Many of my clients have been asking if they can simply bypass the SEC, block US investors, and conduct a 2016/17 style ICO. The answer is usually no, if their Token is a Security, and they’re an American company, they have to comply with Regulation S and lock their tokens for a year before trading can commence. Hopefully a Security Token Exchange will exist once the year is up.
I’ve consulted other lawyers on this Regulation and gotten mixed feedback, not everyone agrees that Category 3 (requiring the one-year lock-up) is necessary. I encourage anyone reading this who has reached another conclusion, please comment or reach out to me, as my clients would love to proceed in that direction; however, I just can’t see how it would be compliant. I recently reached out to the SEC for clarification on the matter, but have yet to received a response.
Primarily, the reason I believe an American Token issuer needs to lock all tokens sold to international buyers for a year is because the SEC said this: “Equity securities placed offshore by domestic issuers under Regulation S will be classified as ‘restricted securities’ within the meaning of Rule 144, so that resales without registration or an exemption from registration will be restricted for a one-year period.”[1] I think part of the confusion is because not all lawyers agree with the semantics that “Security Tokens” are “Equity Securities.” To me, if it looks like a duck and quacks like a duck, it’s probably not safe to call it a unicorn.
What is Reg S?
Regulation S provides an exclusion from the Section 5 registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), for offerings made outside the United States by both U.S. and foreign issuers.[2]
Regulation S consists of five rules:
1. Rule 901 outlines the general statement that the US Registration Requirements apply only to “offers and sales” of securities that occur within the United States and its territories;
2. Rule 902 defines the terminology pertinent to Regulation S;
3. Rule 903 provides a safe harbor for transactions involving issuances of securities that comply with specified guidelines (Primary Offer Safe Harbor);
4. Rule 904 provides a safe harbor for offshore resales that comply with specified guidelines (Secondary Market Safe Harbor); and
5. Rule 905, which provides that equity securities of US domestic issuers sold in compliance with the requirements of the Primary Offer Safe Harbor are deemed “restricted securities” as defined in Rule 144 under the Securities Act and subject to holding periods (and related requirements) before they can be resold without restriction in the United States.
CATEGORY 1: (NO LOCK-UP PERIOD)
Transactions are eligible for Category 1, which imposes the fewest restrictions, IF the issuer is a “foreign private issuer” that reasonably believes there is no substantial US market interest (“SUSMI”) in its securities and the sale takes place in an “offshore” transaction.
What is a Foreign Private Issuer?
The simple answer is that a foreign private issuer is a company that is owned, at least more than 50%, by non-U.S. persons. There are two tests to determine whether a foreign company qualifies as a foreign private issuer: the first relates to the relative degree of its U.S. share ownership, and the second relates to the level of its U.S. business contacts.[3] A foreign company qualifies if U.S. residents hold less than half of its outstanding voting securities. If 50% or less of its outstanding voting securities are held by U.S. residents; or if more than 50% of its outstanding voting securities are held by U.S. residents and none of the following three circumstances applies: the majority of its executive officers or directors are U.S. citizens or residents; more than 50% of the issuer’s assets are located in the United States; or the issuer’s business is administered principally in the United States. These tests are found in Securities Act Rule 405 and Exchange Act Rule 3b-4.
If a foreign company determines that 50% or less of its outstanding voting securities are held by U.S. residents, it would qualify as a foreign private issuer and it need not consider the second test relating to business contacts. If a foreign company, however, determines that over 50% of its outstanding voting securities are held by U.S. residents, the foreign company must consider the extent of its U.S. business contacts. The tests are discussed further below.
1. Shareholder Test
As an initial matter, a foreign company must determine whether more than 50% of its outstanding voting securities are held “of record” by U.S. residents. For purposes of this test, foreign companies must “look through” the record ownership of brokers, dealers, banks, or nominees holding securities for the accounts of their customers, and also consider any beneficial ownership reports or other information available to the issuer.
In recognition of the global nature of modern-day securities holdings and the potentially significant burden created by requiring a “look through” in jurisdictions where the likelihood of finding U.S. holders is small, foreign companies need only examine voting securities held of record in three jurisdictions: the United States; the issuer’s home jurisdiction; and the primary trading market for the issuer’s voting securities, if different from the issuer’s home jurisdiction. Additionally, if the issuer is not able to obtain information about the record holders’ accounts after reasonable inquiry, the issuer may rely on the presumption that such accounts are held in the broker’s, dealer’s, bank’s, or nominee’s principal place of business.
