This is the second part of our webinar covering crowdfunding law in the US. Once again we are joined by one of the leading experts in crowdfunding law in the US to present you with actionable tips on how to navigate the complex US crowdfunding regulations.
This webinar, will help you learn all about the regulations around investment crowdfunding in the US including the critical changes between different pieces of legislation such as:
- Who is allowed to invest and how much money can be raised
- Whether Internet portals can be used
- How much each investor can invest
- The degree of SEC oversight
- Whether foreign companies can participate
- What should you use for token sales
- What regulations are best suited for specific industry sectors and funds vs. individual offers
- What should you use if you want to enable secondary trading capabilities to your investors
Watch the full video here:
Read the full webinar transcript here:
Katipult: Welcome back Mark and for everyone listening in. this is Brian from Katipult. Another webinar and we are going to continue where we left off two weeks ago where we got some technical issues, so we are just going to take it from there. Mark, welcome.
Mark: Thank you very much. I’m sure your audience has gone sleepless sitting next to their computers, waiting for the continuation of this webinar.
Katipult: I am sure they did. Short introductions again. I know last time you said it was sunny and clear day when you were born, but besides that, a short introduction?
Mark: Sure, yes. My name is Mark Roderick and I am a partner in a law firm called Flaster Greenberg and I do crowdfunding. That’s all I do 127% of my time. I’ve been doing crowdfunding since Brian was born. No, that’s not true, but since crowdfunding began. I do nothing but crowdfunding of every kind and description. That’s my brief bio.
Katipult: Perfect, thanks a lot. We had technical difficulties last time as soon as we started going into securities tokens, or just tokens in general. The questions was what can you actually do with these tokens within regulations. I know we introduced last time titles 2,3 and 4. What should you be thinking about before you want to do a toke sale, for example, or a security token versus utility token? Can you share some thoughts about that?
Mark: Sure. I remember using this example, but I will reintroduce it. The distinctions between security tokens is, and I might be repeating information other guests have already talked about and repeating what many of you listeners already know, but at the risk of doing so, my favorite example that I always use, the metaphor is, I’m going to create a chain of movie theaters and I need to raise money. The traditional way to raise money would be to sell stock in my company or in my limited liability company. Investors who now own a part of my company and I are now going to try and build a chain of theaters. Another way to do it is to raise money from future movie goers by selling little blue tickets that you use to get into a theater. There is nothing magical about those tickets. When you buy one it just means that at some future date, if and when we build our theater network, you will be able to see a movie. So, on the one had we have stock, on the other hand we have little blue tickets. That is the difference between a security token. Those little blue tickets are utility tokens. All they do is get me admission to something. Although everybody in the crypto world like to think about themselves as having invented something that has never been seen before on earth, in fact utility tokens have been around for forever. Those little blue tickets weren’t called utility tokens, but they could have been sold in 1922. Exactly the same idea as the most sophisticated high-tech utility tokens being sold today. They just get you admission to something, whether that is admission to storing your files on a super cool blockchain or admission to anything else. They are just really prepaid revenue. That is what a true utility token is and those little blue theater tickets have never been regulated by the SEC. They were not regulated in 1922, they are not regulated today. They are not securities, they are just prepaid revenue items, therefore, if today you want to create a company and maybe it is a blockchain company and you want to sell something that is really a little blue ticket, you can do it without regulation from the SEC and more important without using someone like me. However, very early on in the blockchain world it became apparent that people were selling things that purported to be little blue tickets, purported to be little blue security token, but were not. They would sell them and instead of selling the ticket to a movie going audience saying “Hey, this will get you admission to the theater once it’s built”, they sold them to investors with the promise or the expectation at least, that this little blue movie ticket would increase in value. In fact, it might become super valuable. Buy a roll of tickets and get rich, they would either say or imply. It’s at that point that, what was a utility token - a little blue ticket, was converted into a security. I am not going to spend very much time at all talking about that distinction, but I did want to make a distinction. On one hand you sell something that gets you an admission into the theater – that’s utility token. On the other hand if you sell something that investors buy for appreciation to increase their wealth, that is a security that is going to be regulated by the SEC and in this very fast changing life of the blockchain world, what has now happened actually is most companies have converted from selling little blue tickets and pretending that they were not securities to selling what is in reality just shares of stock that happen to be kept track of on the blockchain and they call those security tokens. In any case, for purposes of this discussion, anything that is marketed and sold as an investment is going to be regulated as such by the SEC. we have seen a number of enforcement actions directed against companies that sort of blinded themselves to that reality. They were selling rolls of little blue movie tickets, but they weren’t selling them to movie goers and they were selling them with the expectation of investment and profits. That moved them into securities law world and that drew attention of the SEC. the distinction between securities and utility token was very intense for maybe two or three months. Today virtually anyone who calls me is resigned to selling a security and, in fact, they are eager to sell a security. The industry seems to be moving back to more traditional stocks and bonds kind of world, although with everything tokenized and on the blockchain. Now it is almost never an issue where everyone is raising money selling securities and therefore we are all within this normal securities law paradox. That was a long answer wasn’t it?
