Thursday, August 22, 2019

SEC Complaint Against a VC Exempt Reporting Adviser

On August 13, 2019, the SEC filed a complaint against Stuart Frost and Frost Management Company, LLC for violating the antifraud provisions of Sections 206(1)-(2) and 206(4) of the Investment Advisers Act.  This case is a reminder that certain provisions of the Advisers Act apply to all investment fund managers, regardless of whether they are registered, non-registered, or exempt (exempt reporting advisers are referred to as "ERAs").  Also, this case highlights once more the importance of proper disclosure of management fees and expenses (and that they have to be reasonable and market).

Mr. Frost, through his investment management firm, managed five venture capital funds that raised about $63 million.  These funds were invested into start-ups incubated by Frost Data Capital, LLC ("FDC"), an entity wholly-owned by Mr. Frost.  Start-ups paid incubator fees to FDC.  The SEC complaint alleges that these incubator fees were not properly disclosed to the investors and, in fact, were exorbitant.  As stated in the SEC press release, the fees were used to finance Mr. Frost's "extravagant personal expenses" and "lavish lifestyle", and when he ran out of money, he would create and fund new start-ups in order to obtain more incubator fees.

Section 206 of the Advisers Act Applies to All Fund Managers

The anti-fraud provisions of the Advisers Act apply to ALL investment advisers, regardless of their status with the SEC or state authorities, or the absence thereof. In particular, Section 206 of the Advisers Act states:

"It shall be unlawful for any investment adviser by use of the mails or any means or instrumentality of interstate commerce, directly or indirectly—

(1) to employ any device, scheme, or artifice to defraud any client or prospective client;

(2) to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client; ...

(4) to engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative."

Further, all investment advisers owe a fiduciary duty to their clients of undivided loyalty and may not engage in any activity that conflicts with the interests of their clients without their prior consent.  As held by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the advisers owe to their clients a duty of good faith and full and fair disclosure of all material facts and a duty to avoid misleading them.

According to the complaint, FDC (wholly-owned by Mr. Frost) was financially dependent on the incubator fees paid by portfolio companies.  FDC charged the portfolio companies $21.69 million in incubator fees.  None of that money went to the investors.  In the fund disclosure materials, Frost and his management company either completely omitted the existence of such incubator fees or misled the investors by saying that FDC would charge incubator fees on a case-by-case basis and at below-market rates.  In reality, every portfolio company was charged with such fees, which were $30,000 - $40,000 per month per portfolio company.  The fees had to be paid even if the portfolio company moved out of FDC's offices.  The service contracts could be canceled only upon a 180-day notice, which meant that the startups had to pay for an additional six month period.  Unsurprisingly, these ongoing payments reduced the chance of the startups to succeed, as they were quickly running out of cash.  Overall, there were 24 portfolio companies.  As of 2018, only several remained active.

ERAs Must File with the SEC 

According to Section 202(a)(11) of the Advisers Act, an "investment adviser" is any person that (1) for compensation (2) is engaged in the business of (3) providing advice (4) as to the value of securities or advisability of investing in, purchasing, or selling securities.  The Advisers Act mandates that all investment advisers must register with the SEC, unless exempt or prohibited to do so.  

A fund adviser may be exempt from registering with the SEC if it is an adviser solely to private funds with total AUM under $150 million and that are (i) venture capital funds (Section 203(l) of the Advisers Act) or private funds relying on Section 3(c)(1) or 3(c)(7) exemption under the Investment Company Act (Section 203(m) of the Advisers Act).  Such fund managers must still file Form ADV with the SEC, but a shorter version.

There is also a duty to file annual updates of the Form ADV.  Frost Management Company failed to renew its ERA filing in 2018 and onwards.

In conclusion, this case reminds us that the SEC has jurisdiction over all investment advisers, including the ERAs and the unregistered advisers.  Being an investment adviser, registered or not, big or small, carries the fiduciary duty of good faith and full and fair disclosure that should not be taken lightly.  

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Friday, August 2, 2019

How Using the Word "MAY" Instead of "WAS" Can Cost You $100 Million

On July 24, 2019, the SEC charged Facebook Inc. $100 million for inaccurately disclosing the risk of misuse of user data.  Facebook agreed to pay, without admitting or denying any wrongdoing.  So, what happened?

According to the SEC complaint, the Facebook public filings (such as the annual reports on Form 10-K or the quarterly reports on Form 10-Q, etc.) informed the public that "our users' data MAY be improperly accessed, used or disclosed" (emphasis added), but in fact, at that time Facebook already knew that it was true.  It all goes back to the infamous Cambridge Analytica scandal (CA paid an academic to collect and transfer from Facebook certain data in violation of the Facebook policies).  Later, CA used such data for clients' political campaigns.  According to the SEC complaint, Facebook discovered the misuse by December 2015 but failed to correct its public company disclosure until May 2018.