2. Business Contacts Tests
If more than 50% of a foreign company’s voting securities are held by U.S. residents, the determination of foreign private issuer status will depend upon the business contacts the issuer has with the United States. Specifically, an issuer must consider whether:
- The majority of its executive officers or directors are U.S. citizens or residents;
- More than 50% of the issuer’s assets are located in the United States; or
- The issuer’s business is administered principally in the United States.
If a foreign company has more than 50% of its voting securities held by U.S. residents and any of the above factors is true, then an issuer will not qualify as a foreign private issuer.
What is an off-shore transaction?
A transaction qualifies as an “offshore transaction” for purposes of the Primary Offer Safe Harbor if (1) no offer has been made to a person located in the United States and (2) either (A) when the buy order is originated, the buyer either is or is reasonably believed to be physically located outside the United States, or (B) the transaction is executed in or through a physical trading floor of an established foreign securities exchange that is located outside the United States.
What is SUSMI?
SUSMI means Substantial US Market Interest for equity securities. It exists if, during the issuer’s past fiscal year, one of the following two criteria is met:
- The US securities exchanges and inter-dealer quotation systems constituted, in the aggregate, the largest market for the securities.
- 20% or more of all trading in the securities took place via the US securities exchanges and inter-dealer quotation systems and less than 55% of all trading in the securities took place via another country’s securities markets.[4]
So long as a foreign issuer reasonably believes that no SUSMI exists with respect to the offered securities, this requirement of Category 1 is satisfied. If an offering falls within Category 1, Regulation S does not impose any requirements beyond the offshore transaction requirement and the prohibition on directed selling efforts.
CATEGORY 2 (40 DAY LOCKUP)
Category 2 is available for sales of equity securities by a foreign issuer that are not eligible for Category 1, provided the issuers are subject to the reporting requirements of the Securities Exchange Act of 1934 (“Exchange Act”). If an offering falls within Category 2, Regulation S imposes certain additional requirements beyond the offshore transaction requirement and the prohibition on directed selling efforts. The principal difference from Category 1 is that the securities may not be offered or sold to U.S. persons, even if outside the United States. Under Category 1, the securities may be offered and sold to U.S. persons outside the United States.
What is a Reporting Company?
A Reporting Company is a Company that issues publicly traded securities and is therefore subject to certain requirements about publicly reporting its earnings and other business information. In September, 2018 the SEC adopted a new definition for a “smaller reporting company” intended to reduce compliance costs and promote capital formation while maintaining investor protections. The minimum requirement is a float of assets no less than $250 million, as well as registrants with annual revenues of less than $100 million for the previous year and either no public float or a public float of less than $700 million.[5]
CATEGORY 3 (1-YEAR LOCKUP)
Category 3 is available for offerings that do not qualify for Categories 1 and 2. These are sales of (1) equity securities by any US issuer, regardless of the presence of SUSMI and the issuer’s Exchange Act reporting status, and (2) equity securities of foreign issuers and debt securities of US issuers when SUSMI is present and the issuer does not file periodic reports with the SEC under the Exchange Act. Category 3 predominantly applies to sales of equity securities by US issuers.
The distribution compliance period (lock-up period) for equity securities sold in a Category 3 transaction (either by a US issuer or a foreign private issuer that does not file periodic reports with the SEC under the Exchange Act) is either one year or, if the securities are issued by a US issuer that files periodic reports with the SEC under the Exchange Act, six months.
Conclusion:
An American company is likely going to be a Category 3 because it does not qualify as a foreign issuer which would be required for Category 1, and it does not qualify as a Reporting Company required for Category 2.
Full Rule:
§ 230.903 Offers or sales of securities by the issuer, a distributor, any of their respective affiliates, or any person acting on behalf of any of the foregoing; conditions relating to specific securities.
(a) An offer or sale of securities by the issuer, a distributor, any of their respective affiliates, or any person acting on behalf of any of the foregoing, shall be deemed to occur outside the United States within the meaning of § 230.901 if:
(1) The offer or sale is made in an offshore transaction;
(2) No directed selling efforts are made in the United States by the issuer, a distributor, any of their respective affiliates, or any person acting on behalf of any of the foregoing; and
(3) The conditions of paragraph (b) of this section, as applicable, are satisfied.
