Never before has it been easier for entrepreneurs to swiftly and efficiently raise staggering sums of money.  Term sheets? Lol. S.A.F.E? K.I.S.S.? You mean C.R.E.A.M.! These days all you need is a dollar and a dream (and a decentralized consensus mechanism). Sand Hill is now competing with a surge of new offerings that may well exist beyond their scope.

Whether or not you want to consider tokens like theDAO, S-DTV’s SNLGs, and Synereo’s AMPs as “investment contracts”, it would be prudent to anticipate that the consumer protection angle will eventually prove too hard for regulators to ignore.¹ Additionally, businesses using tokens to fundraise should not underestimate the likelihood of a 10(b)(5) action or other private rights of actions from investors who may feel wronged about the direction a given project or losses suffered.

So how can technologists responsibly establish and operate their businesses without living in fear of legal repercussions from US regulators or US investors left with a bad taste in their mouth?² 

Enter Regulation S. Reg S provides, among other things³, both foreign and domestic issuers of securities a safe harbor from the onerous registration requirements of Section 5 of the 1933 Securities Act provided that both the offer and sale of securities takes place outside of the United States.  

Issuers can rely on Reg S provided they meet two basic conditions:

1. The offer and sale of the unregistered securities must be made in an offshore transaction;

AND

2. No directed selling efforts may be made by the issuer of the unregistered securities, a distributor, or any of their respective affiliates to US investors.⁴

It’s important to remember that US securities laws are designed to protect US investors and capital markets and do not necessarily have a global scope.  Nonetheless, the internet complicates the nature of these offerings and increases the risk that foreign securities will “flow back” into the United States. All foreign offerings of unregistered securities should be structured carefully with counsel to ensure compliance with the voluminous securities rules and regulations of your jurisdiction.    

Defining an Offshore Transaction

An “offshore transaction” under Reg S focuses on the physical place where securities are offered and sold. The test for whether an offering qualifies as an offshore transaction is as follows:

Was the offer made to a US person?⁵

If the securities offering is made to a US person by an issuer or any of its affiliates, the issuer will be denied a registration exemption under Reg S. 

If the offering was not made to a US person, then one of the following must be true to qualify as an offshore transaction:

1. When the buy order is initiated, the buyer either is, or the issuer/distributor reasonably believes that the buyer is located outside of the United States.

OR

2. The transaction is executed in an offshore market.

To rely on the latter condition, the issuer must execute the transaction in a securities market that the SEC has deemed acceptable to conduct offshore transactions. As of this writing, however, there are no established foreign securities markets that act as an SEC-approved marketplace for token securities.⁷ So this may be a dead end… at least for now.

Far more promising for issuers are the possibilities afforded by the first condition: establishing a reasonable belief that a buyer is not a US citizen and is located outside of the US. Defining territoriality is particularly tricky for blockchain securities which only exist and are offered over the internet. After all, who (and in what manner) can determine where US cyberspace begins and ends?

For example, could an issuer reasonably believe that a Dutch citizen sitting in a NY cafe is located outside of the United States?

To answer this, we must ask a few closely related questions:

1. What kind of issuer is making the offering?;

AND

2. How is the issuer marketing its offering? Does it rise to the level of “directed into the US”?

What kind of issuer is making the offering?

Determining whether an entity is foreign or domestic under Reg S is pretty straightforward.  A “domestic issuer” is defined as any issuer other than a “foreign issuer” and a foreign issuer is any issuer other than a domestic issuer….Like I said, straightforward.⁸ 

Kidding aside, the rules promulgated under Reg S provide a bit more guidance. A domestic issuer is any issuer, other than a foreign government or foreign private issuer, in which:

1. More than 50 percent of the outstanding voting securities of such issuer are directly or indirectly owned by US citizens;

