When the blockchain mania began many commentators and market participants were quick to point out the revolutionary aspects of this technology and began sounding the death knell of the traditional securities industry. They claimed that there would no longer be any need for regulation or any of the historical participants of the financial industry marketplace due to the ability to raise enormous amounts of money with what appeared to be little effort.
Of course, one of the historical market participants was the stock transfer agent. Why would an issuer now need a transfer agent when coins issued on the blockchain would have an immutable record of the issuance and any subsequent transfers? This led to periods of self-doubt and depression with the need for me to spend a lot of introspective time contemplating my role in the universe and whether there was an actual need for what I do.
The Inevitable Advent of Regulation
Contrary to such pronouncements, regulation was inevitable. While everyone complains about the expense and delay of rules, as they say it is all fun and games until someone gets hurt. In contrast to Bitcoin where there is no one to take responsibility for fraud or illegalities involving the cryptocurrency since there is nothing actually being offered and no individual or entity behind it, when dealing with an entity raising funds through an initial coin offering (or ICO) that subsequently fails investors will want to hold the issuer accountable as we have seen in recent lawsuits filed.
Accordingly, on July 25, 2017 the SEC fired the shot heard round the ICO world in the form of a Statement by the Division of Corporation Finance and Enforcement on the Report of Investigation on The DAO. With this pronouncement the SEC told the world that while you may not want it, regulation is here to stay based on the traditional securities regulatory regime. Since then, the SEC’s statement has been reviewed and dissected ad nauseam and many “experts” have chimed in with their views and prognoses.
[clickToTweet tweet=”‘an entity raising funds through an initial coin offering (or ICO) that subsequently fails investors will want to hold the issuer accountable as we have seen in recent lawsuits filed'” quote=”‘an entity raising funds through an initial coin offering (or ICO) that subsequently fails investors will want to hold the issuer accountable as we have seen in recent lawsuits filed'”]
In particular, the tone of the blockchain capital discussions began to change as more and more people talked about the need and desire to conduct a regulated coin offering.
In fact, even the vernacular changed from “ICO” to “STO” or security token offering. This of course was great news for me since I assumed that with the idea of legally compliant security token offerings gaining momentum people would once again flock to our doorstep seeking the assistance and advice of traditional corporate finance participants.
However, much to my surprise, everyone I spoke to (including “experienced” securities lawyers) asked over and over, why do we need a transfer agent if tokens are being issued on blockchain? Once again, I wept in exasperation.
Issuers began conducting their token offerings utilizing the exemptions provided by the SEC under Regulation D. This meant that the tokens were restricted and can still be sold using offering platforms created and run out of various dark corners around the globe (i.e. Estonia, Malta, Cayman, etc.).
To avoid any true SEC oversight all an issuer needed to do was file a Form D to be compliant with regulations. This was a great loophole found by savvy organizers who are typically not regulated and vested members of the securities industry.
But what would happen when these tokens are held for a year, the typical requisite holding period for restricted securities? Can the restrictions on these tokens be lifted automatically by the token smart contract?
[clickToTweet tweet=”what would happen when these tokens are held for a year, the typical requisite holding period for restricted securities? Can the restrictions on these tokens be lifted automatically by the token smart contract? #ICO #Blockchain” quote=”what would happen when these tokens are held for a year, the typical requisite holding period for restricted securities? Can the restrictions on these tokens be lifted automatically by the token smart contract? #ICO #Blockchain”]
It was not important enough for anyone to think about the long-term ramifications or issues surrounding such offerings since in the short-term issuers were able to distribute “regulated” tokens without much additional work. However, are these really regulated token offerings or are they token offerings done to avoid actual regulation?
Furthermore, wouldn’t investors value a truly regulated token that was an unrestricted security and fully tradable?
Taking all of these issues into consideration and even as we continue talking to new industry participants, including the multiple ATS platforms being created and registered with the SEC and FINRA, and the offering platforms located in the United States advertising regulated token offerings, we kept asking what about us? Don’t you need a qualified, experienced, registered transfer agent? The response we continued to receive was why, this is the blockchain.
During the course of the past few months, as the various ATS and token platforms and other service providers began looking to actually enter the corporate finance market to provide services, the realization seems to be setting in that a transfer agent is necessary for a truly regulated token.
