering that must satisfy the same exemption requirements that applied to the original offering.
If the restricted securities have not come to rest, the investor who resells the restricted securities is deemed to be a statutory “underwriter, who is continuing the issuer’s original offering. Because “coming to rest” is an ambiguous concept. So, the SEC issued Rule 144 to create a “safe harbor” to allow both issuers and investors to know when re-sales do not continue the original offering. SEC Rule 144 is one safe harbor. In 2016, Congress created another safe harbor by adding Section 4 (a) (7) to the Securities Act of 1933.
The Preliminary Note to SEC Rule 144 explains the problem:
“The term “underwriter” is broadly defined in Section 2(a)(11) of the Securities Act to mean any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates, or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking. The interpretation of this definition traditionally has focused on the words “with a view to” in the phrase “purchased from an issuer with a view to * * * distribution.” An investment banking firm which arranges with an issuer for the public sale of its securities is clearly an “underwriter” under that section. However, individual investors who are not professionals in the securities business also may be “underwriters” if they act as links in a chain of transactions through which securities move from an issuer to the public.”
If an investor complies with Rule 144, they are not deemed to be a statutory underwriter and the resale of the restricted securities will not deemed to be part of the original offering. Generally, the securities will also cease to be “restricted securities” after the Rule 144 resale and unless purchased by an affiliate if the issuer the securities will thereafter be freely tradable without again requiring an exemption from registration.
To ensure that restricted securities are not resold without complying with Rule 144 or another exemption, the SEC requires issuers to impose transfer restrictions.
The transfer restrictions rules for traditional certificated restricted securities are well known. We repeat them here, because many issuers and investors in the COIN world are not familiar with them.
Resale Restrictions of SEC Rule 506 and COINS and Tokens
The transfer restrictions applicable to COINS or Tokens vary depending on what exemption from registration an issuer uses for the original offering. Some other exemptions from registration (such as Regulation A or Regulation CF) have different resale restrictions than those issued under Rule 506. We discuss Rule 506 below because more than 90% of private offerings use Rule 506.
All securities issued under SEC Rule 506 are “restricted securities.” Rule 506, which is used for most private securities offerings will probably be used for most offerings of COINS and Tokens that are considered securities. So, let’s consider how “restricted” COINS and Tokens can be transferred following a Rule 506 offering.
Rule 502 (d) requires issuers (among other things) to provide written disclosure to each purchaser prior to sale that the securities have not been registered under the Securities Act and, therefore, cannot be resold unless they are registered under the Securities Act or unless an exemption from registration is available.
Issuers are also required to place a “restrictive legend” on the securities highlighting these same facts. Where securities are issued in uncertificated form, issuers and transfer agents typically impose stop transfer orders, which trigger the same transfer procedures, including an opinion from legal counsel that the transfer complies with securities laws.
Removal of such restrictive legends or stop transfer orders typically involves a transfer agent (acting as the “transfer police”) obtaining a legal opinion from securities lawyers that the transfer can proceed under an exemption.
Will the same procedures be used for Utility Tokens that are deemed to be securities under the Howey test?
There is no exemption from resale restrictions simply because securities are evidenced by a Token rather than by stock certificates.
This raises challenges in the context of a “restricted” COIN or Token that is a security – in effect the blockchain acts as the “transfer police” and thus the smart contract used to mint the COIN or Token needs to implement rules to ensure compliance.
Application to SAFT Utility Tokens and Offshore ICOs
Some issuers may choose to comply with resale restrictions even if they think their Utility Tokens are not securities to minimize liability risk – for example the one-year Blackout Period to satisfy Rule 144. If the issuer sold a SAFT and it takes a year to develop the Utility Token, the tacking provisions of Rule 144 should exempt Token transfers by non-affiliates. Rule 144 (d) (3) (ii) provides:
“Conversions and exchanges. If the securities sold were acquired from the issuer solely in exchange for other securities of the same issuer, the newly acquired securities shall be deemed to have been acquired at the same time as the securities surrendered for conversion or exchange, even if the securities surrendered were not convertible or exchangeable by their terms.”
Issuers that may complete development of their Utility Tokens before one year may want to build into their SAFTs the flexibility to delay issuing Utility Tokens until one year has passed.
American companies and their affiliates that sell COINS or Tokens outside the U. S. may have an obligation to ensure the securities “come to rest” outside the U. S. before they are resold into the U. S. See SEC Regulation S for examples of the safe harbor resale restrictions for different types of securities offerings. For Category 3 securities, issuers that are not public reporting companies must ensure that equity securities are not resold in the U. S. for one year.
