The real promise of democratized finance has yet to arrive to the party.
You may think that ICOs have come and gone. And I honestly hope you are right.
In November 2018, the Securities Exchange Commission (SEC) Enforcement Division reported that it was taking action against dozens of fraudulent ICOs, and that it has ordered $3.94 billion in total penalties for fraudulent crypto offerings during the 2018 Financial Year. Simultaneously, the SEC announced its settlement with crypto-marketplace EtherDelta, with fines and collaboration with the company. Pursuant to the settlement, EtherDelta has acknowledged that it should have registered as an Alternative Trading System (‘ATS’) with the SEC, or otherwise operate subject to an exemption, since it provided a marketplace for the trading of Securities.
“EtherDelta had both the user interface and underlying functionality of an online national securities exchange and was required to register with the SEC or qualify for an exemption,” said Stephanie Avakian, Co-Director of the SEC’s Enforcement Division.
The underlying instinct that is arguably responsible for those trillions of dollars exchanged in ICOs during late-2017 and early-2018, and for the EtherDelta marketplace (among other market players) is very straightforward and reasonable — democratized venture finance.
What is this ‘democratized venture finance’?
Democratized venture finance forms the basis of the next wave of ‘tokenized capital offerings,’ separate and clearly distinguishable from the ICO-craze that has all but completely burst. There is a whole new ecosystem of blockchain-startups promising the ability for any private company to raise capital with streamlined regulatory compliance, and the ability for the common citizen to invest and grow alternative asset classes in tokenized shares in private companies.
Despite the present crypto market rout, and the increased supervision of the SEC Enforcement Division over all things ‘tokenized,’ the blockchain remains the promise and salvation for the American dream. This time, the promise is ‘compliant tokenized securities offerings’ with the assistance of this new class of Securitized Token Offering (‘STO’) Platforms, and a surrounding ecosystem of familiar players, including escrow agents, custodians, broker/dealers, transfer agents, alternative trading systems, fund administrators and registered funding portals.
R-Token (and other ‘STO Platforms’)
“Capital formation is killer app of blockchains,” says Napolean Ta, partner at Founder’s Fund, which invested in Harbor (a $28M round, announced in April 2018) together with Andreessen Horowitz, Craft Ventures, Pantera Capital and slew of other Silicon Valley A-list venture funds.
Harbor promises to “reengineer private securities and other real-world assets such as real estate, investment funds, and fine art” with its Regulated Token (R-Token) standard, a “permissioned ERC-20 token on the Ethereum blockchain that checks an on-chain Regulator Service for trade approval.” [R-Token Whitepaper, Summary, line 4]. As of December 2018, word on the street is that Harbor is focusing first on creating a form of tokenized Real Estate Investment vehicle (‘REIT’), perhaps for the relative regulatory simplicity of a real-estate backed offering? Josh Stein (CEO at Harbor) and David Sacks of Craft Capital describe the R Token as follows, in their post “Introducing the Private ICO (PICO)”:
“Harbor designed the R-Token standard to tokenize traditional securities and securitize assets more broadly. It was designed from the ground up to instantiate a wide variety of securities rules, including many of the specific rules within Reg D, Reg S, Section 4(a)(7), Rule 144 as well as KYC/AML and investor accreditation”
There are several other companies also promising to ‘tokenize’ securities (and other real world assets) for private companies in capital formation, and other regulatory compliance requirements, on the Ethereum platform (and other token platforms), including companies like PolyMath (Ethereum ERC-1400 protocol), Securitize, Liquifi (Stellar token), Koreconx (Hyperledger token) and others.
The promise is that private companies will have a new blockchain-enabled compliance mechanism and pathway in their capital formation efforts, and that everyday citizens will be able to invest in their dreams, and maybe even elevate their lives through a truly democratized financial system.
Private company shareholders most often acquire their shares directly from the company in an “exempt” transaction. Companies like Uber, Airbnb, Facebook, LinkedIn, Calm, Robinhood and others sold and granted private shares to many founders, VCs, early employees and others. Early ‘insiders’ often make many millions in their eventual sale of these initial positions. And yet, shares acquired in these exempt transactions (“Restricted Securities”) may not be resold except in compliance with the registration requirements of the Securities Act, or pursuant to an available exemption.
