Initial Coin Offerings: Why the SAFT is DEAD …

Investment in the cryptocurrency industry is currently dominated by the use of Simple Agreements for Future Tokens (SAFTs). While SAFTs were a somewhat novel approach when they were introduced, now that cryptocurrency assets have become almost universally deemed “securities” by the SEC, the use of SAFTs as an investment vehicle is, or otherwise should be, DEAD.

Background:

At its heart, the SAFT is an investment contract which gives the investor the right to receive cryptocurrency tokens from the issuer in the future once they are sold to the general public. Essentially, an issuer will sell its SAFTs to investors and, in turn, use the received investment proceeds (or at least is supposed to use such proceeds) to actually develop the working cryptocurrency tokens. In simpler terms (pun intended), the SAFT is the contractual equivalent of Popeye’s Blimpy agreeing to pay you Tuesday for a hamburger today.

the use of SAFTs as an investment vehicle is, or otherwise should be, DEAD #ICOsClick To Tweet

The contractual form of the SAFT is the result of a joint effort between the Cooley law firm (in particular Marco Santori) and Protocol Lab as detailed in the whitepaper released on October 2, 2017 entitled “The SAFT Project: Toward a Compliant Token Sale Framework.” Promoted as a way for cryptocurrency issuers to perform an “initial coin offering” (ICO) in compliance with U.S. securities laws, the whitepaper provides as follows:

The SAFT is an investment contract. A SAFT transaction contemplates an initial sale of a SAFT by developers to accredited investors. The SAFT obligates investors to immediately fund the developers. In exchange, the developers use the funds to develop genuinely functional network, with genuinely functional utility tokens, and then deliver those tokens to the investors once functional. The investors may then resell the tokens to the public, presumably for a profit, and so may the developers.

The SAFT is a security. It demands compliance with the securities laws. The resulting tokens, however, are already functional, and need not be securities under the Howey test. They are consumptive products and, as such, demand compliance with state and federal consumer protection laws.

To be sure, public purchasers may still be profit-motivated when they buy a post-SAFT utility token. Unlike a pre-functional token, though, whose market value is determined predominantly by the efforts of the sellers in imbuing the tokens with functionality, a genuinely functional token’s value is determined by a variety of market factors, the aggregate impact of which likely predominates the “efforts of others.” Sellers of already functional tokens have likely already expended the “essential” managerial efforts that might otherwise satisfy the Howey test.

The whitepaper acknowledges that the SAFT itself is a security and must be sold in compliance with applicable securities laws. However, it too easily dismisses the fact that the resulting tokens may (in fact most likely will) be deemed to be securities as well.

Put another way, the SAFT was specifically designed to be used to invest in cryptocurrency assets that would NOT be treated as securities. As we know, the SEC has basically taken the completely opposite viewpoint; viewing the majority, if not all, cryptocurrency tokens as securities. The biggest problem with viewing the resulting tokens as securities in connection with a SAFT is that it makes the form of the SAFT non-compliant with existing securities laws as discussed below. 

The Problems:

Before I get into a discussion as to the compliance issues with respect to the SAFT form, it should be noted that this post is NOT intended to be a discussion as to whether cryptocurrency tokens / coins should, or should not, be deemed to be securities or whether any particular offering meets the Howey test. There are several articles that dive into that argument in more detail. In fact, the recent article by David Felsenthal and Jesse Overall gives a great layout as to the current lay of the land in this area. While, in theory (and I stress theory) it is technically possible to have a cryptocurrency token / coin which would not be deemed to be a security, for purposes of this post we are going to assume that all cryptocurrency tokens/coins will be deemed securities. In fact as a general rule, given the SEC’s recent treatment of cryptocurrency assets it would be a good rule of thumb to always assume the same but I digress.

There are two main problems with the SAFT, as I see it. The first issue with using a SAFT is more of a consistency issue rather than a truly regulatory one.

SAFT agreements are being used to facilitate ICOs but they refer to different types of assets. On the one hand, we are conducting an Initial Coin Offering but selling “Simple Agreements for Future TOKENS.”

