Overview of Regulation A+ for Token Sponsors

Token issuers have come under increasing scrutiny with respect to their offerings on the heels of various statements by SEC personnel (see here, here and here).  SEC representatives have testified recently before House and Senate committees that the initial coin offerings (“ICOs”) they have seen are securities offerings and that it is “hard to have an [ICO] without a securities offering.”  These statements along with recent SEC enforcement actions against ICOs have created the desire for token issuers to make their offerings SEC compliant.  Many token issuers have thus begun to offer and issue tokens through certain exemptions from the securities registration regime including Regulation D private offerings and the Simple Agreement for Future Tokens (“SAFT”).  One option many groups are looking into is using Regulation A+ (“Reg. A+”) to offer security tokens publicly.

Background

Regulation A was overhauled through the JOBS Act, resulting in what is now referred to as Regulation A+.  Reg. A+ allows for a registered security to go through a general solicitation process without going through the long and costly IPO process.  Securities issued under Reg. A+ can be freely traded, subject to some restrictions and holding periods.  Another unique feature is that it allows for “testing the waters,” soliciting investors to gauge interest in the offering before or after filing the offering statement.  To qualify to use Reg. A+, an issuer must have their principal place of business in the United States or Canada and not be an ineligible investor (please see our blog post Notes on Regulation A+ for more information).

Reg. A+ has two tiers; Tier 1 allows issuers to raise up to $20 million and Tier 2 allows issuers to raise up to $50 million over a 12-month rolling period.[1]  Below is a side-by-side comparison of the two tiers.

Tier 1 and Tier 2 Comparison

Tier 1 Can raise up to $20 million No limit on amount investor can purchase All types of investors (qualified purchasers, accredited investors, and unaccredited investors) 2,000 investor limit pursuant to Section 12(g) of the ’34 Act Do not need audited financial statements except in special circumstances Must comply with state “blue sky” laws regarding securities registration

Tier 2 Can raise up to $50 million Limits on how much an unaccredited investor can purchase (see below) All types of investors (qualified purchasers, accredited investors, and unaccredited investors) Conditional exemption from Section 12(g) of the ’34 Act restrictions[2] Audited financial statements State “blue sky” laws regarding securities registration are preempted Must file annual, semi-annual, and current event reports after the offering with the SEC

Process

The process will look something like the following:

• Step 1: Entity Formation
  • To start the process, the entity must first be created.  This includes putting together the articles of incorporation and operating agreement, registering the entity with the state(s) in which it will operate, drafting promissory note distribution agreements (a SAFT can be used here instead), and issuing securities.
• Step 2: Draft Form 1-A
  • There are three parts to Form 1-A: Part I: Notification Filing, Part II: Offering Circular, and Part III: Exhibits.
  • Part I: Notification Filing
    • This is a brief summary of information about the issuer, offering, and jurisdictional information.  It can be filled out online and is formatted like the Form D filing.  It requires information such as balance sheet financials, determination of eligibility, a summary of the offering, and designation of the jurisdiction.
  • Part II: Offering Circular
    • The offering circular is a simplified and scaled down version for the Form S-1 and is similar to hedge fund offering documents. It is the primary disclosure document prepared in connection with the Reg. A+ offering.  This section requires information such as risk factors, the business plan, plan of distribution, Management’s Discussion & Analysis (“MD&A”) of Financial Condition and Results of Operations, management interests, and detailed analysis of the securities being offered.
  • Part III: Exhibits
    • The exhibit that are required as part of the Form 1-A include:
    • Issuer formation documents (e., operating agreement, articles of incorporation, etc.)
    • Promissory note agreement (or SAFT)
    • Agreement between issuer and broker-dealer
    • Opinion from legal counsel
    • Consent of auditor
    • Testing the waters materials
    • Escrow agreement (if necessary)
• Step 3: Submission to the SEC
  • Once all the materials for the Form 1-A are assembled, the Form 1-A will be filed for qualification on the SEC’s Electronic Data Gathering, Analysis, and Retrieval (“EDGAR”) system.  Issuers can request that their offering statement be non-public as long as they are publicly filed no later than 21 calendar days before qualification.  Once Form 1-A has been submitted, the issuer will correspond with the SEC regarding the submission to ensure that it is complete.  The offering statement on Form 1-A only needs to be qualified by order of the SEC and issuers will receive a notice of qualification from the Division of Corporation Finance.  With the consent of the Director of the Division of Corporation Finance, issuers are allowed to withdraw an offering statement so long as none of the securities under it have been sold and the offering statemen is not subject to a temporary order suspending the Regulation A exemption.
• Step 4: Notice Filing
  • For this step, the issuer will need to determine in which states to concentrate their selling efforts.  Once the states have been selected, the issuer will need to conduct the required notice filings in each state.  Although Tier 2 offerings preempt state securities registration and qualification provisions, state securities regulators can still require issuers to file any documents that were with the SEC with state with state securities regulators.
• Step 5: Ongoing Compliance
  • Tier 2 issuers are required to file Form 1-K, Form 1-SA, and Form 1-U with the SEC.
    • Form 1-K is an annual report that is filed 120 days after the fiscal year end. It consists of two parts: part 1 contain basic fillable information; part 2 requires the following: business operations of the issuer; transactions with related persons; information about directors, executives, and significant employees; MD&A; and two years of audited financials.
    • Form 1-SA is a semiannual report which is filed 90 days after end of first 6 months of fiscal year. It does not require an audit and includes financial statements and MD&A.
    • Form 1-U needs to be filed within 4 business days of any of the following:
      • Fundamental changes in the nature of the business;
      • Bankruptcy or receivership;
      • Material modification of the rights of security holders;
      • Changes in the certifying accountant of the issuer;
      • Non-reliance on previous financial statements or a related audit report or completed interim review;
      • Changes in control of the issuer;
      • Departures of the principal executive officer, principal financial officer or principal accounting officer; or
      • Unregistered sales of 10 percent or more of outstanding equity securities.
• Final Step: Exit Reporting
  • Tier 1 issuers are required to file an exit report on Form 1-Z through EDGAR no later than 30 calendar days after the termination or completion of an offering.
  • Tier 2 issuers may file an exit report on Form 1-Z if the offering has fewer than 300 security holders of record, offers and sales are not ongoing, and the issuer is up to date on all filings required by Regulation A.

