With Securities and Exchange Commission Chair Jay Clayton making the public announcement last July he believes every ICO he’s seen is a security, every company in the cryptocurrency, blockchain and token world was put on notice that raising capital by selling coins or tokens was entering a different phase in the United States. As a result, securities lawyers like Washington DC-based attorney Kendall Almerico, have been flooded with calls and requests for their services.
I caught up with Kendall, one of the top JOBS Act and Regulation A+ experts in the country, and asked him about the most recent developments in how companies are adapting to the new world of SEC compliant crypto offerings. Having jumped headfirst into the token offering world since the SEC’s announcement, he has a lot to say about the evolving landscape.
I understand your phone has been ringing off the hook since Chairman Clayton’s statement last year.
Yes, it has. Any U.S. company that wants to raise capital by selling coins, tokens or cryptocurrency, and any company that wants to access the 325 million potential investors who live in the United States, must follow securities laws at this point. With my work in the JOBS Act legal realm, I have been talking to dozens of crypto companies. Because the grand majority will use one of two JOBS Act provisions: Regulation D, rule 506(c) (if they limit the offering to accredited investors), or Regulation A+ if they want to access the entire U.S. population, those of us who specialize in JOBS Act offerings and equity crowdfunding have become quite popular!
What do you look for when you take on crypto and blockchain companies to help them raise capital in this newly regulated world?
I have lost count of the number of companies I have had to turn down at this point because they already have done something that is not compliant or legal. The first step is to make sure each company has not already screwed up what they want to do because they were not well informed as to how they should proceed. I ask some pretty simple questions to start, and you would be surprised at how few companies have the right answers.
What do you ask?
I start with the basics. I ask every company to explain to me in a sentence why they need a token and how blockchain is integral to their business. If I had a Bitcoin for every company that came to me with a concept that used the term “blockchain” or “token” without even knowing what it meant or how it was going to be used, I’d be a Bitcoin billionaire. Or maybe a Bitcoin millionaire, depending on the fluctuating exchange rates.
You would be amazed at how many people cannot answer this question in one hour, much less one sentence. Some businesses do not need a blockchain or a token. For example, I do a pretty good job of running a law firm without a blockchain. A pilot does not need a coin to fly an airplane. A chef does not need a utility token to cook a perfect steak.
I realize that blockchain technology is revolutionary in many ways for many things. But, you can’t just throw the term “blockchain” into every business model. If a company is not able to explain in simple terms why they need blockchain in their business, they probably don’t need blockchain, and probably should not be doing a coin offering.
Is there anything else you ask?
Two more things I ask are very important. Are you a U.S. company? I wish I had a dime for every company that said “No, we are based in…” then they name a random country in the Caribbean, “so we do not have to comply with U.S. securities law.” Being incorporated in the Caymans does not make you non-U.S. based if you’re operating out of a WeWork in midtown Manhattan. If you run your company from the U.S., you have to follow U.S. state and federal securities laws even if you have a piece of paper that shows you’re incorporated elsewhere. The SEC is not going to take your word on something like this when it is obvious you are only setting up in another country as a ruse to avoid securities laws. But regardless of where you’re based if you want U.S. investors, you have to comply with U.S. securities laws.
What about reaching U.S. investors?
By the way, this is why the SEC and the state regulators got involved in the ICO world in the first place. When U.S. investors are involved, it is the SEC’s and the state regulators’ jobs to make sure investors are protected. Investors in the U.S. were buying coins in these unregulated ICOs all over the world and many of them were scams so people were losing all their money. That is not going to happen any more if the SEC has anything to say about it, so if you want to reach U.S. investors, be prepared to comply with the SEC’s laws and rules, and those of all state regulators also.
What’s the second thing you ask?
What have you done already? I hate it when I hear, “Kendall, our pre-sale is next week. Would you take a look at our white paper and be sure we are okay?” If they are already online soliciting for their sale, there is a good chance they’ve already violated a law or two. And if they already have anything scheduled in terms of a sale, it’s probably too late for any securities lawyer to help unless they are willing to pump the brakes.
I also hear this one a lot: “We’re okay because we’ve hired” followed by ‘a top ‘ICO’ ‘Blockchain’ or ‘Crypto’ consultant on our Board of Advisors.” I ask these companies if their advisor is a securities attorney who has experience with the JOBS Act and securities token offerings, and then I look at my iPhone to see if the call has been disconnected because there is always dead silence. Ninety-five per cent of these “crypto experts” have absolutely no idea how to do a securities law-compliant token offering in the United States, and many charged these companies a lot of money to give them bad advice.
Were you surprised by the SEC and state regulators jumping into the ICO arena?
