My client, Canis Major Incubator, produced this webinar with my assistance.
Securities Law and Cryptocurrencies
(Editor’s Note: This article was written with the invaluable assistance of Mr. Rane Riley, a third-year law student at Southern Methodist University’s Dedman School of Law, my alma mater.)
Anyone paying attention to world news headlines has witnessed the recent meteoric rise in the value of Bitcoin, a cryptocurrency (or virtual currency) increasing in price per unit from approximately $15 in 2013 to approximately $7,000 per unit as of the writing of this article. It does not require a great deal of insight to recognize the significant role that Bitcoin and other similar cryptocurrencies play in our economy, and their significance as a financial medium of exchange should only increase in the future.
On July 25, 2017, the SEC published Release No. 34-81207 (the “DAO Release”) addressing capital formation through the use of a virtual currency (not unlike Bitcoin) called DAO Tokens. The DAO Release takes the unequivocal position that virtual currencies, when used in capital raising ventures, are still securities under the Securities Act of 1933, as amended (the “Securities Act”), and therefore require registration on both the federal and state level (unless valid exemptions from registration apply). Further, the DAO Release clarifies that any platform that facilitates buy/sell orders in virtual currency digital markets must register as a national securities exchange under the Securities Exchange Act of 1934 (the “Exchange Act”) (or operate under a valid exemption from such registration requirement).
In the DAO Release, the SEC described its investigation of The DAO, an unincorporated organization, and Slock.it UG, a German corporation. The DAO was a virtualized decentralized corporation implementing a distributed ledger (blockchain) to raise capital to fund “projects.” The premise of the capital raising was simple. Investors would send to The DAO Ether (ETH), a cryptocurrency not unlike Bitcoin, in exchange for DAO Tokens issued by The DAO. In this transaction, the DAO Tokens served as the securities, and ETH served as the cash to purchase the DAO Token securities. The ETH raised by the issuance of The DAO Tokens would be used to fund “projects” voted on by a majority of the shareholders of The DAO. Before voting could occur, however, the projects had to be approved by “Curators” who were employed by The DAO. The Curators were given great discretion in their approval process and thus took a vast majority of the managerial decisions out of the hands of the shareholders (entities and individuals who held The DAO Tokens).
Investors in The DAO could expect returns on their investment in two ways. First, returns from funded projects could be either distributed back to investors or retained in the investment pool to fund further investment. Second, investors could trade The DAO Tokens on platforms (secondary market) with other investors. As with stock, holding The DAO Tokens allowed investors the right to receive dividends (returns from projects), or trade the stocks on the secondary market (trade the tokens on platforms).
Under the United States federal securities laws, the term “security” is defined in Section 2(a)(1) of the Securities Act as, among other things, “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement . . . [,or] investment contract”. From the definitive US Supreme Court case, SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), an investment contract “is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” The three main requirements of an investment contract are, (1) investment of money in a common enterprise, (2) with a reasonable expectation of profits, (3) solely from the entrepreneurial or managerial efforts of others (partaking in significant managerial decisions fails to meet the third requirement).
In the DAO Release, the SEC concluded that virtual currencies, when used to raise capital, meet the above stated definition of an “investment contract”. In reaching this conclusion, the SEC makes it clear that “[t]he automation of certain functions through this technology, ‘smart contracts’ or computer code, does not remove conduct from the purview of the U.S. federal securities law.”
Because Section 5 of the Securities Act requires all securities to be registered unless a valid exemption exists, as securities, virtual currencies (when used to raise capital) must be registered or must qualify for an exemption. In this case, a virtual organization raised capital by receiving virtual currency and in exchange issued its own virtual currency. The SEC made it clear that, like issuing stock in return for receiving cash, organizations engaging in this type of capital raising will be subject to the Securities Act and the Exchange Act.
Furthermore, the SEC held that platforms that engage in facilitating trades of virtual currencies must register as national securities exchanges or face penalties under the Exchange Act.
As always, each case is different with different facts and circumstances. Before applying the general rule described in the DAO Release, one should look to the particular facts and circumstances of an issuer’s capital-raising activities.
Regulation D Rule 501(a)(8) Inquiry
A potential client asked me whether their LLC would be deemed to be accredited under Regulation D Rule 501(a)(8) (“[a]ny entity in which all of the equity owners are accredited investors”) if the only members of the LLC were the client (an individual) and his mom (also an individual)? His mom qualified as accredited under Rule 501(a)(5) (net worth of at least $1 million (excluding her home)), but the potential client did not. The potential client actually read through Rule 501, however, and keenly noticed Rule 501(a)(4), which rule qualifies any executive officer or director of the “issuer of the securities being offered or sold” as an accredited investor. The client wanted to form the LLC with the client’s mom, serve as the manager of the LLC, invest through the LLC and qualify the LLC as an accredited investor under Rule 501(a)(8).