This was a material risk, and in Facebook's case, it became a reality.  However, the company did not move it from the category of "possible risks" to the category of "real events".  Rule 10b-5 under the Securities Exchange Act (like Section 17(a)(2) of the Securities Act which is near identical) prohibits companies to make "any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading...".  Most securities lawyers know this phrase verbatim.   Perhaps, there was a question of whether such information was "material" to Facebook's stockholders (there are ongoing debates about the materiality standard, although in this case misusing data of 30 million Facebook users does sound "material").  Perhaps, Facebook management did not actually know about what was happening or was in disbelief.  Perhaps, some people knew but failed to communicate it to others with the disclosure-making responsibilities.  Whatever the explanation is, the fact remains that after Facebook finally publically announced that it knew about the data breach, its share price dropped, underscoring the importance of this information.  Well, this turned out to be a costly misuse of the three letters MAY. 

Drafting disclosure documents is not creative writing.  This skill is rooted in the deep understanding of the legal standards, the industry, the company, and the specific risks the company faces.  It is also based on the information that is being made available to the drafter.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Tuesday, July 30, 2019

Utility Tokens Exist

On July 25, 2019, the SEC issued its second no action letter that enables a company to generate and sell digital tokens that are not "securities" within the meaning of the US securities laws.  This no-action letter provides a no action relief to Pocketful of Quarters, Inc. ("PoQ") that intends to sell Quarters (its native digital tokens) to gamers for use in connection with playing games of the participating developers on their platform.  Just in April of this year, the SEC issued a similar no action letter to TurnKey Jet, Inc.

Below are my observations regarding this no action letter and token issuance in general:
  • This second no action letter helps us delineate the universe of utility tokens.  They are not just a concept that was abused and misused in the 2017-2018 ICOs.  Utility tokens can legally exist within the legal framework of the US laws.    
  • If previously the SEC had only shown us the instruments that cannot be utility tokens (through its cease and desist orders and various enforcement actions), then now, for the second time, we are shown examples of tokens that can be and are utility tokens.  This is incredibly useful guidance when advising clients on how to structure their tokens.
  • PoQ financed the development of its gaming platform through the issuance and sale of Q2 TOkens that were treated as "securities".  The Quarters that are subject to this no action letter are being issued after the platform development has been completed.  Again, this approach (issuing two types of tokens) can be used by others when conducting their token offerings.  
  • Quarters are not redeemable by gamers.  Once purchased, Quarters can only be used within the platform to play games, purchase upgrades, and participate in tournaments.  The only persons who can redeem the Quarters are the participating pre-approved developers and influencers who can earn the tokens by developing games and marketing them to the gamers.
  • Quarters will be sold at a fixed price, and there will be an unlimited supply of them.  This means that there will be no price speculation and no shortage that could affect the price.
  • Quarters cannot be transferred to other gamers, and therefore Quarters cannot be, and will not be, traded on secondary markets.  This means that gamers would not be purchasing the tokens with an expectation to make a profit.
  • Quarters will be sold only for the gamers' personal use within the gaming platform.  
  • Quarters will not be marketed to the public as an investment, and PoQ will make corresponding disclosures in its marketing literature.
As described in the thorough and well-written incoming letter, the Quarters present an example of true utility tokens that others may be tempted to replicate.  However, it is important to remember that only the recipient of the no action letter can legally rely on it.  Other tokens will have different features that may or may not support the legal outcome that these tokens are not "securities".  But still, the PoQ no action letter presents a good model of how to structure an offering of utility tokens that should be studied by the future token issuers.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Sunday, July 21, 2019

Blockstack: First Reg A+ Token Offering

On July 10, 2019, the SEC qualified the first digital token Regulation A+ offering.  This is an important event that could open the gates for other Regulation A+ token offerings that have been patiently waiting for their turn.

It was Blockstack that, after a 10-month wait, was approved for the $28 million offering.  According to Blockstack's offering circular, purchasers of the tokens will not be buying anything that resembles securities in a traditional sense.  Instead, they will receive utility tokens usable on the Blockstack network that consists of a Blockchain platform for developers to build applications.  Tokens are being sold to three groups of people: (i) to the existing holders of certain vouchers, at a discount; (ii) to the general public; and (iii) to app developers and reviewers as rewards.   The offering is being conducted directly by the company through its own website, www.stackstoken.com, where qualifying prospective purchasers can sign an online subscription agreement and transfer the money (at least $100) either in US dollars, Ether or Bitcoin. The tokens will not be sold to the residents of Arizona, Nebraska, North Dakota or Texas.  Union Square Ventures, already a 15% equity holder in Blockstack, has indicated interest to purchase $1 million worth of tokens.  Blockstack expects to issue the tokens 30 days after the close of the cash offering, at which time all proceeds raised in the offering will be released from escrow.  Although the tokens will be unrestricted securities under federal securities law, initially, tokens will not trade on any exchange and will be "time locked", which means that purchasers will not be able to use (or "burn") the tokens on the Blockstack platform.  About 1/24th of tokens will be released from the time lock every month.  Concurrently, Blockstack is selling its tokens in Regulation S private offering to non-US investors.  These tokens will be restricted securities. 