Katipult: It’s really good. Essentially if I’m an investor, I’m going to invest in tokens and they are promising a return on it but they are calling it utility token, then I should definitely stay off that and wait for someone that has securities tokens?
Mark: Yes. Someone who tells you they are selling a token today that is not a security, that is going to raise your eyebrows because there just aren’t any of those sold out there right now. Well that’s probably not true, there are probably some.
Katipult: Someone I talked to recently asked a question about investing in cryptocurrency. Are there any specific rules around that or is it just the same rules as when you’re investing in traditional securities?
Mark: This is another situation. I said that we in the crypto world think of ourselves as doing all these brand new things, but there are not many brand new things that can actually be done. Investing with cryptocurrency is like investing with any other property. Cryptocurrency is property. Why does that matter? It matters mostly for tax purposes. It is a surprise to many people that, let’s say I bought Bitcoin when It was $1000 and now it is $6500. I own a whole bunch of it, I own $100 000 worth and I want to invest in a real estate project. I make my investment and what happens next, because real estate developer needs dollars to pay employees and to buy the land, the immediately developer converts that cryptocurrency into dollars and that event is a taxable event. I, as the one who contributed that appreciated property, the way the complicated US tax laws work, I have to immediately have to pay tax on my gain and that comes as a surprise to many crypto investors. Making an investment with crypto is no different than: I own some rental real estate that I bought low and is now worth a lot of money, I can use that to pay for an investment, but what’s going to happen is when I use it, the person who gets it is going to sell that real estate to get cash and I am going to be taxable on that sale. That’s basically how it works, it is no different than using any other appreciated property.
Katipult: OK, so with the example of buying a coin when it was $1000 and not it is $6500, I need to pay tax on the difference between that, when the developer converts it into cash?
Mark: That’s correct. It is becoming a little mainstream now, there are some companies that are accepting cryptocurrencies, probably not all, probably just Ether and Bitcoin, as investments, which is probably a good strategy because there are a lot of folks out there holding cryptocurrency a little bit nervously and who would like to unload it on a more stable investment. It is becoming possible, there are of course transaction costs involved. You own the crypto, it is not exactly a super efficient market. You may think it is worth $6500. By the time it gets converted and somebody, you, pays those conversion fees and so forth, that $6500 might end up being a lot lower. That’s a risk of holding cryptocurrencies in general.
Katipult: What if you are using foreign currency? In this case non US dollars.
Mark: Great question. Same concept. Now, the price fluctuations are likely to be negligible. It depends, if I am a US citizen and I bought Canadian dollars a long time ago and I am still holding them, I am probably holding them at a loss, because the Canadian dollar has dropped. I can actually a taxable loss on that investment. Most currencies are relatively stable to one another, nothing like the volatility that we have seen in the crypto markets.
Katipult: That was a good answer, I was not actually aware that he needed to pay tax on that, so that’s useful. If we go into secondary trading I know this can happen without blockchain and without tokenizing anything, but if you are going to a market where you want to add a secondary market to your platform for example, so you have your primary market which is going well but you want to give the investors the opportunity to have others buy their tokens or shares for example. Which regulations should I look to if I wanted to do something like that?
