2017 saw a roaring ICO market, with billions of dollars raised by blockchain-based digital asset issuers selling “utility tokens” in initial coin offerings.
As the Securities and Exchange Commission (the “SEC”) began cracking down on token issuers for failing to follow securities laws, in late 2017 and throughout 2018, the U.S. ICO market shifted to a “security token offering” or an “STO” market, where issuers raising capital with digital assets acknowledged that they were selling securities and began complying with longstanding securities laws.
This coincided with a growing desire by companies to issue conventional securities as blockchain-recorded assets, laying the foundation for what many believe will be the ultimate tokenization of all securities, a tectonic shift in how all securities are held and transferred.
As STOs and the tokenization of securities gain momentum and increased adoption, issuers have become concerned about inadvertently becoming public reporting companies by triggering Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”).
If a token is an “equity security” and the token has 2,000 or more record holders (or 500 or more unaccredited record holders), and the issuer has more than $10 million of total assets, then the company is required to register with the SEC and become a reporting company with the SEC, which can be a significant burden. This is a pressing concern for most token issuers – they envision the blockchain allows for easy transfer and subdivision of the tokens, which can swiftly lead to 2,000 or more holders.
Those trying to structure a digital asset so it falls outside the meaning of “equity security” must be aware that for Section 12(g) registration and reporting purposes, the meaning of an “equity security” reaches far beyond the traditional definition of equity, and encompasses a broad range of securities that have similar characteristics to traditional equity.
What is Tokenization of Securities?
The tokenization of securities has a simple objective: to place title to traditional securities like stocks and bonds, along with exotic securities like blockchain-based digital assets, on the blockchain. By “blockchain” we mean the distributed ledger technology pioneered by Bitcoin, which powers both decentralized systems like Ethereum and centralized, an enterprise-based system like Hyper Ledger, which is supported by industry stalwarts like IBM, Intel, J.P. Morgan, and Fujitsu.
Distributed ledgers are intended to record ownership – and transfer of ownership – in a form that is self-executing, transparent, permanent and immutable
To appreciate the benefits of tokenized securities, one must first understand how securities are currently held and transferred without tokenization.
For private companies, stock ownership records are traditionally maintained on a company ledger with ownership evidenced by a paper certificate. Blockchain-based electronic stock registries may replace paper ledgers, centralized database ledgers, and certificates, but follow the same principles and procedures.
When a private security is transferred, if the security is represented by a certificate, then the seller of that security gives the certificate to the buyer along with a signature to effect the transfer. If the private security is not represented by a certificate, then upon transfer, the keeper of the company ledger will update the ownership ledger to reflect the transfer and the new owner.
For publicly traded securities, ownership and transfer records are comprised of a myriad of ledgers among various institutions. First, an SEC-registered transfer agent must maintain the issuer’s stock ledger. On that stock ledger, the entire public float of substantially every publicly traded security in the United States is legally owned by Cede and Company (“Cede and Co.”), a special financial institution that processes transfers of securities on behalf of Depository Trust Company.
Cede and Co. has its own ledgers, which keep track of which DTC-member firms such as clearing brokers, investment advisers, banks, trust companies, and other custodians beneficially own how many shares of a particular security. Each custodian has its own ledgers, which keep track of which investors beneficially own how many shares of a security held by that custodian. Only a few major first-level custodians are listed in Cede and Co.’s ledgers, so there may be multiple institutions and layers of ledgers showing beneficial ownership of any particular security ultimately owned by an investor.
As a result, the current system of holding and transferring publicly traded securities involves a complex cascade of beneficial ownership ledgers among various institutions beginning with legal ownership of the security by Cede and Co. and ending with the ultimate beneficial ownership by the investor in a ledger held by that investor’s custodian.
The current system lacks transparency, is inefficient, and is prone to human and computer error. It involves delay – transfers are typically confirmed two days after being made. A blockchain presents a simple solution for recording ownership and transfer of securities that avoids the myriad of complexities present in the current system. So naturally, companies have turned to tokenizing their securities to maintain ownership and transfer records of those securities on a blockchain.
What is Section 12(g)?
Section 12(g) of the Exchange Act, which was amended by the JOBS Act and the FAST Act, provides that an issuer of securities that is not a specified type of banking institution is required to register a class of equity securities under the Exchange Act if:
- It has more than $10 million of total assets; and
- The securities are “held of record” by either 2,000 (or more) persons, or 500 (or more) persons who are not accredited investors.