It is still uncertain that the Blockstack qualification would, in fact, lead to other Regulation A+ token offerings.  After all, they paid $2 million in legal fees to get the SEC approval, according to the WSJ article and, according to the company's offering circular, their overall expenses related to the offering amounted to $2.8 million.  This is a hefty price tag for a "registered ICO" that others may not afford.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  


Saturday, July 20, 2019

What's next after a Reg A+ offering?

Conducting a Regulation A+ offering may not be enough to provide for the liquidity of a company's shares.

It turns out that companies that undergo a Regulation A+ offering are not likely to list their securities on NASDAQ or NYSE.  Out of 157 Reg A+ offerings that took place from 2015 to 2018, according to WSJ and Manhattan Street Capital, only 11 companies listed on NASDAQ or NYSE.  Out of these 11, 10 are trading at below their initial offering price.

There are also fraud concerns.  Just last month the SEC filed additional charges against Longfin Corp., a company that used Reg A+ to list on NASDAQ.  Longfin listed on NASDAQ in December 2017.  Its shares rose 13 times upon the news that the company was about to acquire a cryptocurrency business.  On April 4, 2018, the SEC accused Longfin of violating securities laws because its chief executives and associates sold shares after the stock price increased.  The complaint was accompanied by a preliminary injunction freezing more than $27 million in trading proceeds.  On June 5, 2019, the SEC added fraud charges for falsifying the company's revenue and fraudulently obtaining a Reg A+ qualification and a NASDAQ listing.   The SEC's civil lawsuits against the company are currently ongoing.

Concerns over fraud and securities law violations, fueled by the Longfin case, prompted NASDAQ and NYSE to revise their listing rules to make it more difficult for smaller companies to list following a Regulation A+ offering.  On July 5, 2019, the SEC approved the new NASDAQ initial listing standards related to the minimum liquidity needed to list on any NASDAQ tier.  You can read about it here.  One of the changes requested by NASDAQ in April, that the company have a minimum operating history of two years prior to listing, was in direct response to Longfin. 

In conclusion, it seems that there will be little or no shortcuts for companies intending to trade their securities on NASDAQ or NYSE, regardless of their size, due to poor liquidity and concerns over fraudulent actions.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Sunday, June 30, 2019

Are Undeveloped Lots Securities?

As we recently found out from the CA Court of Appeals decision in People v. Dunham, undeveloped lots of land may be "investment contracts" and therefore, "securities".

A brief summary of the facts of this case are as follows:  Ronald Duane Dunham convinced several elderly persons in 2004 through 2007 to invest over a million dollars into the purchase of undeveloped lots of land in Cherokee Village, Arkansas and/or support his real estate development efforts.  There was no fund created.  Purchases were made individually.  According to the court opinion, Dunham told the investors that "he would increase land values through the marketing and development of a retirement community."  There were many misstatements in Dunham's promises, which coupled with other misdeeds by Dunham, resulted in a criminal and civil lawsuits being filed against him.  In 2014, a jury convicted Dunham of 20 counts of grand theft, elder theft, and securities fraud.  Although the Court of Appeals reversed six out of 20 counts relating to grand theft (because it was a lesser included offense of elder theft), it affirmed the other convictions, including the securities fraud counts.

This case illustrates the ever more resilient nature of the Howey test that can put just about any investment scheme into the realm of securities laws.  As a way of background (just in case you haven't heard enough about it yet), the US Supreme Court ruled in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) that an investment contract can be a security if it represents investment of money (or other consideration) in a common enterprise with an expectation of profits to be derived solely from the efforts of the promoter or a third party.  Hundreds of pages of legal analysis have been written since then about the Howey Test.  The test has been applied to find receipts for Scotch whiskey barrels, pairs of mating chinchillas, and the sale of beavers raised at a ranch all to be investment contracts.  More recently, the Howey Test has been applied to the initial coin offerings to find that digital tokens that investors received in exchange for their money were securities. 

Similarly here, the court looked at the Howey Test to determine whether the undeveloped lots were securities.  As the court noted:

"Here, like in Howey, Dunham offered investors an opportunity to contribute money and to share in the profits of a Cherokee Village retirement community, which would be managed, sold, and partly owned by Dunham. The lots represented the victims' "shares in [the] enterprise." (Howey, supra,328 U.S. at p. 300.) None of the California victims had any ability to develop homes in Arkansas, and they expected "Dunham and company" to sell their lots for them.  The victims were relying on Dunham to bring professional management, homebuilding, and financing experience to the project."

They all expected a return on their investment.  Even though there was no investment fund or other syndication company created, and there was no management contract between Dunham and the victims, it was clear from the presentations, seminars, and marketing materials that the victims placed their trust in Dunham to develop the lots in order to increase their value. 

