Getting to a Fully Operational Token Platform1
This article discusses recommended strategies for token issuers to finance and develop fully operational and legally compliant token platforms through financing efforts and token distribution plans that are structured early on to address a broad range of potential regulatory issues. We generally recommend a two-step capital raising and token issuance approach that initially involves private offerings to accredited investors of instruments providing the right to receive tokens in the future and then involves public registration or qualification of the tokens. The article also provides a high-level outline of important regulatory considerations that are frequently raised by token offerings and token-related platforms but that are often overlooked until well after a platform's initial design.
Too often, token issuers have been asking the wrong legal and regulatory questions, and sadly, they have too often been receiving bad answers to those questions. In the frothy environment for tokens that (may have) recently cooled off, questions that token issuers often asked were, "How quickly can I do my token offering?", or sometimes, "How quickly can I do a legally compliant token offering?" The question that token issuers should have been asking, we believe, is, "How do I finance and deploy a fully operational and legally compliant token platform as quickly and efficiently as possible?" That is the question we will try to answer in this article.
A bit of condensed history may be helpful. Token issuers that were focused primarily on how quickly they could do their initial token offering took several wrong approaches. First, there were token offerings to the retail public in the United States, in many cases without recognition that the tokens often were securities. Then, token offerings (or offerings of rights to receive tokens) were made in private placements only to accredited investors,2 but with the (generally wrong) view that as soon as the associated token platform became "operational," the tokens would become "utility tokens" that would not be securities. More recently, many token issuers who sold tokens (or rights to receive tokens) in private placements expected that over time, those privately placed tokens would become sufficiently widely used and held, and the associated token platform would become sufficiently "decentralized," so that the tokens would become utility tokens that are not securities.
In a recent article,3 we discussed (among other things) why the U.S. Securities and Exchange Commission ("SEC") and its staff ("Staff") continue to think that most tokens are securities and that a token does not cease to be a security simply because it has utility on an associated "operational" platform. We also discussed our view that, under the Howey test4 and related factors recently laid out by a senior Staff member,5 it is unlikely that most tokens would stop being securities before the time that there is a public offering or a Regulation A+ offering of the tokens. Among the reasons for this is that in order for many token platforms to operate efficiently, the platform must algorithmically or otherwise generate and pay tokens to miners, oracles, verifiers, or others who provide valuable services to the platform and the broader token ecosystem. In order for many platforms to operate efficiently, these tokens must be capable of being delivered to any person (regardless of whether the person is an accredited investor) and must be freely tradeable upon receipt; in general, this requires those algorithmically generated (or other) tokens to be publicly registered or qualified under Regulation A+.
In addition to the regulatory weaknesses in these prior token issuances, there often were and are other—often fundamental and often unaddressed—regulatory concerns. For example, token platforms can, depending upon their functions, raise questions as to whether the platform itself is a broker-dealer, an exchange, a transfer agent, or a clearing agency; purchases and sales of tokens through the platform can raise questions under Regulation M under the Securities Exchange Act of 1934 ("Exchange Act"); and certain recipients of tokens can, under some circumstances, face questions as to whether they need to register as broker-dealers. Let's assume that a particular token platform will in fact become sufficiently decentralized so that the associated tokens are no longer securities quickly after it begins operations. Between the time that the platform begins operations and the time it reaches a sufficient state of decentralization, the associated tokens (presumably) will be securities, and the platform therefore cannot even begin operations—much less reach its goal of decentralization—unless and until it resolves these types of regulatory concerns.
A token issuer whose goal is to finance and deploy a fully operational and legally compliant token platform should, in our view, at the outset develop a well thought-out financing and token distribution plan, and should at the same time consider how it will address the various regulatory issues that will be presented by the token platform it is developing. We will discuss both of these points below.
Financing the Issuer and Distributing Tokens
A token issuer's plan of financing typically should be designed to achieve at least three principal objectives: (1) raising sufficient money to pay for the significant platform development and token registration and distribution costs; (2) distributing a sufficient number of tokens to eventually permit an active token economy and trading market to develop; and (3) registering or qualifying tokens that can be algorithmically (or otherwise) distributed by or on behalf of the platform to miners and others providing valuable services to the platform and the token ecosystem.