AND

2. Any of the following:

a. The majority of the executive officers or directors are United States citizens or residents;

b. More than 50 percent of the assets of the issuer are located inside the United States; OR

c. The business of the issuer is administered principally in the United States.⁹ 

Usually, the legal entities in question are entities that are very familiar.  When dealing with corporate entities such as Delaware C-Corps or a Hong Kong Limited Liability Companies it is easy to determine who has voting control simply “looking through” the entity to determine who owns what.¹⁰  

Similarly, it’s relatively easy to determine the provenance of some notable tokenized crowdsales, especially those whose issuers sell interests in the equity of a business.¹¹ The differences between those entities claiming to be foreign private issuers or domestic issuers simply requires knowing the citizenship of the beneficial owners in control of the issuing entity.

How is the issuer making the offering? Are their marketing efforts being “directed at the US”?

As noted above, when dealing with a medium as ubiquitous as the internet, it is difficult to define territoriality and to determine whether an offer made over the internet falls within US jurisdiction.

The SEC has, however, outlined what kinds of measures it deems adequate to ensure that US persons are prevented from participating in offshore internet offers.

Foreign Issuers:

For foreign issuers, the SEC would not consider an internet offer and its promotion to be directed at the US investors if the foreign issuer’s website: includes a prominent disclaimer making it clear that the offer is directed only to countries other than the United States. For example, the Web site could state that the securities or services are not being offered in the United States or to U.S. persons, or it could specify those jurisdictions (other than the United States) in which the offer is being made; AND the Web site offeror implements procedures that are reasonably designed to guard against sales to U.S. persons in the offshore offering. For example, the offeror could ascertain the purchaser’s residence by obtaining such information as mailing addresses or telephone numbers (or area code) prior to the sale. This measure will allow the offeror to avoid sending or delivering securities, offering materials, services or products to a person at a U.S. address or telephone number.”¹² 

Accordingly, if foreign issuers take these steps and they met the other requirements of the issuer it is likely that they will receive the safe harbor protections of Reg S. 

Domestic Issuers:

On the other hand, how would a domestic issuer of unregistered securities establish a reasonable belief that their offerings are restricted to non-US investors?

In instances where the issuer is a domestic entity using the internet to offer unregistered securities, the risk of flowback to US investors is significantly heightened.  As such, the SEC has stated that: U.S. issuer[s] must[] implement[] password-type procedures that are reasonably designed to ensure that only non-U.S. persons can obtain access to the offer” in addition to placing a prominent disclaimer on the site that states that the securities are not being offered in the US or to US persons.¹³

So, if a domestic issuer took these verification steps (which they probably should be doing anyway for BSA/AML purposes) to ensure that there are no US investors participating in their offering, they may have found an exclusion from U.S. securities laws under safe harbor under Reg S.  

Case Study: The Ethereum Crowdsale

Now that we have established the existence of safe harbors for both foreign and domestic issuers under Reg S, we can use this framework to determine whether an existing crowdsale offering could have qualified for an exclusion from US securities laws under Reg S, had the appropriate steps been taken.

Although it’s not what most people want to hear, the Ethereum crowdsale likely constituted a sale of unregistered securities. Since the process by which I reached this conclusion is relatively lengthy, I’m just going to leave it here

Now, let’s see if a registration exemption under Reg S would have been a viable option for the Ethereum crowdsale.

Who was the issuer of Ether tokens?

It’s likely that Stiftung Ethereum aka the Ethereum Foundation (the “Foundation”), a Swiss nonprofit, was the “issuer” of Ether tokens.  Both Section 2(a)(4) of the 1933 Securities Act and Section 3(a)(8) of the 1934 Securities Act define the term “issuer,” in part, as a “person who issues or proposes to issue any security.”¹⁴

Here, the Foundation and its agents initiated and enabled the sale of Ether tokens.  Specifically, the Foundation: 1. hosted and created the ethereum.org website where Ether tokens could be purchased; 2. pooled all of the crowdsale participants’ bitcoins; 3. developed the software that would become the Ethereum network as we know it today; 4. made the offer to investors to purchase Ether tokens; and (most importantly) 5. directly benefited from the relative success of the amount of bitcoins raised from the crowdsale.¹⁵

Since the Foundation structured the offer and directly benefited from the sale, it is likely that it would be considered the “issuer” of Ether tokens.

