The legal underpinnings of Regulation A will only make it more and more appealing to token issuers. Here’s why.
Every decentralized network has extremely centralized beginnings. One person, or a small group, first has a vision. That vision rides a wave of distribution supported by any number of things: the value of its innovation, the virtue of its idealism, the charisma of its cofounders, the greed of its investor base, the zeal of its believers; the list goes on and on.
One day the vision becomes reality. A team of talented advocates gets together to build it, hoping an audience will come. Legal troubles start when this core, “centralized” group of individuals takes the leap to distribute tokens and “decentralize” the project.
Slouching Towards Decentralization
The term “decentralization” can mean many things to many people. For securities lawyers, the subsets of architectural decentralization and political decentralization (distinguished in this article) carry the most weight. Essentially, is the network built so that no small group of nodes can shut it down? Is it built so that no small group of individuals has control over key governance decisions?
“Decentralization” has become the industry’s goalposts. Even without a clear, agreed-upon definition, most treat it as an ideal worth striving towards. The path to that ideal, the movement from the centralized vision to the decentralized network, has turned out to be a securities law minefield.
Blockchain developers and lawyers alike struggle with how to navigate that minefield. Every offer or sale of blockchain tokens to the general public risks violating U.S. securities laws. Developers want value in exchange for their vision; they also want a wide distribution of users. But capital formation in the United States typically is a highly regulated activity open only to a select group of investors. Enterprising lawyers, myself included, put forth a number of proposals to try to resolve this tension.
The Original Legal Gambits
In 2017, I researched the legal underpinnings for a charismatic and (at the time) little-used “Simple Agreement for Future Tokens” or “SAFT.” That instrument ultimately drew billions of investment dollars into a vehicle built on original, but untested, legal thinking. The SAFT came, at least in part, in response to concerns that a presale mimicking Ethereum’s 2015 presale, offered to U.S. residents, would both require registration under U.S. securities laws and limit U.S. participation to accredited investors.
The SAFT took the industry one step forward. It seemingly provided a path for token sellers to avoid registration under U.S. securities laws. The path was a narrow one, however. SAFT purchasers had to be, in most cases, accredited investors who met relatively high income or net worth thresholds.
Investor savvy forced the industry to take another step. Leading into 2018, investors demanded more than just a right to future tokens. They preferred traditional investment instruments (i.e., a SAFE, a convertible note) with the option for a token kicker. Developers and lawyers obliged. These new mechanisms also provided for an exemption from registration. But, like the SAFT, they could not provide a pathway for open participation. Rather, the investor-led innovations walked token sale negotiating power away from developers and back into the hands of investors.
The Dominance of Reg D
Lawyers watched approximately two years of token sales occur under the frameworks above. Some innovation came through project crowdfunding via Reg CF, but those offerings topped out at a relatively low $1,070,000.
Most offerings occurred under Rule 506 of Reg D. This exemption offered an easy-to-use alternative to registration of a token offering under the U.S. federal securities laws. Most importantly, it did not require pre-approval from the government and had no dollar amount limit. The most burdensome filing requirement was a four-page form. Compare this to Reg A, which required government qualification, back-and-forth with the SEC, and an offering circular with detailed risk disclosures. That process was guaranteed to take months.
A developer in the heyday of token offerings had a clear choice. Either offer only to accredited investors and raise in eight weeks or offer more broadly and raise in eight months. To make the latter option even less appealing among billion-dollar token raises, developers balked at Reg A’s annual $50 million upper limit.
Reg D reigned supreme. Among the fireworks of the crypto boom, Reg A seemed too dull, too onerous, too slow. And the Reg CF innovations came precisely as the secondary markets for digital assets began to crash. Predictably, developers had little appetite for anything other than a SAFT or a token-infused SAFE or convertible note.
The Rationale and Rise of Reg A
Reg A turns 83 years old this year. It was originally intended to be an exemption from registration for small issuances of stock. However, after receiving widespread feedback that Reg A’s then $5 million limit was not useful to small companies in the modern age, Congress directed the SEC to expand Reg A (hence “Reg A+”) to allow exempt capital raises of up to $50 million annually. Of its 83 years, it has been in Reg A+ form for only four years.
Reg A now offers natural appeal to developers who need a massive capital influx to build a decentralized blockchain network. Because it allows capital raising from unaccredited investors, it provides both an exemption from registration and a pathway for open participation in a token sale. It can also be reused each year. Using it, developers would no longer need to position accredited investors as a waystation between themselves and a decentralized userbase. Reg A allows for sales directly to the intended audience.
One major potential downside to Reg A should been noted. It comes with the risk a token initially deemed a security remains so in perpetuity. The company selling the token might have to meet substantial ongoing reporting requirements. These burdens would limit the end-goals of developers who have no desire to create a regulated financial instrument or a reporting entity. While the SEC has provided a framework suggesting a token initially deemed an investment contract may at a later point lose that designation, the industry has yet to see evidence of this happening.
Many developers will shy away from Reg A as a result. Others will brave the uncertainty and test its limits.
Developers and lawyers will start with the 2018 speech by SEC Director William Hinman and search for “the way to when a digital asset transaction may no longer represent a security offering.” They will work with the SEC to offer tokens under Reg A and hope that when transactions in their token no longer represent investment contracts, reporting obligations will vanish.
Developers will see decreased legal fees. Recent filings show Reg A expenses in the token context for legal, accounting, printing, and other costs totaling as high as $2.8 million. This number will certainly go down. And with decreased cost, even more developers will use it to test innovative distribution methods that maximize “decentralization.” Along the way, lawyers will set forth creative legal theories designed to advance discussion under U.S. securities laws. And because Reg A requires back and forth with regulators, the SEC will gain close exposure to the nuances, values, and idealism that drive our innovative industry.
The Latest Gambit
A developer today has more than mere vision. For U.S. distribution, that developer now has a tested distribution method that can net a company up to $50 million each year. In this market, those numbers move people. As developers pursue the next wave of Reg A qualifications, their efforts will ultimately benefit the industry and normalize this pathway.
The Reg A token playbook is being written. Blockstack, YouNow — they rest on page one. As for the rest of the book, those empty pages wait only for innovation-forward regulators, developers, and lawyers to pick up a pen and start drafting.