Saturday, October 21, 2017

Blockchain: Recordkeeping in the 21st Century

Since our last post on cryptocurrency, the price of Bitcoin has risen nearly $1,500. This rapid rise in the value of cryptocurrency is representative of the extreme volatility that has given many investors pause. While cryptocurrency still yearns for acceptance, the backbone of cryptocurrency has already garnered favor with financial intermediaries. The blockchain and distributed ledger technology have indeed vaulted cryptocurrencies to the forefront of the entrepreneurial frontier, but it has greater potential and ramifications for the entire economy.

The blockchain is a record of peer-to-peer transactions categorized into blocks on a distributed ledger. Despite the terms “block” and “distributed ledger,” the blockchain functions similarly to a local bank authorizing and recording a transaction; but instead of only one party holding the entire ledger book, the transactions are recorded communally by member nodes (peer-to-peer network of computers). The blockchain can confirm a transaction almost instantaneously instead of several banks trying to reconcile and audit separate ledgers and transactions. Whenever a transaction takes place on the blockchain, the member nodes of the blockchain develop a new hash and digital signature to update the ledger and create a new “block.” This block, or recorded transaction, is time-stamped and encrypted and will remain with the currency for life. Therefore, cryptocurrencies are made up of a chain of recorded transactions (i.e. blocks) that create the blockchain.

As with other financial technology (“Fintech”), the blockchain is subject to cyber security threats and technical glitches. However, blockchain technology is designed differently than other Fintech. In order for hackers to change the distributed ledger, they would have to infiltrate the specific block they are targeting as well as all preceding blocks in the chain. The individual hash marks in each block ensure that any attempt to change the chain would have to be approved by the other member nodes. Such a change in the historical transaction ledger would be rejected because it would conflict with existing entries. However, the blockchain is still a digital technology and it has not been free of its technical difficulties. For example, Mt. Gox, a former Bitcoin exchange, lost nearly $450 million worth of Bitcoin in 2013 due to a technical glitch. Digital disasters can be avoided or mitigated with proper insurance and cybersecurity policies by the exchanges.  Also, cryptocurrencies and the blockchain will likely see an increase in regulation.

U.S. regulators, central banks, and major financial institutions have already seen great potential in the distributed ledger technology. Chairman Chris Giancarlo of the U.S. Commodity Futures Trading Commission stated in the spring of 2016 that blockchain and the distributed ledger technology “has the potential to link networks of legal recordkeeping the same way the Internet connects networks of data and information.” The U.S. Federal Reserve and its Chair Janet Yellen expect the blockchain to significantly affect current payment systems. Meanwhile, the central bank of Singapore has already hired a consulting firm to manage and develop a blockchain-based platform for interbank payments. While major financial players remain hesitant to accept cryptocurrency, they are more willing to accept the possibilities of blockchain. Financial Intermediaries have participated in the R3 consortium, which recently built a distributed ledger platform specifically for financial services, and have explored the possibility of using the blockchain for interbank settlements.

The blockchain’s use extends beyond cryptocurrencies and indeed has already been used in other industries, including agriculture, health care, and even insurance. In health care, for example, the blockchain can be used to track medical supplies and secure patients’ medical records. The blockchain is also the basis for “smart contracts” which are cryptographic contracts that execute as soon as a condition is met. In the case of insurance, for example, rather than requiring a traveler to contact the insurer once travel plans go awry, a smart contract would be triggered as soon as the traveler’s flight is cancelled.

While the blockchain technology can be used in various industries, its use as the basis for cryptocurrency has stirred the greatest controversy. Despite its general acceptance, the blockchain is just one piece to the cryptocurrency puzzle. More controversial than the blockchain technology is the initial coin offering (“ICO”). Many ICOs have already launched during the latest cryptocurrency craze. These offerings of coins and tokens are not only the subject of much debate, but are also the subject of our next post in this series on cryptocurrency.

This article is not legal advice, and was written for general information purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga of Ross & Shulga PLLC.  We are a New York-based law firm specializing in advising individual and corporate clients on various aspects of corporate and securities law, including initial coin offerings.

Thursday, October 12, 2017

Are Real Estate Syndications Available to Non-Accredited Investors (NY perspective)?

A real estate syndication, although a fancy term, simply means pulling money and expertise together to invest in real estate properties.  It often so happens that some people possess the wealth of knowledge about the real estate market and are great at spotting investment opportunities but don't have the money to invest, while others have the required cash but no real estate expertise or time.  Bringing the first group (sponsors) and the second group (investors) together allows them to purchase and manage far bigger properties than each group could manage on their own.

In a (simplified) real estate syndication transaction, typically an LLC or an LP gets formed, which conducts an offering of its securities and then purchases the property using the proceeds of the offering.  The Sponsor acts as the Manager or the GP of the entity.  Investors can expect to receive two types of income: one from the rental income, usually payable on a monthly or a quarterly basis, and the other one due to the appreciation of the property value at the time of its sale, about 5-10 years down the road.  Investors usually receive a preferred return (about 8%) on their investment, then their money back, with the remainder of the proceeds being shared with the Sponsor (usually 80-20%).