This case reminds us once again to disregard form for substance and focus on the economic reality when analyzing whether any investment is an "investment contract" and therefore is a "security".  Even undeveloped land can be such.  What else?

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  


Tuesday, June 25, 2019

Regulation Crowdfunding Study - June 2019

On June 18, 2019, the staff of the SEC issued a report on Regulation Crowdfunding (in short, Regulation CF).  The report presents a summary of the status of crowdfunding as of now, three years after the SEC final rules for Regulation CF became effective.  Although a great initiative, Regulation CF is too complex and costly to be the main securities law exemption behind capital raising in the U.S.

As a way of background, Title III of the JOBS Act added Section 4(a)(6) to the Securities Act, providing for a new exemption from registration for private placements conducted through an online platform.  Regulation CF provides the regulations that put Section 4(a)(6) into practice.  According to Section 4(a)(6) and Regulation CF, a domestic issuer may raise up to $1.07 million in a 12-month period from unaccredited investors provided the issuer prepares certain disclosures, the investors invest only up to a certain maximum based on the investor's income or net worth, and the offering is conducted through a broker-dealer or a registered funding portal.

In summary, Regulation CF did not prove to be as popular as once anticipated.  According to the report, only 1,351 offerings relying on Regulation CF were initiated in 2.5 years between May 16, 2016 and December 31, 2018, and only 519 offerings were reported as completed.  The average amount reported raised per offering was approximately $107,367 for a total of $108.2 million.  In comparison, in 2016 alone, companies in the United Kingdom and China raised $335 million and $460 million, respectively, under similar crowdfunding exemptions.

Most issuers were early in their lifecycle: an average issuer was formed within two years prior to the offering and employed about three people.  Just over half of the offerings were done by issuers with no revenues.  Only about 10% of the issuers became profitable in the most recent fiscal year prior to the offering.  About one-third of the issuers were from California, followed by New York (about 11%) and Texas (about 7%).

The average offering lasted about four months.  About one-half of the issuers offered equity, 27% - debt, and the remaining issuers offered SAFE or another type of investment structure.

Although the $1.07 million limit in Regulation CF offerings was initially much criticized, a typical offering amount was small: the average target amounts ranged between $25,000 and $500,000.   Only 29 offerings reported raising at least $1.07 million during the three-year study period.  Therefore, the low offering limit seems to be appropriate, although one can argue that many potential issuers avoid Regulation CF because of such low limits.   

The SEC staff noted in the report some issuers' lack of compliance with the ongoing filing obligations.  Issuers have to file an annual report on Form C-AR and the final progress update on Form C-U.  Many survey respondents cited the complexity of regulations and Form C as well as high costs associated with Form C and financial statement preparation as the reasons behind such a lack of compliance.

Overall, the report is full of data that should be analyzed with the view of amending Regulation CF.  Then, those issuers that stay away from conducting a Regulation CF campaign due to the low limits, complex and onerous disclosure requirements, necessary audited financials for larger offerings, and ongoing reporting obligations will rely on the Regulation CF in their capital raising efforts and will allow more unaccredited investors to participate in the startup ecosystem.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.    







Tuesday, June 11, 2019

SEC vs. Kik Interactive Inc. - Another Test for the Howey Test

On June 4, 2019, the SEC filed a complaint in SDNY against Kik Interactive Inc. ("Kik"), a Canadian company, for failing to register the offering and sale of its digital tokens called Kin pursuant to Section 5 of the Securities Act of 1933 (the "Securities Act").

The complaint reiterates the SEC's long-standing position since it first issued the DAO Report in July 2017 that digital tokens may be securities and that the U.S. federal securities laws would apply regardless of whether the consideration paid was virtual currency or whether the securities were issued through a distributed ledger technology instead of in the certificated form.  According to the complaint, the Kik executives knew of the risk that the Kin tokens could be securities under the Securities Act but failed to sell them to the U.S. investors in a legally compliant way.  This complaint did not come as a surprise to the company or the larger blockchain community.   

Although we cannot foretell how the case will turn out (and this may go on to become a full-blown jury trial), there are several interesting observations about the Kik story, including some lessons for future token issuers.  Please note that the observations are based on the facts as they were presented in the SEC complaint.  These facts may be disputed by Kik in the process of litigation.

1.  There were no allegations of fraud made against Kik.  This case is solely about the violation of the registration provisions of the Securities Act.   There have been prior SEC enforcement actions against ICO issuers that did not involve allegations of fraud but they all were settled with the SEC (In re Matter of Paragon Coin, Inc., where the issuer raised $12,066,000, settled with the SEC on November 16, 2018, paid a $250,000 penalty, offered rescission rights to investors, and agreed to register tokens with the SEC; In the Matter of Carrierreq, Inc., d/b/a Airfox, where the issuer raised approximately $15 million, and settled with the SEC on the same day and with the same consequences; and In re Matter of Munchee Inc., where the issuer raised about $60,000 in the one day ICO, refunded all money, and settled on December 11, 2017 without penalty).

