After the Token Sale: How to Navigate the Federal Securities Law Issues
December 19, 2017
Over the last few months, there has been fairly wide-spread recognition that most offerings in the United States of tokens and of Simple Agreements for Future Tokens (SAFTs) are securities offerings.1 As a result, most U.S. token and SAFT offerings are made solely to accredited investors in private placements under Rule 506(c) of Regulation D.2 On December 11, 2017, the Securities and Exchange Commission (SEC) dramatically emphasized the wisdom of this approach, both by publicly taking action to stop an unregistered public token offering, and through a written (and fairly unusual) statement by the SEC's Chairman discussing securities law issues related to token offerings.3
There has been much less public focus, however, on how the federal securities laws impact token issuers, token platforms, and token holders after the token or SAFT offering is completed. At some point, many (but by no means all) tokens that start out as securities may no longer be securities,4 and the federal securities laws may then no longer be relevant to the tokens or to the token platform.
Until a token no longer is a security, the federal securities laws will impose a number of restrictions and limitations on the company that issued the tokens, on purchasers and sellers of those tokens, and perhaps on token holders who would like to use the tokens for their intended commercial uses on the relevant token platform. This article will try to help token issuers think through some of these issues, especially in light of the relatively limited guidance on or public discussion of these issues by the SEC.
In this article, the term "S-Tokens" refers to tokens that are currently securities, but eventually will or may not be securities, because they have or will have some anticipated use or utility on an issuer's platform, and not to tokens that are digital representations of securities (such as tokens representing common stock or limited liability company interests, which are and presumably always will be securities). The term "platform" refers to the online protocol or protocols developed by a token issuer and on which a token is designed to be used.
Can Holders Use S-Tokens on the Platform?
We believe the answer is yes, even though the SEC and the courts have not yet addressed this issue. As discussed below, a U.S. holder can sell or transfer a token that is a security only in limited circumstances and ways. Nonetheless, we believe that a token holder may use such a token on a platform to obtain commercial goods or services, and that the transaction should not be treated as a securities transaction.5 We believe that this is true regardless of whether the holder is or is not an accredited investor.
How Can Non-Accredited Investors Receive S-Tokens?
We believe that there are several ways, some of which are listed below, although the SEC and the courts have not yet addressed this issue. In general, non-accredited investors cannot participate in the pre-sale or similar offering of tokens or an SAFT.6 However, in many cases, it is important for non-accredited investors to have access to S-Tokens, including to help generate and support significant use of the platform. Among the ways we think issuers may get S-Tokens into the hands of non-accredited investors are:
- Limited Direct Sales. We believe that an issuer should be able to sell S-Tokens directly to platform users, regardless of whether those users are accredited investors, if:
- the number of tokens sold are reasonable in relation to the number of tokens needed to engage in commercial transactions on the platform;
- the issuer imposes restrictions reasonably designed to prevent the same purchaser from purchasing so many tokens that it is likely that the tokens are being purchased for investment, rather than commercial purposes;
- the issuer receives a representation from the purchaser that she intends to use the tokens for commercial purposes on the platform, and if possible (although often this is not possible) codes the tokens so that their first use must be for a commercial transaction on the platform;
- the price at which the issuer sells the tokens is reasonable in light of the market value of the tokens; and
- the issuer discloses to the purchaser that the direct sale of tokens, and the use of the tokens on the platform, are commercial transactions that are not subject to the protections of the federal securities laws.7
- Sales to Employees (Rule 701). A company can sell or award its S-Tokens (or SAFTs for S-Tokens) to its employees, directors, and bona fide advisors and consultants, pursuant to a written compensatory benefit plan (the plan must be for compensatory purposes, and not for capital-raising purposes, and must meet several other requirements as well).8 We believe that employees and others who purchase or receive S-Tokens pursuant to such a plan, regardless of whether they are accredited investors, should be able to use those S-Tokens to engage in a bona fide commercial transaction over a platform, although again the SEC and the courts have not yet addressed this issue.
- Giveaways. We believe that a company should be able to give away limited numbers of S-Tokens to individuals, regardless of whether they are accredited investors, if the terms of the giveaway reasonably suggest that the recipients are likely to use the S-Tokens for commercial purposes on a platform.9 These terms may include giving each person a limited number of tokens and obtaining representations that they will use the tokens for commercial purposes on a platform.
- Registration or Qualification. A company may register its S-Tokens under the Securities Act (generally on form S-1) or qualify the S-Tokens pursuant to a Regulation A or A+ offering, and after that registration or qualification, the S-Tokens could be freely offered to non-accredited (and accredited) investors. While several companies are in the process of registering or qualifying their S-Tokens, and others are considering doing so, these are expensive processes, and many companies do not have the resources (or time) to register or qualify their S-Tokens.
