As the expression goes: “Look before you leap.” But if you are an innovator, determined to blaze a trail never before navigated – there is not much to look at. Being a pioneer can be a lonely and dangerous adventure. Nothing could be more true when it comes to navigating the maze of Securities and Exchange Commission (SEC) rules and regulations if you are a US issuer in a fundraising mode – determined to eschew garden variety paper certificates and book-entry securities by issuing security tokens (a/k/a digital securities) in a so-called “security token offering” or STO.
If you are satisfied with raising money from (only) accredited investors, there is a clear regulatory path for the initial issuance of security tokens, as far as federal securities laws are concerned. But if an issuer wishes to expand its investor base to non-accredited investors and raise more than $1 million, as a practical matter the only path open to an issuer is either a fully registered, SEC reviewed offering, with burdensome ongoing reporting obligations, or Regulation A+, a kinder, gentler alternative to a registered offering.
It Takes More than an Acronym
Regulation A+ has its pluses and minuses: It allows an issuer to include non-accredited investors in the offering, and provides immediate liquidity to investors, but with a catch: there is an SEC review process, a $50 million annual cap, and some ongoing reporting requirements.
Indeed, this is the very path proposed by a recently formed trade association, Institute for Blockchain Innovation, boasting 60 industry members including Indiegogo, Finova, and 500 Startups – the “JCO” – “JOBS Crypto Offering.” When I wrote about this in May 2018 on Crowdfund Insider, I described the “JCO”:
“The so called JCO is essentially a two-step process, whereby an issuer first conducts an offering to accredited investors under Regulation D, and then follows this with either a Regulation A+ offering or a fully registered offering. This second step allows an issuer to include non-accredited investors in the offering. More importantly, by utilizing Regulation A+, or a fully registered offering, the investors will receive securities (e.g. tokens) available for immediate resale under federal law, compared to the 12 month holding period under Regulation D for private company offerings.”
Problem solved to create a regulatorily compliant path for “public” token offerings?
Pioneer crowdfunding platform StartEngine and its seasoned securities counsel, Sara Hanks of CrowdCheck, apparently thought so when it sought to qualify its security token offering in a Regulation A+ offering in June 2018.
How’s that working out?
Well, from my vantage point, with the benefit of hindsight, StartEngine’s Reg A+ security token offering appears to be the proverbial canary in the coal mine. Unlike their first Reg A+ offering of conventionally formatted securities filed back in June 2017, which cleared the SEC in three months, by all accounts the second Reg A+ offering, this time for security tokens, appears to have stalled – StartEngine having recently privately announced that it is commencing a Regulation D offering while it waits on the SEC for clearance of its Reg A+ filing.
More on the StartEngine Regulation A+ STO below – a good case study for those issuers contemplating a security token issuance – though the StartEngine Reg A+ filing remains very much a work in progress.
The jury (SEC) is still out on that one, and it is unclear how long the deliberations will last. And StartEngine is not alone. As of this date, I am aware of no security token which has cleared an SEC review, either under Regulation A+ or a full registration.
Some Blockchain Basics – Fact Versus Fiction – The KPMG Report
In November of 2018, KPMG published a 38-page Report entitled “Institutionalization of Cryptoassets.” It included input from such crypto notables as CoinBase and Morgan Creek Crypto (Anthony Pompliano and Chris King), which is well worth a close read. Leaving no doubt as to KPMG’s take on cryptoassets, the first section of the Report was entitled “Crypto is a Big Deal.”
One of the “use cases” of blockchain presented by KPMG was the tokenization of securities, lauding its potential benefits:
Tokenization -the creation of natively digital tokenized representations of traditional (and emerging) assets that are issued, traded, and managed on a blockchain can reduce friction and overhead costs associated with the issuance, transfer, and management of traditional assets such as securities, commodities, and real estate assets. Cryptoassets that are tokenized versions of traditional assets could also fit well within existing regulatory frameworks, which may mitigate some regulatory uncertainty surrounding newer cryptoassets. Tokenization of traditional assets could also help increase liquidity, codify rules and regulations, and increase transparency throughout the asset lifecycle.
The premise of the Report was that in order for crytoassets to grow and thrive as a new asset class, institutional acceptance was essential:
Cryptoassets have potential. But for them to realize this potential, institutionalization is needed. Institutionalization is the at-scale participation in the crypto market of banks, broker dealers, exchanges, payment providers, fintechs, and other entities in the global financial services ecosystem. We believe this is a necessary next step for crypto to create trust and scale.