Many founders, early stage investors, venture capitalists, employees and others who acquire Restricted Securities can become indefinitely locked-in to their investment unless the issuing company itself creates liquidity events or opportunities. Restricted Securities are also often subject to limitations on resale imposed by the companies themselves, including mechanisms such as legends, rights of first refusal, state law observances and other limitations that can control when, how much or to whom shares may be resold.
The underlying problem that R-Token (and other ‘Securitized Token Offerings’ or ‘STOs’) seeks to address is the resulting illiquidity, or illiquidity that results purely from regulatory complexity. The assumption is that a market for private shares in early-stage companies already exists, but the regulatory labyrinth restricts democratic access to it. Would you want to buy shares of early stage no-brainers like Uber, Bumble, Bird or Tinder, if you understood the risks and even if you don’t have the personal liquidity of a Billionaire?
Holders of Restricted Securities have very few pathways to liquidity for their investment absent an eventual initial public offering (IPO) or sale of the company in which they are invested. At present there is no real unfettered secondary market for Restricted Securities (several hybrid ‘exemptions’ to this general rule exist, including NPM and SharesPost).
The promise of an Alternative Trading System that lists tokenized securities is an appealing one, providers are sought after, and the list is short. Very few of the STO Platforms in development are yet claiming to be aiming to be a registered broker/dealer, nor a registered ATS nor transfer agent.The regulation in this area is tricky (even ‘labyrinthine’), and recent SEC actions in the cryptographic token space, the marketplace space and against liquidity providers generally, are worth considering, which we will do below.
First, though, some background.
The JOBS Act
One relic from the Obama-years that has so far evaded the ire and wrecking crew instincts of the Trump Administration is the JOBS Act, which heralded a new hope in the world of democratized finance.
The Jumpstart our Business Startups Act (the “JOBS Act”) significantly increased the shareholder number threshold prior to registering under the Securities and Securities and Exchange Acts, and under it many large tech companies with substantial numbers of shareholders, have remained private. Pursuant to the JOBS Act, companies may have up to 2,000 shareholders before becoming subject to the reporting and other obligations of public companies, triggered under the Acts.
The JOBS Act expanded start-ups’ ability to raise capital from Accredited Investors, and relieved restrictions surrounding communications that a company may make in its early capital formation activities. As well, the JOBS Act brought with it the onset of two ‘crowdfunding’ exemptions from full Securities reporting requirements, Regulations A/A+ and “CF” (CrowdFunding), enabling a new class of crowdfunding for startups from non-Accredited Investors, leveraging a new concept of registered ‘platforms’ like SeedInvest and Republic.
As a result of the JOBS Act, even if you are not an Accredited Investor, you can invest today over regulated platforms like SeedInvest and Republic, in companies like: Farm-in-a-box, Roomi , MindMate and others. Your investment amounts are limited according to a formula that takes into account your actual income. As a Non-accredited investor, you are still restricted from participating in the better deals, on the better platforms, and the deals where the real money can be made.
SecondMarket (now NPM) and SharesPost
Two independent secondary market platforms, SecondMarket and SharesPost emerged circa 2009 as facilities for effectuating the resale of Restricted Securities in private companies, and are worth mention. Both platforms provide a continuously operating, structured, electronic marketplace for transactions in private company Restricted Securities. Both platforms facilitate transactions within a legally compliant transaction setting. Both platforms are best described as ‘hybrid’ structures, facilitating liquidity for private holders of Restricted Securities and prequalified investors, in close collaboration with the private companies themselves.
SecondMarket emerged in 2009 primarily to provide a platform for employee shareholders of Facebook to sell some of their shares prior to Facebook’s eventual IPO. SecondMarket was designed to deal with the liquidity needs of early investors, employees and venture capitalists, and to provide a relatively efficient means of buying and selling private company shares. SecondMarket operated initially as a broker-dealer, and eventually as an Alternative Trading System (“ATS”) performing similar to a stock exchange in accordance with Regulation ATS under the Exchange Act. SecondMarket was a market maker in private company shares, and later expanded to be a secondary market for “alternative investments” generally.
