Providing investors liquidity through a secondary marketplace is a valuable capability to firms in private capital markets, especially with the rise of ICOs and tokenization of assets.
This is why many online private capital markets platforms are looking for secondary trading capabilities.
This webinar with experts from Homeier Law PC aims to teach you everything you need to know about the regulations in the US around the secondary markets and adding secondary trading capabilities to your online crowdfunding or investment management platform.
We joined one of the leading law experts in the US to help you learn:
- What are the benefits of having the secondary trading capability on your crowdfunding or investment platform
- What are the main regulations in the US regarding secondary trading
- Best practices and real-life examples of secondary trading in real estate, private equity or private lending
- The role of SEC in the secondary market
- How cryptocurrency and blockchain fit into the secondary market
Read full transcript here:
Katipult: Welcome everyone. We have Charles Kaufman and Michael Homeier. We are going to talk about secondary market or security tokens. So, Charles and Michael, please give a short introduction about yourselves and we can get started.
We have a primary focus in the securities practice within the alternative finance arena. We’ve been fortunate toward over 500 securities offering projects in alternative financing over the last, almost ten years now.
Starting with immigrant investor financing in the US, moving on to the investment crowdfunding when the US adopted those laws starting in 2012 and now we are able to apply that experience and those avenues for capital raising for clients looking to conduct token and coin projects in the new world of crypto.
So from LA, hello everyone and Charles, do you want to say howdy as well?
Charles: Hi, I’m Charles Kaufman and I am happy to share this practice with Michael and personally I’ve been active in advising companies both public and private, on compliance with securities laws and raising capital through additional and alternative financing for about 20 years now.
We’ve been active in crowdfunding since it first became available a few years back and now we are very active in the digital asset related capital raising world, which is typically taking advantage of crowdfunding to raise money.
Michael: Terrific, and you all know that our focus for today’s conversation is on secondary markets for securities tokens. This is an area of prime interest for investors beyond the appreciation that they are hoping to secure by making an investment in a token or coin offering.
They are also interested in monetizing that investment either by selling at some point in a secondary transaction not back to the issuer, but to a repurchaser, either to monetize the appreciation of their investment or occasionally for more pure traditional liquidity reasons, such as a life event or changed life circumstances that suddenly present a need for them to cash out and receive back money that they can use to accomplish those changed life circumstances.
The secondary trading of token and coins is a high priority for most investors, because it is a high priority for most investors it is obviously a high priority for issuers themselves. Most, but not all issuers are going to be motivated by what drives their investors, not only to get them in the door, but to make them happy in the long run, since that helps get them in the door.
So with that in mind, we think that this is a really, really hot topic. Perhaps one of the hottest topics in crypto today, although it may be all too often overlooked, it should not be at the beginning of the token or coin raise. It should be kept in mind for the future, when investors are on-boarded and coins or tokens are sold, those investors are likely to be with the project for a period of time measured in years. Although under certain circumstances, that opportunity for liquidity sooner than that, perhaps even instantaneous liquidity, can be secured and that is of course a high priority for certain issuers that go in that direction.
We have a disclaimer slide that we zip through quickly, but just to make a point, this is how you always know that you have attorneys giving a presentation: they routinely will include these disclaimers saying “We are not technically responsible for the information we’re providing here", primarily because information should always be tailored to individual business owner or investor’s personal case. That’s impossible to do in an educational presentation like this. We are going to be presenting general information and general guidance. Anybody interested in specific information tailored to their own situation should obviously consult with a legal or tax or investment professional for that directed tailored information.
So the first of our slides is the one entitled “The basics”. This first slide is really to point out distinction between cryptocurrency or utility token on the one hand, which is not heavily regulated by the US securities laws here in the US, versus tokens or coins that are sold in order to raise capital, which are considered to be securities, that is investment opportunities and if sold in the US by an US issuer and/or US investors, then those securities need to be either registered with the US government, specifically with the SEC, or an exemption from the registration needs to be secured, so that those investment opportunities may legally be sold to investors. Those later group of investment opportunities that are regulated by US law, and heavily so, not only in their initial issuance, but also in the ability and timing for an issuer to facilitate secondary trading that is subsequent resales of the investment by the purchaser or subsequent even by the downstream purchasers, are heavily regulated as securities investments under US law.
What we’d like to do here is focus on the securities token aftermarket sales of securities tokens, which again, are highly regulated, and as we mentioned at the beginning of our presentation, this is a topic of primary importance to investors and hence, most issuers. Here we find investment opportunities which are considered securities under US law, are regulated by two sets of laws in the US, which, as you well may know, is what’s called a Federal Republic, that is there is a federal government with its laws, and then each of the states are separate mini countries and each of them have their own set of securities laws that don’t govern nation-wide as do the federal laws, but protect residents and occasionally issuers who are within that particular state.