Notably, the Report identified as one of the key challenges facing the institutionalization of cryptoassets is compliance with regulatory obligations.
Consumer research giant Forrester Research has also weighed in on the potential of blockchain and cryptoassets in a recently published Report. Though the Forrester report is behind a paywall, the title of the report is telling, particularly in terms of managing expectations:
“Predictions 2019: Distributed Ledger Technology
Continued Hype And Unrealistic Promises Drive Risk Of A Looming Blockchain Winter”
In a separate section accessible to the public on the Forrester home page, it cautioned:
The Age of the Customer was never going to be easy: customers flexing their muscles, the pace of digital, quiet destruction of industry lines, GDPR as an emerging law of the land, and a new breed of technologies deeply rooted in knowing who your customers are and how they behave. This is an unforgiving market where a leader’s decisions — or lack of decisions — have great consequence but little precedent. You need facts: A seasoned voice that can connect the dots and combine breakout strategies with operational pragmatism, that knows that the pace of ideas and dialogue is fast but the real pace of teams and organizations making deep-rooted change is relatively slow. Forrester Research focuses on the hardest, most important dynamics of the day; dynamics that have the potential to create extraordinary opportunity for some and put others in desperate straits.
This caveat is applicable to navigating the regulatory labyrinth ensnaring crypto assets, not the least of which is compliance with US securities laws: the real pace of change in this area is slow, to be sure, creating both opportunities – and pitfalls.
The Long Learning Curve of Blockchain Based Applications
I rarely second guess my articles once they are in print. But my recent article on security tokens and Regulation A+ had me rethinking the completeness of my analysis – when it came to the use of Regulation A+ as a viable path to putting newly issued cryptosecurities in the hands of the general public.
In theory, Regulation A+ is well suited for this purpose. However, in practice, no Regulation A+ filing has yet to clear an SEC review. I attributed this primarily to the existence of a long learning curve by the SEC in the cryptoasset/tokenized security world. I neglected to mention that there is also a long learning curve for issuers who proceed down this uncharted Regulation A+ route, even with the most capable and seasoned advisors.
Looking Under the Hood of the StartEngine Regulation A+ SEC Filing
We do not, yet, have any case studies of a security token offering which has cleared an SEC review, something which the cryptoasset industry is painfully aware of. This led me to take a closer look at StartEngine’s Regulation A+ filing, hoping to learn some lessons as to how to guide an issuer through this process. As noted above, their first Regulation A+ offering, for non-crypto securities, cleared the SEC in three months. The second Regulation A+ offering, for security tokens, remains pending after five months.
I began my deep dive into the StartEngine Regulation A+ securities token offering by putting their “Risk Factors” disclosures under the microscope.
Under the terms of this offering, the investor has the choice of either receiving his or her securities in traditional or digital form. I compared the Risk Factors section, as contained in the original June 2018 filing with the most recent amendment of November 2018. The risk factor disclosures had nearly doubled in size, the majority of the additional disclosures focusing on risks raised by issuing securities in tokenized form rather than traditional book entry or certificate form.
Presumably, most of these new disclosures were prompted by SEC comments generated during their review. (Unfortunately, the public will not be privy to the SEC comments until after the Form 1-A Offering filing is “qualified” by the SEC.)
Managing Industry and Investor Expectations
What is clear from the new, revised disclosures is that some of the promised benefits of digital securities are a ways off in time – in particular, speed of execution of transactions, and the benefits of a “smart contract” built on the blockchain.
Other potential benefits of blockchain technology, such as decentralization and transparency, are likely to never be incorporated into the digital securities ecosystem.
Long-standing institutional practice and regulatory constraints will continue to require a centralized stock transfer agent in the foreseeable future. And the “transparency” promised by distributed ledger technology is not a good fit for security ownership, trumped by privacy concerns.
Let’s take a look at speed of execution, a potential benefit of digital securities often cited by observers, including KPMG.
In fact, one of the more visible entrants in the cryptosecurity secondary market space calls itself “tZero” – a reference to the time it would be expected to complete a trade of digital securities in the secondary market. The current standard in the securities industry for tradeable securities is T + 3 – meaning that in US markets a trade would normally settle in three days. tZero hopes to whittle settlement time down to seconds through use of blockchain technology and smart contracts.
