Category: Corporate Law

Securities Law and Cryptocurrencies

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 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

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

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

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.

Required Information

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.

What information do I need to form an LLC?

This is a frequently asked question that I thought would be useful to answer here.

For your Texas LLC, we will need you to pick a name.  The more unusual the name, the better it is from an availability standpoint, but simplicity is equally as important because you will be transacting business in the name of the entity.

For a manager-managed LLC (which I almost exclusively recommend to clients), we will need to identify the “Managers” of the LLC in the Certificate of Formation that we will file with the Secretary of State.  These people are the equivalent of the LLC’s board of directors.  We also must supply addresses for the managers, but that may be any address, not just a home address, including a business address or a post office box.

You will need to identify the registered agent.  The registered agent is the person who will receive a copy of the lawsuit if the LLC is ever sued.  The registered agent can be one of the Managers, the law firm that you hire to form the LLC, or a third-party registered agent service provider.

After identifying the Managers, who are the owners, what level of control will they have, and how is cash paid back to them?

To discuss any of these points, please feel free to call me.