As you’d expect, federal law applies everywhere in the US, state law applies to residence of that state or issuers located in that state. The federal law has a disclosure standard, the requirements to either register securities or more commonly in the crypto world, to issue securities under an exemption from registration, are primarily based on the disclosure of all material facts by an issuer, before investors can make their investment decision, in order for the investment decision to be as informed as possible.
The documentation that companies prepare in order to comply with the US securities law disclosure imperative of giving all of this detailed information to investors so that their investment decision can be an informed one, is an extensive set of information about the business, about the principles behind the business, about what they intend to do for themselves with the money that they are raising, how they are going to deal with investors as far as giving them a voice in operation of the business, how the investment opportunities could be repurchased by the issuer in some cases or how those investment opportunities could be subsequently resold by a purchasing investors.
By contrast the state securities laws for the most part also have a disclosure imperative. It says that as long as you give investors full detailed information about the investment opportunity, the federal government and big states are not going to substitute its or other independent judgment of whether or not the investment opportunity is what they think us good or bad and allow what they think is good and disallow what they think is bad. The government does not substitute its subjective judgment as to an investment. Once full disclosure is complied with, the disclosure regime under US federal law and many states, has been satisfied.
What is dangerous is that some states, and remember, their laws apply to that state to protect their residents and to regulate issuers in that state, they may have a different standard. For example, state of California is notorious for having not simply a disclosure requirement, but for actually substituting its independent judgment whether the investment opportunity is a good one or not. Only if they think it is a good investment will they allow, under its laws, an investment that they can control, to proceed.
This means that if issuers need to be concerned about federal law, they only need to be concerned about full disclosure. If additionally they need to be concerned about certain states, they need to know whether or not those states have not just a disclosure, but a subjective judgment call that the state will make, whether or not they wish the investment opportunity to be offered to their residents. Charles, I think you wanted to address the cryptocurrency exchanges?
Charles: Moving on to focus on the secondary market and how these things can be resold among other existing holders, we have in the US about 20 cryptocurrency exchanges that are currently active. They have familiar names like Kraken or Bittrex, and they trade established cryptocurrencies and potentially utility tokens like Bitcoin, Ether, Ripple.
Until about a year ago, many of them were listing privately issued coins and ICOs that were in fact being issued for capital raising purposes but had the promise of being utility tokens being out in the marketplace. Year ago the SEC issued warnings to both investors and these exchanges that the ICO issuances were securities and that they were not eligible to be traded on these cryptocurrency exchanges, so all of them purged ICO coins ant they are no longer available.
In terms of the things that are actually traded on the blockchain and moving back and forth on the blockchain, the only authorized trading that’s going on now is in digital assets that are not deemed to be securities like Bitcoin and Ethernet and that are trading on these exchanges. There are efforts underway to develop exchanges and we’ll talk more about that, that can trade securities that are digital assets and that exist on the blockchain. So far, we don’t have that.
A lot of times people will first come to as a security lawyer when they are doing an ICO and they are told by cryptocurrency exchange that they need a legal opinion, that what they are issuing is not a security and we have to give them the bad news that there really is not enough clear guidance now for anyone to issue that type of opinion. Certainly if the coin is being issued in the first instance to raise capital, it’s going to be deemed a security. You just can’t go out on a cryptocurrency exchange. It will have to be on something that is authorized to do secondary trading of securities.
There has actually been some bad history and one of the reasons why firms will not give these opinions is not only the fact that really isn’t a bright line we’ve been given by the SEC, but because the SEC has actually warned law firms that have given some of these opinions, telling companies that if they were issuing utility token when it was actually security, in the SEC’s view they were aiding and abetting unauthorized or unregistered public offerings. There was a thought at one time that even if the opinion was wrong it would give some protection to the company if they would get it, but those, but those opinions were just not given anymore.
Katipult: Do you see changes happening to all of this, to the guidance that these companies need, are there roles coming into place that can actually help them, or is it going to be the same way it has been until now?
Charles: We are starting to see some rules coalesce. The first real indication that we had was in an address from director of the corporation finance division of the SEC, Inman, about six weeks ago. He outlined a number of factors whether something is a security or indicate that it’s a cryptocurrency or a utility token that won’t be regulated by the securities laws. His words do not have the force of a regulation, but they were published by the SEC and they are starting to give us some guidance and a few hard and fast things that we can say now are, if you are issuing it to raise capital, it’s a security. Or at least it’s a security offering. What you are issuing may at some point evolved into being a pure coin, but at the time you are issuing it for capital, it’s a security.
One of the key things the SEC is going to look for in determining whether something has evolved into being a cryptocurrency or a coin and is no longer security, is whether there is an identifiable management group that controls the market or the coin, or the people are going to look towards to see future value, or is it something that is now truly decentralized and its value is determined by market factors. Is it something that people are going to buy to use and spend and that they are paying about as much as they expect to have value for it, or are they buying it because they think it’s going to appreciate in the future, that would make it more of a security.
We are hoping we get these types of factors in a more official pronouncement from the SEC, that we can more rely on and use in a proceeding with the SEC if they question us or have doubts, but at this point it is still kind of a loose test.