If an issuer is required to register the securities as required by Section 12(g), then the issuer will become a reporting company and be subject to periodic and current reporting requirements with the SEC.
What are “equity securities” under Section 12(g)?
For purposes of Section 12(g), the definition of equity securities reaches beyond the common understanding of equity. The term is defined in Exchange Act Rule 3a11-1, which states:
“The term equity security is hereby defined to include any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so.” (Emphasis added).
Instead, many security tokens provide the token holder a contractual right to receive a share of the revenue or profits of the organization issuing the tokens. Because an equity security includes a “certificate of interest or participation in any profit-sharing agreement,” a tokenized security that does not represent pure equity, but rather represents a profit-sharing agreement falls within the definition of an equity security under Exchange Act Rule 3a11-1. Accordingly, if the other criteria requiring Section 12(g) registration is met, then the issuer of those security tokens will be required to register the tokens with the SEC and become a reporting company.
In an attempt to avoid being classified as an equity security, some token issuers design their tokens to give holders of their tokens the right to receive a share of the revenue of the organization, rather than its profits. With the same goal in mind, some token issuers design their tokens to grant token holders a royalty that fluctuates based on the performance of the company issuing the tokens. However, these approaches are misguided because the definition of an equity security under Exchange Act Rule 3a11-1 must be interpreted more broadly.
Legislative History of Section 12(g)
To understand Section 12(g) and the definition of equity securities under Exchange Act Rule 3a11-1, it is instructive to understand the rationale behind Section 12(g).
Prior to 1964, only issuers with securities registered on a national securities exchange were subject to the reporting requirements of the Exchange Act. At that time, issuers of securities that were traded on over-the-counter exchanges were not subject to the Exchange Act reporting requirements, because “too little was known about the over-the-counter market in 1934 to enable Congress feasibly to devise provisions as specific as those related to listing securities.”
A part of the reason Congress adopted Section 12(g), increasing the scope of the disclosure system, was a belief that issuers that met the criteria of Section 12(g) “had sufficiently active trading markets and public interest and were in need of mandatory disclosure to ensure the protection of investors.” Section 12(g) was intended to apply to companies with an active trading market and the shareholder threshold was seen as an indirect measure of market activity.
Accordingly, the record shareholder threshold in Section 12(g) was intended to create bright-line rule for requiring registration without the vague test of an “active trading market.” If a token is listed on an exchange and is actively being traded, then an active trading market will clearly exist for the token. Even if a token is not yet listed on an exchange but the issuer intends to create liquidity for token holders by placing the token on an exchange, then issuers should be aware that an active trading market could exist for the token once it is listed, creating a compelling argument Section 12(g) registration.
For Section 12(g) purposes, all securities are either debt securities or equity securities
When faced with the question of whether a security is an equity security, courts typically examine the security in question by comparing its characteristics to traditional debt securities (e.g., bonds) and traditional equity securities (e.g., stock) to determine which of those two general types of securities the security in question more closely resembles.
A debt security, defined in Exchange Act Rule 3a12-11, includes any security that is not an “equity security” as defined by Section 3(a)(11) of the Exchange Act and Exchange Act Rule 3a11-1. In the adopting release for Exchange Act Rule 3a12-11 (the “Adopting Release”), the SEC notes that it solicited comments in considering whether the definition of a debt security should be more specifically defined and commenters “supported the broader definition primarily because of the risk that certain innovative securities may not fit squarely within pre-conceived categories.”
The SEC noted in the Adopting Release that because of this concern by commenters, “as well as the desire of the Commission to simplify an issuer’s determination as to whether a debt or equity security is at issue, new Rule 3a12-11 provides that the term ‘debt security’ will include any security that is not an ‘equity security’ as defined by the Exchange Act and the rules thereunder.”
This rationale makes it clear that the SEC made a conscious decision to classify securities that don’t fit the exact mold of a typical debt or equity security as debt securities by default.
Moreover, in the proposing release for Rule 3a12-11, the SEC solicited comment as to whether hybrid debt securities should be considered to be debt or equity securities for purposes of Rule 3a12-11, but the SEC received limited comment on this topic.
The SEC noted that, after further consideration, the agency believed that “no further clarification regarding hybrid securities is necessary; if a security is not an equity security as defined by the Exchange Act and the rules thereunder, then the security will be considered a ‘debt security’ for purposes of Rule 3a12-11.” Accordingly, for purposes of Exchange Act Rules 3a11-1 and 3a12-11, there are only two categories of securities, debt and equity, and unless a security falls within the definition of an “equity security,” it is a “debt security” by default. Therefore, when analyzing if a security token is an equity security, that analysis must lead to one of two results, either the token is an equity security or a debt security.
