Digital Assets and Restricted Securities Background
Many recent Initial Coin Offerings (ICOs) and other token sales are being conducted through a Simple Agreement for Future Tokens (SAFT) or other private placement that exempts the token from registration as a security with the SEC. Tokens sold through these structures have become hot investments, and access to deals selling these tokens is generally difficult to obtain. Accordingly, many investors are creating private funds, unincorporated investment groups, syndicates or other types of investment-fund-like structures (“syndicates” or “investors” for the purposes of this post) to invest in these tokens or SAFTs. Many times these syndicates are established with the stated intent or objective to make distributions of the tokens immediately upon receipt. Effectively the sponsors of such structures have created a de-facto distribution system for VC like investments into blockchain projects. The question is how such a distribution structure fits with traditional securities regulations – specifically, can privately placed tokens (securities) be distributed shortly after receipt? The answer is probably no.
Background on Unregistered Securities
SAFTs, tokens from a SAFT, or other private placements are in most cases going to be unregistered securities (unless the token or instrument later becomes registered with the SEC which is highly unlikely). In general federal securities laws prohibit the transfer of unregistered securities unless an exemption applies to the transfer. Any person then who has possession of, and then transfers, an unregistered security without complying with an applicable exemption is breaking the securities laws and subject to civil penalty (fine, rescission, bar from industry, etc). Additionally, many private placements and SAFTs contain contractual provisions that restrict transfer of tokens for a certain amount of time after issuance (with a wink and a nod from the token issuer that “everyone transfers them anyways”). Unless there is an exemption allowing for the transfer of the tokens (restricted securities), the transferor would be both breaking securities laws and breaching contractual representations made to the token sponsor.
Given the above framework, investors or syndicates will want to find an exemption so they can transfer the tokens in accordance with securities laws (the risk posed by breaching a contractual representation to the token sponsor is beyond the scope of this post). Among statutory exemptions, Section 4(a)(1) the Securities Act of 1933 (the “Securities Act”) provides an exemption from registration of the securities if the sales/transaction is not conducted by an issuer, dealer, or underwriter. These terms all have precise definitions, but in this context we would be most concerned about the transferor being deemed an “underwriter” which is defined, in part, as “any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking.” This is a broad definition, and because of the stated or not-stated intent of creating a distribution structure for tokens, the syndicates described above may well be considered “underwriters” in this context and need to find another exemption on which to rely.
Investors my be in luck though as there are two other common exemptions that may be available – Rule 144 and Section 4(a)(1 ½).
Rule 144 of the Securities Act allows public resale of restricted securities if certain conditions are met. The central condition is that the unregistered securities are held by the investor for a period of at least one year. Further, the transferor/investor may not be an affiliate of the issuer. There may be reduced holding period requirements if the issuer is subject to the Exchange Act Reporting requirements, but this is not a likely scenario in the digital asset space. We believe for most syndicate groups, Rule 144 is the best way to comply with the transfer restriction. Of course, certain syndicates operating in this space might want or need to distribute the tokens before the expiration of Rule 144’s one-year holding period, and while imperfect as a solution, Section 4(a)(1 ½) (discussed below) may grant another option.
Section 4(a)(1 ½)
As mentioned above, Section 4(a)(1) of the Securities Act provides an exemption from registration for transactions by any person other than an issuer, underwriter, or dealer. Section 4(a)(2) of the Securities Act provides a separate exemption for transactions by an issuer through a private offering. Over time, through case law and acknowledged by the Securities and Exchange Commission (the “SEC”), the “Section 4(a)(1 ½)” exemption was created. This exemption generally is an exemption for private offerings, similar to Section 4(a)(2), but for entities that are not issuers.
To avoid being deemed an underwriter (and to ensure that a resale is sufficiently private), the investor/transferor must be able to show that it did not purchase the restricted securities with a view to distribution or resale. In order to show this the investor/transferor should examine the following criteria :
- Number of Purchasers – there should be a limited number of purchasers of the restricted security. This generally can be satisfied if there are less than 25 purchasers.
- Investment Intent – the investing entity’s intent in purchasing the tokens or SAFT should be to hold for an indefinite period of time and not with a view to resell or distribute. The longer the investing entity holds the tokens or SAFT, the better the argument for the investor/transferor’s original intent. Generally, in conjunction with other facts and circumstances, holding the security for at least six months will evidence the investor/transferor’s investment intent. The investor/transferor should also obtain a representation from purchasers that (1) the purchase is being made as an investment and not for resale and (2) any subsequent transfer will be made only in an SEC-registered transaction or in compliance with an exemption from registration.
- Offeree Qualification – the investor/transferor of the token or SAFT should determine whether the buyer can hold the securities for an indefinite period of time and assume the risk of the investment by looking to the experience and sophistication of the buyer.
- Information – the investor/transferor should provide access to all information about the investment and business of the issuer that would be necessary to the buyer. The investor/transferor should also provide access to any nonpublic information if it is an insider with such information.
- Private Offering – No form of general advertising or general solicitation may be used in reselling the securities.
Because of the facts and circumstances determination for Section 4(a)(1 ½), the safest approach to addressing these restricted securities’ holding periods is for the investor/transferor to hold the securities for greater than one year in order to fall under the Rule 144 safe harbor.
Other Issues to Consider
There are a number of additional items that should be considered in the context of transferred digital assets that may have been issued as private securities:
- Securities v. Non-Securities. The restricted securities transfer rules apply to securities – they do not apply to non-security instruments. Entities that invest in tokens and SAFTs may want to consider taking a position that the tokens are not securities and therefore not subject to securities laws. Such a position would entail a facts and circumstances determination, and taking such a position is likely a risky strategy based on recent comments from SEC Chairman Clayton. Also, taking the position that a SAFT is not a security would be problematic if the SAFT included language that it was a restricted security or otherwise contained a restrictive legend.
- Distribution to syndicate owners. If an entity wants to distribute the tokens or a SAFT instrument to its underlying owners, it should be aware that the above exemptions do not apply to a distribution to a syndicate’s underlying owners. Additionally, the SEC would likely consider an in-kind distribution of tokens in exchange for redemption of interests in a syndicate as consideration sufficient to constitute a sale.
- Regulation S. Non-US investors may consider investing in a SAFT or purchasing tokens under Regulation S of the US securities laws. While such investors would be non-US investors, Regulation S contains a one-year holding period similar to Rule 144 for sales to US persons so resale of such instruments would potentially be limited.
- Timing. No official guidance has been issued regarding holding periods and SAFT instruments. We do not know whether the holding period begins when a SAFT is issued or once the actual tokens are issued (i.e. whether the SAFT and tokens are separate securities). In cases where tokens are issued after a significant period of time following the SAFT execution, this determination may be significant. Again, a determination one way or another will require a facts and circumstances analysis.
Investors should be aware that SAFTs and tokens in which they invest may be restricted securities that may not be resold absent an applicable exemption. With respect to digital assets, this issue is nascent and evolving, but investment managers should be cognizant to follow the securities laws in the absence of additional guidance from the SEC. Please reach out if you have questions on any of the above.
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry. Please contact Mr. Mallon directly at 415-868-5345 if you have any questions on this post.