In July 2018, Coinbase – one of the largest cryptocurrency platforms — announced that it had won regulatory approval for a trio of acquisitions. This announcement generated a lot of publicity that Coinbase is on its way to creating the first marketplace on which blockchain-based tokens classified as “securities” can be traded. As it turns out, Coinbase never received regulatory approval for the acquisitions. However, the announcement was nevertheless a potentially significant event for the future of crypto trading.

In order to operate an exchange for securities, an entity must register as a national securities exchange or operate under an exemption from registration, such as the exemption provided for alternative trading systems (ATS) under SEC Regulation ATS. An entity that wants to operate an ATS must first register with the SEC as a broker-dealer, become a member of a self-regulating organization, such as FINRA, and file an initial operation report with the SEC on Form ATS.

Because Coinbase is neither registered as a national securities exchange nor operates under an exemption, it cannot operate an exchange-based trading platform for blockchain-based securities. However, the recently announced acquisitions indicate that Coinbase may be headed in that direction. The three companies acquired by Coinbase were:

  • Venovate Marketplace, Inc. (registered as a broker-dealer and licensed to operate an ATS)
  • Keystone Capital Corp. (registered as a broker-dealer)
  • Digital Wealth LLC (registered as an investment advisor)

By acquiring companies with the proper licenses already in place, Coinbase may be able to speed up its plan to create an exchange-based trading platform for blockchain-based securities as a regulated broker-dealer.

What exactly are blockchain-based securities anyway?
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If you find the title of this posting confusing, let me explain:  On June 28, the SEC announced revisions to the definition of “smaller reporting company”that will significantly expand the number of companies that fit within that category (i.e., “smaller gets bigger”).  As a result, more public companies will be able to reduce the disclosure they are required to provide under SEC rules (i.e., “which means less”).  The new definition will go into effect 60 days after publication in the Federal Register.

Background

The SEC adopted the reduced disclosure requirements applicable to smaller reporting companies, or SRCs, in 2007. These reduced requirements were intended to ease the costs and other burdens of disclosure for small companies.  The reduced requirements enabled SRCs, among other things, to:

  • present only two (rather than three) years of financial statements and the related management’s discussion and analysis;
  • provide executive compensation for only three (rather than five) “named executive officers”;
  • omit the compensation discussion and analysis in its entirety;
  • present only two (vs. three) years of information in the summary compensation table; and
  • omit other compensation tables, pay ratio disclosure, and narrative descriptions of various compensation matters.

In addition, SRCs that are not “accelerated filers” (companies that must file their Exchange Act reports on an accelerated basis) need not provide an audit attestation of management’s assessment of internal controls, required by the Sarbanes-Oxley Act.  More on this below.
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For the first time since 2015, the SEC has its full complement of five commissioners.  That’s a good thing.  And at least one new Commissioner – Robert Jackson – seems to have hit the ground running.  For example, he made a speech in San Francisco just the other day in which he expressed his disfavor of dual-class stock, suggesting that it would create “corporate royalty”. Specifically, because shareholders in at least some dual-class companies have no voting rights, leadership of the company could be passed down through the generations in perpetuity.

Commissioner Jackson is a smart man – I’ve seen him speak at a number of programs, and he’s demonstrated his intelligence as well as his telegenic appearance.  His use of the “corporate royalty” meme also shows that he’s witty, though don’t think we need to worry too much about CEO titles becoming hereditary.

What I do think we may need to worry about is where he goes with his concerns.  Specifically, the point of his speech is to suggest that exchanges adopt mandatory sunset provisions so that their dual-class structures would fade away over time.


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Photo by hamad M

Initial Coin Offerings, or ICOs, have generated a lot of buzz recently as a new method by which companies can raise capital to fund their businesses. At the same time, the SEC has been cracking down on ICOs that involved the offer or sale of a security that was not registered or structured to comply with an exemption from registration. For example, the SEC announced last week that it halted a $600 million ICO by AriseBank, which allegedly involved the offering of a coin that was a security without properly registering the transaction. Despite the apparent scrutiny of ICO transactions by the SEC, there’s much uncertainty in the space as to when securities laws may or may not apply to a specific ICO transaction.

Currently, we are seeing two primary types of ICOs – those that involve the sale of a “security token” and that are intended to be offerings of a security and those that involve the sale of a so-called “utility token,” which do not involve the offer or sale of a security. The primary difference between these two types of tokens is that a utility token is designed such that it has some intrinsic value that is not based upon prospective price appreciation. For example, a cloud computing company might sell utility tokens that are redeemable with the issuer for storage space on the issuer’s servers. In this sense utility tokens are not unlike gift cards where a purchaser is acquiring something that can be redeemed for products or services from the issuer in the future. Like gift cards, an incentive to purchase a utility token could be that the token offers a discount to the normal price for the issuer’s goods and services. While a secondary market for the utility token might develop, just like there are secondary markets for the purchase and sale gift cards, issuers usually intend for these tokens to fail the Howey test, which is the test that is used to determine whether something constitutes an “investment contract” (which would be a security) for federal securities law purposes.
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Initial coin offerings have taken off in 2017.