Mark: That is a great question and it is a pretty big question. Let me start by making the distinction again between tokens that are little blue tickets and tokens that are securities. Tokens that are truly little blue tickets aren’t securities and therefore could be completely unregulated. You could right now create an exchange of little blue tickets from different movie theater chains and that would be an unregulated market. You can do that however you wanted. You can also think of a timeshare market. There is a secondary market for timeshares completely unregulated. Timeshares are not securities. But the world you and I live in is the world of securities. Because most tokens these days are securities I’m going to answer the question talking about security tokens. I don’t need to hyphenate that, we’ll just call it securities. The first point I’ll make, there is nothing new about exchanges for securities tokens. This is very, very frequently misunderstood, I get this question so many times from people calling. They will say “Well, this is a security but I want to tokenize it so it will be freely tradable”. Legally that is a complete non sequitur. A security that happens to be a token is subject to precisely the same rules on secondary trading as a security that is a 50 years old, dog-eared, coffee stained share of stock sitting in someone file cabinet. There are no special rules for secondary trading of securities just because they happen to be tokens. It’s exactly the same rules. Now just in a parenthesis, I will say because some of your listeners are probably saying “That’s not right, that’s not right”, the parenthesis is from a practical, mechanical perspective. Yes, anything that is kept track on a blockchain is easier to keep track of. It is easier from terms of functionality to have a secondary market of tokens than it is to have a secondary market of 52-year old pieces of paper. Yes, that is true, it is easier functionally, practically, but legally they are identical. The same set of rules, and those rules generally provide that for private securities, and most token securities are sold in private offering, The general rule, and I am going to oversimplify so don’t get mad at me, is you generally have to own them one year and then they are freely tradable under what we refer to in the US as the SEC rule 144. They are freely tradable and always have been. Private securities have always been freely tradable. The same rule applies to security tokens. Now, how many calls has Katipult received in the last 12 months from people wanting to establish a public exchange for security tokens? I bet that number is higher than 25.
Katipult: Yes, that’s correct.
Mark: Everyone wants to establish an exchange for security tokes and many people believe they were the first ones to think of an idea. The thing is, it is hard to have an exchange for privately held securities. Those exchanges have been legal for many decades and yet how many such private exchanges are there? There are a couple and why are there so few and why do they do such limited volume relatively speaking? The answer has nothing to do with the law. It’s that a privately held security is something that very few people want to buy. It is like trying to sell your timeshare. Again, to go back to that market, very inefficient market. Market by definition, a private security, there is no current information about it, there is no current representation about it. It is just a very hard thing to sell. All the people wanting to establish an exchange for security tokens at some point have to face this economic issue, not a legal issue that private securities are just a tough sell. Now hopefully, the economic desirability if having a secondary market will have a ripple effect so issuers of security tokens will provide more of the kinds of information that public issuers of securities provide in order to make their securities more saleable on a secondary market. But that is speculation on my part. The general rules it that these thing are saleable as they always have been. To create a secondary market in the US you need a broker dealer involved. The broker dealer has to create something called an alternative trading system or ATS. Not a huge deal to do that, one has to register with the SEC and that is all very possible, it is not all that expensive. It’s really not the legal hurdles, it is how do we get people to list their securities here and more importantly, how do we get people to buy them?
Katipult: That is very interesting. When I talk to people, not only in the secondary market but also to someone who is interested in stuff like this, it is always the whole liquidity that you are providing your investors, your whole selling point for creating a secondary market.
Mark: Yes. That’s kind of little bit of fiction around the blockchain world, that simply because the security is tokenized it is going to have more liquidity. As they say, we will see about that. It is not immediately obvious to me that there will be significantly more liquidity for privately owned security tokens than there is for privately owned real estate limited partnership interests. But, we’ll see.
Katipult: Yeah, it is definitely an interesting view that you are bringing here. Everyone is just talking about liquidity and not really being critical around this, so I like that you are bringing that to the table as well.
