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Token Distribution and Unregistered/Restricted Securities

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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.

Potential Exemptions

Section 4(a)(1)

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

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.

Conclusion

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.

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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.

Simple Agreement for Future Tokens (SAFT)

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SAFT Background for Cryptocurrency Funds

As we discussed in a recent post, the SEC Report on the DAO, issued in July of this year, discussed how the SEC views Initial Coin Offerings (ICOs). One key takeaway from this report was that some digital assets/ tokens fall within the definition of securities, depending on the facts and circumstances related to the nature of the particular digital asset/token. If an ICO is considered an offer and sale of a security, then that offering must comply with federal securities laws.  This means the token must either be registered as a security with the SEC or that the token qualifys for an exemption from registration requirements.

In an attempt to comply with SEC regulations and account for some of the uncertainties around regulation of these digital assets, some recent ICOs have launched using a Simple Agreement for Future Tokens (SAFT) along with an accompanying offering memorandum. The SAFT, modeled after Y Combinator’s Simple Agreement for Future Equity (SAFE), is an agreement offering future tokens to accredited investors. Instead of offering an immediately available token, these SAFTs offer the right to a token upon a triggering event. SAFTS are intended to be private offerings exempt from registration with the SEC. Notably, Protocol Labs, Inc. offered the right to purchase Filecoin tokens through a SAFT earlier this year. Since then, multiple other ICOs have launched using SAFTS, including Unikrn, StreamCoin Labs, and Kik Interactive.

Overview of SAFT documentation

As part of some ICO launches, investors are subscribing through a SAFT and accompanying offering memorandum.  The SAFT is an agreement signed by both the issuer and the purchaser of the future tokens. The general SAFT template includes various provisions which we outline below.

  • Country legends – disclaimers directed toward specific countries, including statements on registration and restrictions on transfer of the tokens.
  • Sale information – purchase amount and price, token amounts, and vesting period.
  • Background information – various events including network launch, dissolution events, and termination events are discussed. A network launch will generally trigger an issuance of tokens based on the purchase amount of each investor.
  • Purchaser and Issuer representations – various representations made by both the issuer and purchaser are included. Notably, the purchaser will represent that it has been advised that the SAFT is a security and has not been registered, and cannot be resold without the consent of the issuer. The agreement also includes the procedures for purchase of rights under the SAFT including the form of payment.
  • Miscellaneous/ transfer provisions – various miscellaneous provisions including transfer restrictions and rights under the SAFT.

SAFT Offering Memorandum

The offering memorandum is similar private placement memorandum (PPM) for a traditional hedge fund and provides the prospective investor with information on the structural and business aspects of the offering. Below is a non-exhaustive list of some of the major sections of the offering memorandum:

  • Legends and securities laws notices
  • Table of contents
  • Company overview
  • Description of the directors and management
  • Terms of the purchase rights and the SAFTS
  • Risk factors
  • Description of the use of proceeds
  • Description of the plan of distribution

Potential Issues

There are a number of potential issues, including legal and regulatory, that may arise through the use of SAFTS.

Is a SAFT a security?

The SEC has applied the Howey test to digital assets, concluding that a token may be a security based on specific facts and circumstances. To determine whether tokens are securities, the SEC has looked to whether there 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 drafters of SAFTs have generally taken the position that SAFTs are securities (e.g., investment contracts). The SEC has commented in the past on SAFEs with respect to crowdfunding, mentioning that SAFEs are a type of security, warning investors to be cautious. SAFTs that are limited to accredited investors will likely elicit less concern from the SEC as they are not aimed at retail investors. It remains to be seen, however, whether the SEC will also consider SAFTs securities in a similar context with SAFEs. While any determination on whether the SAFT is a security will likely be based on the specific use of the underlying tokens, it seems likely that many SAFTs would be deemed securities because the purchasers are investing money (or other digital assets) in the rights to the future underlying token with the expectation of profits from the efforts of the issuers of the SAFT.

Restrictions on transfer

Under a SAFT, there is typically a restriction on the purchaser’s ability to transfer or make use of the tokens until the tokens are vested. Vesting takes place once the network is launched and the tokens are mined. A purchaser generally can, however, transfer its rights in a SAFT to another person or entity with the consent of the company issuing the SAFT. Below is a non-exhaustive list of some of the major provisions that should be in the transfer agreement.

  • Transfer of the SAFT
  • Consideration
  • Consent of the company that issued the SAFT
  • Transferor representations and warranties that it owns the SAFT and is able to transfer
  • Transferee representations that it will be bound by the terms of the SAFT

Source of funds

Many of these SAFTs allow purchasers to use various forms of consideration for these contracts including US dollars, Bitcoin, and other digital assets. This may raise anti-money laundering concerns around the source of the funds used for these purchases.

How do regulators view SAFTs?

US regulators have not provided specific guidance on the use of SAFTS. As discussed previously, the SEC has stated that some tokens are securities. Additionally, earlier this year, the SEC charged a businessman with allegedly running two fraudulent ICOs and appears to be taking an increasing interest in these issues. The SEC has mentioned the crowdfunding regulations in the SEC Report on the DAO, and the SEC seemed to be highlighting an option for certain fund sponsors. Given also that the SEC has commented on SAFEs with respect to venture and crowdfunding, it is possible that regulators will draw certain parallels between SAFEs and SAFTs in its views on these instruments. Unfortunately, until regulators issue additional guidance, it is not yet clear whether the SAFT in some cases will be sufficient to satisfy the SEC or other regulators.

Looking Forward

The SAFT represents some investment managers’ response to the concerns of the SEC and may encourage more ICOs to be based in the US. We hope the SEC and other regulators comment on their view of SAFTs, although much of the discussion over whether a SAFT or token is a security will remain a facts and circumstances determination.

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For more information on this topics related to the digital asset space, please see our collection of cryptocurrency fund legal and operational posts.

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 cryptocurrency focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.