I think it is valuable to take your question a step further. We can say the safest thing is to say that it is a security and follow the security laws when you issue it, but that can result in a lot of aftermarket restrictions. Even the SEC will admit that the Securities act and the Exchange act regulations aren’t really appropriate regulatory schemes for tokens and cryptocurrencies.
Challenge that a lot of companies now have is to separate what they are selling for capital from what they eventually want to have as a token that is freely tradable, fractionalized, liquid, accredited, unaccredited purchase, anyone can use them in commerce. You have to somehow separate that from your capital raising effort if you want to give that freedom to the token that’s being issued.
What we are focusing on is the instrument that’s being sold for investment value that you are admitting as a token. These fall into two categories. The first are the coin like digital assets that people want to be used in commerce and in an industry to be clearly traded, to have value to report exchanges of value that people are selling for capital so they are saying “Treat them like security”.
We also have something called a tokenized security. This is like a conventional stick or a bond that pays dividends, interest, or represents an interest in a company that you grow and there is an increasing movement that, rather than having these be recorded as stock certificates or conventional registry, to make them into digital assets in the hope that it will make them clearly more tradable, that it will make dividends, voting and other things more automatic.
This is another category of digital asset that is going to need to be concerned with aftermarket trading being done with conformance with US securities laws once it’s issued. Like Michael said, once you have decided that you are issuing a security, you are usually going to take advantage of one of the crowdfunding mechanisms that are now legal in the US, to broadly advertise securities to potential investors and sell them over the internet. A detailed explanation of those is beyond the scope of this presentation, but you should know that some of these require you to limit yourself to accredited investors, some of them look a lot like an IPO, so called Regulation A+, which we will be discussing more. It is like a mini IPO up to fifty million dollars.
The crowdfunding method that you choose and the way that you offer these securities initially will determine the restrictions that they will have once they’re in the marketplace, your aftermarket restrictions. The most used exemption, 506 C or Title II of the JOBS Act crowdfunding, is very limited regulation, easy to issue an unlimited amount of securities as long as you limit yourself to accredited investors and verify that they are accredited.
However, securities that you issue that way and under most exemptions are restricted securities. Can’t be resold in the US, usually for a period of one year and that can impede them taking advantage of their blockchain nature and limit liquidity. If you do use Regulation A+ they are immediately liquid. If your securities are restricted because you used one of these other exemptions, Rule 144 usually is going to govern the resales of securities if you can issue them under a restricted method and they won’t be able to be resold unless they are registered.
There is some limited ability and actually a lot of token issuers are interested in this, if you do an accredited investor only offering to get your security tokens out, then the restricted securities that can’t be freely resold for a year, there is some limited liquidity you can have during one year period. It is mostly under a new rule, Rule 407, or an old rule which has a funny name, Rule 401 ½. It is called that because you won’t find it in a rulebook, it was developed by the judges and accepted by the SEC as something that naturally follows from the rule but isn’t there.
These methods allow securities to be resold among accredited investors, as long as you make sure you meet some information requirements and you limit the resales to accredited investors. This is wealthy individuals. To be accredited means that you have at least half a million dollars in net assets apart from your house or you’re making $250 000 or more in a year or $300 000 as a couple.
There are now marketplaces that set up alternative trading systems. Some of the ones you’ll find are called share post equities and / or equity date, where people sign on and establish that they’re an accredited investor and then they can buy and sell these restricted securities among themselves, that they are not just passing out to the ordinary rank and file investor.
Someone who’s purchased restricted securities in a private offering can also resell them under Regulation S. It allows a company to sell securities without restriction in an offshore offering to the US, where they abide by certain safeguards to make sure they are truly offshore.
Individuals can also take advantage of Regulation S. Someone who is holding a restricted security can sell it to an individual outside of the US, or he can sell it to be traded on a market outside of the US, if it is an offshore only trading market.
These are ways that someone who is doing an accredited investor offering and telling their investors they are basically locked up for a year can give them some escape valve and some limited liquidity, where they can experience resales before the one year is up.
This is a little detail on this slide about 407 and 401 ½, it was determined some time go that under the securities laws, that if an issuer can sell to an accredited investor or could sell in a private transaction, someone holding recently restricted stock could actually have that same ability. So they combined the rules that applied for 401 and 402 to make 401 ½. Then fortunately, the SEC codified this as a rule a couple of years ago under something called a Fast Act.
Now you actually have a safe harbor, where you know you are complying with SEC laws if you sell your restricted stock to another accredited purchaser, as long as you satisfy certain conditions, including a certain amount of available public information that the company has to make available, has to verify that it is correct.
One of the great advantages of these 407 sales is that they are exempt from blue sky. One of the things that has allowed markets to develop that are accredited investor only markets and give this liquidity under 407 is that they are exempt from blue sky. So even the state can’t tell a broker that they can’t make this transaction between the accredited investors or that this market can’t make that transaction between accredited investors, because as long as the technical requirements of 407 are allowed.