(b)Additional conditions -
(1)Category 1. No conditions other than those set forth in § 230.903(a) apply to securities in this category. Securities are eligible for this category if:
(i) The securities are issued by a foreign issuer that reasonably believes at the commencement of the offering that:
(A) There is no substantial U.S. market interest in the class of securities to be offered or sold (if equity securities are offered or sold);
(B) There is no substantial U.S. market interest in its debt securities (if debt securities are offered or sold);
© There is no substantial U.S. market interest in the securities to be purchased upon exercise (if warrants are offered or sold); and
(D) There is no substantial U.S. market interest in either the convertible securities or the underlying securities (if convertible securities are offered or sold);
(ii) The securities are offered and sold in an overseas directed offering, which means:
(A) An offering of securities of a foreign issuer that is directed into a single country other than the United States to the residents thereof and that is made in accordance with the local laws and customary practices and documentation of such country; or
(B) An offering of non-convertible debt securities of a domestic issuer that is directed into a single country other than the United States to the residents thereof and that is made in accordance with the local laws and customary practices and documentation of such country, provided that the principal and interest of the securities (or par value, as applicable) are denominated in a currency other than U.S. dollars and such securities are neither convertible into U.S. dollar-denominated securities nor linked to U.S. dollars (other than through related currency or interest rate swap transactions that are commercial in nature) in a manner that in effect converts the securities to U.S. dollar-denominated securities.
(iii) The securities are backed by the full faith and credit of a foreign government; or
(iv) The securities are offered and sold to employees of the issuer or its affiliates pursuant to an employee benefit plan established and administered in accordance with the law of a country other than the United States, and customary practices and documentation of such country, provided that:
(A) The securities are issued in compensatory circumstances for bona fide services rendered to the issuer or its affiliates in connection with their businesses and such services are not rendered in connection with the offer or sale of securities in a capital-raising transaction;
(B) Any interests in the plan are not transferable other than by will or the laws of descent ordistribution;
© The issuer takes reasonable steps to preclude the offer and sale of interests in the planor securities under the plan to U.S. residents other than employees on temporary assignment in the United States; and
(D) Documentation used in connection with any offer pursuant to the plan contains a statement that the securities have not been registered under the Act and may not be offered or sold in the United States unless registered or an exemption from registration is available.
(2)Category 2. The following conditions apply to securities that are not eligible for Category 1 (paragraph (b)(1)) of this section and that are equity securities of a reporting foreign issuer, ordebt securities of a reporting issuer or of a non-reporting foreign issuer.
(i) Offering restrictions are implemented;
(ii) The offer or sale, if made prior to the expiration of a 40-day distribution compliance period, is not made to a U.S. person or for the account or benefit of a U.S. person (other than a distributor); and
(iii) Each distributor selling securities to a distributor, a dealer, as defined in section 2(a)(12) of the Act ( 15 U.S.C. 77b(a)(12)), or a person receiving a selling concession, fee or other remuneration in respect of the securities sold, prior to the expiration of a 40-day distribution compliance period, sends a confirmation or other notice to the purchaser stating that the purchaser is subject to the same restrictions on offers and sales that apply to a distributor.