Here is the answer. If my potential client’s LLC does not qualify as an accredited investor under Rule 501(a)(1) (at least $5 million of total assets), and one of the LLC’s members (i.e., the potential client) qualifies as accredited only under Rule 501(a)(4) (any executive officer or director of the “issuer of the securities being offered or sold”) but not under Rule 501(a)(5) (an individual with a $1 million net worth (excluding value of principal residence) or $200,000 of income ($300,000 with spouse), under the SEC’s Interpretive Release 33-6455, the LLC itself will not qualify as an accredited investor under Rule 501(a)(8) (“[a]ny entity in which all of the equity owners are accredited investors”).
Here is the text of the interpretive release:
Entities Owned By Accredited Investors–Rule 501(a)(8)
Any entity in which each equity owner is an accredited investor . . . is accredited under Rule 501(a)(8).
(24) Question: All but one of the shareholders of a corporation are accredited investors by virtue of net worth or income. The unaccredited shareholder is a director who bought one share of stock in order to comply with a requirement that all directors be shareholders of the corporation. Is the corporation an accredited investor under Rule 501(a)(8)?
Answer: No. Rule 501(a)(8) requires “all of the equity owners” to be accredited investors. The director is an equity owner and is not accredited. Note that the director cannot be accredited under Rule 501(a)(4). That provision extends accreditation to a director of the issuer, not of the investor.
Similar language is included in the SEC’s Division of Corporation Finance Manual of Publicly Available Telephone Interpretations. This answer is saying that Rule 501(a)(4) can make my client an accredited investor with respect to the LLC, but the LLC can’t turn around and say that all of its equity owners are accredited. This is the case because one of the LLC’s owners, my client, is only accredited under Rule 501(a)(4), and “[t]hat provision extends accreditation to [the] director of the issuer [i.e., the LLC], not of the investor [i.e., again, the LLC, but in its role as investor rather than issuer of securities.]
Interestingly, the next question in this interpretive release reads as follows:
(25) Question: Who are the equity owners of a limited partnership?
Answer: The limited partners.
By this reasoning, the general partner would not be deemed to be an equity owner and thus my client could form a limited partnership instead. My client could own an LLC that would serve as the general partner of the partnership, and under this interpretive release, the only equity owners are the limited partners. In that case, as long as the limited partners are accredited, the ownership by my client of an interest in the LLC (as general partner) seems not to disturb the status of the partnership as accredited. Go figure!
Raise $5 Million From Non-Accredited Investors Under Amended Rule 504
On October 26, 2016, the SEC adopted final rules amending Rule 504 of Regulation D under the Securities Act of 1933, as amended (the “Act”). This amendment to Rule 504 was effective January 21, 2017, and the repeal of Rule 505 (described herein) was effective May 22, 2017.
Rule 504 and Rule 505 of Regulation D historically were exemptions from registration for offerings of limited size and character. While Rule 506 allows issuers to sell an unlimited dollar amount of securities to a theoretically unlimited number of investors (as long as they are solely accredited investors), historically, Rule 505 limited offerings to $5 million in any twelve-month period. Rule 505 offerings could be sold, however, subject to restrictions on advertising (or “general solicitation”), to an unlimited number of accredited investors and up to 35 non-accredited investors. Rule 504 had a $1 million limit but there was no limit on the number of investors who could invest, regardless of their status as accredited or non-accredited. While Rule 505 included the expansive disclosure requirements of Rule 502(b) for non-accredited investors, Rule 504 did not include any specific disclosure requirements. Revised Rule 504 The amendments to Rule 504 adopted by the SEC which are now in effect increased the offering limit under Rule 504 from $1 million to $5 million. Following effectiveness of this rule, the SEC has repealed Rule 505. While the dollar limit under Rule 504 has increased, there has been no change in the number of investors permitted in a Rule 504 offering, and the rule itself places no limits on the number of investors (accredited or not). The amendments to Rule 504 also subject issuers to Rule 506(d) bad actor disqualifications, providing additional investor protection.