I received a ton of emails, most of them spam, over the past few years with the newest hottest ICO offers, and I saw the news about the crazy amount of money being raised. I think most securities lawyers saw these ICOs raising millions with no disclosures, no investor protections, no financial statements and no real information revealed other than hype and the repeated use of the term “blockchain.” Not only were these obvious sales of securities, many of them were just blatant scams that couldn’t pass a sniff test in allergy season. No, I can’t say that seeing the SEC jump in and state regulators filing enforcement actions and class action suits being filed was at all surprising.
So, let’s get to the $64,000 question: How does a company do a legal and compliant ICO?
First, a company needs to assume that what they are selling is a security, because the SEC is certainly going to assume that. You can’t call something a “utility token” and assume you can get away with not following securities laws. It does not matter what you call it if it cannot pass the Howey Test, or if you are selling it with the idea that the purchaser may be buying something that will increase in value over time, you should treat it like a security. There are well-defined exemptions that allow U.S. companies to sell securities without registering, so follow those laws in your token sale, and the capital raise portion should be legal.
Are you talking about Regulation D, Regulation A+ and Regulation S?
Those are the big three. There are others, including Regulation CF and full registration through an S-1, but Regulations D, A+, and S are the most common exemptions companies should consider depending on their needs.
What are the pros and cons of each?
Let’s start with the most common: Regulation D. Under Rule 506(b) or 506(c) a company can hold a security token offering and raise an unlimited amount of capital from investors inside and outside of the United States. But, if you want to advertise or solicit investors at all, which most token offerings do, you are limited to accepting investments from accredited investors, those folks who make $200,000 per year in income or have a net worth of more than $1,000,000. If you have a strong company, and a strong blockchain proposition, Regulation D is the fastest and least expensive method of raising capital. But, keep in mind, the base of potential investors is very limited and many sophisticated investors are scared off by all the negative publicity surrounding ICOs.
What about Regulation S?
I’ve seen a lot of companies try to combine Reg D and Reg S, and use Reg S to bring in non-accredited investors from outside the U.S. While this strategy has worked for some, I’m not a big fan of this combination. Why would you want to use a U.S. law to exclude all U.S. investors who are not accredited, but let non-accredited investors for other countries invest?
Also, there are very strict rules surrounding how you can solicit with Reg S, which most companies fail to understand. For example, if you are relying on a Reg S exemption, you cannot offer your securities to any investor in the United States. If I can see your Reg S offering on your website from my office in Washington DC, you have probably already blown the exemption. Not surprisingly, I have been able to access nearly every Reg S token offering I have been told about on my phone or laptop, even though the companies advertise that they are doing an SEC-compliant coin offering. If I can see it, they are not compliant.
That leaves Regulation A+
To me, Reg A+ is the holy grail for token security offerings. Everyone can invest, not just rich people. The tokens sold can immediately be listed on an Alternative Trading System (ATS) and are liquid and tradable. I love that the SEC must qualify a Reg A+ offering before it can be sold. This means if you have any problems in your offering, there is a likelihood it is going to be flagged by someone at the SEC before you start selling, rather than after when something goes wrong like with Reg D or Reg S.
What are the downsides? It is not cheap to do, but nowhere near as expensive as an S-1 and full registration with the SEC. You will have ongoing reporting requirements and a company is limited to raising $50 million per year. While most companies would be thrilled with raising $50 million per year, this limitation would prevent some companies from using Reg A+ if their capital needs are higher. That said, a Reg A+ raise can be done in conjunction with a Reg D offering, if it’s structured correctly, to raise more than the limit.
The selling part seems to be fairly straightforward, follow the existing securities laws and a company will be okay?
Pretty much, but then the big problem occurs after the sale of the security tokens and you get into the great unknown. What happens after someone purchases the token or coin? Can they sell it outside of an ATS? How? Can they use it as a currency? Can they use it as a utility token? There is a huge amount of uncertainty as to how the courts and regulators are going to treat security coins and tokens after they are in the hand of investors.
Does trading the security tokens on an exchange or an ATS solve part of the problem?
Part of the problem, yes. This is one reason why I like Reg A+ so much. As soon as the offering closes, the Reg A+ securities tokens may be listed on a secondary trading platform and be bought or sold. This immediate liquidity is a huge selling point. There are rules and restrictions that limit sales under Reg D and Reg S, so this is not possible with either of those exemptions.
But there are also issues here where there is uncertainty. Let’s say a company sold $100 million in security tokens with a Regulation D, Rule 506(c) offering. I’ve seen similar companies where they think they are “SEC compliant” because they copied someone else’s “white paper” that claimed to be SEC compliant. I commonly see that these companies, most of whom relied on a “crypto expert” from outside the U.S., did not hire securities counsel and as a result, did not perform proper AML/KYC, did not take reasonable steps to verify each accredited investor, did not do Bad Actor checks, or did not file their Form D. As a result, they are not compliant and may not be able to list on an ATS. In fact, they may have to go back to their investors and offer each the opportunity to get their money back.