As I mentioned before, real estate syndications involve an offering of securities of the property purchasing entity, which means that it must qualify for a federal and state exemption from registration under the applicable securities laws.  It is relatively straight forward to conduct such an offering if the deal has only accredited investors.  Such transaction can meet the requirements of Rule 506(b) or Rule 506(c) and then be exempt from state regulation pursuant to the federal legislation enacted in 1996 (NSMIA) that preempts state regulation of Rule 506 offerings.  States can only require a notification of the offering and a filing fee along with such notification.  For example, in New York, issuers must file a notification form 99 and submit other documentation, as I previously explained on this blog. 

But which exemptions are available to non-accredited investors?  Here are some of them:

1.  Rule 506(b) and State Notification.  Offering and sale of securities can be made to up to 35 non-accredited investors using Rule 506(b) of Regulation D.  However, these investors have to be sophisticated (either alone or with their representative).  This means that they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.  Such offering has to be made pursuant to an offering memorandum that contains an enhanced level of disclosure (i.e., it costs more and takes longer to prepare it).  On the state level, Rule 506(b) offerings are not regulated by the states, so a simple notification and filing fee are enough (although in New York it is not that simple).  Remember that the issuer relying on a Rule 506 offering must file Form D with the SEC.

2.  Intrastate Offerings and NY Policy Statements 101 or 105.  If the sales are made only to investors who are residents of a single state where the property is located, the purchasing entity can qualify under Section 3(a)(11) of the Securities Act for an exemption from registration for intrastate offerings.  The Rule 147 and the new Rule 147A were promulgated by the SEC to serve as safe harbors for Section 3(a)(11) exemption.  Rule 147A intrastate exemption, that became effective in April 2017, allows the issuer to rely on the intrastate exemption even if it was organized in a different state (so, a Delaware LLC that is purchasing a property in NY and has all NY investors may qualify).  I previously wrote about the new Rule 147A here.    The issuer does not have to file Form D, but compliance with state securities laws is required.

In New York, the issuer could rely on a Policy Statement 101 (offerings to no more than 40 people) or 105 (no filing required) for an exemption from registration, although some disclosure would still need to be made.  Although investors in these small offerings do not have to be accredited, they still must be sophisticated, have sufficient means for the investment, and have a pre-existing relationship with the principals of the issuer.  The "no filing" required exemption described in Policy Statement 105 may be used only for offerings to no more than nine investors in total, each of whom is sophisticated, has sufficient means, and a pre-existing relationship with the principals of the issuer.

3.  Rule 504 and NY Policy Statement 100Rule 504 was amended effective in January 2017 to allow companies to raise up to $5,000,000 in any given 12-month period but without the use of general solicitation and advertising.  Such offerings must be registered with the states or comply with applicable state securities law exemptions.  In certain circumstances, companies may use general solicitation and advertising, such as when they conduct the offering "exclusively under one or more state laws that require registration, public filing and delivery to investors of a substantive disclosure document before sale".  Form D has to be filed.

In New York, companies can rely on Policy Statement 100 to apply for a  corresponding exemption from state registration. The application asks for very detailed disclosure.  The current filing fee is 2/10th of 1% of the amount of the offering of securities, with the minimum fee of $750 and the maximum fee of $30,000.  The use of general solicitation and advertisement is not permitted.

4.  Regulation A+ and NY Policy Statements 101 or 105Regulation A+ (Regulation A was amended in 2015 and became known as Regulation A+) allows companies to raise up to $50 million, and is divided into Tier 1 and Tier 2 offerings.  In a Tier 1 offering issuers can raise up to $20 million but must comply with the registration procedures in every state where the company plans to sell its securities.  Any investor can participate in these offerings.  A Form 1-A that requires detailed disclosures and financial statements must be filed with the SEC.

Tier 2 offerings (up to $50 million) are exempt from state regulation, but have limits on how much non-accredited investors may invest.  Tier 2 offerings are very involved, and are considered like "mini-IPOs".  They are significantly more expensive and time consuming to prepare than a Rule 506(b) private placement.

5.  Section 4(a)(6) of the Securities Act / Regulation CF and State Notification.

As you know, the SEC adopted Regulation Crowdfunding (or Regulation CF) to implement Title III of the JOBS Act.  It became effective on May 16, 2016.  (Side note: have you noticed how many of these rules/regulations have been updated just recently?? The securities law is probably one of the fastest developing areas of law nowadays.  Just wait for regulations relating to crypto-tokens).  I will not bore you with all the details here because you can read about it in detail in my other blog post.  Although non-accredited investors can participate, the overall size of the offering is limited to $1,000,000, which is probably too small for a typical real estate syndication deal.  Also, there are limits as to how much individual investors can invest based on the investors' income and net worth.  Just like with Rule 506(b), states are preempted from regulating Section 4(a)(6) offerings.