Courts have suggested that ownership characteristics are central to determining whether a security is an equity security and that equity securities should be distinguished from debt obligations such as bonds which represent no ownership interest. Courts have held that bonds are not intended to be equity securities because the bondholders are only entitled to a fixed rate of return and do not share in the profits or losses of the issuer. A debt security includes an obligation to pay the holder of the security a stated amount of money at a certain time and under certain conditions, regardless of the issuer’s financial status. Additionally, the Supreme Court noted that “there is no one characteristic, not even exclusion from management, which can be said to be decisive in the determination of whether the obligations are risk investments in the corporations [i.e., stock] or debts.”
Accordingly, when analyzing whether a token is a debt security or an equity security, one must look at the specific rights attached to the token to assess whether those rights resemble the characteristics of equity ownership, including whether the token holder’s expected return depends on the financial success of the issuer.
If a token provides its holder the right to receive a share of the revenues of the issuer, or a royalty from the issuer based on the performance of the company, then a court is likely to deem that token to be an equity security because it exposes the token’s holder to risks typically associated with equity ownership.
Anti-circumvention – Record Holders vs. Beneficial Holders
The number of holders test in Section 12(g) specifically applies to holders of record, not beneficial owners.
Securities are deemed “held of record” by each person who is identified as the owner of those securities on the books and records of the company, with some exceptions. Token issuers may be tempted to attempt to avoid Section 12(g) by designating a trustee, an entity, or a third party to be the record holder of tokens on behalf of multiple beneficial owners to restrict the number of record holders of the token. However, this approach is likely to fail due to the anti-circumvention provision in Exchange Act Rule 12g51(b)(3), which states:
“If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of Section 12(g) or 15(d) of the [Exchange] Act, the beneficial owners of such securities shall be deemed to be the record owners thereof.”
Thus if the primary purpose of designating a record holder to hold tokens on behalf of multiple beneficial owners is to avoid Section 12(g), because of Exchange Act Rule 12g51(b)(3), each beneficial owner will be treated as a record owner for purposes of Section 12(g), preventing the token issuer from escaping registration under Section 12(g).
In particular, if an active trading market exists and 2,000 or more beneficial holders have a tradeable position, it is likely Section 12(g) requires registration no matter the number of record holders.
Proper Legal Advice is Crucial
Although the tokenization of securities can include tokenizing traditional types of debt and equity securities, in the current market of security token offerings, many issuers are able to successfully market their tokens even when those tokens provide fewer rights than a traditional debt or equity security.
As long as the STO market welcomes these types of exotic securities, whether those securities fall under the definition of “equity security” will continue to be a key issue that security token issuers must consider.
Because a primary attraction of tokenization is making securities easily tradeable and capable of being infinitely fractionalized, STO issuers must expect that at some point the security tokens will have a relatively large number of holders, Section 12(g) registration and reporting can be an important issue to consider when structuring a security token and the rights attached to it. If an issuer is required to register its tokens under Section 12(g), then that issuer will have relatively onerous periodic and current reporting requirements under the Exchange Act.
Before offering any security tokens for sale, it is essential to consider the consequences of its structure with the aid of experienced corporate and securities counsel.
With a special thank you to Jor Law and Scott Purcell for their contributions to this article.
Michael B. Saryan is an attorney and senior counsel at Lexcuity PC (the new name of Homeier Law PC), where he advises clients in securities law matters and corporate transactions, including cryptocurrency transactions and STOs. Michael maintains a focus on keeping at the forefront of new regulations for compliance and best practices in the STO space. For nearly a decade, Michael has advised businesses in various stages of their lifecycles – from emerging companies to Fortune 100 companies – guiding his clients to navigate the legal landscape of corporate and securities laws. Michael typically advises clients raising capital through private securities offerings or experiencing a major corporate event, and he serves as outside general counsel for many of his clients.
Charles Kaufman is an attorney and shareholder of Lexcuity PC (the new name of Homeier Law PC), a leading law firm advising clients in both traditional and non-traditional financing. With over 23 years of experience advising growing businesses, providing leadership in crowdfunding, corporate finance, legal and strategic affairs and global compliance, Charles is a key advisor in the cryptocurrency and STO space helping companies navigate the ever-changing regulatory landscape.