Rule 401 ½ is broader , doesn’t have as many technical requirements, but it isn’t a safe harbor. You would probably have trouble getting a legal opinion from the lawyer saying “For sure this transaction falls into 401 ½”, where 407 is a safe harbor and it is safe.
S0 let’s talk about liquidity and how blockchain assets may differ from traditional markets in offering liquidity in the aftermarket. This is one of the things that are driving what I refer to as the tokenized security, something that’s like the conventional stock certificate or a bond that’s being put on the blockchain trading in this conventional way.
The stock market has for a couple of centuries now, been able to tell people there’s a reliable price for their stock, that they can sell it or that they can buy more stock based on volume. Traditional stock markets depend on many willing buyers and sellers being out in the marketplace at any moment so you have an efficient establishment of the tradings.
Traditional markets, like the New York Stock Exchange, the American Stock Exchange have people called specialists who are constantly processing these purchases and sales. If you see an old movie, it isn’t done this way anymore. Where you had these guys with hats and slips of paper in them, running around the desks, processing things frantically throughout the trading day, it’s now done electronically. Or you have a market maker, which is basically a broker who matches buyers and sellers. That is the way NASDAQ has traditionally operated.
Blockchain offers the promise of doing it in another way, through smart contracts. You have the medium where buyers and sellers are entering the market and putting in the buy or the sell offer, it could be immediately and automatically executed on the blockchain. This, like other advantages of the blockchain, we are talking about disintermediation. Technically you are always going to need the presence of a broker, but it does mean that purchases and sales could proceed automatically without intervention or intermediation. This could be a new way that you could set prices for stock or that stocks can have a market pricing mechanism without as much intervention from the markets.
The question is, will this really work if trading is sporadic or if you only have a few buyers and sellers. The promise that we are being told is that this is going to create markets for emerging companies that have previously been held only by venture capitalists or angel investors, that earlier on somebody on the blockchain can buy and sell their shares through a trading medium that will reliably set the price.
The unknown is whether there would actually be enough trading activity, or if someone put a big purchase order and it drives the price up so you really don’t have liquidity, or if someone wants to sell a bunch of shares, is it going to drive the price down so you don’t really have liquidity. At least the promises are there that disintermediation, smart contracting will provide new ways to help liquidity for companies that didn’t traditionally have it.
One thing that you need to be very aware of in terms of aftermarket trading and your choice of strategy if you’re going to issue a security token or tokenized security, and your strategy is to have it freely traded and to be on a market, you have to be very concerned about information. Information is not just a regulatory requirement, it has actually been, according to most analysts, what drives liquidity.
If you look at the traditional stock markets, even the NASDAQ, there could be a company that is fully listed on NASDAQ and fully meets all of its requirements and is actually a profitable company, but if it doesn’t have analysts that follow it and our publishing analysis on it so investors can feel comfortable, that they have some information on the company, it won’t have trading volume. It can be on NASDAQ and still have a trading volume of a 1000 shares in a week and not have true liquidity. If someone wants to sell 100 000 shares, the price would plummet. If someone wants to buy 5000 shares, the price would spike and they won’t be able to fill their order.
There is a theory that all movements in the market, prices going up and down for stock, are based on the investors assumption that they have better information that the market. “Today the market is pricing the stock at $12, but I know that where this industry is going it really should be $14, so I’m going to buy it for $12 and I think it’s going to go up”. Or vice-versa, if there is some pitfall ahead, I’ve looked closely enough into this company to know that they’ve got a problem and I’m actually going to short it. I’m going to sell my stock because I don’t think it is going to go up.
If you take this information far enough it becomes insider trading and that is perhaps one of the reasons this information is a bit controversial, but actually everyone is trying to get that information advantage. They are looking at analyst reports and analysts are calling the company and trying to get background information.
So, information about companies really drives liquidity and if your company is dark to public and there isn’t a lot of insight on it, it doesn’t matter that you are on the blockchain or have an easy way for people to buy or sell it. There just isn’t going to be that much buying and selling interest.
The other thing to be aware of, and this is where the regulatory concern comes from, is that information can prevent fraud. The worst example in companies that are small micro cap, nano cap companies that have spotty trading, they tend to be victimized in the US market by something called a pump and dump, where abusive brokers go out and prey on the investors who don’t really know about the company, they may even not know about the capitalization, they may not know that one share represents a billionth of a company and not a millionth of a company when they are buying and selling these shares. The regulated markets and the mainstream markets all require a degree of information that prevents this from happening. Since the 33 and 34 Act were put into place, information requirements became the hallmark of market trading.
To move to a little more pragmatic expression of this, we have a hierarchy of trading forums for fully tradable securities in the US. A lot of times when someone is doing their offering and trying to figure out what their aftermarket liquidity will be, they look at the words freely tradable and that is the end of the story.
But that is not the end of the story, you don’t truly have liquidity unless you can be forum, and we have a hierarchy of trading forums that that offer a lot of liquidity, like the US Stock Exchange and NASDAQ, and then we have trading forums where sporadic trading can take place, like Pink Sheets, but these have very little liquidity because they have low volume.