The SEC took two strong steps this week toward increased regulation of the cryptocurrency markets and specifically regulation of Initial Coin Offerings (“ICOs”). These steps included the halting of an ongoing ICO and a strong statement by the SEC’s chairman regarding ICOs and their status under the Federal securities laws. These steps were the SEC’s strongest actions to date regarding ICOs, but what is the probable long-term result here? This is getting very interesting as you pit the regulators and their application of traditional securities law concepts against an increasing strong demand in the investment community to invest in these cryptocurrency vehicles.

An ICO involves the offering of a token, “coin” or other digital product. In exchange for their investment, investors receive these tokens or coins. The company then uses the proceeds of the ICO for various corporate purposes similar to a regular offering of securities. ICOs have generally not been registered with the SEC.

On December 11, 2017, the SEC halted the ICO that was being conducted by Munchee Inc., a company that developed a restaurant review app. This action was based on the fact that the company had not registered this offering with the SEC. This ICO involved the issuance of MUN Tokens by Munchee, which the company said might increase in value. Munchee planned to raise about $15 million in this ICO. The SEC said that an investor could reasonably expect to earn a return on these Tokens, and accordingly the Tokens issued in the ICO were “securities” and should have been registered under the Federal securities laws. Munchee accepted the SEC’s findings without admitting or denying anything. The company agreed to halt the offering and to return all proceeds that it had received from investors in the offering.

The investigation of this matter was conducted in part by the SEC’s new Cyber Unit (a division of its Enforcement Section). The SEC had also issued other materials regarding concerns with cryptocurrencies and ICOs, including an Investor Bulletin issued on July 25, 2017 and a Report of Investigation issued on the same date.
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waldryano
waldryano

I don’t know when Congress decided that every piece of legislation had to have a nifty acronym, but the House Financial Services Committee recently passed (on a partisan basis) what old-fashioned TV ads might have called the new, improved version of the “Financial CHOICE Act”.  The word “choice” is in solid caps because it stands for “Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs”.

Whether and for whom it creates hope, opportunity or something else entirely may depend upon your perspective, but whatever else can be said of the Act, it is long (though at 589 pages, it is slightly more than half as long as Dodd-Frank), and it addresses a very broad swath of issues.  Here’s what it has to say about some key issues in disclosure, governance and capital formation, along with some commentary.
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SMU Central
SMU Central

Things are looking pretty good for the venture capital industry. Potential VC investors have a lot of money available, and industry and geographical trends show a positive outlook for VC investing in the near term. There are numerous factors that could negatively affect the outlook for VC investments, but it certainly appears that substantial VC investment activity could occur over the next twelve months.

The most significant positive factor for VC activity in the near term is the supply of available cash. According to a recent report, VC funds currently have approximately $120 billion available for investment. Even though this is a composite number that is applied across the whole VC industry, it is a huge amount of available investment funds.

Another positive factor is the increase in corporate VC investment. In a relatively short time (aided by large amounts of cash on corporate balance sheets), corporate investors have begun to play a key role in the VC industry, especially in larger deals. Last year corporate VC deals comprised 25% of total VC deals, and this percentage will continue to increase. See my prior blog post on the rise of corporate VC investors (Corporate Venture Capital Investments – Good for Startups?).


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Photo by Oblivious Dude
Photo by Oblivious Dude

The SEC’s Division of Corporation Finance recently issued new Compliance and Disclosure Interpretations (“C&DIs”) for Securities Act Rule 701 which clarify application of the Rule in the context of mergers. In a nutshell, Rule 701 provides an exemption from SEC registration requirements for private companies, private subsidiaries of public companies and foreign private issuers to offer their own securities, including stock options, restricted stock and stock purchase plan interests, as part of written compensation plans or agreements, to employees, directors, officers, general partners and certain consultants and advisors.

Under Rule 701, the aggregate sales price or amount of securities sold in reliance on Rule 701 during any consecutive 12-month period must not exceed the greatest of $1 million, 15% of the total assets of the issuer (measured as of the issuer’s most recent balance sheet date, if no older than its last fiscal year end), or 15% of the outstanding amount of the class of securities being offered and sold in reliance on Rule 701, (again, measured at the issuer’s most recent balance sheet date, if no older than its last fiscal year end). If the aggregate sales price or amount of securities sold during any consecutive 12-month period exceeds $5 million, the issuer must deliver specific written disclosures a reasonable period of time before the date of sale, including a copy of the summary plan description under ERISA or, if the plan is not subject to ERISA, a summary of the material terms of the plan, information about the risks associated with investment in the company’s securities, and financial statements meeting the requirements of the SEC’s Regulation A as of a date no more than 180 days before the date of the sale.

In the context of a merger transaction, the newly issued C&DIs provide the following guidance:
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Photo by Chad Cooper
Photo by Chad Cooper

Good, but not surprising, news for issuers considering a Regulation A+ offering. Back in May 2015, Massachusetts and Montana sued the SEC in an attempt to invalidate the Regulation A+ rules.  Montana had attempted to obtain an injunction to prevent the Regulation A+ rules from going into