What we learn from amendments to the StartEngine offering circular is twofold: issuance of digital securities is not necessarily fast – and so-called smart contracts may not be all that smart.
Presumably, in response to an SEC review comment, the amended Offering Circular contains a new risk factor, in the first in the section addressing specific risks of digital securities. This risk factor is entitled:
“There is uncertainty as to the amount of time it will take for us to deliver securities to investors under this offering.”
Read further and you will discover that there is more than “uncertainty” – there is, potentially, what many investors would consider unconscionable delay in the issuance process for their securities, digital or otherwise:
“Although, based on our experience in our prior offering, investors who provide the information required by the subscription agreement and give accurate instructions for the payment of the subscription price should receive their securities in no more than six months, we cannot guarantee that you will receive your securities by a specific date or within a specific timeframe.” [Emphasis added]
No mention of expedited delivery for those investors who elect to receive their securities in tokenized form.
And How About Those Smart Contracts?
There is a new risk factor, entitled “The smart contracts will have limited functionality and you will only be able to transfer Tokens through the transfer agent.” When you read on, you learn the following:
“The smart contracts that govern each of the Common Tokens and the Preferred Tokens are different from other smart contracts used for securities tokens in other offerings. The smart contracts in this offering provide that wallet holders and third parties will not be able to transfer Tokens. If you elect to hold your shares in the form of a Token, you will not be able to transfer the assets in and out of the wallet without the involvement of the stock transfer agent. The stock transfer agent will need to validate all transfers and communications before any transfers may be made.”
Read on in the Offering Circular and you will learn that “The smart contracts allow for StartEngine Secure to both grant and remove Tokens from a wallet and nothing else.” Putting a finer point on the limitations of the StartEngine smart contract, we are also then told:
“The smart contracts do not have transfer functionality and only the transfer agent may transfer the shares. The terms of the smart contracts do not impose any additional limitations on the transfer of Tokens.”
So much for decentralized, blockchain-based systems – and their purported benefits for digital securities. The transfer agent is a regulatory lynchpin for traded securities. Don’t expect this to change anytime soon.
The Future of Security Tokens and SEC Reviews
I expect that security tokens have a long and bright future. But make no mistake – this is an evolutionary process – not a revolution.
As I noted in an earlier article, we are not yet even in the proverbial “early innings” – with one observer recently remarking that the stadium is still being built. The StartEngine case study demonstrates that perhaps we do not yet have optimal pathways to even get to the stadium – either from a technological or regulatory point of view.
The current status of the StartEngine Regulation A+ security token offering is unclear. But what we do know, according to a recent article in Crowdfund Insider, is that in early November 2018 StartEngine embarked upon a new, private placement of security tokens to accredited investors, at a 25% discount to the Regulation A+ offering – to conclude no later than when the Regulation A+ offering is cleared by the SEC. Not a hopeful sign five months after the initial SEC filing.
And a close look at the most recent StartEngine filing suggests that both StartEngine, the SEC and security token advisors still have a ways to go on the security token offering “learning curve” as they chart new waters for Regulation A+ and security tokens.
Perhaps I missed it, but when I reviewed the StartEngine proposed form of amended Certificate of Incorporation submitted to the SEC, conversion of the offered preferred stock into common stock still requires the holder to deliver a paper certificate – something I expect will not go unnoticed much longer by StartEngine and the SEC.
With the benefit of hindsight, there was likely an easier and better path for StartEngine to put its security tokens in the hands of the general public without indefinite delays at the SEC – utilizing Regulation A+ or a fully registered offering. So too for issuers contemplating the syndication of assets amenable to digitalization, such as collectibles (e.g. automobiles, art) or real estate.
I leave this discussion to another day – and in a less public setting than this article.
Samuel S. Guzik, a Senior Contributor to Crowdfund Insider, is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience in private practice. Guzik is also former President and Board Chair of the Crowdfunding Professional Association (CfPA) and CfPA Legislative & Regulatory Special Counsel. A nationally recognized authority on the JOBS Act, including Regulation D private placements, investment crowdfunding and Regulation A+, he is and an advisor to legislators, researchers and private businesses, including crowdfunding issuers, service providers and platforms, on matters relating to the JOBS Act. As an advocate for small and medium-sized business, he has engaged with major stakeholders in the ongoing post-JOBS Act reform, including legislators, industry advocates and federal and state securities regulators. His articles on JOBS Act issues, including two published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, have also served as a basis for post-JOBS Act proposed legislation.