(3)Category 3. The following conditions apply to securities that are not eligible for Category 1 or 2 (paragraph (b)(1) or (b)(2)) of this section:
(i) Offering restrictions are implemented;
(ii) In the case of debt securities:
(A) The offer or sale, if made prior to the expiration of a 40-day distribution compliance period, is not made to a U.S. person or for the account or benefit of a U.S. person (other than a distributor); and
(B) The securities are represented upon issuance by a temporary global security which is not exchangeable for definitive securities until the expiration of the 40-day distribution compliance period and, for persons other than distributors, until certification of beneficial ownership of the securities by a non-U.S. person or a U.S. person who purchased securities in a transaction that did not require registration under the Act;
(iii) In the case of equity securities:
(A) The offer or sale, if made prior to the expiration of a one-year distribution compliance period (or six-month distribution compliance period if the issuer is a reporting issuer), is not made to a U.S. person or for the account or benefit of a U.S. person (other than a distributor); and
(B) The offer or sale, if made prior to the expiration of a one-year distribution compliance period (or six-month distribution compliance period if the issuer is a reporting issuer), is made pursuant to the following conditions:
(1) The purchaser of the securities (other than a distributor) certifies that it is not a U.S. person and is not acquiring the securities for the account or benefit of any U.S. person or is a U.S. person who purchased securities in a transaction that did not require registration under the Act;
(2) The purchaser of the securities agrees to resell such securities only in accordance with the provisions of this Regulation S (§ 230.901 through § 230.905, and Preliminary Notes), pursuant to registration under the Act, or pursuant to an available exemption from registration; and agrees not to engage in hedging transactions with regard to such securities unless in compliance with the Act;
(3) The securities of a domestic issuer contain a legend to the effect that transfer is prohibited except in accordance with the provisions of this Regulation S (§§ 230.901 through 230.905, and Preliminary Notes), pursuant to registration under the Act, or pursuant to an available exemption from registration; and that hedging transactions involving those securities may not be conducted unless in compliance with the Act;
(4) The issuer is required, either by contract or a provision in its bylaws, articles, charteror comparable document, to refuse to register any transfer of the securities not made in accordance with the provisions of this Regulation S (§§ 230.901 through 230.905, and Preliminary Notes), pursuant to registration under the Act, or pursuant to an available exemption from registration; provided, however, that if the securities are in bearer form or foreign law prevents the issuer of the securities from refusing to register securities transfers, other reasonable procedures (such as a legend described in paragraph (b)(3)(iii)(B)(3) of this section) are implemented to prevent any transfer of the securities not made in accordance with the provisions of this Regulation S; and
(iv) Each distributor selling securities to a distributor, a dealer (as defined in section 2(a)(12) of the Act ( 15 U.S.C. 77b(a)(12)), or a person receiving a selling concession, fee or other remuneration, prior to the expiration of a 40-day distribution compliance period in the case ofdebt securities, or a one-year distribution compliance period (or six-month distribution compliance period if the issuer is a reporting issuer) in the case of equity securities, sends a confirmation or other notice to the purchaser stating that the purchaser is subject to the same restrictions on offers and sales that apply to a distributor.
(4)Guaranteed securities. Notwithstanding paragraphs (b)(1) through (b)(3) of this section, in offerings of debt securities fully and unconditionally guaranteed as to principal and interest by theparent of the issuer of the debt securities, only the requirements of paragraph (b) of this section that are applicable to the offer and sale of the guarantee must be satisfied with respect to the offer and sale of the guaranteed debt securities.
(5)Warrants. An offer or sale of warrants under Category 2 or 3 (paragraph (b)(2) or (b)(3)) of this section also must comply with the following requirements:
(i) Each warrant must bear a legend stating that the warrant and the securities to be issued upon its exercise have not been registered under the Act and that the warrant may not be exercised by or on behalf of any U.S. person unless registered under the Act or an exemption from such registration is available;
(ii) Each person exercising a warrant is required to give:
(A) Written certification that it is not a U.S. person and the warrant is not being exercised on behalf of a U.S. person; or
(B) A written opinion of counsel to the effect that the warrant and the securities delivered upon exercise thereof have been registered under the Act or are exempt from registration thereunder; and
(iii) Procedures are implemented to ensure that the warrant may not be exercised within theUnited States, and that the securities may not be delivered within the United States upon exercise, other than in offerings deemed to meet the definition of “offshore transaction” pursuant to § 230.902(h), unless registered under the Act or an exemption from such registration is available.
[ 63 FR 9645, Feb. 25, 1998, as amended at 72 FR 71571, Dec. 17, 2007]
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[1] https://www.sec.gov/rules/final/33-7505.htm
[2] Offshore Offers and Sales, Securities Act Release №33–6863 (April 24, 1990) (referred to below as the Regulation S Promulgating Release), text at note 1.
[3] https://www.sec.gov/divisions/corpfin/internatl/foreign-private-issuers-overview.shtml
[4] https://uk.practicallaw.thomsonreuters.com/1-382-3853?transitionType=Default&contextData=(sc.Default)&firstPage=true&comp=pluk&bhcp=1
[5] https://www.sec.gov/rules/final/2018/33-10513.pdf