This is patently clear when reviewing the applicable SEC regulations which state specifically that a transfer agent is necessary for a Regulation A offering. Now, after it looks like the requirement for a transfer agent is being recognized, the question remains. What is our role in the scheme of an offering on blockchain?
Initially, we moved forward under the assumption that the transfer agent would need to build a technology platform (or license one from a third party) to be able to issue tokens to the blockchain and monitor those tokens, similar to technology currently utilized in the traditional systems on a centralized ledger. We proceeded accordingly and have the capability to take a smart contract created by an issuer or create a smart contract on behalf of the issuer and serve as a transfer agent in the same fashion we always have.
Recently, however, we have seen a couple of significant shifts in the marketplace that may have further ramifications on the role of a transfer agent.
While in the beginning most issuers were simply satisfied to create and offer a simple token to raise capital, this has changed dramatically. Issuers have come to embrace the capabilities of the blockchain and are designing more complex tokens not only for the purpose of raising capital but to provide further utility functionality in their respective marketplaces. This presumably is the result of market determinations that notwithstanding the utility nature of a specific token, it will probably be viewed by the SEC as a security.
Therefore, when creating a utility token why not just make it into a security as well? This is a complicated twist, because traditionally a transfer agent simply interacted with securities and their investors. Now we are broadening the horizon of potential holders to go beyond mere investors to include those seeking the token for utility benefits as well.
Second, we have seen the growth and development of multiple service providers who have been involved with ICO’s and now want to remain relevant in the world of STO’s as well. We are now being approached not by issuers wishing for our assistance to issue tokens utilizing our technology, but by participants who have technology and insist on transfer agents interacting with issuers on their platforms utilizing the technology already in place or being developed for this purpose and have no desire to license it to transfer agents. Rather, they want to continue their involvement and relationship with the issuer and token marketplace
So where do we go from here?
We are experts on issuing stock, warrants and other traditional securities on our current systems but what is our role when dealing with utility functionality or employing third party technology not designed or built for a transfer agent to facilitate issuances and monitor securities on the blockchain?
First and foremost, it is important to recognize that transfer agents (along with other market participants, such as legal counsel and auditors) are often referred to by the SEC as “gatekeepers”.
As such, our role is vital to maintaining the integrity of the securities marketplace. This is true if a security trades on NASDAQ, NYSE, or any blockchain ATS, that may develop for the trading and exchange of security tokens. While there are those who advocate for no, or minimal regulation of token offerings, that quickly changes when there is fraud and an investor looks to the government for help after the fact.
[clickToTweet tweet=”While there are those who advocate for no, or minimal regulation of token offerings, that quickly changes when there is fraud and an investor looks to the government for help after the fact #ICO #STO” quote=”While there are those who advocate for no, or minimal regulation of token offerings, that quickly changes when there is fraud and an investor looks to the government for help after the fact #ICO #STO”]
While many offerings were closed on a restricted basis under Regulation D, it is too soon to know what the ramifications may be. What will happen when a token is eligible to have restrictions removed?
Have the smart contracts been written to allow restrictions to automatically expire after one year and if so, what about tokens held by affiliates of the Issuer, that are subject to more stringent requirements?
Although “smart contracts” are presumably smart, they cannot possibly be created to address all the regulations and compliance issues that may arise.
After many sleepless nights and numerous debates and review of applicable rules and regulations we have put together some of the basic requirements that we believe a blockchain system should be able to provide to a registered transfer agent that has been engaged in to ensure that a token offering is truly a regulated STO.
However, this should not be taken as legal advice and as the industry, technology and regulations change this analysis will need to be reviewed and reanalyzed (i.e. more sleepless nights).
First, it is essential for any transfer agent to be able to oversee and confirm the actual closing of any token offering, including the issuance of tokens (restricted or unrestricted) for compliance review to insure legal requirements are met.
To the extent that restricted tokens are being issued, there must be a plan and system in place with respect to the eventual removal of the restrictions for free transfer of tokens. This needs to be reviewed to make sure that the tokens, and the token holders are actually eligible for this transfer.