As a general rule, reporting under the Exchange Act is required once an issuer has 500 investors, or 2,000 if all investors are accredited. Consequently, unless some other limitation applies (such as Section 3(c)(1) of the Investment Company Act of 1940, which limits certain investment funds to 100 investors), issuers relying on Rule 504 who include non-accredited investors will be limited to 500 investors.
Rule 504 is not available to an issuer who is subject to the Exchange Act reporting requirements, investment companies, or development stage companies that either have no specific business plan or purpose or has indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies, or other entity or person.
Rule 504 permits public solicitation of investors only under certain circumstances. General solicitation is allowed when the offering is registered under state law or when the offering is permitted under a state law that allows general solicitation solely to accredited investors.
Coordination with State Blue Sky Laws
The Rule 504 offering exemption does not, however, preempt state blue sky laws as does Rule 506 of Regulation D. Consequently, an issuer relying on Rule 504 must identify corresponding state securities law exemptions for the states where the issuer’s investors reside.
Rule 506(b) Information Delivery Requirements to Non-Accredited Investors
As we know, Regulation D of the United States Securities Act of 1933, as amended (the “Act”), provides exemptions from the Act’s securities registration requirements, most notably, the registration exemptions found in Rule 506: Rule 506(b) and Rule 506(c). Many people get very excited when they learn that they can include up to 35 non-accredited, but “sophisticated” in an offering under Rule 506(b) (no use of advertising or general solicitation). Rule 502(b)(1) sets forth specific information delivery requirements that must be satisfied for issuers selling securities to non-accredited investors relying on Rule 506(b). As a practical matter, for disclosure purposes, once the issuer shares this information with one investor, the issuer likely would be foolish not to share it with all of their investors, accredited and non-accredited alike.
Under Rule 502(b)(1), the following information must be provided to non-accredited investors in a Rule 506(b) offering:
1. Assuming that the issuer is not subject to reporting under the Exchange Act of 1934 [NOTE: most private issuers of securities will not be subject to Exchange Act reporting], prior to the sale, the issuer must provide the investor with a disclosure document including the same information that would be included in a statement filed with the SEC if the securities were registered under either the Act, or pursuant to the exemption from full registration found under Regulation A. This information delivery requirement should be satisfied if the issuer makes available to investors an offering memorandum (also known as an offering circular or private placement memorandum) prepared by a competent securities attorney.
2. The issuer also must deliver financial statements to the investors within 120 days of the start of the offering. Very generally, assuming an issuer cannot obtain audited financial statements without unreasonable effort or expense, financial statements may be unaudited but the issuer’s balance sheet (dated within 120 days of the start of the offering) must be audited.
Rule 502(b) also requires that the issuer provide a summary of any written material concerning the offering that the issuer provided to accredited investors but had not previously delivered to the non-accredited investor. If the issuer provides all of the offering materials to the non-accredited investor that it provided to the accredited investor, then this requirement should be satisfied as being inapplicable.
Importantly, the issuer must make available to each non-accredited investor at a reasonable time prior to the purchase of securities the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information that the issuer possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy of the other issuer information required to be provided (described above). It is always advisable for issuers to include a representation in their subscription agreement that the investor has been given such opportunity to ask questions, and that the information about the issuer has been made available to them.
The issuer should include in their disclosure document specific disclosure that the securities have not be registered, and, therefore, cannot be resold unless they are registered or unless an exemption from registration is available.
These are not the only requirements that must be satisfied for a Rule 506(b) offering, but these are important requirements that are frequently overlooked in the initial excitement that an offering is available to non-accredited investors.
As a crowdfunding attorney, most of my attention has been focused on the US federal JOBS Act, the new federal legislation that President Obama signed into law in 2013, the final rules of which only went into effect in 2016.
Another significant, recent amendment to the federal securities laws was enacted on December 4, 2015 when President Obama signed the Fixing America’s Surface Transportation (FAST) Act. Remarkably, the primary emphasis on this legislation was not to change the securities laws, but rather to provide long-term funding for surface transportation infrastructure planning and investment.
Despite being focused on transportation infrastructure financing, the FAST Act added a new securities registration exemption, codified as Section 4(a)(7) of the Securities Act of 1933, as amended. Section 4(a)(7) applies to resales of securities that investors purchase in a private placement offering. These types of issuers are almost exclusively the types of clients I have represented in my career. In the past, the SEC rules required investors to hold their private securities for at least a year before re-selling (provided that the company itself allowed such resale). The SEC was primarily concerned with underwriting transactions involving a broker/dealer who would purchase the shares of the private company stock and immediately sell them to their investor network, much as an issuer does in an IPO. This prohibition against underwriting is included in the new Section 4(a)(7) exemption, which provides that resales may occur without regard to the investor’s holding period if all of the following conditions are satisfied:
The purchaser must be an “accredited” investor. Note that there is no language in the statute requiring the verification of the investor’s status as “accredited” so self-verification is acceptable.