2.  Kik raised approximately $100 million from more than 10,000 investors, about half of whom were U.S. investors.  This was a large offering that was bound to attract the attention of the regulators.

3.  Kik actually conducted two Kin offerings that became integrated.  The first offer and sale took place from early July to September 11, 2017, whereby Kik received approximately $49.5 million from about 50 investors, including 21 U.S. investors.  This was a private offering of SAFTs (Simple Agreements for Future Tokens) only to accredited investors.  The company provided a PPM to the investors and filed a Form D, treating SAFTs as securities.  The SAFT contracts obligated Kik to generate and distribute half of the tokens at the time of the public sale that had to take place before the September 30, 2017 deadline or return to the investors 70% of the funds.  Since the company was running out of money, it had no choice but to conduct the public sale of tokens that took place between September 12-26, 2017, including distributing Kin tokens to the early investors, prior to the deadline.  The offerings were integrated in part because of (i) the proximity in time between the SAFT offering and the public sale (the last SAFT was sold on September 11, 2017, one day before the launch of the public sale), (ii) the fact that the tokens issued in the public sale and the tokens underlying the SAFT had the same characteristics, and (iii) the fact that the company failed to distinguish between the funds received through SAFTs and the funds received from the general public.

4.  Kik did not offer the Kin tokens to the Canadian investors in its public sale made to the retail investors from September 12 to September 26, 2017.  Interestingly, based on the advice of its Canadian counsel and after engaging into discussions with the Ontario Securities Commission, Kik excluded Canadian investors from the public sale because, based on a Canadian test that is similar to the Howey test, the Kin tokens were determined to be securities under Canadian law.  However, Kik did not reach out to the SEC and did not restrict U.S. investors from purchasing the tokens.  In fact, only the residents of Canada, Cuba, China and North Korea (and residents of New York and Washington states) were excluded from the offering. 

5.  Kik failed to treat the underlying Kin tokens as securities when it offered and sold them through the SAFTs.  The company knew at the time of offering and selling the SAFTs that it would not be able to build the "Kin Ecosystem" before the token distribution date, which, according to the SAFT contracts, had to take place before the September 30th deadline.  This tight deadline allowed only for a window of several months (and in the case of the SAFT sold on September 11th, only a 20-day window) to do so, which was clearly insufficient time to build a fully functioning platform for the Kin tokens with all the features promised by Kik.  Therefore, it was not reasonably possible for the Kin tokens to exist as "utility tokens" on the "Kin Ecosystem" and they had to be treated as securities.  The fact that they did gain some utility later should be irrelevant to the analysis of the initial distribution of the Kin tokens back in September 2017.

6.  The public sale was conducted several months after the SEC issued its DAO Report, warning issuers that tokens could be securities.  However, Kik did not heed the SEC guidance.

7.  In its press release issued on June 4, 2019, Kik referred to its Kin tokens as a currency and alleged that the SEC stretched the Howey test "well beyond its definition".  It is a question of fact whether Kin is now more like a currency rather than a security.  It is a different question of fact whether Kin was more like a security than a currency at the time of its initial issuance in 2017.  It should be noted that at the time Kin tokens were issued, the company was still building its "Kin Ecosystem" where Kin tokens could be used for payments, and therefore, unlike Ether, was not decentralized and depended on the efforts of Kik's developers.  As the SEC noted in paragraph 126 of the complaint, "There was, simply, nothing to purchase with Kin at the times Kik sold the tokens through September 26, 2017...". 

It will be up to the courts to decide whether Kin tokens were securities at the time of their issuance.  Since the SEC's complaint is in line with its prior enforcement actions and interpretive releases on the subject, the outcome of the Kik case may either reaffirm once again the SEC's position or, if Kik were to prevail, return the Wild West of 2017 ICOs.

Perhaps, instead of applying and perhaps "stretching" the old Howey test one more time, it is time to adopt a new legal regime suitable for digital asset offerings (as it is being done in multiple jurisdictions across the globe)?  But then remember,  the courts are not legislative bodies and are bound to apply the law as currently written.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  



 

Wednesday, May 15, 2019

What to expect from your STO legal adviser

I have previously written about the steps to prepare for a security token offering ("STO") and now would like to zero in on one of them: selecting the team.

The choice of the STO legal adviser can render your offering a success or failure.  Don't select merely based on price.  It is important to look at the prior experience with this type of offerings and the overall qualifications.  Get references.  Remember that you are hiring a legal team whose core members are experts in securities and corporate law, and its other members cover tax and other relevant subject areas.

