By Luke Saunders, co-founder and CTO at blockchain advisory firm AmaZix
ICOs kicked off a new method of fundraising four years ago, with 2017 seeing the peak of the ICO phenomena coincide with crypto prices reaching their highest point in history. However, they soon witnessed a steep decline in popularity entering 2018, as exit scams and fraudulent token sales took their toll on investor’s faith and interest in ICOs.
In their place, STOs have grown in popularity, looking to provide redemption for an industry littered with the corpses of failed projects. But the nature of STOs means that, depending on the jurisdiction, there are several factors you’d need to take into account in order to be compliant. When deciding to launch an STO in the USA, these are the top things all business will need to consider before doing so.
The U.S. Securities and Exchange Commission (SEC)
In any discussion about securities regulation, the logical place to begin is with the SEC – gatekeeper to the US domestic market and the body which is often regarded as the unofficial “world finance police”. For if cryptocurrency is our new frontier, the SEC is the sheriff come to town, meting out its own punitive brand of justice.
Many have fallen under the SEC’s jurisdiction, including Munchee, which was shut down after its utility token was deemed a security in December 2017, as well as Paragon Coin and Airfox which each received a $250,000 fine in November 2018. In this climate, the eagerness of US startups to engage with the regulatory body from the outset is perfectly understandable. However, the cost of registration can escalate into hundreds of thousands of dollars.
Exemptions exist as an alternative option for businesses looking to avoid incurring the high cost of registering with the SEC. In the US, any security must either be registered with the SEC or qualify for an exemption, with the latter usually being the favoured choice.
That is not to say an SEC exemption is an easy route to conducting an STO; it just happens to be easier than the alternative route of your security being fully registered with the SEC. While there are plenty of exemptions available, there are three choices that are most popular among businesses, for a number of different factors.
Reg D Exemptions
Currently, most security token offerings that have sought an exemption have done so under the Reg D filing, with two such high-profile examples being tZERO and StartEngine.
There are a number of different rules a security can file under Reg D, including Rule 506 (b), Rule 506 (c) and Rule 504. Rules 506 (b) and (c) pre-empts state regulations nationwide, while Rule 504 does not pre-empt state regulations, meaning that it must also comply with regulations in each individual state it sells securities.
The key advantages of this type of exemption, and the reason why it is often the more popular route for businesses looking to become compliant, is that Reg D exemptions provide the ability for an unlimited raise and fast approval speed.
Furthermore, under Rule 506 (b) and (c), it is an appealing option for those seeking funds from institutional and accredited investors. However, those same restrictions may appear antithetical to the disruptive, democratizing vision which plays a part of so many blockchain projects.
Reg A+ Exemptions
This exemption is also popular and has often been referred to as the “mini Initial Public Offering”, allowing non-accredited investors to participate. However, at the time of writing, only one Reg A+ STO has yet been passed by the SEC.
On April 12, 2019, Blockstack filed for a $50m Reg A+ STO, with many tipping it to be the first blockchain project to gain the go-ahead from the SEC. On July 10, 2019, the SEC cleared Blockstack to hold the first regulated token offering.
There are two main types of Reg A+ exemption, Tier 1 and Tier 2. In both cases one of the initial filing requirements is that two years of financial statements are submitted for the scrutiny of the SEC. Reg A+ is therefore tailored to startups that have already established their businesses prior to making their offering public.
A Tier 1 offering is also subject to state review as it does not pre-empt state regulations. Although Tier 2 offerings do include investor restrictions, it is the responsibility of investors to self-certify their net worth. Tier 2 exemptions also require the issuer to make annual disclosures for as long as their shareholders number 300 or over after the first year. This includes a semi-annual report, current reports, and ongoing audited financials.
There are a number of things which make Reg A+ STOs appealing, but the headline feature is that non-accredited investors can participate. At this time, however, the drawbacks are numerous. Reg A+ exemptions are far slower to process than Reg D, more expensive, and incur disclosure requirements for Tier 2 exemptions.
Reg CF Exemptions
Regulation crowdfunding, otherwise known as regulation CF, is designed to allow startups to quickly raise up to $1.07 million in funds. It allows general solicitation and pre-empts state regulations. However, a Reg CF must be conducted through a registered platform only, and there remains a 12-month lock-up on securities after purchase.
So, Is the STO the New ICO?
Due to regulatory concerns, conducting an ICO in the US is an extremely risky affair. With this in mind, blockchain projects based in the States would be wise to look at the possibility of conducting a security token offering, with exemptions the best option available.
Reg A+ has arguably gathered the most excitement since it is perceived to most closely resemble an ICO. However, as Blockstack remains the only Reg A+ to have passed the SEC’s requirements to date, it is clear that there are many hurdles for businesses to clear before achieving this exemption. Therefore, the most practicable options currently for conducting an STO on US soil, and with US investors, are Reg CF for small raises, or Reg D for institutional investors only.