Don’t Panic! US Securities Exemptions for Initial Coin Offerings

So you were ready to do an initial coin offering (ICO), and then the Securities Exchange Commission released an investigative report concluding that DAO tokens were securities.  Seasoned securities attorneys have always known that token sales could implicate securities laws if the tokens were treated as securities.  Not every token is a security though.  If you want to dive into it deeper, there’s a great article on Coinbase entitled “Securities Law Framework for Blockchain Tokens” which references a fantastic analysis by Debevoise & Plimpton (where former SEC Chair Mary Jo White is practicing).  For the purposes of this article, we’re going to assume that your ICO is for tokens that are securities.

Stop.  Breathe.  It’s ok.  Securities laws existed before ICOs did, and the world of finance grew despite it.  One might argue that finance flourished because of good regulation.  Securities laws aren’t going to destroy ICOs.  It’ll be more complicated to put ICOs together, but it still can be done.  The US securities laws are broad and expansive, so this article isn’t going to be able to cover everything.  Instead, we’re going to focus on common exemptions to the registration requirement under the Securities Act of 1933.  Note that you may also need to analyze states laws as well as those of foreign jurisdictions that your ICO touches. 

As indicated on the SEC website, the ’33 Act, which is also known as the “truth in securities” act, has two basic objectives:

  • require that investors receive financial and other significant information concerning securities being offered for public sale; and
  • prohibit deceit, misrepresentations, and other fraud in the sale of securities.

To achieve these objectives, securities laws generally provide that any offer to sell securities must first be either registered or qualified with the appropriate governmental body or satisfy an available exemption.  This is a process which is extremely time-consuming and costly.  Accordingly, those who raise capital generally seek an exemption to the registration requirement instead.

This article will assume that most ICOs will be generally solicited and marketed throughout the United States and abroad with a total capital raise in excess of one million dollars.  When it comes to US federal laws, there are only a few exemptions to registration which are practical for ICOs.

Rule 506(c)

For decades, private companies raised capital using the Regulation D, Rule 506 exemption to avoid registration.  Each year, over a trillion dollars is now raised using this exemption.  Unfortunately, that Rule, which has now been reclassified as Rule 506(b) doesn’t allow for general solicitation or advertising.  Rule 506(b), in effect, was a securities offering that could only be made to a private network of friends, family, and investors that you had a pre-existing substantive relationship with.  However, the Jumpstart Our Business Startups Act (the JOBS Act), which was signed into law by President Obama in 2012, created a number of ways for companies to be able to legally crowdfund securities.  As ICOs generally count on public solicitation, this was a huge development.

As part of the JOBS Act, a new Rule 506(c) of Regulation D was created.  In most respects, it is similar to Rule 506(b) with two major differences: 1) you can generally solicit with Rule 506(c) but you cannot with Rule 506(b), and 2) with Rule 506(c) you must verify that your investors are accredited investors, but with Rule 506(b), your investors can self-certify as to their accredited investor status.

Rule 506(c) is going to be the most commonly used exemption from the US securities law registration requirement in the ICO space because it has reasonably low upfront and ongoing costs, it’s easy to do, and has no limits on the amount of money that can be raised through it.  As an added incentive, the Rule 506(c) exemption preempts state securities laws that require registration so compliance with Rule 506(c) at the federal level helps take care of some of your state securities laws responsibilities as well.  The main drawback to Rule 506(c) is that you have to take certain “reasonable steps” to verify that your investor is an accredited investor, but that process is easily handled by a service.  Another drawback is that the securities offered under a Rule 506(c) offering are restricted securities.  There are mechanisms to sell restricted securities, but they are not supposed to be freely tradable.

Reg A+

The JOBS Act also created what is commonly now known as Regulation A+.   Reg A+ is a dramatic improvement upon the old Reg A which was so impractical that it was rarely used.  Reg A+ is an interesting exemption because it allows for general solicitation and advertising and it allows for both accredited investors and non-accredited investors to invest.  As an added bonus, the securities offered in an Reg A+ offering are freely tradable with some exceptions.  There is a Tier I and Tier II capital raise under Reg A+, but in general, ICOs would not use Tier I and would only rely on the Tier II exemption instead.  Tier II allows up to $50 million dollars to be raised and preempts state securities registration laws whereas Tier I only allows up to $20 million dollars to be raised and does not preempt state securities registration laws.