Below is a summary of the services that (in my opinion) you should expect from your legal team:
  • Advising on the choice of jurisdiction, both from the corporate and tax perspective, depending on the physical location of an asset/interest to be tokenized, targeted investors, availability of banking services, and relevant securities regulations and other applicable laws;
  • Choosing the right corporate structure for the special purpose entity (“SPE”) that will conduct the STO; 
  • Engaging with local counsel to implement chosen structure and supervise its organization and corporate governance; 
  • Preparing all necessary corporate governance documentation; 
  • Assisting in developing the token terms; 
  • Structuring the STO to qualify for an exemption from registration in the U.S.; 
  • Preparing a private placement memorandum (“PPM”), including the offering details, legal disclaimers, company overview, risks relating to the offering, the company and the industry, and financial reports; 
  • Preparing subscription / token purchase agreement or Simple Agreement for Future Tokens (“SAFT”) that summarizes the terms of the investment and captures investors’ consent to such terms; 
  • Conducting a legal review of the issuer website, announcements on all social media platforms, the White Paper, if any, and marketing materials;
  • Preparing Terms of Use for the issuer website; 
  • Developing or reviewing Know-Your-Customer / Anti-Money Laundering questionnaires; 
  • Reviewing and commenting on the agreements with other service providers in the STO process; 
  • Making applicable U.S. federal and state securities law filings; 
  • Working together with the tax, accounting, marketing, and other service providers to create legally compliant internal and external documentation related to the STO; and 
  • Working with local counsel in the selected jurisdictions (as applicable) where the tokens will be sold to ensure that the tokens are offered and sold within the legal parameters of each such jurisdiction and that correct lock-up periods and caps on investor counts are implemented.
Conducting an STO is not a small undertaking.  And selecting the right legal team is one of its key components.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Sunday, May 12, 2019

Preparing for a panel discussion on raising seed capital, successfully

I am in the process of organizing an event geared towards my favorite crowd: startup founders.  They are the most demanding group of clients I have.  There are many adjectives I would use to describe them: enthusiastic, big believers, convincing, lost, demanding, unreasonable, whining, driven, and again, enthusiastic.

For the upcoming panel discussion, I've invited as speakers two partners at venture capital firms that invest into NYC-based and international startups, an experienced angel investor who is on the board of one of the largest angel groups, and a founder of a startup that successfully raised capital before.  As a moderator, my job will be to ask them questions, the answers to which should help the audience.  What are the questions that I should ask?  What are the questions that, if you knew the answer to, would help your company get funded?

Audience participation here is welcome!

And BTW here is the link to the event:
https://www.eventbrite.com/e/successful-capital-raising-for-startups-tickets-61307312823

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Saturday, May 11, 2019

Getting Started with Your Security Token Offering

On April 18, 2019, we conducted a joint webinar on raising capital by conducting security token offerings.  My colleague and I covered the legal side of how to conduct an STO in compliance with applicable laws.  The team at tZERO handled the technical and logistical aspects of hosting an STO and actually generating tokens.  They also addressed such questions as secondary trading of the security tokens.  You can view the entire webinar here: https://www.youtube.com/watch?v=r2oSwVmIE9s

After the webinar, I created the following guide summarizing certain points that a potential STO issuer should consider.  Here is my step-by-step guide:

Step 1: Understand the regulations

Conducting a securities token offering involves issuing securities. Every offer and sale of securities must be registered with the Securities and Exchange Commission (the “SEC”) pursuant to the registration requirements of Section 5 of the Securities Act of 1933 (the “Securities Act”) unless such offering qualifies for one of existing exemptions. I previously posted a brief summary of several commonly used exemptions and regulations here.

Step 2: Understand the technology

Choosing the correct blockchain for your token is the next big decision you have to make. It needs to be secure and integrate well with different platforms and exchanges (just imagine what a costly mistake would be selecting a blockchain that does not work with your chosen security token exchange!). Most of the token industry issues tokens based on the Ethereum blockchain and the ERC-20 protocol because of its interoperability and simplicity to design. However, the ERC-20 token does not have any transfer restrictions.

The following are the four standards that build on top of ERC-20 protocol and that are specifically designed for security tokens:

ST-20 developed by Polymath
R-Token developed by Harbor
ERC-1400
ERC-1404 developed by Tokensoft

Each has a unique set of conditions tailored specifically to security tokens. Often, the choice of a platform for token issuance will help determine which standard will be used since several platforms have their own standards, such as Polymath and Harbor.

Step 3: Choose the token issuance platform

Choosing the right platform has a direct effect on the success of the offering. Several platforms have emerged that offer tokenization services to issuers. Some provide only technical assistance in generating the tokens, whereas others offer a more comprehensive set of services that include, in addition to tokenization, assistance with determining the terms of the offering, smart contracts creations, KYC/AML built-in checks, marketing assistance, and integrations with other blockchain participants.

Examples of token issuance platforms include Securitize, Polymath, tZERO, Securrency, Harbor, and Swarm, among others. Given that the platforms offer different services at different pricing points, issuers should obtain quotes from several platforms and choose the one best suited for their needs and budget.

