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In previous articles, we’ve explored what makes a cryptocurrency a “security” under U.S. law.
Why is this important?
Because if you want to sell a “security” to the public you must comply with SEC regulations that govern securities offerings. At a minimum, this means registering the offering with the SEC via a registration statement and providing investors with a detailed prospectus describing the offering, the rights and privileges of the security being offered, and the use of proceeds.
The SEC has already indicated that it believes the vast majority of ICOs are securities offerings and should be registered with the SEC. From Munchee to Titanium, the SEC has begun to crack down on unregistered token sales. At Crypto Law Insider, we expect to see this happen more frequently as the SEC’s stance becomes clearer and its enforcement efforts more focused.
The “simple” answer for most projects looking to raise money from US investors is to comply with the registration and disclosure requirements of a public offering. Unfortunately, these requirements can easily cost a project hundreds of thousands or more in legal, accounting and other professional fees. Not to mention the extraordinary amount of time and effort needed by the project’s executive team to oversee the process.
Fortunately, there is one simple and effective way to exempt an offering from the intrusive and expensive registration requirements described above.
Raise money via a non-public offering!
When Congress passed the Securities Act of 1933 and Securities Exchange Act of 1934, it realized that the SEC did not have unlimited resources and that its need to regulate securities offerings should vary depending on the number of investors, their sophistication, and the size of the offering.
The more investors, money and lack of investor sophistication, the more likely the SEC needed to be involved. Conversely, the smaller offering size, the fewer the investors, and the greater their sophistication, the less likely the SEC needed to be involved.
The result was a securities registration exemption: the non-public offering.
The U.S. Congress realized that SEC registration is both unnecessary and overly burdensome when the size of the offering is small and investors are sophisticated or have the information they need to protect themselves. It therefore exempted “non-public” offerings from the SEC registration requirements.
It’s this “non-public” offering exemption that lets us go to our parents and raise $25,000 so we can open the restaurant we’ve always dreamed about without registering our offering with the SEC.
While this exemption is commonly used (albeit unknowingly by most), it lacks clear bright line standards for qualification. Instead, the determination of “non-public” is a facts and circumstances analysis that looks at a number of characteristics, including the number of prospective investors solicited, the size of the offering, and the manner in which the offer is presented to prospective investors.
This test has been examined through many court rulings and the focus of the inquiry is often a sliding scale analysis based on whether the prospective investors have access to sufficient information, like the information that is available through the registration process, and whether the prospective investors are sophisticated. The more sophisticated the prospective investors, the less information they need to make an informed decision.
As you can imagine, reliance on this exemption is risky as there are no clear-cut rules for how many prospective investors may be approached, how much money may be raised, what levels of disclosure are necessary and how sophisticated the investors must be.
To facilitate the purposes behind the non-public offering exemption, and to ensure that a more coherent bright line test could be used, the SEC created Regulation D.
Regulation D provides exemptions to the public offering registration requirements via Rules 504 and 506. These Rules incorporate various limitations relating to how securities can be offered, to whom they can be offered and purchased by, and the size of the offering itself.
Rule 504 provides an exemption for issuers raising small amounts of capital. To qualify for this exemption, a company:
Can offer and sell up to $5 million of its securities in any 12-month period;
- May sell to an unlimited number of investors;
- May sell to accredited investors (a sophisticated investor or one with a great deal of money) and non-accredited investors; and
- Cannot use general solicitation or advertising to sell the securities unless the offering is restricted to accredited investors.
When a $5 million dollar cap is not sufficient, Rule 506(b) can be used for issuers that wish to raise an unlimited amount of capital. To qualify for this exemption, a company:
- Can offer and sell an unlimited amount of its securities;
- May sell to an unlimited number of accredited investors;
- May sell to 35 non-accredited investors, provided they receive sufficient information similar to what would be provided in a registered offering; and
- Cannot use general solicitation or advertising to sell the securities.
When a company really wants to get the word out about its offering and believes that a general solicitation is necessary, it can still raise an unlimited amount of funds if it utilizes Rule 506(c). To qualify for an exemption under this Rule, a company:
- Can offer and sell an unlimited amount of securities;
- May sell to an unlimited number of verified accredited investors;
- May not sell to any non-accredited investors; and
- May use general solicitation or advertising to sell the securities;
Form Reg D
Regardless of which exemption is used, all companies that comply with the requirements of Regulation D must file what is known as a “Form D” electronically with the SEC after they first sell their securities.
Form D is a brief notice that includes the names and addresses of the company’s promoters, executive officers and directors, and some details about the offering, but contains little other information about the company.
What does this mean for Crypto Law Insiders?
Regardless of which jurisdiction you operate from, if you accept money from US investors or even solicit US investors you are subject to SEC regulations.
For many ICOs, and token offerings, this means you’ll need to either register your offering with the SEC and comply with the onerous reporting and disclosure requirements of a public offering or fit within an exemption.
Unless you’re already a large company with a large war chest, your only good option is to limit your offering so that it fits within Regulation D and is exempted from registration. This means you’ll want to focus your raise on accredited investors.
If you choose this option, be smart and hire a quality law firm to assist you from the beginning. There are no cutting corners with the SEC and a little work up front can save you millions on the back end.