Is the Foundation a foreign or domestic issuer?

It is likely that the Foundation would be classified as a foreign issuer.  

Because of the significant non-US membership of the Foundation and the Foundation’s agents, it is likely that more than 50 percent of the Foundation’s assets are directly or indirectly owned by non-US citizens. Therefore the Foundation would likely be considered a foreign private issuer.  This is just an assumption from an outsider’s perspective, however.¹⁶ 

Did the Foundation’s offering take place in an offshore transaction?

Obviously, no. As the “Launching the Ether Sale” blog post makes clear, the Ether crowdsale did not prohibit US investors from participating and, in fact, explicitly encouraged US participation by not blocking the US after all. YAY.”¹⁷  

Because the Ether crowdsale took place over the internet, did not contain a disclaimer barring US participation, and specifically courted US investors, a court could easily find that the offering did not take place in an offshore transaction.  In not taking the appropriate precautions, the Foundation effectively forfeited its right to rely on the Reg S safe harbor.  

But for the sake of completeness…

Did the Foundation make “directed selling efforts” into the United States?

Yes, they did. As detailed above, the Reg S rules make specific pronouncements on how a foreign issuer’s internet offer can avoid the registration entanglements of the Securities Act .  

There was no disclaimer on the Foundation’s landing page, there was no pronouncement as to the specific jurisdiction through which the crowdsale was being offered,  and there were no procedures developed to discourage US investors from participating. As such, the Foundation would not be afforded a safe harbor under Reg S and has left itself open to scrutiny or legal attack by regulators and private parties.¹⁸

Conclusion: The case of the Ethereum crowdsale is particularly disappointing considering that the Ethereum Foundation could have taken advantage of the safe harbor provisions of Reg S. I’m hopeful that other technologists will take the appropriate steps to guard themselves from unnecessary legal and regulatory exposure in order to better secure the longevity and scalability of their projects. 


ENDNOTES:

[1] Take your pick from this list of unregistered securities.  See http://www.icocountdown.com/.  Compare with funding portals wherein business make significant risk disclosures.  See https://republic.co/

[2] To establish a claim under Rule 10b-5, plaintiffs (including the SEC) must show (i) Manipulation or Deception (through misrepresentation and/or omission); (ii) Materiality; (iii) “In Connection With” the purchase or sale of securities, and (iv) Scienter. Private plaintiffs have the additional burden of establishing (v) Standing – Purchaser/Seller Requirement; (vi) Reliance (presumed if there was an omission); (vii) Loss Causation; and (viii) Damages. 17 C.F.R. 240.10b-5

[3] The following analysis focuses on the applicability of issuers relying on the safe harbors of Regulation S pursuant to Rule 903.  Notwithstanding the above, Rule 903 further distinguishes between three categories of transactions based on the type of security being sold, whether the issuer is a reporting issuer under the Securities Act of 1934, and whether there is a “substantial US market interest” or “SUSMI”.   The analysis listed above is limited to a general discussion of issuers making overseas offerings over the internet.

[4] See 17 C.F.R. §230.903 and generally https://www.sec.gov/rules/final/33-7505.htm for further information about the final Reg S rules as implemented.

[5] See 17 C.F.R. §230.903(k)

[6] See 17 C.F.R. §230.902(b).  for a list of designated offshore securities markets.