So, NYSE, NASDAQ, NYSE AMERICAN, they have information and reporting requirements that actually go beyond what the SEC require. They also have listing requirements that the stock has to have a certain minimum price. All of these things are intended to drive the volume, so you actually get an efficient market and investors know what they are purchasing. All of these national exchanges require full Exchange Act reporting and these are the quarterly reports, annual reports and current reports that public companies in the US file.
Pretty much every industrialized country has a securities regulation regime, has recognized national markets that follow these very similar information requirements. They always require audited financial statements, so the investors can have reliability on the financial information that’s been provided.
In US, in addition to reporting an oversight there are also governance standards the stock exchanges require that boards have a majority of independent directors, they require that there has to be audit committees and compensation committees and you also have the Sarbanes-Oxley requirements that people are certified, that companies have good internal financial control. This is very rigorous and very expensive to maintain regime, to get yourself on a national exchange.
Then we have a lower, I would say and emerging middle tier called alternative trading systems. The best known are over-the-counter OTC markets, OTCQX and OTCBB. These are maintained by FINRA, the US quasi-governmental agency that regulates brokers and dealers and it has two tiers: an upper tier that is not supposed to have shadier companies like penny stock companies are companies that have merged into a shell to try to do a backdoor to go public, but these are companies or markets that have more sporadic trading, they are based on a bid and ask system where someone interested in buying puts out a buy offer or someone interested in selling puts out a sell offer and they get matched up by broker dealers. Lower threshold to get in and lower reporting requirement, and the OTCQX in particular is becoming more credible.
It used to be a place where national exchange companies that fell off the wagon, that stopped providing enough information or got delisted, or their stock price was too low, they would fall down to the OTCQX and it would be a kind of a graveyard for companies, but it’s actually becoming a lot more credible as a junior market. For example, last year OTCQX had 70 companies that graduated from there to the NYSE and NASDAQ, which hasn’t typically been the case before. T
his is all just part of the JOBS Act and an effort to restart what is called the IPO on-ramp, that a lot of growing companies with promising technology in the middle market were not being picked up by the national agencies and not doing IPOs to get them on national stages, so alternative trading system is kind of like a training wheel on your bike, to get you up to the status where you could be on the national market.
The other thing is, one of the principal crowdfunding exemptions, Regulation A+, before you can raise up to 50 million dollars, it’s kind of junior IPO, you have to provide your materials to the SEC. Most companies doing it were not that interested in the aftermarket, but it has actually been designed to allow you to list on the OTC immediately after the offering.
The information requirements that you have to provide in connection with a tier two Reg A+ offering also satisfy OTC and you could be listed. OTC is not considered a national exchange, it is considered and ATS, or an Alternative Trading System. ATSs are a program that the SEC has been promoting to try to encourage new types of markets to develop, like accredited investor only markets that I discussed earlier, like the OTC, and we are actually seeing a great deal of interest. None are online right now, but we are going to see ATSs that are designed for blockchain assets. TZERO is probably the best known, Coin Base has also announced that they are a cryptocurrency exchange, that they are going to have some of these ATSs.
In theory, once these are all online, if you meet their information requirements you would be able to do what you used to do by going on a cryptocurrency exchange after an ICO, but you’ll be able to go on one of these exchanges and your securities tokens would be trading on the exchange.
The lowest tier where you end up, you are freely tradable but you are not listed on a market is what we call the Pink Sheets, also operated by FINRA, and then Isolated Unsolicited Trades. This is what happens when you have no public information available and it is not really suitable for the blockchain because they are not supposed to be traded by broker dealers, broker dealers are supposed to tell the investors this isn’t a suitable investment for you because there isn’t information available. That should only allow very sporadic trading.
With the hierarchy that I have just showed you, it kind of matches the hierarchy of public information and what you are going to need to provide in the aftermarket. Again, this is something to think about when you do the token securities offering is, where you ultimately want to be, to allow aftermarket trading.
The gold standard is Section 12 of the Exchange Act. This is what is required by the national exchanges, quarterly reports, annual, current reports of information, you have to have audited financial statements, your auditor has to be a member of the Public Company Accounting Board, a peer review board. All of these to comply with the Section 12 of the Exchange Act, you are probably looking at at least a million dollars a year just in compliance costs and maybe companies that can do it for as little as $200 000, but generally it is an expensive proposition. You have to know that having that full liquidity is enough of a goal that you are going to step up to that type of work.
Regulation A reporting is the type of reporting that you are required to do if you do a Regulation A+ offering, that 50 million dollar IPO offering. It is a scaled down version of Exchange Act reporting. You do annual report, semi-annual report and you do have some current reporting required. You do have to have audited financial statements that are audited in accordance with GAAP. You don’t have to have an auditor that is a PCAOB member, although most auditors in this area would be. There are a lot of PCAOB certified auditors in US. Still, there is a significant expense in this but nowhere near the expense of Section 12 of the Exchange Act.