Step 4: Set up the issuer entity and resolve corporate governance questions

The legal structure of the issuer varies greatly, and occasionally we see the issuer setting up a separate subsidiary to conduct a securities token offering. Although it is possible to form a foreign entity to conduct the STO, such a structure requires compliance with the laws governing the issuance of tokens in the home jurisdiction as well as compliance with the laws of each country where the investors are located. Also, setting up a foreign entity will preclude reliance on certain exemptions described in my separate post, such as Regulation CF or Regulation A+ (both Tier 1 and Tier 2).

Step 5: Structure the terms of your security tokens

There are no standard terms for security tokens. Some are structured to be more like shares in a corporation and offer voting and dividend rights. Others evidence a loan and the right to be repaid with interest, which may sometimes be convertible into an equity-like instrument. Yet other tokens can represent a profits interest or a revenue share, or simply a fractional ownership of an asset. One of the initial steps of an STO process is creating a summary of the token terms together with a competent legal adviser.

Step 6: Select your STO team

The very first step in conducting a successful security token offering is assembling a team of service providers with prior experience in STO issuances. You will need to select a legal adviser, a token issuance platform, and possibly a marketing agency and a broker-dealer. Depending on the type of offering you elect to conduct, you may also need to retain services of a transfer agent and engage local counsel in jurisdictions where you intend to sell the tokens.  In the future, I'll write about what types of services to expect from your legal adviser.

Step 7: Understand resale restrictions and secondary trading

It is important to carefully select the right exchange for your security tokens. Many exchanges allow trading of cryptocurrencies and utility tokens. Hosting the trading of security tokens requires exchanges to get additional regulatory approvals.  It is my understanding that there are currently only two U.S. centralized exchanges that are authorized to trade security tokens: tZERO and
OpenFinance.

There are several others that are in the process of getting the necessary regulatory approvals to trade security tokens. You should learn the listing requirements and understand the regulatory compliance of the exchanges ahead of conducting your STO.

I hope this guide, together with the webinar, will help you find answers to some of your questions regarding raising capital through the issuance of security tokens.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.  

Overview of US federal securities law exemptions available for raising capital

Every offering of securities must be registered with the SEC unless it qualifies for an available exemption and I am often asked to describe various types of exemptions and regulations that are available to private companies raising capital.  I go over Regulation D, Regulation CF, Regulation A+ rules with clients about once a week.  I also teach the same at Fordham Law School.  Below I am posting a summary that I hope you will find helpful.  Note that the table does not include all available exemptions and regulations.  Email me if you'd like a nice pdf version.


Regulation CF (Crowdfunding):

Amount to be Raised:
Up to $1,070,000 in a 12-month period

Type of Issuers:
US entities only
Other limitations apply

Investors:
Any investor (accredited[1] and non-accredited).  However, there are limits as to how much non-accredited investors can invest depending on their net worth or income.

Marketing Limitations:
Issuers can only communicate and market through a registered crowdfunding portal.  Any type of marketing and communication is permitted through the portal (so long as not misleading).  Outside of the portal platform, only very limited factual communications are permitted.

Resale Limitations:
These are restricted securities that generally cannot be resold for one year unless (i) back to the issuer, (ii) to an accredited investor, (iii) as part of a registered offering, or (iv) to a family member or for estate planning purposes.

Filing Requirements:
Issuers must file Form C with the SEC and update it annually so long as, generally, securities issued in Regulation CF offering are outstanding.

Information Requirements:
In addition to providing disclosures about the company and the offering, the issuers must provide financial statements (which have to be audited if the offering exceeds $535,000 and the issuer has sold securities in reliance on Regulation CF before).

General comments:
Although cheaper than conducting a Regulation A+ offering, the $1.07 million cap on the gross proceeds makes it a relatively expensive undertaking.  Also, the issuer must conduct its offering through one of the registered crowdfunding portals.


Regulation D Rule 506(b):

Amount to be Raised:
Unlimited

Type of Issuers:
Any issuer, including foreign issuers
Certain limitations apply (such as that the issuer cannot be a “bad actor”)

Investors:
Unlimited number of accredited investors and up to 35 non-accredited but financially sophisticated investors. 

Marketing Limitations:
No general solicitation or advertising is permitted.  Offers and sales should be made only to those investors with whom the issuer has pre-existing relationship.

Resale Limitations:
Restricted securities (i.e., not freely tradeable generally for at least one year)

Filing Requirements:
Issuers must file Form D with the SEC within 15 days after the first sale.  The issuer also needs to make notice filings in every state where the investors reside.

Information Requirements:
If the issuer accepts money from non-accredited investors, it must provide a private placement memorandum with specific mandated disclosures specified in Rule 502 of Regulation D.

General comments:
This exemption may not be suitable for those offerings that are conducted online through unrestricted web portals because of the restriction on solicitation and advertising (because posting offering details on a website is generally considered to be advertising).