Aside from trading on an exchange or ATS, what are some of the other secondary market problems?
Let’s say you own one share of Apple stock. You can’t walk into a 7-11, plop your stock certificate on the counter, and buy a Slurpee and a bag of M&Ms. So, if you buy a token or coin as a security, how you are allowed to use it outside of trading it on an approved exchange or ATS is still up in their air.
Let’s take it a step further. Assume the 7-11 store owner allowed you to pay with your share of Apple. Now, the next customer steps up to the counter and pays for her purchase in cash. The store clerk hands her the Apple stock certificate as change. She is now the owner of a share of stock that has been through two owners in just a few minutes. Yet, there is no mechanism to track that transfer of that share of stock. The 7-11’s cash register can’t track it. The store owner has not filed any kind of report. The original owner has not notified anyone.
Securities laws limit how someone can trade shares of private stock and someone has to track all the movements like a transfer agent would. There are no regulations I am aware of that would allow a share of stock, or a security token, to be used as a currency. Yet, many of the coins being sold are being touted as a cryptocurrency that will someday be used like fiat cash or credit cards.
So what is the answer?
Excellent question. And I’ll give an excellent lawyer answer: it depends.
SEC Chair Clayton made a statement many have interpreted as saying it is possible that something may be sold as a security, then later become something other than a security. So, it seems the SEC may have cracked open the door to allowing a security token to become a cryptocurrency or utility token at some point. Based on comments from some of the people at the CFTC (which is impressively supportive of the crypto community for a governmental or regulatory entity, by the way), I think the prospects of this are promising. But, as far as I know, there are no legal means to do so today. Someone may test this in the courts and a crypto-friendly judge may allow it, or Congress could pass legislation, or the SEC or CFTC or other regulators may issue laws or rules that explain how this could happen.
The reality is that until we get some legislative, regulatory or judicial guidance on how a security can become something else, these problems will not go away, and companies selling security tokens will need to be aware of the risks they are taking by using this capital raising method. If they only use their security tokens like regular securities, they will likely be fine. But try to use it in a way a share of Apple stock cannot be used, and you are entering the lawlessness of the Wild Wild West.
What is the SEC’s stance on blockchain raises and their current approach to possible regulation?
In my opinion, this is the greatest misconception in the crypto world. Because of all of the subpoenas, lawsuits and enforcement actions, people assume that the state regulators and the SEC hate all things crypto or blockchain.
This could not be further from the truth. My experience is that they are very open to this new method of raising capital, as long as you follow securities laws and protect investors. The SEC is well aware that if they shut down all crypto offerings, another country will become the leader in this area, and billions of dollars of capital will flow out of the U.S. They do not want this to happen, so they are working with securities lawyers and their counterparts at the CFTC, Department of Treasury, FinCen and others to try to find solutions.
Yes, you have a target on your back if you do a crypto offering. But, as long as you have a justifiable legal basis in securities law for what you plan to do, the chances are the SEC is not going to stand in your way.
When can we expect to see some new laws and rules to clarify the uncertainty?
Remember you are talking about agencies that were told by Congress in the text of the JOBS Act, that they must promulgate rules to allow equity crowdfunding by Jan. 1, 2013, nine months after the law was signed. It took them three years, four months and five days to finalize those rules.
By the way, that is not a criticism. The SEC was asked to create a brand new method of capital creation, a new regulated entity called a funding portal and to make up detailed rules that fly in the face of 80 years of securities laws. That was not an easy task and they wanted to get it right.
This is very similar. First, Congress has not acted, so the SEC may not have any authority to create much in the way of new rules to apply to all sales of coins, tokens and cryptocurrency. In addition, if a company comes up with something that is either a currency or commodity and is not a security, the SEC is outside of its jurisdiction to regulate it. Finally, any rules about crypto will necessarily be like the equity crowdfunding rules – they will be creating regulations surrounding something never seen before and that does not conform to 80 years of securities law precedent.
The simple answer is, this is going to take time. While I expect to see judicial rulings and maybe some no-action letters, the chance of seeing actual SEC rules that clarify all of this any time soon is not very likely.
Any parting words?
The days are gone of some random millennial plagiarizing a white paper found on Google while their tech geek buddy sets up a website to promote and accept Bitcoin for an ICO followed by millions of dollars magically appearing unless those people want to risk going to jail or being sued.
Anyone who wants to do this right in the U.S. is going to need experienced securities counsel. They are very likely going to need a licensed broker-dealer. They are going to need a secondary trading platform. They are probably going to need accountants and maybe auditors. Doing this right is not going to be cheap. But, then again, getting sued or arrested and having your business shut down is far more expensive than simply doing this legally and compliantly from the beginning.