No general solicitation or advertising is allowed in connection with the transaction.
I am assuming for the sake of this article that the issuer is not a “reporting” company (that is, its business information is not required to be reported publicly under the Exchange Act). In that case, the issuer must have agreed to make available the following information: its name and the names of any of its predecessors; the address of its principal executive offices; the exact title and class of the security; the par or stated value of the security; the number of shares or total amount of the securities outstanding as of the end of the issuer’s most recent fiscal year; the name and address of the transfer agent, corporate secretary, or other person responsible for transferring shares and stock certificates; a current statement of the nature of the business of the issuer and the products and services it offers; the names of the officers and directors of the issuer; the names of any persons registered as a broker, dealer, or agent that shall be paid or given, directly or indirectly, any commission or remuneration for such person’s participation in the offer or sale of the securities; the issuer’s current balance sheet and profit and loss statement and similar financial statements for the prior 2 years or for such part of the 2 preceding fiscal years as the issuer has been in operation, prepared in accordance with GAAP.
If the seller is a control person with respect to the issuer, a brief statement regarding the nature of the affiliation, and a statement certified by such seller that they have no reasonable grounds to believe that the issuer is in violation of the securities laws or regulations.
The seller cannot be subject to the disqualification provisions of Rule 506(d). These provisions primarily preclude the use of either Rule 506 exemption by persons who previously have been convicted of, or found liable for (through an administrative determination), securities fraud.
The issuer must actually be engaged in business and is not in the organizational stage, in bankruptcy or receivership, and is not a blank check, blind pool, or shell company that has no specific business plan or purpose or has indicated that the issuer’s primary business plan is to engage in a merger or combination of the business with, or an acquisition of, an unidentified person.
As noted above, no underwriter may be involved in the transaction.
The sale must be with respect to a security of a class that has been authorized and outstanding for at least 90 days prior to the date of the transaction.
Note that the issuer must agree to permit transfers. The issuer is obligated to disclose the rules regarding transferability in advance of the time that the purchaser acquires their shares, and typically, the issuer’s primary concerns are that it can keep track of who its shareholders are, and that the exemption that it relied on to sell its private securities is not affected adversely by the subsequent resale of the securities.
To learn more about how this new Section 4(a)(7) exemption might be able to help you in your business, please call me to discuss.
I was present at the death of my stepfather, Richard, on February 28, 2017, and his passing has impacted me greatly. I know Rich’s wife (my mom) has been affected by his passing even more than me.
Rich experienced a stroke in October 2016 that left him with aphasia, the inability to speak or verbally communicate except on a very limited basis. Even though Rich was 89 years old, he had spent his entire retirement years actively travelling and spending up to 8 hours a day, even up until the time of his stroke, translating Medieval Latin and Greek theological texts into English. Rich was a highly intelligent person and the loss of his capacity to express himself verbally was a death sentence because of the enormous reduction in his quality of life.
In 2012, Rich wisely had executed a physician’s directive and power of attorney that were still in effect at the time of his stroke. He specified that he did not want his life to be sustained through artificial means, and specifically, he did not want a feeding tube. Before Rich’s death, the nursing facility asked my mom about this, and she said that that was a decision he already had made ahead of time. It was an easy decision for her because Rich, when in his sound mind many years prior to the time of his stroke, had executed a document that allows a person to express his wishes for medical treatment anticipating that there may be some point in the future when he may be physically unable to express his wishes himself. This document is a physician’s directive, and my mom and I also were given Rich’s medical power of attorney so that we were authorized to communicate his wishes about his medical treatment to the care facility on his behalf.
My advice here is for you to discuss this matter with the people with whom you are closest, the people whom you list as your emergency contacts when you get a new job or sign a lease for example. If you want your life to be artificially sustained (i.e., life support), make sure you understand the costs of that continuing treatment (up to $300/day JUST for the bed at the nursing facility, which in Rich’s case was not going to be covered by Medicare). Also, I encourage you to research for yourself whether typically people recover after a feeding tube is inserted. Some do, and that is why I am limiting my advice here to this: discuss this issue with your loved ones, and once you come to decisions about end-of-life care, speak with me or another attorney about preparing a physician’s directive and medical power of attorney.