To achieve these objectives, we generally recommend that token issuers use a two-step capital raising and token issuance approach. First, a token issuer generally will privately offer accredited investors an instrument that includes a right or an option to receive tokens in the future. Second, the token issuer will publicly register tokens or qualify the tokens under Regulation A+.
The Private Placement(s)
- The private placement is (or the private placements are) designed to help meet the first two objectives: 1, raising significant money and 2, over time distributing a significant number of tokens.
- The private placement is typically made under Rule 506(c) of Regulation D under the Securities Act of 1933 ("Securities Act"), which allows the token issuer to make "general solicitations"—that is, to generally advertise and sell to any purchaser who is an accredited investor.
- The token issuer in any token-related private placement should prepare and deliver a detailed disclosure document having risk factors that are carefully tailored to the proposed tokens and token platform.
- The token issuer also should pay careful attention to how it intends for the platform to operate, and whether any securities law or other regulatory issues may affect or alter the platform's operation or may affect the disclosure the token issuer provides to investors.
- Typically, issuers do not sell the tokens directly, but instead offer an instrument that provides the right to receive tokens in the future.6
- This instrument has often been referred to as a "Simple Agreement for Future Tokens" or "SAFT." Many SAFTs provide that tokens will be delivered as soon as the related platform becomes "operational. This approach assumed (often mistakenly, as discussed above) that tokens would cease being securities immediately upon being capable of use on an operational token platform. As a result, many SAFTs may provide that tokens may need to be distributed at a time when the tokens are securities that are not freely tradeable or transferable.
- We refer to this type of instrument generally as a "Deferred Delivery Agreement for Tokens," or "DDAT." One of the key differences between a DDAT and a SAFT is that tokens typically are distributed under a DDAT a year and a day after the sale of the DDAT, when the tokens become freely tradeable pursuant to Rule 144 under the Securities Act.
- A direct private placement of tokens presents potential regulatory issues. The tokens generally could not be resold or transferred for a year and day from the time of their initial purchase, without perhaps causing legal concerns for both the token issuer and a purchaser who resold the tokens within a year. For many tokens however (such as certain tokens issued on the Ethereum blockchain), it may not be possible for the token issuer to restrict transfers.
- Increasingly, DDAT offerings are being combined with other private offerings, including conventional offerings of common or preferred stock of the token issuer, equity, or debt securities that are mandatorily convertible into tokens, and equity or debt securities that are convertible into tokens at the option of either the token issuer or the security holder.
- Token issuers also may engage in other private transactions, including sales or distributions of DDATs, to existing security holders or employees.
- Token issuers also often sell DDATs to non-U.S. persons7 in a separate offering under Regulation S under the Securities Act.
- A sale to non-U.S. persons must comply with all applicable laws of each country in which offers or sales are made.
- If a token issuer sells tokens directly to foreign purchasers, the token issuer must take steps to prevent those tokens from being resold into the United States or to U.S. persons for at least a year.
The Public Offering or Regulation A+ Offering
- The public offering or Regulation A+ offering is intended to at least meet the third objective: registering or qualifying tokens that can be distributed to miners and others providing valuable services to the platform and the token ecosystem.
- The public offering or Regulation A+ offering also may be used to meet either or both of the first two objectives: raising significant money, and distributing a significant number of tokens.
- The public offering or Regulation A+ offering also may achieve other purposes, such as permitting the token issuer to "air drop" or otherwise give away tokens, attracting token purchasers who might be reluctant or unable to purchase tokens that cannot immediately be freely traded, attracting token purchasers who are concerned generally about regulatory compliance by token issuers, and potentially facilitating the wide distribution of tokens and decentralization of the token platform necessary for the tokens to no longer be considered securities.
- In another recent article,8 we discussed (among other things): why many token issuers may find a Regulation A+ offering to be more attractive than a registered offering; the significant level of disclosure that will likely be required in a successful Regulation A+ offering circular; and why we believe the SEC will approve Regulation A+ token offerings, even though none have yet been approved.
- We anticipate that a successful Regulation A+ offering (or registered offering) will be expensive, and in many cases likely will cost well in excess of $1 million.
- The cost of a Regulation A+ offering (plus the associated accounting, auditing, printing, filing, and other related costs) is part of the reason that many token issuers will want to attempt to raise a significant amount of money in one or more private placements before moving on to a Regulation A+ (or registered) offering.
- Similarly, token issuers that pursue a Regulation A+ (or registered) offering should factor into their budgets and fundraising the costs of preparing and filing their required periodic reports.