See the issue?

Now some might say that I am splitting hairs and a year ago, when these terms were used almost interchangeably, I might have agreed. However, today the terms “coin” and “token” in the cryptocurrency space have taken on more specific, and distinct, meanings.

Typically the term “coin” refers to more transactional based cryptocurrency assets whereas the term “token” refers more to a type of investment vehicle. The distinction was even noted by SEC Chief Accountant Wesley Bricker in a statement released late last year when he put forth specific definitions of the two terms, stating (in pertinent part):

The term “coin” can be used to describe a certain feature of a type of distributed ledger software program. The term “coin” arises because the rights and responsibilities associated with such a feature may be exchanged among the parties who make use of the software program. Exchanges that occur are tracked within the software program using a form of a distributed ledger.

The term “token” can refer to some manner of a claim against an entity (or against its assets, cash flows, residual value, future goods or services, and so forth) that arises from the use of distributed ledger technology. A “token” is referred to as such because it embodies or serves as a representation of the claim or claims. An entity may extend such a claim to others in exchange for proceeds of varying forms, obtained by offering the so-called “tokens” to others in exchange.

Bringing this back to the issue, using a SAFT to facilitate an ICO is not only sloppy, it can potentially be misleading to investors as they are fast becoming very different assets.

As an example, you wouldn’t ask an investor to sign a Stock Purchase Agreement to purchase an interest in an LLC or partnership would you? (If you don’t know why that is an issue please call a lawyer immediately).

I get that “SAFC” (i.e. “Simple Agreements for Future Coins”) and “ITO” (i.e. “Initial Token Offering”) don’t have the same ring to them but the more these two types of cryptocurrency assets become distinct from one another the more necessary it becomes to ensure that the terms are used consistently so as not to be deemed to be misleading potential investors.

The second problem with the SAFT, and what may be its coffin nail, is that it does not comply with the SEC’s views in C&DI 139.01 which provides as follows (emphasis added):

Question: Where the offer and sale of convertible securities or warrants are being registered under the Securities Act, and such securities are convertible or exercisable within one year, must the underlying securities be registered at that time?

Answer: Yes. Because the securities are convertible or exercisable within one year, an offering of both the overlying security and underlying security is deemed to be taking place. If such securities are not convertible or exercisable within one year, the issuer may choose not to register the underlying securities at the time of registering the convertible securities or warrants. However, the underlying securities must be registered no later than the date such securities become convertible or exercisable by their terms, if no exemption for such conversion or exercise is available. Where securities are convertible only at the option of the issuer, the underlying securities must be registered at the time the offer and sale of the convertible securities are registered since the entire investment decision that investors will be making is at the time of purchasing the convertible securities. The security holder, by purchasing a convertible security that is convertible only at the option of the issuer, is in effect also deciding to accept the underlying security.

Now there is a lot to unpack there but before I get into specifics, let’s remember what a SAFT boils down to: It’s a private security sale (typically to accredited investors only under Rule 506(b) or (c)) where the investor will automatically receive tokens once the issuer sells the tokens “to the general public in a publicized product launch” (typically referred to as a “Network Launch).

Now again assuming that the resulting tokens are securities, the only SEC compliant method for facilitating a sale of such tokens to the “general public” is to register the securities (i.e. via Reg A+ or a full blown IPO). Yes there is Reg CF and Rule 506(c) which will allow for a form of public sale but when we are talking about a cryptocurrency asset being made public we are talking about expected widespread use, and large volumes, which would basically make those exemptions unworkable so we will ignore them and assume a full registration of the subject tokens will be required.

Pulling that all together, a SAFT sold in a private security sale would give the investor the right to automatically receive tokens once the issuer registers its tokens with the SEC for public sale. Put another way, by using a SAFT an issuer is essentially doing a private pre-sale of its future public securities which is a big no-no in eyes of the SEC.

The above C&DI may not seem readily applicable on its face. However, I am currently working with CERES Coin LLC in connection with its proposed Rule 506(c)/Regulation A+ cryptocurrency offering, and have personally discussed this issue directly with the SEC.