- Foreign Purchasers. Subject to compliance with applicable foreign law, a company may sell its S-Tokens to non-U.S. people who are not accredited investors, and those people can use those S-Tokens for commercial purposes on a platform (again, as permitted by applicable foreign law).10
- Purchases on Foreign Exchanges by U.S. Non-Accredited Investors. It currently is relatively easy for a U.S. person, regardless of whether she is an accredited investor, to purchase S-Tokens on foreign exchanges and other token trading markets. In general, the federal securities laws do not prohibit or regulate the purchase of securities; instead, they regulate the offer and sale of securities.11 As a result, the mere purchase of an S-Token on a foreign exchange by a U.S. person who is a non-accredited (or accredited) investor generally is not prohibited by the federal securities laws.12 This conclusion assumes that the purchaser does not know or have reason to know that the seller of the S-Tokens is a U.S. person, and that the purchaser does not buy the S-Tokens with the intention of reselling them in the United States.
This analysis, though, misses what may be the more important federal securities laws issues with U.S. persons purchasing S-Tokens on foreign exchanges. First, as discussed below, a foreign exchange or trading market that generally permits U.S. persons to buy and sell S-Tokens may need to register in the United States as an exchange or as an alternative trading system (ATS).13 Second, a U.S. company could be deemed to have made an impermissible public offering in the United States if the company takes steps to list its S-Tokens on a foreign exchange which permits trading by U.S. persons.14
How Can Holders Sell S-Tokens?
We believe that there are several ways that a holder of S-Tokens, such as an accredited investor, or a vendor who has received those S-Tokens in exchange for goods or services on the Platform, can sell those S-Tokens; again, though, the SEC and the courts have not yet addressed this issue.
- One-Year Holding Period (Rule 144). An S-Token, including an S-Token purchased pursuant to a SAFT, should become freely tradeable after one year from the sale of the S-Token or the SAFT.15 One important limitation to this rule is that the one-year holding period starts all over again at any time the company that issued the S-Token, or an affiliate of that company, holds the S-Token.16 So, for example, when the company that issued the S-Tokens also provides goods or services in return for S-Tokens, the one-year holding period for those S-Tokens starts again each time the company resells those S-Tokens.
- Accredited Investor Sales After Three Months (Section 4(a)(7)). An accredited investor may, under certain conditions, resell S-Tokens to other accredited investors, after 90 days from the time the S-Token was first sold.17 As a practical matter, this provision may not be attractive because, among other reasons: (i) the company that issued the tokens must make certain information available to the purchaser, including the company's audited financial statements,18 which many companies that issue S-Tokens don't have; and (ii) the seller cannot sell the S-Tokens by means of a general solicitation or general advertising,19 which significantly limits the ability of sellers to find potential purchasers for the S-Tokens.
- Sales on a U.S. Exchange or ATS. Several entities have announced plans to create a regulated market in the United States that would permit the trading of S-Tokens. Assuming the Financial Industry Regulatory Authority (FINRA) grants the ATS applications to permit these markets to operate, individuals who sell tokens on these markets will be subject to the one-year or (if applicable) three-month holding periods described above, unless the tokens are registered with the SEC on form S-1 or qualified under Regulation A or A+ (these options are discussed below).
- Foreign Sales (Regulation S). A U.S. person generally can sell S-Tokens directly to non-U.S. purchasers who are located outside of the United States.20 Most offshore sales of S-Tokens, though, likely occur through offshore exchanges and trading markets, rather than as direct sales to a known foreign purchaser. These sales are technically problematic because, in order to take advantage of the SEC rule governing offshore sales (Rule 904), any foreign exchange on which the S-Tokens are sold would have to be specially designated by the SEC.21 Not surprisingly, few (if any) foreign exchanges that permit trading of tokens have been specially designated by the SEC.22
Rule 904, however, is a "safe harbor."23 This means that a seller of S-Tokens can't "violate" that rule; she either complies with the rule and knows that her sale of S-Tokens is consistent with the federal securities laws, or she does not comply with the rule and she takes the risk that her sale of S-Tokens does not comply with the federal securities laws.
A U.S person who sells S-Tokens on a foreign exchange, and who does not know or have reason to know that the purchaser of those S-Tokens is or will be a U.S. person, may have a reasonable argument (but not a rock-solid argument) that she did not violate the federal securities laws by making that sale. As discussed above, a U.S. person who buys S-Tokens on a foreign exchange has a fairly strong argument that her purchase did not violate federal securities laws, if she did not know or have reason to know that the seller of the S-Tokens was a U.S. person, and if she did not purchase the S-Tokens with the intention of reselling them in the United States.24
- Rule 144A. Certain very large institutions (but not humans), called qualified institutional buyers (QIBs), generally may freely buy S-Tokens from and sell S-Tokens to each other, subject to certain information requirements.25 Anecdotally, QIBs currently appear not to be a significant segment of the S-Token secondary markets.
