2018 has been a tumultuous year on the regulatory front for the blockchain industry.
The year began with news that the SEC had issued dozens of subpoenas for blockchain startups that had issued unregistered token offerings, spreading alarm throughout the crypto world. These investigations have recently resulted in penalties, mandatory securities offering registrations and in some cases reimbursement to investors, for a few blockchain companies.
SEC Director William Hinman issued informal guidelines that bitcoin and ether were not securities because those networks had become “sufficiently decentralized.” Now, as the year winds to a close, we hear that the SEC will issue “plain English” guidance on the security token analysis as soon as early 2019.
In this uncertain regulatory environment, most blockchain startups contemplating token offerings are steering away from the public crypto markets and venturing into the brave new world of security token offerings. The buzz on the street is that “STOs” may be the next big wave for blockchain fundraising.
However, many blockchain startups initially planned their business model around what they perceived to be a utility token – a software license to use the token on a platform, often as the currency to pay for services or earn rewards in a digital marketplace powered by a blockchain.
As these start-ups shift their plans from doing ICOs toward the regulatory landscape of STOs instead, the biggest question is whether the STO is going to be the panacea everyone is looking for: what unresolved legal issues for STOs do we confront in 2019? What cutting edge issues are currently boggling the minds of securities attorneys as they begin to execute these STOs?
Using Security Tokens on a Blockchain
Most STOs that are currently being initiated are private placement securities offerings to accredited investors.
However, the private placement poses a number of unresolved problems for blockchain companies wishing to use the tokens on their platforms. These issues will have to be analyzed carefully under the facts and circumstances of each blockchain platform, but some general considerations include:
- Accreditation: Will the accredited status of investors have to be checked every time that the platform issues tokens, even where the tokens are being issued as rewards earned on the platform?
- One-Year Lockup: Will initial token users have to hold the tokens for a year each time they earn tokens on the platform before using them for functional purposes on the platform such as paying for services?
- State Issuer Dealer Registration: Will blockchain companies have to register as issuer dealers with several states that have such requirements before they can transact in their own securities on their platform? The American Bar Association published a useful article on state issuer dealer registration laws. Although these issuer dealer laws usually affect primarily public offerings of securities rather than private placements, a different novel question is presented by blockchain platforms that deal in their own securities on an ongoing basis after initial issuance.
- Registration as an Alternative Trading System (“ATS”): If the blockchain platform is acting as a marketplace to bring together sellers and purchasers of security tokens, at what point does it need to register as an ATS? The SEC has yet to issue clear guidance regarding the circumstances under which a blockchain platform dealing in security tokens would be regarded as a securities “exchange,” particularly in difficult cases where the platform does not call itself an exchange of any kind.
Brave New Frontier of Reg A+ STOs
For blockchain companies that intended their tokens to be sold to the general public rather than accredited investors, without resale restrictions, all eyes are on the backlog of exempt public security offerings, or Regulation A+ STOs, currently sitting with the SEC awaiting approval.
Although blockchain companies that have filed Form 1-As under Regulation A+ generally regard their discussions with the SEC as confidential, the grapevine has relayed that there are currently unresolved obstacles to SEC compliance for these offerings. Hopefully in 2019, we’ll see the first qualifications of Reg A+ STOs and the exempt public securities offering will no longer be considered an “experimental” area.
Problems for Secondary Trading
Once hurdles with regard to federal securities laws on resales are cleared, blockchain companies will have to figure out some way to comply with state Blue Sky laws regarding secondary trading.
Each state offers a set of exemptions under which secondary trading may take place, with many states offering an “unsolicited brokerage transactions” exemption. 2019 will be the year when issues regarding state securities laws on secondary trading must be resolved.
Conclusion: Looking Ahead
2019 promises to be an exciting and eventful year for security token offerings.
For the first time, the blockchain industry will figure out if there is a way forward from the SEC’s informal guidance that most token offerings will have to be registered or issued under an exemption from registration. Furthermore, a wild card has been thrown into the regulatory mix with the recent introduction of a new bill amending the Securities Act to define cryptocurrencies as not being securities so long as they are utilized on a functioning network.
It is far from clear that STOs will provide an easy solution for blockchain start-ups that planned a utility token model and are now steering clear of the public crypto markets, but undoubtedly securities attorneys will throw in their best efforts to resolve these issues.
Startup Arca Seeks SEC Approval for US Treasury Bond-Backed Stablecoin
Arca is seeking regulatory approval to sell a new type of stablecoin to retail investors.
The Los Angeles-based digital asset manager filed a prospectus with the Securities and Exchange Commission (SEC) Friday for a bond fund whose shares would be tokenized on the ethereum blockchain. Arca hopes the SEC will approve the product later this year, a spokesperson said.