There is a little bit of a fishbowl effect when companies do go into this type of reporting regime, it can be an awakening. They have to give an insight of what their board of directors is discussing, what their financial plans are for the next quarter, you have to kind of live in that fishbowl. So if you feel that you are a company that is better off privately pursuing its business, not letting competitors and others know that much about what they are doing, you may not want to step up to this level.
Then, when you get below this level of reporting, there is something called a manual exemption. It is now maintained by a company called Mergent. It used to be maintained by Standard & Poor’s, which lists companies subscribed to it and they list information in it. This information is enough for a broker dealer to make the market of a stock, it is typically enough to trade on the OTC and it also exempts you from blue sky regulation in 39 states. You can pretty much have a national market in your stock if you are complying with the manual exemption.
Then there is something we could call an Alternate Reporting Standard for the OTC and other ATSs. The OTC has its own reporting standard, which is somewhat less than Regulation A reporting standard that you can comply with to be on the OTC and they police it if you are on the OTCQX. Each of these emerging ATSs, whether it’s TZERO or ATS that is going to be developed by coinbased or security tokens, they will have an information standard that you have to maintain in order to stay on them. We don’t quite know what they are now, but they will be somewhere in this middle area.
The absolute minimum is what’s called the 15C211. This is a broker rule and it says that a broker is not supposed to quote a price or make a market in a stock unless it has this minimum level of information. It is really minimal. It’s the name of the company, of its directors, disclosure about who owns the company, the most recent financial statement that doesn’t need t be audited, it doesn’t even need to be GAAP, it can be done in accordance with the Income Tax Common Reporting Standard. That’s the bare minimum.
If you do not meet that minimum you should not be recommended by brokers to investors and the broker shouldn’t be making the market in this stock. By design and by regulation, Regulation A+ reporting which you have to do when you do Regulation A+ reporting, complies with 15C211. You will always be safe if you are compliant.
Michael: We wanted to mention the Exchange Act registration that can happen to a company through the back door or almost by accident, at least for to those who are not paying attention.
Way back in the slides we described the federal disclosure standard, compared it to the state blue sky disclosure standard versus subjective government judgment standard in some states. The two primary US securities laws that were mentioned on that slide are the Securities Act of 1933 which regulates what are considered primary transactions. That’s when the token or security issuer makes the initial sale of its investment opportunity to its first purchasers.
Then there is the Securities Exchange Act, the second act, and as its title suggests, it is involved in focusing on secondary transactions which are resales by an initial purchaser to a subsequent purchaser and by subsequent purchasers to subsequent purchasers.
The exchanges, as has Charles indicated, these are the mechanisms by which willing sellers, who previously purchased, are trying to find willing buyers to repurchase these securities or tokens from those upstream purchasers.
The Exchange Act is intended to govern most of those kinds of resales that do not involve the issuer directly receiving money for its initial sale of its investment opportunities, its tokens. The Exchange Act requires registration by those companies that wish to be registered in order to facilitate these secondary transactions, thereby enabling their investors to buy and sell and that can have a significant upside impact on the company as well as encouraging investors to buy the investment opportunities of those companies, because they know that there is going to be a market where they can dispose of them when they wish for a reasonable price.
However, some companies are not paying attention and believe that Exchange Act registration, getting into this system where the government regulates these transactions is something they may not be looking to do initially and perhaps not even at all, but the law say that if the company gets to a certain large enough size, then the company has no choice. It can no longer not be registered under the Exchange Act. Instead, it’s going to go ahead and accept a registration obligation and get itself listed on an exchange.
Essentially to take on these informational reporting obligations that Charles has described, which of course take time, money, involve a lot of additional complexity and work and all things being the same, company would rather not have to do it until it really knew it wanted to and had assessed the benefits outweigh the cost.
If a token issuer issues his tokens under the Regulation A exemption for crowdfunding, it doesn’t have to register under the Exchange Act until its total assets reach 75 million dollars. There is a two year phase so there is planning in advance of need, but companies need to be aware of the fact that the obligation will arise when they have sufficiently large amount of people engaged in holding their investment opportunity. This includes subsequent repurchasers of an investment that that is likely to be much more fractionalized than the old fashion shares or bonds.
The whole point of blockchain is to facilitate actualization and selling of smaller and smaller increments of an investment opportunity. Under that logic it is very realistic that a company could quickly become subject to a registration obligation under the Exchange Act. The very nature of blockchain issued securities would be to facilitate larger and larger ownership.
Companies need to keep aware of whether or not Exchange Act registration is going to become an obligation and in certain cases whether or not they wish to pursue an allowable, if it is at the time, transfer of what they initially issued as a security token to a utility token when and if the SEC allows a recognition that something was initially issued as an investment opportunity and a security token could be transferred into a utility token. In a sense you’d be taking these tokens off the desk, as far as counting them toward the registration obligation requirement, and obviously you would be putting off that obligation for a longer period of time by being able to convert them if you can to utility tokens.