The major downside with Reg A+ is the significant upfront legal costs of going through the SEC review process and ongoing maintaining annual and semi-annual reporting requirements under Tier II.  Because of the complexity of Reg A+ offerings, they normally take longer to execute than a Reg D or Reg S offering.  Still, Reg A+ is a very interesting exemption for the ICO markets.  There are already a few people working on Reg A+ ICO offerings, so you will see them hit the marketplace soon.

Reg S

Reg S exempts offers and sales of securities “that occur outside the United States”.  In short, the Reg S exemption is useful when all the offers and sales activities are completed entirely offshore and made only to non-US Persons.  For the ICO marketplace which is international, this is already very powerful.  Everyone wants US investors though, which Reg S doesn’t allow.  However, a Reg S offering can be concurrently conducted alongside another offering that can be made to US investors.   For example, one might be able to use the Reg S exemption for offshore investors and then a Rule 506(c) exemption for domestic US investors.  When running concurrent offerings, careful attention must be paid to the method of offering and sale of the securities to make sure that the offering is in compliance with all of the conditions of each exemption it hopes to rely upon. It’s best to consult with a securities attorney experienced with the interplay between the concurrent exemptions.  There may be situations where relying on a single exemption is superior to attempting to utilize multiple exemptions.

The limitation of Reg S is that it is only a federal exemption.  A company that relies on Reg S must separately seek a state securities exemption.  For some states, this may mean that you effectively cannot have a Reg S that is generally solicited, even if the general solicitation only takes place abroad.

Rule 506(b)

This article only briefly mentioned Rule 506(b) as a part of the Rule 506(c) discussion because Rule 506(c) is the more obvious exemption for generally solicited ICO offerings.  There is a way to use Rule 506(b) to crowdfund investors in an ICO as well, but that’s beyond the scope of this article.  Stay tuned for a separate article on how Rule 506(b) can play a role in ICOs.

Reg CF

No need to address this recently created securities exemption as it is capped at just $1.07 million and simply too small.

Compliance

Properly compliance with the exemptions is crucial.  It is extremely important to understand what you can or cannot do with each exemption.  If you are unable to rely on any exemption, then your offering would require registration, which would be prohibitively expensive and time-consuming for all but a few ICOs.


 

Jor Law is a co-founder of VerifyInvestor.com, the resource for accredited investor verifications trusted by broker-dealers, law firms, companies, and investors who insist on safety and reliability. These verifications are required by federal laws for generally solicited Regulation D, Rule 506(c) capital raises. Jor Law is also a co-founder of Homeier Law PC, where he practices corporate and securities law, including helping companies take advantage of alternative forms of capital raising such as venture capital, EB-5 finance, Regulation D, Rule 506(c) offerings, Reg A+ offerings, and crowdfunding.

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  • Jor, really helpful article! I wonder why did you say that 506(c) will be the most popular for ICOs, if such securities are not freely tradeable, while all ICOs today rely on tokens to trade on exchanges.

    • Jor Law

      Gene, Reg A+ has the advantage there, but many will shy away from it because of high upfront costs, SEC review, ongoing costs, and maximum raise limitations. Many of the ICOs that are attempting to comply have been moving forward with the Rule 506(c) or Reg S exemption although there are certainly those who are also planning to use Reg A+. I could be wrong, but I think 506(c) edges Reg A+ if Reg A+ isn’t changed.

      • Jor, thank you for your reply. Indeed $50M limit is a drawback, not to mention compliance costs. But without free token trading the community may not even accept it. I wonder if people even realized that FileCoin will not be tradeable, as they applied for Reg D.
        By the way, isn’t $50M limit per year, and then you can raise again?

        • Jor Law

          It’s possible that restricted securities later become tradable (like other private companies that eventually register their securities), so a Reg D now might just be a stepping stone. But I do get your point with respect to having tokens be freely tradable.

          It’s actually not clear that Filecoin won’t be tradable. Certainly, the SAFT has trading restrictions, but the underlying tokens might not have the same restrictions.

          With Ref A+, $50m is the annual limit (and hopefully it gets raised over time).

          • Jor, thank you for clarifications. Last question, regarding token tradability in case of Reg D. You said: 1) it is possible that restricted securities later become tradable – did you mean the IPO? 2) SAFT has trading restrictions but underlying tokens may not have the same restrictions – how is that possible?

          • Jor Law

            Gene, too complicated of a discussion to discuss in full here. For 1, essentially it could be some form of registration. For 2, read through the Filecoin PPM and also the Securities Framework that Debevoise published (link above). Both will give you insight as to why Filecoin and their counsel took the position that the underlying tokens probably will not be securities (but…it’s possible that they could be considered securities).

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