Mark: I hate to be the downer. In the crypto world it can seem almost cultish, some of the degree of optimism and how we are changing the world and how everything is going to be different, so if you just make some practical observations it can sound very negative. I don’t want to sound negative, I do believe that blockchain is a super important technology. I do believe that it is not going to be long before all securities are tokenized. There is just no reason not to sell once the cost of the technology comes down, which inevitably it will. There is no reason to sell securities that aren’t tokenized. It just won’t seem that big of a deal when t happens. There was a time when spreadsheets were brand new. Oh my gosh, we could keep track of things on spreadsheets. Well now, no one sells you a security and says “Guess what Brian, this security is kept track of on Microsoft Excel”. Nobody makes that claim because it’s just standard way to do things and I think that will be true for blockchain securities as well. It is just going to be ”that’s just how things get done”. I am very optimistic about the technology. It is very hard to change the world. Not many things change the world.
Katipult: Sure. I always think when I read up on blockchain and all that, blockchain is at the stage where we got first introduced to internet for example, very, very early stages.
Katipult: At that point, who knew that we could send emails or look at videos, cat pictures or whatever. There are so many options and it’s just interesting to be able to see how this is going to evolve.
Mark: You are absolutely right. You can take any other important technology as well. You can take automobiles, you can take airplanes, both super transformative technologies and you can make a couple of observations. One is that at the beginning of the automobile industry you didn’t know who was going to win, and you didn’t know for quite a long time. most automobile companies went out of business and so did most airplanes companies and so did most internet companies. It’s never a case of “because my company is using this technology that means we are going to be super successful”. There are always going to be winners and losers. The other observations is, we now take all those technologies for granted. We don’t sat “Oh my God, I am going to get to fly an airplane from New York to Toronto, I don’t have to ride a horse anymore. Each evolution we take for granted. You might even go a step further and say “Well, have any of the technologies changed the world fundamentally, how human beings interact with one another?” The internet certainly has significant effect, including some great stuff and some not so great stuff. Anyway, that is a philosophical discussion outside. I get paid more for that kind of observation, Brian… I’m just kidding. It’s probably something your listeners don’t want to hear about.
Katipult: I remember not having a mobile phone. I am that old. Having a piece of paper with all your friends from school numbers on and then just dial the number at home and hope someone is going to pick up. I can relate to that.
Mark: All of us wonder as we are getting emails and calls from work and so forth on Sunday afternoon whether we’re better off or worse off. Blockchain technology will be very transformative. Maybe not in exactly the ways that people believe will be the case today. I’m not saying that I know, I just know that at the beginning of the internet age, I don’t know that anyone or certainly very few people would have predicted exactly how the internet would be transformative and disruptive. That’s the hard thing. Certainly no one was thinking about iPhones back in 1994. I think the blockchain will be the same thing. There’s going to be some super, super cool blockchain application and probably the most successful blockchain company hasn’t been formed yet. That seems like a pretty good bet, which means there are enormous opportunities yet to come.
Katipult: I fully agree. Just so we don’t go into too much discussions, I I think the audience might not be that interested in, otherwise we can set up a webinar for thoughts about the world.
Mark: Yeah, blockchain philosophy.
Katipult: A question I have gotten from one of people I talk to a lot, they are not specifically around blockchain, because it seems like everything that’s on blockchain or tokenizing the same rules apply to data storing for any other security, but that’s really about disputes. How would I actually handle, what consent mechanisms are actually needed for all of that?
