In 2017, we worked with a US-based asset manager that wanted to issue shares via blockchain technology to raise funds. The company deliberately chose to raise this funds from the public rather than private investors. This means it had to apply for a Regulation A qualification. We were the third-ever company to go down this road. In this article, I shortly describe how security offerings work in the US and what our role in this project was. If you consider issuing securities using blockchain technology, or possible preparing it already, this article provides some valuable insights.
We received many questions regarding our US experiences at foreign events.
In short - how security offerings work in the US
In the US the securities market is strictly regulated and monitored by the Securities and Exchange Commission (SEC). The SEC had oftentimes expressed that issuers of cryptocurrencies, whether it is a security or not, must comply to regular security regulations. This means issuers must register their offering with the SEC. This can ben an expensive, boring and lengthy process.
In 1946, the US introduced the Howey test. This test determines whether 'something' is classified as an 'investment contract' or not. If that's the case, then this 'something' is considered a security and is then subject to securities laws. Under these laws, any offer or sale of a security must either be registered with the SEC or meet certain conditions for an exemption. There are several exemptions from registration requirements, allowing companies to offer and sell their securities without having to register the offering with the SEC. This saves a significant amount of money and time, plus full registration is often not even feasible for companies.
One of these exemptions is a Regulation A. This is an exemption from registration for public offerings that do not exceed $50 million in a one-year period. In comparison, another exemption is for example Regulation D, but this exemption does not allow you to raise money from the public but only from accredited investors nor will the security be freely tradable after the offering. Since no money is raised via the public, a Reg D exemption is faster and cheaper than a Reg A. In both cases, still lots of paperwork and preparations are required.
The company wanted to stay focused on their asset management activities and outsourced the preparation and execution of the tokenized securities offering. We were responsible for a large part of the project. Our responsibilities included project management, drafting documents for the Regulation A filing, and representing the organizations towards lawyers, software developers, investors and other stakeholders.
Two important topics were:
How can we 'transform' the current shares into crypto tokens without losing value and usability for the current shareholders?
How to utilize the innovative possibilities of blockchain technology and still be compliant without automatically falling back into the existing (and outdated) structures?
What have we done specifically?
Legal - blockchain x securities laws
Drafted documents (Form 1-A) for a Regulation A qualification (in collaboration with the lawyers) and submitted these to the SEC.
Answered comments of the SEC and re-submitted the documents.
Discussions with lawyers and policy makers regarding blockchain-based employee stock option plans, tradability of tokenized securities on decentralized exchanges, and secure storage of unsold tokens.
Discussions with i.a. broker-dealers and transfer agents regarding their role in the issuance. According to law certain organizations must play a specific role during an issuance, but technological developments have made some of these organizations obsolete.
As a first-mover and the very early stage of 'security tokens' we constantly had to explain the processes, the benefits, and even what blockchain actually is. Even today (2020), there are very few Regulation A qualified token offerings.
Technological - programmable securities
We communicated with the developers and managed the progress. We understood the technology and could therefore translate the legal requirements to technological requirements. In essence, we 'designed' the token. This includes:
What blockchain and token standard do we use?
How 'fractionalized' will the share be? Cryptocurrencies can be divided up to 18 decimals or more. That means you theoretically could own 0.000000000000000001 share. Is that allowed? Is that desirable? What's the impact on the tradability? Interestingly, the SEC had a different point of view than the Dutch financial authorities (AFM).
How will dividend be payed? In stable coin, crypto or fiat? What type of interface is needed for the company as well as the investors?
How can shareholders vote via blockchain technology during the Annual General Meeting (AGM)?
Further, we discussed:
'Retrievability' of a token. Imagine you own 10% of the tokens, but you lose the access to your wallet; what happens with the tokens? Nobody can ever access these anymore. Should there be a technological function that the 'zombie tokens' can be retrieved? If so, who has access to this functionality?
How will the raised funds stored? Do we have to use an escrow? If so, what are the costs and how do you connect this escrow account to a smart contract? Where do you store the private keys and recovery phrases and who can access these?
How do you set up employee stock option plans? How can employees exercises their right to buy?
How do you avoid insider trading?
Structure of the token offering
With the US securities law, you do not want to:
Issue tokens in multiple rounds. 'Classic' initial coin offerings were organized in several rounds. This is not possible for a security offering, since each round is considered a new offering and thus requires additional paperwork and/or qualification.
Have a softcap. If you do want to have a softcap you must use a SEC-approved provider of escrow accounts.
Give a discount on your tokens / shares. This requires quite some additional paperwork.
Promote your offering in other countries. Well, you can, but you'll be subject to the securities law of the country you are promoting your offering in.
Together with the company and the US lawyers, we drafted the strategy of the offering, including:
Via what platform the tokens will be offered, considering the KYC/AML requirements.
On what platform (security token exchanges) the tokens will be listed after the offering.
New opportunities for people powered societies
It was a long, late night (due to time differences) and sometimes frustrating process, but it gave so much insights in the technology and the opportunities for SMEs and society in general. Even though securities laws differ greatly among countries, the opportunities the technology provides can most of the times be replicated in other areas. Yet, policy makers often want to treat new innovations as 'normal' and put these innovations into existing boxes.
However, security tokens should not automatically be forced into regulatory structures that are (1) designed by incumbents for incumbents, and (2) for traditional models of finance. We should recognize that cryptographic tokens are programmable securities that have a variety of capabilities (such as digital multi-signature escrow) and as such, can offer much more flexibility and reliability when it comes to responding to the needs of organizations or society in general. It can be a great facilitator in supporting the SME economy, countering financial inclusion and equality, and even addressing environmental impacts.
Lets explore these opportunities together.