SharesPost also entered into the secondary market in 2009. Structured as an online bulletin board, buyers and sellers could post bids for shares of large, well-known private companies. SharesPost also restricted participation to prequalified Accredited Investors, and that restriction continues today. SharesPost has expanded to create a special purpose vehicle — the SharesPost 100 Fund — a closed-end management investment company registered under the Investment Company Act of 1940, which invests in directly in the private companies comprising SharesPost 100. The SharesPost 100 Fund is open to investment by a broader spectrum of investors, with a small minimum investment amount, and with no accreditation requirement.
Accredited Investor Restriction
Both SharesPost and SecondMarket (and its successor, NPM) restrict participation in their platforms to pre-qualified Accredited Investors. This is based on several factors, including the absence of information about the private company issuer available to buyers and sellers, and an expectation that Accredited Investors are capable of evaluating the merits and risks of an investment decision.
There was also a ‘convention’ (though not a rule) often referred to as Section 4(a)(1–1/2), which was essentially a cross between Sections 4(a)(1) and Section 4(a)(2) of the Securities Act, a private offering exemption, by which individual holders of Restricted Securities could resell them in transactions that, if they were being offered by the issuer, would qualify as exempt private offerings. This convention has been codified in Section 4(a)(7) to the Securities Act, which exempts sales of restricted and control securities from registration provided the securities are sold only to Accredited Investors. This is one reason why it makes sense for SharesPost and SecondMarket (NPM) to restrict participation on their platforms to Accredited Investors.
Persons who sell securities in compliance with Rule 144 will not be deemed to be statutory underwriters (i.e. engaged in a distribution of the shares) for purposes of other applicable exemptions, including the ordinary exemption in Section 4(a)(1), which provides an exemption for a transaction by a person other than an issuer, underwriter or dealer.
Rule 144 distinguishes between “Affiliates” (i.e. those that have control of the company) and Non-affiliates. Under the Securities Act, non-affiliates holding restricted shares for at least one year are free to make unlimited resales of those shares without further restrictions. For non-affiliates holding options, the one-year holding period commences on the date an option is exercised and the exercise price is paid, not from the date the option is granted.
Under Rule 144, for both Affiliates and Non-affiliates, there must be adequate current information about the company publicly available before the sale of Securities can be effectuated. According to the SEC, “For non-reporting companies, this means that certain company information, including information regarding the nature of its business, the identity of its officers and directors, and its financial statements, is publicly available.” [Emphasis Added]
Rule 144 provides a safe harbor for holders of restricted securities to resell their securities to the public, and “unrestricts” the securities. This means that while Rule 144 is not the exclusive method by which restricted securities can be resold, compliance with the provisions of the rule means that the transaction is in compliance with federal securities laws and regulations.
It is important to note that Rule 144 only applies to holders of restricted securities attempting to resell them and is not available to issuing companies of the security.
Rule 144 permits resale of restricted securities as long as several conditions are met. The conditions that must be met depends on whether the selling security holder is an “affiliate” of the issuer company, which is defined as a person or entity with control of, controlled by, or under common control with, the issuer company (affiliates are typically an executive officer, director, or controlling shareholder).
For Affiliates, there are additional requirements under Rule 144 for sales of Restricted Securities, including “Trading Volume Formula” restrictions limiting the number of shares that can be sold in a 3-month period to one percent of the outstanding shares and also further reporting requirements.\
It is unclear if securities that would be acquired in a Title III/Section 4(a)(6) equity crowdfunding offering could be resold pursuant to Rule 144. Section 4(a)(6) does not designate the acquired securities as restricted as defined under Rule 144, instead explicitly restricting them through a one-year holding period unless resold (1) to the issuer, (2) to an accredited investor, (3) as part of a registered offering, or (4) to a member of the family of a purchaser or in connection with the death or divorce or other similar circumstance of the purchaser. The SEC’s rules for equity crowdfunding also make no explicit reference to Rule 144.