In conclusion, as you can see from this (simplified) analysis of current securities laws, it is quite possible for non-accredited investors to participate in real estate syndication deals, but participation of non-accredited investors requires extra legal and other fees and time to complete the deal.  Each of the rules mentioned above contains a myriad of exceptions, provisos, special circumstances and requirements, all of which have to be accounted for in order to complete a successful real estate syndication transaction.  Sometimes, inviting just a few non-accredited investors may not be worth the extra expense.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

Monday, October 2, 2017

Cryptocurrency: the Origin and Growth of Coinopoly

Mired in the aftermath of the U.S. financial crisis, the year 2009 may have started one of the largest financial revolutions since the birth of paper currency in 1690. Much like its predecessors, cryptocurrency faces an uphill battle of understanding, trust, and proper regulation. Eight years since its inception, cryptocurrency has maintained its allure with startups and financial intermediaries, but is still a misunderstood concept to many. We hope to clarify this misunderstanding in a series of posts, beginning here with the basics of cryptocurrency and later discussing blockchain, initial coin offerings, and the current laws and regulations applicable to this industry.

Cryptocurrency is, by any other name, a currency—a medium of exchange used to purchase goods and services. Or, as some have suggested, cryptocurrency is a “peer-to-peer version of electronic cash.” However, this currency has two qualities that distinguish it from traditional bills and coins. First, cryptocurrency is a virtual currency that is created through cryptography (i.e. coding) and developed by mathematical formulas through a process called mining. Secondly, unlike traditional bills and coins that are printed and minted by governments around the world, cryptocurrency is not tied to any one government, and thus is not secured by any one government. This is often referred to as being decentralized.

Cryptocurrency is based on a cryptographic code that can be created (as described by Ethereum here) or based on existing open source software available through platforms like GitHub. Open source software is freely accessible code intended to be shared and improved. We discussed it in more detail in one of our previous blogs. The readily available open source software is what makes cryptocurrency decentralized—no one person or entity has the ability to control how many types of cryptocurrency are out there. According to, currently, there are close to 900 different cryptocurrencies. In comparison, there are about 180 currencies in the world that are recognized legal tender, and virtual currency is not among them.

As a decentralized currency, cryptocurrency is not subject to the inflationary pressures of legally recognized tender. For example, the cryptocurrency Bitcoin has a finite number in circulation, meaning the 21 million outstanding Bitcoins are all there will ever be. Because it cannot be reprinted or minted, like government backed bills and coins, its value is determined by basic economic principles, including supply and demand and allocation of scarce resources. A finite number of Bitcoins means that when the demand for Bitcoins increases and the supply stays the same, then the price of Bitcoin would increase, and vice versa.

Being a decentralized currency comes with flaws, especially as it relates to value. Giving someone a $20 bill has immediate and apparent value because it is backed by the full faith and credit of the U.S. Treasury. A cryptographic code on the other hand has initially little value. This is where the term “mining” comes in. The owner of the original code of the cryptocurrency works with miners to build the currency’s value. In other words, the original coin holder—the developer of the code—needs to exchange the coin for something. The original coin holder will provide coins to miners and, in exchange, the miners will process transactions by confirming and writing them into the distributed ledger. These transactions are recorded as blocks in a long list on the ledger, which creates the blockchain (which will be discussed in detail in the next post). Whether it is an ordinary bank account to withdraw cash from or it is cryptocurrency’s distributed ledger, both function as a historical record of value based on entries (i.e. transactions) from the third-party servicers—banks when dealing with cash or miners when dealing with cryptocurrency.

Of course, the virtual coin only has value if it can be exchanged for traditional goods and services, like the $20 bill. This heavily relies on marketing the cryptocurrency as a valid form of payment; not unlike paper money back in 1690. As described by Chris Ellis, developer of Feathercoin, “Money is a ledger, it is a tool that people will use as a way of achieving their goals and satisfying their needs.”

Various cryptocurrencies have developed into household names, such as Bitcoin, Ethereum, Feathercoin, and many others because of the potential use now available to cryptocurrencies. Cryptocurrencies can be stored and carried around in different types of wallets, including physical wallets that look like paper money, flash drives, and online wallets, and can be exchanged for goods and services at restaurants, online retailers, television providers, and even donated to charitable organizations. Our law firm, for example, accepts Bitcoin payments. As opposed to concerns from critics that this is just Tulipmania and we are ascribing value to an otherwise valueless item, the potential for cryptocurrencies as a medium of exchange is enormous.

The growth in cryptocurrencies begs the questions regarding security, rules and regulations, and ultimately how to utilize the blockchain and cryptocurrencies in other sectors or the financial industry. The following posts in this series will cover these issues and more in depth.

This article is not legal advice, and was written for general information purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its authors, Andrew Silvia and Arina Shulga of Ross & Shulga PLLC.  We are a New York-based law firm specializing in advising individual and corporate clients on various aspects of corporate and securities law, including initial coin offerings.