Regulation D Rule 506(c):

Amount to be Raised:
Unlimited

Type of Issuers:
Any issuer, including foreign issuers
Certain limitations apply (such as that the issuer cannot be a “bad actor”)

Investors:
Accredited investors only

Marketing Limitations:
General solicitation and advertising are permitted. 

Resale Limitations:
Restricted securities

Filing Requirements:
Issuers must file Form D with the SEC within 15 days after the first sale.  The issuer also needs to make notice filings in every state where the investors reside.

Information Requirements:
None

General comments:
Many issuers rely on this exemption.  The issuer has to take reasonable steps to verify that purchasers of securities sold in any offering under Rule 506(c) are accredited investors.


Regulation A+ (Tier 1):

Amount to be Raised:
Up to $20 million per year

Type of Issuers:
US and Canadian entities only
Certain types of entities (such as shell companies, issuers of penny stock or other types of investment vehicles) are ineligible

Investors:
Accredited and non-accredited investors 

Marketing Limitations:
Generally marketing and advertising are permitted, but certain limitations exist.  When using “test-the-waters” marketing or before the registration statement has been qualified with the SEC, the issuer has to specifically state whether a registration statement has been filed and if yes, then provide a link to the filing.  Also, there needs to be a disclaimer saying that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC.  All solicitation material must be submitted to the SEC as an exhibit. 

Resale Limitations:
Unrestricted securities, but limitations on trading exist

Filing Requirements:
Issuers must file Form 1-A with the SEC and get qualified.  Companies need to count their shareholders for the purposes of Section 12(g) registration.

Information Requirements:
Form 1-A requires detailed disclosures about the issuer, including financial statements which need not be audited unless audited financial statements already exist.  Generally, the level of disclosure is similar to that required in an initial public offering. 

General comments:
Issuers raising money in a Regulation A+ Tier 1 offering must comply with the individual "blue sky" laws of each state where they plan to sell their securities.


Regulation A+ (Tier 2):

Amount to be Raised:
Up to $50 million per year

Type of Issuers:
US and Canadian entities only
Certain types of entities (such as shell companies, issuers of penny stock or other types of investment vehicles) are ineligible

Investors:
Any accredited and non-accredited investor.  However, there are limits on how much non-accredited investors may invest depending on their net worth or income.

Marketing Limitations:
Generally marketing and advertising is allowed, but certain limitations exist.  When using “test-the-waters” marketing or before the registration statement has been qualified with the SEC, the issuer has to specifically state whether a registration statement has been filed and if yes, then provide a link to the filing.  Also, there needs to be a disclaimer saying that no money is being solicited and that none will be accepted until after the registration statement is qualified with the SEC.  All solicitation material must be submitted to the SEC as an exhibit. 

Resale Limitations:
Unrestricted securities (at the federal level)

Filing Requirements:
Issuers must file Form 1-A with the SEC and get qualified.  After the offering, the issuer has ongoing reporting obligations.

Tier 2 offerings are exempt from complying with state “blue sky” laws (although states can (and generally will) still require that information provided to the SEC also be filed with the state, and that the issuer pay filing fees.

Information Requirements:
Form 1-A requires detailed disclosures about the issuer, including audited financial statements.  The level of disclosure is similar to that required in an initial public offering.

Tier 2 issuers are required to include audited financial statements in their offering documents and to file annual, semiannual, and current reports with the SEC on an ongoing basis. 

General comments:
Companies are required to engage the services of a transfer agent.


Regulation S:

Regulation S is an exclusion from the registration requirements of the Securities Act for offerings made outside of the United States by both U.S. and foreign issuers.  A compliant Regulation S offering must follow two general conditions: (i) the offer or sale must occur in an “offshore transaction” and (ii) there be no “directed selling efforts” into the United States. 

Regulation S transactions are divided into three categories.  Category One, which includes offers and sales by “foreign issuers” for which there is no “substantial U.S. market interest” or offerings of securities in “overseas directed offerings” is the least restrictive, with no resale limitations.  Category Two securities, which include securities issued in equity offerings by reporting foreign issuers and offerings of debt securities, non-participating preferred stock by reporting issuers or non-reporting foreign issuers, may not be resold to U.S. persons during a 40-day distribution compliance period.  Category Three is typically the most relevant for the smaller private issuers.  Category Three includes offerings of all other securities, including equity offerings by domestic non-reporting issuers (i.e., private companies with no reporting requirements with the SEC).  Resales to U.S. persons of securities issued in Category Three offerings are restricted for one year unless they are done in compliance with an available resale exemption. 




[1] Rule 501(a) of the Securities Act defines accredited investors (in the case of natural persons) as those whose individual net worth (alone or with a spouse) exceeds $1 million (excluding the value of their primary residence) or those whose annual income exceeded $200,000 (or $300,000 together with their spouse) in each of the two most recent years and they reasonably expect reaching the same income level in the current year.

This article is not legal advice and was written for general informational purposes only.  It does not express anyone else's views except for the author's.  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.