First of all, I am not an attorney, so this isn’t legal advice, seek counsel, yaddie yaddie…
Regulation Crowdfunding is colliding with the ICO phenomenon and there are a lot of regulatory issues to be addressed. Section 12(g) of the Securities Exchange Act requires companies with assets of $10 million and a certain number of “holders of record” of a class of equity securities (2,000 holders, or 500 non-accredited holders) to register that class of securities with the SEC and become fully-reporting.
This isn’t something companies looking to raise funds through a token offering of a non-utility token are prepared to handle.
The SEC has continued to assert the position that many coins or tokens in ICOs are securities, although there has been little clarification of whether the securities in question are treated differently if the financial securities token represents debt or equity.
For now, let’s assume the tokens being offered either represent a share in the profits of the issuer or include some aspect of profit share in a way to be considered an equity equivalent. Let’s also assume the token sale raises at least $10 million to invoke the clause of Section 12(g).
We’re assuming that the tokens will trade using blockchain technology and be transferred through smart contracts. Whether that really works for the securities of corporations required to manage cap tables is another topic for another time, but for now let’s keep the focus on Section 12(g).
Public blockchain technology is anonymous by its nature; issuers will know how many transactions there are and how many “addresses” on a chain hold tokens. They will never know how many investors are behind those addresses. One address could be a wallet that holds the tokens of a syndication of buyers. Or one person could have many addresses; one that is used for directly owned investments, one for holding the syndications of tokens being managed for the syndication; and one for their illicit money-laundering business.
At present, the only way of counting the “number of investors” that trigger the 12(g) registration requirement is to treat each address as if it were one holder of record, in the same way you would treat a broker holding in street name. And we think you have to assume that each “holder” is non-accredited, unless you manually build some KYC verification process into your smart contract.
So where does that leave the token issuer?
It will ultimately depend on which type of securities offering it is making. If the issuer is making a Regulation A offering, a conditional exemption from Section 12(g) might be of some help. The exemption applies only if the issuer has revenues of less than $50 million, makes its required ongoing filings and engages a registered transfer agent.
But does this process affect the crowdfunding transfer agent?
Can you “tokenize the tokens”? Can you issue a token to an address owned by the issuer (and that’s what the transfer agent will keep track of), then chop up the tokens and transfer them via blockchain technology. This begs the question as to whether the captive address or the addresses holding the tokenized tokens should be treated as the “holders of record”; there’s an argument to be made either way. But at least this way you manage to engage a transfer agent and can stay within the conditional exemption until you have revenues of $50 million.
Issuers making offerings under Regulation D are going to experience a different problem. There’s no conditional exemption from 12(g) for Reg D private placement. So they are left with three alternatives: build a custom code algorithm into the smart contract that prohibits transfers except to existing token-holders once there are 500 token-holding addresses, take the approach that a captive address that tokenizes the tokens is the sole holder of record, or ultimately register with the SEC.
Plug here… 10XTS’s XDEX platform is a fintech ecosystem designed to address these questions by ensuring issuers and investors are always within compliance of the law. Custom programming of tokens in the wide-open blockchain ICO space has left many of these issues unaddressed. We’re working to bring clarity, governance, reporting, and administration to the space.