Mark: Well, that’s also a great question. I guess there are two answers. One is that disputes involving blockchain are going to be handled the same way other disputes are handled, through error. Tedious, expensive judicial systems. The second answer is, well how do you resolve disputes arising under so called smart contracts? There are companies out there who are building in to smart contracts the opportunity for any party to the smart contract hit the pause button. In other words, the whole idea of smart contracts, the whole benefit of smart contracts is that they are self-executing. This condition is satisfied, this condition is satisfied, this third condition is satisfied, therefore automatically under the smart contract something happens. Money gets transferred, a deed gets transferred, something happens. In my lawyer world, I am not sure I would recall that a contract, that just looks more like a computer program to me. People have acknowledged that “Hey, wait a second, human activity is complicated and even though this condition, this condition and this condition might be satisfied, something we haven’t thought about has also happened or failed to happen and because it has happened or failed to happen that money shouldn’t be transferred after all”. So there are companies out there that have introduced sort of add-ons to smart contracts that allow parties to hit pause and to trigger a dispute resolution process. One, I think it is absolutely necessary because except in the very simplest situations, human activity is very complicated and you are never going to think of everything and therefore you do need a way to halt the operation of the smart contract. It is very useful, necessary even. Two, of course, it calls into question the usefulness of the smart contract in the first place. If it can be stopped at any time and now rather than having the contract self execute we’re in court or in some other dispute resolution form, arbitration or whatever you want to call it, we haven’t accomplished very much by having the contract on the blockchain and referring to it as a smart contract. This is a situation where I think the hype of the blockchain got ahead of the practicality. You are never going to stop human beings from acting like human beings, and this is not a philosophical observation, it is an observation of someone who has been practicing law for a long time. Human beings are complicated creatures, they are self interested and they are greedy at times and very difficult to predict. The idea that technology would eliminate those characteristics of human beings was always going to be proven false pretty quickly. The mechanisms that people are now building into smart contracts to stop the execution and get into a dispute resolution system I think are great and necessary, but there may be a better way. Maybe we shouldn’t really be relying on that smart contract in first place. There are always going to be disputes and if we can figure out a better way to resolve disputes that would be terrific. I am not sure it is a technology solution however. So that’s my answer to your simple question.
Katipult: OK, perfect, thanks. With all this hype with the blockchain and smart contracts and all of that came out, that we are going to have smart contracts on all platforms, but there was still a need for a paper trail that could indicate the dispute and if you need to go to court the judge will probably not be able to read this smart contract. There still needs to be a signed subscription agreement for example. Going to our philosophical webinar, at some point it could be that lawyers and judges in the future would be able to read stuff like that.
Mark: As a practicing lawyer I’ve been doing this for decades and I’ve written hundreds and hundreds, probably thousands of contracts. I always brag that only one contract that I’ve written in my career was ever litigated, so for the most part the contracts have worked. Even though I wrote them, I am not sure I would have ever felt comfortable having them automated, because part of the art of writing a contract is deciding what to include and what not to include. There is a famous saying with engineers building bridges that it’s easy to build a bridge strong enough carry traffic. Any engineer can design a bridge that’s strong enough. The art is designing is designing a bridge that is not too strong, in other words that’s not overbuilt and that’s true when you are designing contracts. Every contract can be 150 pages. The simplest concepts, because you can always think of these things that could in some alternative universe happen and write a paragraph in the concert to deal with it. The art of writing contracts is to think about this situation with these parties at this moment in this industry and decide what is important, what we should deal with and what we shouldn’t deal with. By definition every contract is imperfect because someone was making those decisions and that someone could have been wrong. Something could happen that that person drafting the contract simply anticipate. That doesn’t mean the contract was a bad contract, but it does mean that there always has to be a mechanism to resolve disputes, that’s all.
Katipult: Great answer. I’ve got a question here from the audience. I think it’s going back to Bitcoin. What happens if you purchase goods using Bitcoin? Do you pay capital gains at the point of transaction?
Mark: The answer is yes. A straightforward yes. You have exchanged appreciated property just as if you owned a piece of real estate and used it to buy groceries one day. You go to the grocery store, “Here’s my real estate, here’s the deed to this piece of real estate. I bought it for $10 000, now it’s worth $50 000”. Well, let’s not talk about groceries. Let’s talk about Tesla , a Tesla model 3 and they are going for, let’s say $55 000. So I bought real estate for $30 000, it’s now worth $55 000. I take my deed into Tesla dealership, hand over the deed and drive away in my brand new Tesla. Actually it drives me away possibly. I immediately pay capital gains tax on that $25 000 of appreciation and it’s exactly the same as if I used my Bitcoin that had appreciated from 30 to 55.
Katipult: Maybe now we can go in and talk a bit about, maybe this is going to be a bit specific but, what regulations fit best for certain business models for example? If you have funds versus individual offerings, what regulations would make the most sense?