A lot of companies do this because of this next slide, the blue sky woes. Not only do they need to be worried about federal compliance, they also need to worry about state compliance. The states for the most part like to follow the federal example, but they need to be watched to see if they have an independent obligation that the company needs to honor, which again will likely involve not an impossible task, but additional cost and effort. They need to factor this into their planning.
How ATSs may function with that and why they may enable companies to find additional exemption, which they are not automatically exempted by, we are in the state of flux as ATSs for crypto get clarified. The possibility that we discussed at the end of this slide is something where we hope the industry ends up and where people in the industry will be agitating to encourage the government to acknowledge that ATSs traded tokens may allow for a lighter registration obligation. Again, this is in the future, it is in significant flux at the moment and we wanted to call it into your attention as a cautionary note.
Charles, what about these token trading systems as the new frontier?
Charles: I’m going to try to touch on these last slides quickly so we have a little bit of time for questions.
Currently, there is no ATS that is authorized to trade blockchain assets. No one can tell you that you have token security that you are issuing today that you will be able to list with them, have them freely tradable on ATS and have the token exist in definitive form on the blockchain.
It is possible to put your blockchain assets into a depository of them trading through receipts or derivatively on an exchange, but that’s not really bringing you the full advantage of the blockchain. People want it to be blockchain top to bottom and we don’t have yet anyone authorized to do that.
We have a couple of possibilities that are supposed to come onto the market very soon, within a matter of weeks or months. TZERO is probably known and is being launched by overstock.com and they’ve been very aggressive in merging or acquiring other market actors to try to put together a solution for people to queue and then trade blockchain assets that are securities on their market. We understand that they are negotiating with the SEC their ultimate rules that they will have for listing.
Coinbase made an announcement a couple of weeks ago that they have been approved by SEC and then had to issue a retraction that nothing had been approved by the SEC, because the SEC does not technically give approval to ATSs. We know they are very close as well from those announcements.
Bittrex has said that they are in dialogue, Kraken say they may pursue an exchange.
These are going to be out there, it’s hard to give comfort to people issuing security tokens today that these will definitely be there in a month or two, when they want them to be, but we do believe they will be out there soon. The SEC doesn’t really want to stand in the way of these, they are just looking for the proper mechanisms to allow for investor protection.
Going back to our discussion of information, we don’t know what the information requirements will be. It will have to be something tailored to blockchain assets and it will have to be at least in conformance with 15C211. How much more will they require in terms of information we do not know.
One of the things holding up the development of these ATSs is they require a kind of an ecosystem of their own to operate. An ATS, the securities on them, have to be transferred by a blockchain transfer agent that’s registered with the SEC. Currently, no registered SEC transfer agent has established a blockchain mechanism for recording securities and definitive form on the blockchain. I think there has been one experiment offering that has been done that way and a lot of the more digitized transfer agents are working towards this. Right now there isn’t a transfer agent that could handle a blockchain asset for one of these ATSs.
Then, tokenized securities developers, Polymath is one of the best known, they are working on developing a protocol for the securitized tokens that will give you everything you need to have in additional security but handled through smart contracts under a token protocol. So payment of dividends, establishing a dividend voting and voting dates, obtaining tax information when it’s pass-through entity like a lead share that needs to have tax information. All of these need to be automated and these tokenized security developers are working on that and are also supposed to go live soon.
Michael: To start our conclusion, these are the paths to liquidity, security tokens that are currently available, there is the Reg A, Reg A+ qualification. Such tokens are immediately liquid if issued under Reg A or of course if registered as an IPO under the Securities Act.
If an ICO is conducted under Regulation D by contrast, to accredited members only, keep in mind that those securities are subject to a one year lockup unless some other avenue can be found. It is a difficult task to accomplish, but one opportunity could be to conduct offering outside of the US and list it on an exchange that excludes US investors and inside the US purchasers could be able to resell on an offshore exchange. Finally there is the option of conducting a Reg D accredited investor only offering, but again, ordinarily requires a one year holding period after purchase, but follow it with Regulation A+ and include some of those tokens issued under prior Reg D in the Reg A+, in order to secure through the qualification process the liquidity the A+ ordinarily conveys, but there can be traps and pitfalls for the unwary. You need to consult closely with experienced securities council to make sure you avoid those traps. But, it is an avenue that if properly drafted, could be taken.
Charles: Just as a last point of view, a lot of companies that are already public have been announcing blockchain initiatives and they’ve been subject to a specific SEC scrutiny and enforcement action. If you are already public and you are announcing that you are going to be issuing a coin, you have to be careful how you announce it.
Particularly companies adding blockchain to their name and experience the spike in their stock price as a result of that have been whacked by the regulators. It’s a bit of a dilemma, because if you’re making material expenditures or doing things to move into the blockchain, you are required to report some of that to the public.
You just have to be careful to only report steps that you’ve actually taken and provide cautionary language about all the uncertainty related to those steps, so that you are not seen as unjustifiably hyping your stock and trying to increase your value based on something speculative.