Also important to note is that Rule 144 is only available where the security-holder purchased the securities without a view to distribute or resell the securities — that is, the securities-holder purchased for investment purposes for her/his/its own account. Although issuers typically have purchasers sign statements that the purchasers are purchasing only for their own account and not with a view to distribution, if a security-holder who purchased its securities from the issuer publicly states or clearly indicates her/his/its intent to resell as soon as legally possible, the holder may lose the benefit of Rule 144.
Harbor, and the other STO Platforms, remain bullish that a “Reg D Compliant STO” can solve the liquidity issue, and thus democratize venture finance (following from “Introducing the Private ICO (PICO)” by Harbor’s CEO Josh Stein, and David Sacks, of Craft Capital):
“The SEC has a 3-part mission: (i) protect investors, (ii) maintain fair, orderly, and efficient markets, and (iii) facilitate capital formation. The Reg D-compliant PICO serves all three interests, providing a common, reliable, and efficient way to raise funds with slowly expanding liquidity as the risks to investors lessen and become better known.”
Practical Challenges: Share “Legend” Removal & State Law Observances
If a holder of Restricted Securities has met the conditions in Rule 144, they can sell Restricted Securities to the public under an applicable exemption in the Securities Act, and after the initial exempt sale (and a holding period), those shares become freely tradable.
However, holders of Restricted Securities remain restricted from transferring those securities until they have had the legend removed from the share certificate. Only a transfer agent can remove the legend, and a transfer agent will not remove the legend without an opinion letter from the issuer’s counsel that the restrictive legend can be removed. State law, not federal law, governs any disputes surrounding the removal of legend.
To begin the legend removal process, an investor contacts the company that issued the securities, or the transfer agent, to ask about the procedures involved in legend removal. Removing the legend can be a complicated process requiring a holder of Restricted Securities to work with an attorney who specializes in Securities Law.
Private companies generally want to maintain control over their equity and every facet of transactions in their securities. The requirement of legend removal forces second market participants to apprise the issuer company, and be subject to its tacit approval of the sale. Company controls also negatively impact the secondary market platforms and participants. Transactions cannot be settled without compliance with whatever rights of first refusal are in place for shares of a particular company. That process was not scalable for SharesPost and SecondMarket (NPM), and they changed their business models accordingly.
Both SharesPost and SecondMarket (NPM) now provide a wide range of services to private companies heavily focused on company-controlled liquidity events, rather than on facilitating secondary market transactions as platforms for buying and selling shares. In the case of the Nasdaq Private Market, transactions by holders of Restricted Securities can be made, but only issuer company-approved Accredited Investors may participate. SharesPost continues to allow shareholders needing liquidity ahead of an IPO or sale of the company to post their shares for sale, and does so largely based on established relationships with private companies and accommodation of the particular investor preferences and rights of those companies and transfer processes. SharesPost maintains a community of prequalified Accredited Investors to achieve this end.
State Law Observances
Offers and sales by individual private company shareholders made in reliance on a Securities Act exemption also require reliance on an exemption from registration and qualification under the securities laws of each state in which the shares are sold. Some form of secondary trading exemption exists in all States, although not necessarily defined as such, and not uniformly. The consequences of a state securities violation in connection with secondary market transactions fall on the private company, individual sellers of the securities in secondary transactions, and the operator of the platform facilitating the sales. The lack of uniformity, and the consequences of violation (which include rescission of the sale, and administrative enforcement action by state administrators), were practical challenges that proved to be problematic for liquidity creation, and caused NPM and SharesPost to model themselves as they have (more of a hybrid ‘liquidity’ model, structured as an exchange, and with a close connection with the issuer companies).
State law is also in flux surrounding cryptocurrencies, and how they should be regulated. It is worth noting that at the end of January this year, Square Inc. launched a service for users of its Cash app that allows users to trade in Bitcoin (barring those users in New York, Georgia, Hawaii, or Wyoming due to regulatory uncertainty). One month later, free stock trading platform Robinhood released ‘Robinhood Crypto’ for a select group of customers, a service that currently gives them access to buy and sell Bitcoin and Ethereum (available only in California, Colorado, Massachusetts, Montana, Missouri and Mississippi due to state regulatory uncertainty).
Registering as an ATS?