[7] Id, at Note 6

[8] The term foreign issuer as defined here encompasses both foreign private insurers and foreign government issuers.  For the most part, the following analysis assumes that we are in foreign private issuer land; See 17 C.F.R. §230.902(e)

[9] Said differently, an issuer incorporated or organized under the laws of a foreign country will qualify as a foreign private issuer if either (i) 50 percent or less of the outstanding voting securities of the issuer are directly or indirectly held of record by residents of the United States; or (ii) none of the following three circumstances applies: (a) the majority of the executive officers or directors of the issuer are United States citizens or residents; (b) more than 50 percent of the assets of the issuer are located in the United States; or (c) the business of the issuer is administered principally in the United States.

[10] In September 1999, the SEC adopted amendments to the definition of foreign private issuer that, in effect, changed the underpinnings of the shareholder test such that the test focused more closely on beneficial ownership of the foreign company’s securities, as opposed to record ownership of the foreign company’s securities. SEC Release 33-7745 (Sept. 28, 1999), at Section II.E.

[11] For an easy case in crypto land, take a look at Erik Voorhees’(EV) sale of shares in SatoshiDICE(SD) and FeedZeBirds(FZB) it is relatively easy to determine who had control of the token issuance.  Although both SatoshiDICE and FeedZeBirds were unregistered corporations as represented by EV and the the SEC order, EV was a US citizen who exercised control over both entities/projects, despite the offerings sale through a Romanian based bitcoin exchange.  It seems likely that EV exercised at least a 50% or more controlling interest in both SD and FZB because of his heavy involvement in the project as well as his being the only individual who was names in the SEC cease and desist order.  Therefore, it is likely that the issuance of shares in SD and FZB would fall within the definition of domestic issuer were EV to seek the safe harbor protections of Reg S as well as complying with the remainder of the regime.

If on the other hand, the Romanian Exchange Bitcoin Exchange, MPEx was a greater than 50% partner with EV in connection with the ownership interests in the corporations holding SD and FZB “shares” and the ownership interest of MPEx was decidedly non-American, I would think it likely that the issuer would likely be classified as a foreign private issuer.

[12] See SEC Release 33-7516 (March 23, 1998) at Section III.B. (https://www.sec.gov/rules/interp/33-7516.htm) “Re Use of Internet Web Sites To Offer Securities, Solicit Securities Transactions, or Advertise Investment Services Offshore”.

Further, the SEC has not, at the time of this writing, commented on whether blocking investor access on the basis of IP addresses and issuing a disclaimer would be sufficient for foreign private issuers.  Blocking IP addresses not only strikes at the territorial component of the Reg S safe harbor but is a more effective method of blocking US investor participation in foreign private offerings than obtaining telephone numbers and addresses or self-certification on investors that they are not US citizens.  

[13] See Id at Section IV.B

[14] See Section 5 of the Securities Act of 1933 and Securities Act of 1934

[15] See “Launching the Ether Sale” (July 22, 2014) (https://blog.ethereum.org/2014/07/22/launching-the-ether-sale/)

[16] The exercise of determining the “ownership” of the Foundation is a lengthy legal exercise in and of itself and requires much further analysis.

[17] See “Launching the Ether Sale” (July 22, 2014) (https://blog.ethereum.org/2014/07/22/launching-the-ether-sale/)

[18] But even you think that the Foundation was likely the “issuer” of Ether tokens(you’d be wrong but ok) then they would most certainly be considered a “promoter” of the Ethereum crowdsale.   A promoter is defined as:

(i) Any person who, acting alone or in conjunction with one or more other persons, directly or indirectly takes initiative in founding and organizing the business or enterprise of an issuer; or

(ii) Any person who, in connection with the founding and organizing of the business or enterprise of an issuer, directly or indirectly receives in consideration of services or property, or both services and property, 10 percent or more of any class of securities of the issuer or 10 percent or more of the proceeds from the sale of any class of such securities. However, a person who receives such securities or proceeds either solely as underwriting commissions or solely in consideration of property shall not be deemed a promoter within the meaning of this paragraph if such person does not otherwise take part in founding and organizing the enterprise.” Securities Act of 1933, Rule 405, 17 C.F.R. § 230.405.

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