Mark: As you know, you and I will both be generalizing here because there are always exceptions. Those are actually two great examples for the following reasons: an individual asset versus a fund, and I am going to define a fund as I think you intended as a pool of assets whereas and individual asset might be an apartment building in Austin Texas, a fund might be 30 apartment projects across the south-eastern US. My analogy is individual stocks versus mutual funds in the public stock markets. A small minority of Americans and probably Canadians too but I am more familiar with the Americans, tries to choose individual stocks. The vast majority of Americans prefer mutual funds, as they should. At least I think they should, because very few people have the expertise or the time to evaluate individual stocks. They are better off relying on an expert, meaning a mutual fund manager. That is certainly borne out by the statistics, most people prefer mutual funds to individual stocks. In mind it is exactly the same if we are talking about whether real estate or startup technology companies, very, very few people have the expertise to choose an individual apartment complex. I’ve been representing real estate developers for decades and I don’t think I have that expertise frankly. Most people are better off investing in funds, that is a pool. What that translates to, to answer your question, is that an individual property is probably going to be well suited for plain vanilla rule 506C or rule 506B offering marketed to accredited investors only, because it is likely to be accredited investors who at least believe to have the expertise to choose individual apartment complexes, whereas the fund makes much more sense to conduct an offering under, for example, regulation A, because with regulation A we can now allow non-accredited investors in at low-minimum investment amounts and it is that much larger number, much larger pool of retail non-accredited investors who are going to prefer that fund because, again, using the analogy of the real estate fund to the mutual fund. That is how we typically would advise and how we typically see done individual properties or individual companies as rule 506B or rule 506C offerings and a pool of properties or companies as regulation A offerings. Now, of course there are going to be exceptions. Title 3 is sort of an exception. Title 3 companies tend to be very, very small companies and ideally they are the kinds of companies that the individual investors can understand. One category of title 3 issuer has been breweries, companies that make beer. I am not sure that individual investors actually understand the business model but they understand beer and are eager to invest in a company like that that they know something about. A local restaurant. Restaurants have been pretty successful using title 3. so that is kind of an exception, very small companies that individual investors can understand, maybe that are located in the same town as the investor and the investor wants to support that business. That’s title 3. Outside title 3, the difference to keep in mind is the individual stock picker versus the mutual fund investor.
Katipult: Perfect. I think that leads a bit into my next question or maybe more an observation than a question. Which sectors or which regulations are best fit for some sectors? With title 3 you were mentioning breweries, restaurants, let’s define it in a more broader way – startup companies for example. It is the local community that usually helps you get the funding. For something like that title 3 would be good but for real estate for example, you probably wouldn’t use a title 3 unless it’s a very small raise you are doing, because you have a maximum, right?
Mark: Yes, that’s right. I should mention that there are exceptions to every rule. There is a client of mine called Small Change and they do title 3 real estate. As you might imagine based on your observation they don’t do luxury garden apartment project. They do local community real estate. An example of an offering would be they do these very eco-friendly, community-friendly tiny houses in neighborhoods that have good public transportation and otherwise sort of contribute to the community. They don’t need a lot of money for them. I guess that was to prove that there are exceptions to every rule but in general yes, you are absolutely right.
Katipult: I think with that we hit the time mark of 45 minutes per webinar. We have gone a few minutes over and unless there’s anyone from audience with any really important questions they want answered then I think we should call it for now so people have not a full hour to listen through but 62 minutes. I just want to thank you for joining this webinar. It has been a real pleasure having you on and I hope the audience enjoyed it too.
Mark: Well let’s thank your audience for listening. You and I are excited about the opportunities for crowdfunding. We talked about blockchain as a transformative technology. You and I believe crowdfunding is transformative legal structure that can bring tremendous investment opportunities to the masses and cut out the middleman. I know you and I are aligned in that and we’re excited about it. This is something we do not to just make a living but we’re really excited about it and for the opportunities that it offers, so we want to thank the audience for wanting to learn more.
Katipult: Well put. Again, crowdfunding is not a new invention, it has been going along for a lot of years, but it’s about using new ways. Thank you audience, everyone for listening. Thank you Mark for joining, I hope we can find another topic.
Mark: And thank you for hosting it Brian.
Katipult: It’s been a real pleasure. Next week we have another webinar coming up so you should be getting some invites for that soon. Thank you everyone and hope you enjoy your day and listen to you soon.