Michael: One last cautionary note, the presale term, people seem to think there is something magical and mystical about sticking the term presale onto tokens or coins that they are actually selling.
Remember that under US law substance governs over form, it doesn’t matter if you call it a presale, if in fact what you are doing is selling an investment opportunity to investors. To American investors it needs to be compliant with the US securities law even for almost every presale that is an investment opportunity.
There is nothing magical that gets you out by just attaching a label “presale” to what is otherwise a sale of an investment opportunity regulated by the US securities laws.
Katipult: That was really good, thank you. Is there a concurrent oversight with CFTC?
Charles: I wouldn’t call it concurrent oversight, there is obviously coordination between SEC and CFTC. CFTC is Commodity Futures Trading Commission and if you are deemed to be a coin or a cryptocurrency, not a security, and you fall outside of the SEC regulation, it doesn’t mean you are completely outside regulation.
First you are considered a commodity and that means that any derivative, like future interest in it, is going to be under the FTC and it has to be traded on a CFTC registered exchange, like the Chicago Board of Trade.
We are starting to see Bitcoin futures and similar derivatives based on cryptocurrencies and coins traded on CFTC registered exchange.
It is possible to be under both a security and a commodity with the concept that you may originally go out as a security and evolve into not a security, there may be reasons to have joint oversight, but I think basically at this point you basically fall under one regulatory scheme or the other.
And just to know, even if you are selling a definitive Bitcoin or cryptocurrency not a derivative, there is still some regulation. You fall under the US FTC, Federal Trade Commission.
If you are not delivering something you said you would deliver or if the coin people get is not what it was advertised, you can fall into regulation as well.
I want to take this opportunity to thank you guys and I just have one small question here. Since you guys have been in business for so long, how did you find the transition of going into the digital world, with all these regulations and them translating into the digital world?
Charles: The way it worked, the frustration really is that the regulators, particularly the SEC, did not want to develop a new paradigm. They wanted to fit everything into the existing paradigm.
In one way it makes it easier for us as securities lawyers because everything has to fit in the same categories we have been dealing with for the last ten – twenty years, but it is hard because the regulation we have just spoken of are not a good fit for a true cryptocurrency, a true coin.
We are looking for more guidance from SEC. we can tell people when they are definitely coloring outside the lines that need to worry about enforcement, and we wish we could give people more clear guidance.
Michael: This is an area where there is an awful lot of change and it is happening even as we speak. That always makes folks nervous, but at the same time it is undeniably the case, that even here in the US, there are more avenues than ever before for businesses to raise money through these kinds of alternative financing mechanisms, whether it’s investment immigration or it is investment crowdfunding or it’s crypto, the coin technology, the blockchain technology driven issuers, there are more avenues for legally raising capital for both wealthy, accredited investors and more middle class or retail, the unaccredited investors, not only here in the US, but internationally as well that it has been ever before. So, while there is an industry in flux and while we are relying on the 80% same-old same-old, the way it always used to be and we worry about the 20% that is unique about this particular area, it is a very exciting place to be. Not only for us professionals trying to help businesses, but also the businesses themselves, trying to raise capital from investors, and finding a bigger pool of excited and interested investors then ever before, because those investors themselves have an opportunity to accomplish from this investment what they want, which is not only appreciation of their investment, but the opportunity to sell that investment and reap the benefits of that in a realistic term rather than waiting until someone passes and it goes to somebody else. It is an exciting place for us to be in and it is a place where business can actually accomplish its goals.
Katipult: Thanks very much for those answers. With that said, I think we are actually over time now. Last question came in now, do you have a minute or two more?
Katipult: Is there any risk in explaining secondary market’s works to investors?
Charles: Yes. Because of the early stage and the fact that, for example, there aren’t currently ATSs that can trade blockchain assets in definitive form available, there is going to be a certain amount of speculation as to the aftermarket that your investors have. Whenever you have restrictions on the security you are issuing, you have to have it in the offering documents. Warn people that they may not have the liquidity and that they may not have it for a long time. Anything that you promise them in terms of trying to list on it, we see this in a lot of offerings now where they say, when these changes are available, we intend to list on them. You have to accompany that with a lot of cautionary language, because they are not available yet and there is risk involved. If you warn people to the maximum, that you may have to hold onto these securities for a long time, that you may lose all of their money, they may never be saleable, that we are going to try to follow this other path but there are no other assurances, that should ameliorate a lot of the risk telling investors about secondary market opportunities.
Michael: Very true.
Katipult: Thank very much, with that I think we can say thank you very much to Charles and Michael. Thank you for joining and thank you for helping me educate anyone who joined here and anyone who is going to listen to this afterwards about rules and regulations regarding secondary market. It has been a really interesting hour we have here, I definitely learned a lot and there is a lot more I can learn, so we are going to continue with these webinar sessions. I’m going to talk to you guys what we can bring to the audience next time. Thank you very much and everyone have a good day.