The Arca U.S. Treasury Fund would be available to the general public, but not traded on any stock exchange or alternative trading system, according to the filing.
However, shares in the fund (referred to as “Arca UST Coins”) would be represented as ERC-20 tokens, which run on top of ethereum. And Arca is framing the product as a form of stablecoin, or cryptocurrency designed to maintain parity with a traditional asset like the U.S. dollar, although the company cautioned that it may be slightly less stable than other such products on the market.
The minimum investment in the fund would be $1,000, with a target net asset value (NAV) of $1 per share. At least 80 percent of the fund would be invested in U.S. Treasury securities, with the rest in debt issued by various public or private entities inside and outside the U.S.
“It is therefore anticipated that the underlying portfolio, and the NAV of Arca UST Coins, will have relatively little volatility,” the document says. “Accordingly, although holders of Arca UST Coins could experience greater NAV volatility compared to typical stablecoins, such volatility will be relatively limited.”
Investors would receive quarterly dividends from the interest payments, according to the prospectus, although the fund’s “investment objective is to seek maximum total return consistent with preservation of capital.” In other words, stable value rather than big profits.
To buy shares from the fund or from another investor, traders “must first establish a wallet address through the Arca application and ensure that it is whitelisted with the Transfer Agent,” according to the prospectus. “Once an investor’s wallet address is whitelisted, the investor can use the Arca application to transfer money from a linked bank account to the Fund in return for shares of the Fund.”
It is not clear how many of these purportedly dollar-pegged tokens Arca aims to sell; the prospectus says the offering would need to raise $25 million for the fund to have viable operations.
Arca is not to be confused with NYSE Arca, one of several firms seeking to launch a bitcoin exchange-traded fund (ETF) in the U.S.
The SEC Just Released Its Long-Awaited Crypto Token Guidance
The U.S. Securities and Exchange Commission (SEC) has published fresh regulatory guidance for token issuers, nearly half a year in the making.
The guidance focuses on tokens and outlines how and when these cryptocurrencies may fall under a securities classification, according to the document.
SEC Director of Corporation Finance William Hinman first revealed that the regulator was developing new guidance for crypto tokens last November, and other members of the agency, including FinHub head Valerie Szczepanik and Commissioner Hester Peirce, have repeatedly said that SEC staff was working on the document.
In November, Hinman said the “plain English” guidance would help token issuers easily determine whether or not their cryptocurrency would qualify as a security offering.
The guidance includes examples of both networks and tokens that fall under securities laws, as well as a project which does not.
The framework itself outlines a number of factors that token issuers must consider before evaluating whether or not their offerings qualify as securities. These factors include an expectation of profit, whether a single or at least central group of entities are responsible for specific tasks within the network, and whether a group is creating or supporting a market for a digital asset.
Referencing the oft-cited Howey test, the guidance highlights “reliance on the efforts of others,” reasonable expectation of profits, how developed the network is, what the tokens’ use cases might be, whether there is a correlation between a token’s purchase price and its market price and a host of other factors.
The guidance also details how issuers should look at tokens previously sold, both in evaluating whether they should have been registered as securities, as well as whether “a digital asset previously sold as a security should be reevaluated.”
The criteria for this reevaluation include whether:
- The “distributed ledger network and digital asset are fully developed and operational” (meaning individuals can immediately use the token for some function);
- The token is focused on a specific use case rather then speculation;
- “Prospects for appreciation” in the token’s value are limited; and
- If billed as a currency, the token actually operates as a store of value.
While this guidance has been a long time coming, and provides some legal clarity for token issuers, it is not a legally binding document, and should be seen more as a guideline.
Peirce has said in the past that staff-issued guidance does not carry the weight that guidance issued by the Commissioners would.
Speaking at New York University in March, Peirce explained:
“Now staff guidance is staff guidance. The Commission can go ahead and bring enforcement actions anyway but staff guidance does carry a bit of weight, but I would like to do something more formal at the Commission level so people have a little bit more certainty.”
While the guidance discusses securities classifications, other questions remain unanswered. In particular, the SEC has yet to provide clarity around the idea of custody for broker-dealers holding cryptocurrencies.
The key issue around custody comes from the fact that while broker-dealers can easily verify that cryptocurrencies in any given wallet belong to them, it is harder to prove that no one else has access to the holdings.
Szczepanik said during a panel at the D.C. Blockchain Summit in March that these firms “need to show that they have possession and control and that could be hard to demonstrate with a digital asset.”
“A digital asset … is controlled by whoever possesses the private key, and it’s hard to prove a negative,” she explained.
Also Wednesday, the SEC issued its first-ever no-action letter authorizing a startup’s token sale to go forward (full story here).
Read the full guidance here:
Read the full guidance here:
DLT Framework by CoinDesk on Scrib