- Registered or Qualified S-Tokens. As discussed earlier, some companies that issue S-Tokens or are considering registering the S-Tokens, or qualifying them under Regulation A or A+. This permits the company to sell the S-Tokens to any purchaser, regardless of whether the purchaser is or is not an accredited investor. Holders of registered or qualified S-Tokens generally may resell those S-Tokens, especially on an exchange or ATS, regardless of whether the purchaser is or is not an accredited investor.26
Other Emerging Securities Law Issues
- Broker Registration Issues—Paying Distributors of S-Tokens. In general, a person or entity who receives compensation (in any form) for selling or distributing securities, such as S-Tokens, must be a registered representative of, or registered as, a broker-dealer.27 As a result, a company issuing S-Tokens (or a SAFT for S-Tokens) generally should not pay any person for distribution, introduction, finder, or investor referral services, unless that person is a broker-dealer or a registered representative of a broker-dealer.28
- Investment Company Issues. Companies that issue S-Tokens can inadvertently become investment companies (such as a mutual fund) if, as is sometimes the case, the company holds a significant number of S-Tokens for itself. If, for example, a company sells its S-Tokens to more than 100 investors, and the company holds S-Tokens whose value, either initially or over time, exceeds 40 percent of the value of the company's total assets, the company can be an investment company.29 An investment company is subject to significant substantive provisions under the Investment Company Act, including (among others) restrictions on affiliated transactions, limitations on leverage and borrowing, limitations on its ability to issue options and restricted stock to officers and directors, limitations on its capital structure, and a requirement that it hold all securities (such as S-Tokens) with a bank or another qualified custodian.30
- Reporting Company Issues (Section 12(g) of the Exchange Act). Generally, a company should not become a "reporting company"—that is, a company that must (among other things) file annual, quarterly, and other reports with the SEC—by virtue of issuing S-Tokens. A company must register as a reporting company if it has total assets of at least $10 million, and has 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).31 We believe that S-Tokens should not be treated as a class of equity securities,32 because S-Tokens typically lack any similarity to equity securities.
Some companies that issue S-Tokens, however, may give S-Token or SAFT holders the ability under some circumstances to convert into common or preferred stock of the company. Those companies should consider whether that conversion feature may cause the company to become a reporting company if the S-Tokens (or SAFTs) are held by 2,000 or more record holders. And, of course, tokens that are digital representations of equity securities (such as common stock issued in the form of tokens) presumably are equity securities in their own right.
- Will the SEC Give a Company a Pass on These Issues, Since the SEC Hasn't Given Any Guidance on Them? No. A company that issues S-Tokens cannot ignore the federal securities laws, even though the SEC may not have given substantive guidance on how those laws apply in novel situations, such as those presented by S-Tokens. A company may dramatically reduce the risk of lengthy SEC (and perhaps token-holder) litigation, however, if the company can demonstrate good faith attempts to comply with the federal securities laws, even if subsequently the SEC (or a court) determines that the company was not in full technical compliance with those laws.
For more information about the regulation of coin offerings, please contact Robert H. Rosenblum (202-973-8808, firstname.lastname@example.org); Susan Gault-Brown (202-973-8809, email@example.com); or any member of the fintech regulatory practice at Wilson Sonsini Goodrich & Rosati.
This article is authored by Robert H. Rosenblum, with significant assistance from Susan Gault-Brown, Amy Caiazza, and Tyler Kirk. The opinions expressed in the article are the authors' views and do not necessarily reflect the views of Wilson Sonsini Goodrich & Rosati.
By contrast, an instrument like a share of common stock is always a security, and has no non-security commercial purpose. A buyer or seller of a share of common stock therefore always reasonably should expect the protections of the federal securities laws.
Nonetheless, the thrust of Rule 903 and of Regulation S is to limit the ability of securities sold outside of the United States to flow back into the United States, at least for some period of time, and there are several provisions in Rule 903 that apply to offshore offers and sales of S-Tokens, and that may be inconsistent with a U.S. (or any) company listing its S-Tokens on a foreign exchange that permits U.S. buyers and sellers to participate. See, e.g., Rule 902(c) and Rule 903(a)(2) (prohibiting directed selling efforts made in the United States, which could include registering S-Tokens on a foreign exchange and publicizing to U.S. investors the availability of that foreign exchange for purchases and sales of the S-Tokens).
In addition, the definition of a debt security for purposes of Regulation S includes "any security other than an equity security." As a result, assuming that an S-Token is not an equity security, it arguably should be treated as a debt security for purposes of Regulation S, even though many S-Tokens lack any traditional indicia of debt securities, such as the rights to principal and interest payments from the issuing company, or the right to participate in any assets, revenue or other economic performance of the issuing company. If S-Tokens are or may be debt securities for purposes of Regulation S, then Rule 903 may require the company issuing the S-Tokens to impose other restrictions on the S-Tokens that are inconsistent with a listing on a foreign exchange. See, e.g., Rule 902(g) and Rule 903(b)(3), requiring U.S. companies that issue S-Tokens overseas to, among other things, disclose that U.S. persons may buy and sell the S-Tokens only if they are registered under the Securities Act or if they are sold pursuant to an available exemption from registration.
Also, if S-Tokens are debt securities for purposes of Rule 903, then a U.S. company that issues the S-Tokens overseas would need to have those S-Tokens represented by a temporary global security which is not exchangeable for definitive securities for at least 40 days following the closing of the offering. See Rule 903(b)(3)(ii)(B). While many SAFTs may not be exchangeable for definitive securities for at least this 40-day period, it is not clear that many SAFTs technically are "temporary global certificates" within the meaning of Rule 903.