- The process for preparing, filing and obtaining approval of a Regulation A+ offering likely will take at least 6 to 9 months (although that time frame may become shorter over time).
- Because tokens can be delivered pursuant to a DDAT a year after the sale of the DDAT, a token issuer may consider beginning the Regulation A+ process shortly after the completion of the DDAT offering, which may give the token issuer a reasonable expectation that the Regulation A+ offering will be declared effective near the time the DDAT tokens will be delivered.
- Once the DDAT tokens are delivered and the Regulation A+ offering is declared effective, the related token platform should be able to begin full scale operations.
Other Regulatory Considerations
As discussed earlier, when token issuers are structuring their tokens, token offerings, and platforms, they should also consider a range of other issues under federal and state securities and other laws, rules and regulations. We outline several of these issues in the table below. Generally, these considerations fall into several buckets: (1) additional issues related to distribution of the tokens as securities; (2) issues related to potential regulation of issuers, service providers, and users as broker-dealers; (3) other potential securities law issues; and (4) issues raised by other potential types of federal and state regulation.
The table provided below is not exhaustive, and each token issuer will have to assess how these and other issues apply not only to its token offering but also to the operation and functionality of its platform.
Additional Regulatory Considerations to Consider When Designing a Token Platform
|Distributions of Tokens
|Can a token issuer engage in airdrops, mining, and other "free" forms of distribution?
||Not without complying with the securities laws. According to the SEC, these forms of distribution still involve an offering of securities and therefore require registration or qualification under the Securities Act for distributions to non-accredited investors and for the tokens to be freely transferable.9
|Can a token issuer distribute tokens to employees or founders?
||Yes, but distributions to founders or employees must be made in compliance with the securities laws. Most frequently, this occurs through compliance with Rule 701 under the Securities Act, which allows distributions to non-accredited employees of a company pursuant to a written compensatory benefit plan that meets certain requirements.
|Are token issuers subject to restrictions on buying or otherwise receiving their tokens back at the same time they are selling DDATs or tokens?
||Yes. Federal securities regulations generally prohibit an issuer from buying and selling its own securities at the same time.10 This can be an important consideration as issuers develop their platforms, because users may need to be able to sell or give their tokens back to an issuer (or an affiliate of the issuer) for the platform to function.
|Can a person who helps find purchasers or markets tokens for an issuer be subject to laws related to broker-dealers?
||Yes. A person or entity who receives compensation (including in tokens) for marketing, selling, or distributing securities, or who receives any form of compensation based on securities transactions at all, must be a registered representative of, or registered as, a broker-dealer.11 Because tokens are securities, people who are paid to market them or find purchasers are likely to be broker-dealers subject to registration and regulation.
|What happens if a token issuer uses an illegally unregistered broker-dealer for marketing or other purposes?
||A token issuer may have aiding or abetting or similar liability for an illegally unregistered broker-dealer's activities, and the issuer may need to rescind (or buy back) the tokens sold by the unregistered broker-dealer. The SEC and state regulatory agencies also may impose additional sanctions.
|Can token issuers inadvertently become broker-dealers?
||Yes. Token issuers can become subject to broker-dealer laws if they engage in activities such as sponsoring secondary markets in tokens (and receiving payment for them) or generally receiving payments based on transactions in tokens.
|Can users of an issuer's platform become subject to broker-dealer laws?
||Yes. Users of a platform may become broker-dealers by, among other things, receiving payments (including in the form of tokens) for selling or distributing tokens (on or off the platform).
|Are there legal exchanges for trading tokens in the United States?
||Not currently, although this may change. Any legal exchange will need to register as an exchange or alternative trading system.12 At the time this article was published, that had not yet occurred.
|What happens if a token issuer lists its tokens on an illegal exchange?
||An issuer that does this could be viewed as aiding and abetting illegal activity or as engaging in an illegal distribution of its tokens.
|Other Securities Laws Issues
|Can a token issuer be required to file ongoing reports even outside those required based on a public offering?
||Yes. An issuer must register as a "reporting company"—that is, a company that must, among other things, file annual, quarterly, and other reports with the SEC—if it has total assets of at least $10 million and a class of "equity securities" held of record by 2,000 or more investors (or by 500 or more investors who are not accredited investors).13 This may or may not apply based on token distributions, depending on the nature of the tokens. For example, tokens that provide holders with significant voting rights in, and/or revenue or profits from, the token issuer could be treated as equity securities of the token issuer.