Timeline

The timeline for a Reg. A+ offering will look something like the following:

• Week 1: The initial discussion of terms and the offering will take place.  The issuer and their legal counsel will create a detailed legal and operational timeline.
• Week 2: The issuer will form the necessary entities, start drafting Form 1-A, and begin gathering the needed financials statements and other documents.
• Week 3-4: All documents and financials will be finalized and submitted to the SEC.
• Week 5: The issuer will begin the notice filing process and conduct the necessary ongoing compliance.
• Week 6 and on: The issuer will begin back and forth discussion process with the SEC regarding the offering.

Issues & Other Items to Consider

There are a few items to consider when choosing to register under the Regulation A exemption:

1. Testing the Waters – If testing the waters occurs after filing the offering statement, any solicitation materials used must be preceded or accompanied by a preliminary offering circular or contain a notice informing potential investors where and how the most current preliminary offering circular can be obtained.  These solicitation materials must also be included as an exhibit when the offering statement is submitted for nonpublic review or filed.
2. Tier 2 Unaccredited Investor Limit – In a Tier 2 offering, an unaccredited investor can purchase no more than: (a) 10% of the greater of annual income or net worth (for natural persons); or (b) 10% of the greater of annual revenue or net assets at fiscal year end (for non-natural persons).
3. Auditing – Tier 2 issuers will need to have their financial statements audited and should begin this process as soon as possible.  However, if a Tier 1 issuer has had previously audited financial statements, in certain cases they may need to submit these.
4. Solicitation through Electronic Communication – An issuer is allowed to “test the waters” through platforms that limit the number of characters or text that can be included and still satisfy the requirements of Rule 255 if: (a) the electronic communication is distributed through a platform that limits the number of characters or text that may be included in the communication; (b) including the required Rule 255 statements together with the other information would cause the communication to exceed the platform’s characters or text limit; and (c) the communication contains an active hyperlink to the required Rule 255 statements and prominently conveys important or required information through the hyperlink.  However, if an electronic communication can contain the Rule 255 statements in their entirety along with the other information without exceeding the platform’s characters or text limit, it is not appropriate to only include hyperlink to the required statements.
5. Payment for Securities – For both tiers, an issuer can accept payment for the sales of its securities only after its offering material have been qualified by the SEC.  In addition, issuers under Tier 1 offerings generally must have their offering materials qualified by state securities regulators in each state in which it plans to sell securities.
6. Secondary Sales – For the 12 months following its first offering, no more than 30% of the aggregate offering price may be sold by security holders.  After the 12 months, secondary sales by affiliates will be subject to the 30% limit over a 12-month period.  Secondary sales by non-affiliates at this point will only be curtailed by the maximum offering allowed under each tier.

Conclusion

Thus far, Reg. A+ provides the most flexibility for SEC compliant ICOs.  Although there are reporting obligations and other restrictions, Reg. A+ allows for what is essentially a “mini-IPO” without the cumbersome process.  As token issuers look to be compliant, we are likely to see an uptick in Reg. A+ offerings.

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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.  Bart can be reached directly at 415-868-5345.

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[1] This rolling 12-month period means that each month you will need to recalculate the aggregate sales, dropping off the sales from more than 12 months ago. For example, if an offering pursuant to Reg. A+ started in January of 2018, it means that by February of 2019 initial sale of securities from January 2018 are no longer in the aggregate total (thus only calculating February 2018 – February 2019 sales).

[2] As long as the issuer remains current with their periodic reporting, engages the services of a transfer agent registered with the SEC pursuant to Section 17A of the Exchange Act, and meets the size-based requirements similar to those of a “smaller reporting company” under the Securities Act and the Exchange Act.