Both SecondMarket (now NPM) and SharesPost started their journeys as registered broker-dealers, and later registered as ATS Exchanges. In a recent ruling the SEC provided several quotes surrounding such registration that are germane to this question facing Harbor and other STO Platform providers:
”A platform that trades securities and operates as an “exchange,” as defined by the federal securities laws, must register as a national securities exchange or operate under an exemption from registration, such as the exemption provided for ATSs under SEC Regulation ATS.”
“An entity seeking to operate as an ATS is also subject to regulatory requirements, including registering with the SEC as a broker-dealer and becoming a member of an SRO.”
“Some online trading platforms may not meet the definition of an exchange under the federal securities laws, but directly or indirectly offer trading or other services related to digital assets that are securities. For example, some platforms offer digital wallet services (to hold or store digital assets) or transact in digital assets that are securities. These and other services offered by platforms may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things.”
None of the ‘STO Platforms’ have designated themselves as an Alternative Trading System as yet. The resonating answer to the ‘marketplace’ question seems to be: We partner with market providers, the STO platform is merely a technology provider, and actual transfers of securities will take place on an existing trading platform, or ATS. Enter OpenFinance Network, and other focused marketplaces and exchanges (names that come to mind here at present include tZERO, SLICE, SharesPost, Airswap and others).
OpenFinance Network (OFN) is a trading and settlement platform for the alternative asset industry. The platform serves as a conduit between issuers, investors, and industry stakeholders, offering streamlined access to liquidity and asset transfer efficiencies. OFN appears to be leveraging the ‘broker/dealer’ status of Sageworks Capital, LLC, an affiliated entity, a registered broker-dealer and a member of FINRA & SIPC. More information about the OpenFinance Network can be found in this blogpost, and this blogpost. We look forward to hearing more about the substantive offerings of OpenFinance Network, and other ‘marketplace’ providers for the real ‘liquidity’ that Compliant STOs promise.
The Promise — Rule 144 and beyond
The promise of the R-Token, and other emerging ‘STO Platforms’ (like Koreconx, Polymath, Securitize, Liquifi and perhaps even SeedInvest, with its recent purchase by Goldman-backed Circle) is to provide a pathway towards an unfettered secondary market for any private company in its initial capital formation.
The R-Token seeks to address the liquidity issue, using an Ethereum-based blockchain (ERC-20) and a protocol Harbor calls the ‘Regulator Service’ and describes thus: “The Regulator Service can be configured to meet relevant securities regulations, Know Your Customer policies, Anti-Money Laundering (AML) requirements, tax laws, and more.” Other ‘STO platforms’ are choosing various other underlying token platforms; Koreconx, for example, has pinned its platform to Hyperledger, Polymath to Ethereum ERC-1400 platform, and Liquifi to the Stellar Token.
The R-Token white paper promises full regulatory compliance with all securities regulations. Many observers are eagerly awaiting the first R-tokenized security offering, beyond Real Estate. The STO Platforms’ promise is to democratize the capital formation ecosystem, and to enable companies to streamline the regulatory compliance process, from issuance through full liquidity. Two recent SEC administrative decisions are worth referencing for purposes of analogy, from the ‘second wave’ of secondary markets, Equidate and EquityZen.
Equidate created a financial instrument somewhat similar to Phantom Stock, essentially ten-year-term “forward contracts” entered into between the shareholder and an Equidate affiliate, acting for an investor for future delivery of the shares in exchange for immediate liquidity representing the proceeds paid through Equidate, into an account for the shareholder by the investor, in the amount set by the terms of the contract. The shareholder retained his or her ownership of record, associated voting rights, and position in the company’s capitalization structure. The company didn’t need to deal with rights, constraints, or challenges by existing shareholders that it may face when altering its capitalization structure, or as commonly referenced, its “cap table.”
When the company conducts an IPO, or there is another transaction resulting in the shares becoming freely tradable, delivery of the shares was to be made by the shareholder facilitated by Equidate, and ownership would transfer. The “derivative” Equidate model was intended to provide liquidity to private company shareholders who would receive cash based on the value of the private company shares covered by the contract. The Equidate derivative model did not survive.
