SEC Proposal Could (Eventually) Unleash Security Token Sales

Companies looking to raise funds via security token offerings (STOs) might soon get some relief from regulatory burdens in the U.S. 

The Securities and Exchange Commission (SEC) published a proposal to amend its capital formation rules for early-stage startups of all stripes earlier this month. If adopted, the modified rule would raise the cap on proceeds to $75 million from $50 million for security offerings sold under Regulation A+ and to $5 million from $1 million for Regulation CF (crowdfunding). 

These rules, which put the Jumpstart Our Business Startups (JOBS) Act of 2012 into practice, allow companies to raise funds from the public without having to register as a public company.

More broadly, the proposed rule amendment could mark a shift in how the SEC perceives the token space. 

“I think there’s also a bit of recognition from the SEC that the world is changing and they’re going to adapt which I think is very good and healthy,” said Muneeb Ali, CEO of Blockstack, which raised $23 million under a Reg A+ exemption last year.

The proposal may even be a sign the SEC is moving to “unclog the blockage of approvals” for companies looking to raise funds compliantly, said Vince Molinari, the former CEO and co-founder of regulated token trader Templum. 

To be clear, young companies might not be able to raise funds soon, regardless of regulation, given the impact of coronavirus on the world’s economy. Both traditional and crypto markets saw immense volatility last week, with the S&P 500 tanking more than 7 percent twice and bitcoin fluctuating between $3,900 and $8,000.

Rather, the SEC’s proposed changes may lay the groundwork for easier fundraising after an eventual recovery. The agency said it was seeking to “harmonize, simplify and improve” the guidelines surrounding capital formation.

“This particular proposed rule has great potential to help everyone including those in the DLT/blockchain space to raise capital,” said Dina Ellis-Rochkind, counsel in the government affairs practice of the law firm Paul Hastings.

Daniel Gorfine, former head of the Commodity Futures Trading Commission’s fintech wing LabCFTC, agreed, saying the proposed rule change could expand the number of compliant security offerings based around tokens.

Internet fundraising

Enacted nearly a decade ago, the JOBS Act essentially provided a bridge between the internet and financial markets through investing, including the potential to expand investment opportunities including for small businesses and startups, Gorfine said. 

“Then crypto and its underlying blockchain technology gained global mindshare towards the end of the last decade, and demonstrated how the Internet and social media could disintermediate traditional actors involved in the capital-raising process,” he said. 

Initial coin offerings (ICOs), which became fashionable during the crypto bull market of 2017, allowed investors to directly purchase from ventures. “Unfortunately, many of the capital-raising efforts done through ICOs failed to comply with securities laws,” Gorfine noted. A raft of SEC enforcement actions followed. 

Security tokens typically represent traditional securities, meaning they’re often backed by a real-world asset despite being built on a blockchain like Ethereum. Unlike most of the ICOs seen in 2017, security tokens are usually sold in a manner compliant with federal laws. 

Ellis-Rochkind, who worked on the JOBS Act as a Senate staffer, noted that currently, most compliant token sales are using exemptions derived from the law. 

The SEC’s proposal would make it easier for startups to conduct security token offerings, she said. 

“The SEC is providing regulatory relief when it comes to private placement and exemptions,” she said. “It’s not a gigantic step, but it makes it easier to raise capital.”

The general public can weigh in on the amendment by emailing or filling out a form on the SEC’s website. The comment period will remain open for 60 days after the filing is published in the Federal Register, the official national document archive (the filing was not in the Register as of press time).

The comment period might be a good opportunity for stakeholders to seek clarity on some outstanding questions, such as when tokens might transition from something that appears to be a security to something that does not appear to, Ellis-Rochkind said. (Some crypto advocates believe there is room under the law for “utility tokens,” meaning tokens which have a function and do not meet the legal definition of a security, but which might still be used in sales and secondary trading. SEC Chair Jay Clayton disagrees with this premise.)

“If you believe and I’m not saying I do, if you think the SEC is doing this case by case, if you believe that something can change into a utility or service or good, this is an opportunity to really put proposals in front of the SEC,” she said.

Better bang for buck

The immediate impact of the proposal would be that companies – including crypto startups – can raise more as they build out their systems and try to launch novel products.

The proposal doesn’t discuss tokenized offerings in depth, but it does consider them, Gorfine noted. 

“By harmonizing the types of securities that could be offered through Reg CF and Reg A+, it stands to reason you could essentially run a tokenized security offering through the crowdfunding exemption up to a $5 million cap as proposed by the SEC,” he said. 

Ali called the proposal “a step in the right direction,” and said he would expect more companies to look at the new caps.

While the Reg A+ fundraising cap is immense, he said the Reg CF change is likely far more significant for companies. Firms raising $50 million to $75 million are already established and likely on their second or third fundraising rounds, he said. Companies looking to raise through Reg CF are more likely to be early-stage firms.

“The difference between $1 million and $5 million is huge. I think $5 million is a very healthy limit and we might see a lot more people doing it,” he said. “The legal overhead is a lot lower with a Reg CF.”

Essentially, companies could see a greater return per dollar spent on legal fees and efforts.

But Molinari said the Reg A+ amendment might have a wider impact. In his view, the modified Reg A+ “could be a perfect mechanism” for digital securities, as it provides one possible answer to the question of “what is a security or what is not.”

In practice, how the SEC ultimately defines the lockup period for tokens will also have an impact, he said. If a company can begin trading tokens within a few months of the sale, it would benefit them. However, if a company has to wait longer than six months, it may not be worth it.

“If it takes 6-12 months it’s not going to get market acceptance because companies can’t afford to sit around and wait that long,” he said. 

The proposed amendments would also create a “demo day” carve-out for companies which would let them present their businesses to potential investors without violating rules prohibiting “general solicitation.” In addition, the changes would require clearer communications to investors.

Long-term shift?

Gorfine noted that Simple Agreement for Future Tokens (SAFTs) and Simple Agreement for Future Equity (SAFE) were mentioned in the proposal, though the SEC appears to be warning against these fundraising methods. 

Molinari said he expects to see additional movement on the capital markets front in the long term.

“Ultimately these developments could help satisfy the original intent of the JOBS Act by leveraging the potential of crypto and blockchain technology to give retail investors access to startup and small business investment opportunities,” Gorfine said.

Still, being able to raise funds is only half of the story, Ali said. In his view, how a security token project can transition to a decentralized, operational network is equally as important as the sale itself. 

His company is working on defining how this might look, though there is currently no framework for other startups to look at. 

“The SEC is actually taking a very deep, thoughtful look at these problems. It’s clearly on their agenda, it’s clearly on their minds, and I do think it’s a positive signal that they’re highlighting crypto,” he said. While the agency is moving slowly, the enforcement actions it has taken may be helping regulate the space to protect against fraudulent token sales. 

Ellis-Rochkind concluded by saying entities in the crypto space should engage with regulators at the right places. “This is the best chance of getting anything done,” she said. 

Sebastian Sinclair contributed reporting.