|Can a token issuer inadvertently become an investment company?
||Yes. A company that holds securities whose value exceeds 40 percent of the total value of its non-cash assets is generally an investment company.14 Many token issuers hold more than this amount in their own tokens prior to distribution. Although many token issuers can reasonably conclude that the tokens they have created and issued do not constitute securities when held in their own hands, there is no clear guidance on this issue. In addition, companies that receive tokens from other token issuers (for example, in exchange for services) could become investment companies.
|Other Federal and State Regulatory Issues
|Does a token offering require registration as a money transmitter?
||Possibly. Ordinarily, issuing securities does not cause a company to need to register as a money transmitter on its own. However, token issuers that provide exchange-like or similar services on their platforms may be required to register as money transmitters and/or money services businesses.15
|Does a token issuer need to conduct Office of Foreign Assets Control ("OFAC") checks?
||Yes. Any U.S. person that sells tokens must comply with OFAC regulations, which generally prohibit transactions with people and countries subject to sanctions under laws enforced by OFAC.16 To comply with OFAC regulations, token issuers should consider verifying the identities of investors in their token offerings, determining the country of each investor, and identifying whether investors or their countries are on the list of prohibited persons and countries in the OFAC database.17
|Does the Commodity Futures Trading Commission ("CFTC") have jurisdiction over tokens, token issuers or token offerings?
||Possibly. Tokens that are securities are generally not subject to the CFTC's jurisdiction.18 However, the CFTC has jurisdiction over commodity futures, options, and swaps,19 and the CFTC views certain tokens (such as Bitcoin) as commodities.20 As a result, the CFTC would view derivative products on these tokens as subject to its jurisdiction. The CFTC also has authority to oversee retail commodity transactions that are entered into on a leveraged or margined basis, subject to an exemption where "actual delivery" occurs within 28 days.21
|Are token issuers subject to the New York BitLicense rules?
||Possibly. The New York BitLicense rules, which generally require anyone who operates a virtual currency business in the state to apply for and be granted a license to do so, appear on their face to encompass any token issuer issuing, selling, or otherwise distributing its tokens in New York State. A number of people have suggested that the BitLicense Rules should not apply to tokens that are securities, and there are at least some theoretical bases for this position. However, the BitLicense rules do not provide any direct support for this position, and to date there has not been any express guidance from the state of New York addressing this issue.22 As a result, token issuers should consider prohibiting sales or other distributions to New York persons.
|Are there other significant state regulatory issues that token issuers should be concerned with?
||There are a variety of other state (and federal) law issues that could arise with respect to tokens, depending upon the functions of the tokens and of the related platform (e.g., state lending laws, state insurance laws, state gaming laws, etc.). Each token issuer must consider what federal and state (and international) laws and rules may apply to its specific tokens and its specific platform.
1 Authored by partner Robert Rosenblum and associates Amy Caiazza, Tyler Kirk, Julie Krosnicki, Aaron Friedman, and Ajani Husbands at Wilson Sonsini Goodrich & Rosati. This article reflects the views of the authors, and do not necessarily represent the views of Wilson Sonsini Goodrich & Rosati or other lawyers at the firm. This article is not, and cannot be relied upon as, legal advice to any person or entity.
2 In general, an accredited investor is a natural person with an annual income of at least $200,000 (or $300,000 with a spouse), a natural person with a net worth of at least $1 million (exclusive of the value of her house), or an entity with at least $5 million in assets. Rule 501(a) of Regulation D under the Securities Act.
3 See Robert Rosenblum, Amy Caiazza, Julie Krosnicki & Aaron Friedman, Why the SEC Thinks Most Tokens Are Securities and When the SEC Thinks a Token Might Stop Being a Security, WSGR: Practitioner Insight (Aug. 1, 2018), https://www.wsgr.com/wsgr/Display.aspx?SectionName=publications/PDFSearch/Practitioner-Insight-tokens.htm.
4 SEC v. W. J. Howey Co., 328 U.S. 293 (1946).
5 William Hinman, Director, Division of Corporation Finance, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at Yahoo Finance All Markets Summit: Crypto (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
6 As technology increasingly permits token issuers to restrict tokens from being resold for at least a year, token issuers may also more frequently sell tokens directly. These direct sales, however, may pose regulatory, tax, accounting, and other considerations for the token issuer, so as with all token-related decisions, it is important for the token issuer to consider all options before deciding whether to issue tokens directly or through a deferred delivery agreement.