Second, we are happy to see that most industry participants have incorporated KYC / AML into their offering systems to confirm that any investor and recipient of tokens is being “whitelisted”. This process must be expanded beyond the initial offering to include future transferees of these tokens as well.
Third, it is specifically the role and responsibility of the transfer agent to maintain records to be able to track the issuance, transfers, and ownership of securities issued.
Accordingly, systems need to be built with the ability for transfer agent to generate and create all relevant reports that coincide with the true identities (i.e. not just computer code) relating to any token that has been issued. This will require any registered ATS to work closely with the transfer agents to make sure that there are mechanisms in place for this data to be created and transmitted.
Fourth, is where things get interesting and addresses some issues that many industry participants have not focused on, helping token holders.
Every day we interact with security holders who have invested in public companies and are either confused by the process or have issues that they need assistance with. The biggest concern that we have (and what we believe many industry participants have) is cyber security.
There have been too many stories of wallets being unlawfully accessed or hacked by unauthorized users. We therefore need a mechanism in place so that claims regarding the theft of tokens can be addressed and appropriately reported to the SEC.
Unlike Bitcoin holders who lost their ability to access their wallets and had no one to turn to for help, we now have an issuer standing behind the tokens it issues, and that issuer will need someone to be able to help these holders access their securities.
[clickToTweet tweet=”Unlike Bitcoin holders who lost their ability to access their wallets and had no one to turn to for help, we now have an issuer standing behind the tokens it issues, and that issuer will need someone to be able to help these holders access their securities” quote=”Unlike Bitcoin holders who lost their ability to access their wallets and had no one to turn to for help, we now have an issuer standing behind the tokens it issues, and that issuer will need someone to be able to help these holders access their securities”]
Fifth, there are many ancillary services that, although not required under relevant regulations, transfer agents regularly provide that we believe will be necessary for tokens as well.
I am referring to proxy and voting services and dividend payments. While these services may not be required for all tokens and is dependent on the specific features of the individual tokens being created, we are seeing more and more tokens being planned and created that contemplate crypto-currency payments or token dividends being paid out to token holders as well as giving token holders the ability to vote on items or questions to be presented in the future. Of course, we have to be mindful, that any payments being made must also contemplate appropriate reporting to our friends at the IRS.
This is the issue of dormant and lost token holders and potential “escheatment” obligations. I am sure right now you are rushing to Google to look up, what the hell is escheatment. This is a little-known detail that many are probably not familiar with, and while not currently an issue, will become one as this industry develops and matures.
While we understand what it means to lose a stock certificate, how do you lose a security holder or how do you lose a token holder listed on the blockchain?
These questions involve issues that are generally governed by state law and may be caused by the death of a token holder or caused by inactivity of the token holder account (i.e., no transfers, votes, etc.). In such cases, there may be a requirement to transfer these tokens to the applicable state and failure to do so can have significant financial repercussions.
While this is only a basic summary of the issues involved and our thought process, this article has been very cathartic in affording me the opportunity to unburden my soul.
I hope that this has also been helpful to you as well and provided a glimpse into the ideas we have had in this new and exciting time that we like to refer to as the future of the securities market. Or the present, if you are ready to launch your own truly regulated STO. In which case, please call us and join my sleepless nights as we embark on the journey together into this brave new world.
Yoel Goldfeder serves as the CEO of Vstock Transfer, a leading stock transfer and registrar company. Goldfeder is a licensed attorney with over fifteen years of corporate and securities law experience. He has represented both small and large companies and investors throughout his legal career dealing with mergers and acquisitions, joint ventures and corporate financing, including both public and private securities offerings, specializing in PIPE transactions and reverse mergers. Goldfeder obtained his Juris Doctorate from Georgetown University Law Center, after receiving a BA in Accounting and a B.S. in Political Science from Brooklyn College. He is admitted to practice law in New York and is also an Adjunct Assistant Professor at Baruch College, teaching courses in business law and business organizations. Goldfeder is also currently a member of the Legal Committee of the Securities Transfer Associate. In addition, Goldfeder was the co-author of “Regulation of Small Business Issuers – An Executive Handbook,” a book geared to the executives of small public companies and co-authored an article on Equity Crowdfunding published in the Bringham Young University International Law & Management Review.