In December 2016, Equidate agreed to settle SEC charges that it violated federal securities laws by failing to register “security-based swaps,” which are expressly defined to securities under the Securities Act. Equidate consented to an SEC order without admitting or denying the findings, and agreed to pay an $80,000 civil money penalty. Equidate had stopped offering and selling security-based swaps in December 2015 as a result of the SEC investigation. Today, Equidate operates a conventional ATS platform providing accredited investors with access to pre-IPO equity of private companies, and permitting those companies to maintain control of their cap table and voting rights.
The EquityZen platform also involved a derivative structure, but one in which a special purpose vehicle (the Fund) was the key component. The Fund would purchase private company shares, with approval of the company, and abiding by any right of first refusal held by the company. The shares were then to be held in the Fund. Investors are members of the Fund (organized as an LLC), for which EquityZen acted as the Managing Member of the Fund. The assets owned by the Fund (and indirectly by its members) were to be the shares the fund has purchased from private company shareholders in actual share transfers, through which the Fund acquires ownership. Membership interests in the Fund were to be offered and sold only to prequalified Accredited Investors.
The security-based swap in this case was a financial contract that promised to pay the economic value of restricted, private company stock upon a liquidity event, i.e., transferring the economic outcome on referenced shares of stock upon the occurrence of one or more specified liquidity events. The Dodd-Frank Act regulatory structure requires, among other things, that security-based swaps may not be sold to persons who are not “eligible contract participants” without an effective registration statement filed under the Securities Act of 1933, and trading in these swaps must occur on regulated exchanges. EquityZen restructured its market and, as with Equidate essentially as a matching engine for direct sales of private company shares to Accredited Investors in issuer approved transactions.
Tokenized securities transfers (and swaps for cryptocurrencies) are subject to concurrent regulatory jurisdiction by several federal and state agencies. Courts and regulators have recognized cryptocurrency as a commodity, and as such regulated by the CFTC, but that jurisdiction is incomplete, and other agencies claim jurisdiction as well, including the SEC, FINRA, DOJ, IRS, Treasury Department and state agencies.
On March 6, 2018, Judge Jack B Weinstein of the US District Court for the Eastern District of New York ruled that virtual currencies are commodities under the Commodity Exchange Act (CEA) and therefore subject to the Commodity Futures Trading Commissions (CFTC) authority. While discussing CFTC jurisdiction over virtual currencies Judge Weinstein states:
The CFTC, and other agencies, claim concurrent regulatory power over virtual currency in certain settings, but concede their jurisdiction is incomplete.
See App. C, CFTC Chair, Congressional Testimony (“[C]urrent law does not provide any U.S. Federal regulator with such regulatory oversight authority over spot virtual currency platforms [not involving fraud] operating in the United States or abroad.”)
By allowing the purchase of unregistered securities by the public (and often promised to be effected with various cryptocurrencies), many STO Platforms could risk being labeled an “exchange” (commodities and/or securities) that may attract concurrent oversight by several agencies and other authorities, including the CFTC (as a “commodity”), the SEC (as “securities”). Concurrent jurisdiction may also expose them to regulatory oversight by Treasury (anti Money-laundering), State regulations, and private exchanges self-regulation initiatives, and any combination of the above.
The promise of democratized venture finance is exciting; we remain intrigued and simultaneously somewhat cautious as we observe this new cohort of STO Platform providers, as they launch their technologies into the complex regulatory world of capital formation. Increased regulatory agency scrutiny over tokenized offerings and the offering platform providers may play a judicious role, as the companies prepare their tokenized security platforms and products for primetime.
All comments and input on this and other matters are welcomed!
If you become interested to issue any compliant tokenized security through any STO Platform described above, we would love to help! Please contact us at Thompson Bukher LLP.
 In October 2015, Barry Silbert sold SecondMarket to Nasdaq for an undisclosed amount, and it operates today as Nasdaq Private Market (npm.com). The Bitcoin Investment Trust (BiT), originally formed under the SecondMarket banner, which had raised $60 Million on public markets, became part of Silbert’s next venture, along with Genesis Global Trading, operating under Digital Currency Group (also originally formed under the SecondMarket banner).