7 Rule 902(k)(1)–(2) of Regulation S under the Securities Act.
8 Robert Rosenblum, Amy Caiazza, Ben Dickson, Tyler Kirk, Julie Krosnicki & Aaron Friedman, Regulation A+ Offerings for Tokens: What is the SEC Waiting For?, WSGR: Practitioner Insight (Aug. 28, 2018).
9 See, e.g., In the Matter of Joe Loofbourrow, Securities Act Rel. No. 7700 (July 21, 1999) (stating that "the lack of monetary consideration for 'free' shares does not mean there was not a sale or offer" for purposes of the Securities Act); In the Matter of Tomahawk Exploration LLC and David Thompson Laurance, Admin. Proc. File No. 3-18641 (Aug. 14, 2018) (same).
10 See Regulation M under the Exchange Act.
11 Under Section 3(a)(4) of the Exchange Act, a broker is a person "engaged in the business" of effecting transactions in securities (such as tokens) for the accounts of others. Section 15 of the Exchange Act generally requires that anyone who meets this definition register as a broker-dealer. According to the SEC and its Staff, factors indicating that a person is "engaged in the business" of being a broker-dealer include, among others, the receipt of compensation for broker-like activities (such as marketing securities or finding investors) and the receipt of transaction-based compensation generally. See, e.g., Persons Deemed Not To Be Brokers, Exchange Act Release No. 22172 (June 27, 1985) (noting that "the receipt of transaction based compensation often indicates that such a person is engaged in the business of effecting transactions in securities"); BondGlobe, Inc., SEC Staff No-Action Letter (Feb. 6, 2001) (describing factors, including compensation, that indicate a person is a broker-dealer); Brumberg, Mackey & Wall, P.L.C., SEC Staff No-Action Letter (May 17, 2010) (stating that transaction-based compensation is a hallmark of broker-dealer status).
12 See generally Exchange Act § 6(a) (requiring registration of exchanges); see also Public Statement, Divisions of Enforcement and Trading Markets, Statement on Potentially Unlawful Online Platforms for Trading Digital Currency (Mar. 7, 2018) (stating that online platforms that offer "trading of digital assets that are securities... must register with the SEC as a national securities exchange.").
13 Exchange Act §12(g).
14 Investment Company Act § 3(a)(1)(C).
15 Money transmission services include "the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means." Rule 100(ff)(5) under the Bank Secrecy Act of 1970.
16 See Trading with the Enemy Act of 1917 (covering restrictions on North Korea, Cuba, and transaction control regulations); International Emergency Economic Powers Act of 1977 (covering restrictions on diamond trading, Sudan, Iran, Zimbabwe, the Balkans, terrorism, narcotics, nonproliferation, Syria, and Burma); United Nations Participation Act (covering restrictions on diamond trading); International Security and Development Cooperation Act (covering restrictions on Iran); Cuban Democracy Act (covering restrictions on Cuba); Cuban Liberty and Democratic Solidarity Act; Antiterrorism and Effective Death Penalty Act (covering restrictions on Cuba, North Korea, Iran, Syria, and Sudan); Foreign Narcotics Kingpin Designation Act.
17 These lists are accessible through the OFAC website (https://www.treasury.gov/resource-center/sanctions/Pages/default.aspx).
18 Commodity Exchange Act § 2(c)(2)(D)(ii)(II) (excluding agreements that constitute securities from the CFTC's jurisdiction).
19 Commodity Exchange Act § 2(a)(1)(A).
20 The CFTC could also consider Ether a commodity in light of statements from the Staff that based on "the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions[,] . . . [a]nd, as with Bitcoin, applying the disclosure regime of the federal securities laws to current transactions in Ether would seem to add little value." See William Hinman, Director, Division of Corporation Finance, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at Yahoo Finance All Markets Summit: Crypto (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
21 CFTC, Retail Commodity Transactions Involving Virtual Currency, 82 Fed. Reg. 60335 (Dec. 20, 2017).
22 N.Y. Comp. Codes R. & Regs. tit. 23, §200.1 et seq. (Regulations of the Superintendent of Financial Services applicable to Virtual Currencies).
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