The most important language with respect to the use of SAFTs is the underlined language above. As the SEC sees it, if a SAFT investor will automatically receive tokens in the future when (and if) the tokens are registered, without any other investor involvement, then the tokens need to be registered as of the date the SAFT is sold … period. Now take that in.

The primary purpose of the SAFT is to allow for early investors to participate (typically at a discount) prior to the tokens being sold to the general public. If the tokens have to be registered before the SAFT can be sold then there is no real purpose for using the SAFT and all utility of the SAFT form is negated.

As the SEC sees it, if a SAFT investor will automatically receive tokens in the future when (and if) the tokens are registered, without any other investor involvement, then the tokens need to be registered as of the date the SAFT is sold … period. #ICOClick To Tweet

Now you may be saying to yourself “wait a minute, the above C&DI question specifically refers to convertible securities which are being registered under the Securities Act and SAFTs are not registered when sold so this C&DI doesn’t apply!

That’s a great point and one I specifically asked the SEC as well. Their response was that the registration or non-registration of the convertible security (in this case the SAFT) would not change the remainder of the C&DI analysis, in particular the bolded result above.

Also, before you look to take advantage of the language in the C&DI which appears to create a loophole for SAFTs which convert after one (1) year, per my discussions with the SEC the one (1) year period alone isn’t going to be enough. While of course not binding, my takeaway from my discussions with the SEC was that they were more concerned with the fact that a SAFT is convertible solely at the option of the issuer as opposed to when the SAFT was convertible and felt that if the entirety of the investors decisions regarding the future tokens were made at the time a SAFT was purchased that the tokens needed to be registered as of such date (i.e. in line with the underlined language above).   

Conclusion:

The SAFT was developed specifically assuming that the underlying tokens would not be treated as securities by the SEC. Whether or not the use of the SAFTs in this context is, or was, SEC compliant is moot.

We now know that the SEC views the overwhelming majority of cryptocurrency assets as securities. Accordingly, as noted above, the SAFT is simply not an SEC compliant method for privately selling interests in cryptocurrency assets. This is evidenced by the apparent targeting of SAFTs by the SEC as reported by both the Wall Street Journal and CoinDesk. While the majority of the SEC’s guidance in this area has come in the last couple months, such treatment began with its ruling concerning the sale of the DAO tokens back in July of 2017, well before the issuance of the white-paper, and shouldn’t come as a surprise.

Please note, I am not saying that there aren’t ways to privately sell interests in cryptocurrency assets in a manner which is in compliance with U.S. securities laws. As noted above, I am personally working with CERES Coin LLC on its proposed Rule 506(c)/Regulation A+ cryptocurrency offering and we are using a “Private Investment Agreement” (dubbed a “PIA”) we believe properly addresses the above issues to facilitate the private investment portion of the offering.

Moreover I know that StartEngine has abandoned the SAFT and is working on its own SEC compliant investment vehicle. Per Howard Marks of StartEngine, the SAFT was a promising idea but failed to offer protections for investors.”

What you should take away from this post is that any issuer continuing to use SAFTs to sell cryptocurrency assets to U.S. investors is going to get burned eventually, probably sooner rather than later.

Moreover, U.S. investors who elect to invest in SAFTs (including those who insist on the use of such forms) might not face any direct SEC action but the SEC may ultimately come down on the issuing company which may (and most likely will) materially and adversely affect the value of their investment.

I cannot stress this enough, if you are an issuer or an investor in this space you need to align yourself with the right attorneys and other advisers to help navigate the numerous landmines that are waiting for the unwary. 


 

Anthony Zeoli is a Senior Contributor for Crowdfund Insider.  He is a Partner at the law firm of Freeborn in the Corporate Practice Group. He is an experienced transactional attorney with a national practice specializing in the areas of securities, commercial finance, real estate and general corporate law. Anthony drafted the bill to allow for an intrastate crowdfunding exemption in Illinois that eventually became law.

 

 

 

 

 


 

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