As we discuss in an earlier article, however, SEC rules restricting transfers may destroy the business case for issuing COINS and Tokens. https://gatewaycapitalx.com/2018/03/01/securities-re-sale-restrictions-the-achilles-heel-of-icos/
On the other hand, some Tokens are meant to represent securities. These “tokenized” securities may be stock, debt, warrants, or contracts like SAFES, KISSES and BITES that issuers want to be tokenized to create efficient stock transfer systems where sellers can make automated transfers to buyers.
Tokenized securities fit more neatly into traditional SEC transfer rules than Utility Tokens and COINS that are created to be spent to buy technology, products and services.
SEC Rules Affecting Smart Contract Design Choices for Automated Securities Transfer Systems
Different issuers will have different goals. Smart contracts can be designed to achieve specific goals. The issues you should consider when designing automated securities transfer systems if COINS or Tokens are or might be securities, include the following:
|One-Year Blackout Period
||Imposing a one year blackout period after the offering will allow all non-affiliates to resell freely under Rule 144. This uniformity makes administration simpler.
|Prohibit Affiliates from owing Tokens
||Affiliates can never resell freely under Rule 144. Some Rule 144 conditions to re-sales always apply to affiliates. They don’t disappear after one year, because they are “control” securities. Insider trading and fraud rules also make it prudent to exclude affiliates from owning Tokens. (Note: affiliates can own certificated securities that have the same economic rights as Tokens, but that transfer outside the smart contract.)
|Only allow re-sales to Accredited Investors
||This will position you to permit re-sales under Section 4 (a) (7) in you make financial and other information available and comply with other Section 4 (a) (7) requirements. But be careful, because Section 4 (a) (7) prohibits public solicitation by sellers.
Limiting re-sales to Accredited investors will also help you deal with Section 12 (g) issues discussed below.
|Limit the number of owners of the class of equity securities
||Have your smart contract reject any transfers that would increase the number of Token owners above the Section 12 (g) triggers for public reporting if your token is an “equity security” and you have $10 Million in assets at the end of any year. Record owners must be less than 2,000 total owners of which less than 500 can be unaccredited investors. (Note: the number of record owners includes all securities of the same class whether or not evidenced by a Token.) This is important only if you are concerned that trading will force you to become a public reporting company before you are ready to comply with securities laws.
|Require consent of the Issuer
||Requiring the issuer’s consent for potential buyers to have the opportunity to purchase Tokens on resale allows the issuer to require buyers to make representations about being Accredited Investors and KYC/AML issues. Issuer consent can also be conditioned on imposing new transfer policies to adapt to changing securities and other rules.
|Issuer Repurchase Rights
||Giving the issuer the right to repurchase Tokens under defined conditions gives the issuer leverage to enforce the other rules. It may also discourage hacking and other illegal activity.
We note that SEC in its directive re DOA Tokens and ICOs in July 2017 raised the question whether Token transactions violate the “securities exchange” provisions of Section 6 of the Exchange Act. See 15 U.S.C. §78e. In that context, the SEC was addressing platforms that effect transactions in the securities of multiple issuers, but issuers should not assume that they can totally ignore Section 6 of the Exchange Act. A review of past SEC no-action letters suggest that issuers would be wise to implement rules described in the no action letters. The SEC has not yet set forth guidelines for automated stock transfer systems. Therefore, retaining the flexibility to make changes is important.
Smart Contract Features
In implementing a smart contract to power your automated securities transfer system, keep in mind a few technical rules that can help keep you achieve your securities compliance goals described above:
- All Tokens will be subject to the same rules in your smart contract.
- Build flexibility into your smart contract and transfer policies to make changes as securities rules change over time.
- Your best friends in your smart contract are the power to:
“Burn” means to terminate or destroy all or less than all of the Tokens that have not been sold or that have been Rejected through the smart contract.
“Reject” means the ability to take possession (or otherwise eliminate ownership) of all or less than all outstanding Tokens with or without paying compensation.
“Replace” means the ability to (i) terminate the original smart contract governing outstanding Tokens, (ii) record a new smart contract to create a class of replacement tokens and (iii) and automatically replace all or less than all outstanding Tokens with such replacement tokens.
“Repurchase” means the right to repurchase (i.e. Reject) a Token. The power to repurchase is a useful tool for eliminating Token owners that break your rules.Remember, you offering only lasted a few weeks or months. Your smart contract driven transfer system has to withstand the test of time in a fast changing world.
These tools will enable you to enforce the issuer’s rights and fulfill the issuer’s obligations through the smart contract as circumstances change.
Remember, your ICO or other securities offering only lasted a few weeks or months. Your smart contract driven securities transfer system has to withstand the test of time in a fast changing world.