SEC’s Path to Registration - Part II

Lessons from Crypto Projects’ Failed Attempts to Register with the SEC

March 23, 2023 | Rodrigo Seira, Justin Slaughter, Katie Biber

See Part I here.
See Part III here.

1. What is SEC registration?

The grand bargain of the US securities laws is that any issuer selling securities to the general public must provide the public with a set of disclosures approved by the SEC. These laws are intended to address information asymmetry and ensure that the investing public has the material information necessary to make informed investment decisions. The securities laws are not intended to turn the SEC into a gatekeeper or “merit regulator” that itself decides which projects are investable and which are not. Congress meant for discretion to remain solidly in the hands of individual investors.1

According to this framework, whenever a crypto project is distributing tokens in a “securities offering,”2 it must be either registered with the SEC or comply with an exemption from registration. Most frequently, crypto projects rely on exemptions for private offerings made only to “accredited investors” or only to non-U.S. persons.

However, there are four main paths to registering or qualifying a token offering that includes non-accredited investors under the Securities Act of 1933 (the “1933 Act”):

  1. a “mini-IPO” under Regulation A pursuant to Form 1-A3;
  2. offering under Regulation Crowdfunding pursuant to Form C4;
  3. a typical IPO by a domestic issuer on Form S-1; and
  4. an IPO by a foreign issuer on Form F-1.

In order to register or qualify an offering, the issuer needs to fill out the appropriate form and submit it to the SEC with other documents, including typically 2 years of financial statements. The SEC will review the submission and provide comments which must be sufficiently addressed through written answers and subsequent amendments of the filed forms. Only after the SEC’s comments are fully addressed and the form is “effective” or “qualified” can the issuer begin to sell the securities.5

Even if the token distribution is exempt from the registration requirements of the 1933 Act, if the tokens are considered “equity” securities and the project meets certain minimum asset and holder requirements,6 they may also be required to register under the Securities Exchange Act of 1934 (the “1934 Act” and together with the 1933 Act, the “Securities Acts”) by filing Form 10. Form 10 is automatically effective 60 days after it is filed. However, the SEC can provide comments that need to be addressed to prevent the registration from being revoked.

Many crypto projects are understandably concerned that, in exercising discretion when commenting on and approving registration statements (or not), the SEC could overstep its mandate and act effectively as a merit regulator, depriving the public from their ability to choose their own investments. But the SEC’s job is to ensure adequate disclosure of securities opportunities for investors, not to decide what investors can invest in. That power remains entirely with the American people.

In addition, most SEC registration forms reference yet other SEC regulations, most notably Regulation S-K and S-X, which provide for a wide variety of specialized disclosures. There are also “schedules” for registrants in certain industries, such as oil & gas and banking, to address the unique elements of those industries. There are even special rules for issuers of asset-backed securities, excepting these issuers from some requirements applicable to “traditional companies” and adding other disclosures. But has the SEC done the same for companies working on crypto projects? No.

2. What obligations do SEC registered projects have?

Registration is not a “one and done” process. When a project registers a token it will also become a publicly-reporting company that must file annual, quarterly, and current reports, and become subject to the proxy, tender offer, Sarbanes-Oxley, and a host of other rules.7

Once a project has registered a token, either under the 1933 or 1934 Act, that token will only be able to trade on a National Securities Exchange, Alternative Trading System (“ATS”), or by brokers OTC.8 In addition, many intermediaries dealing with the token will be subject to onerous regulation. However, as stated by Coinbase in its petition for rulemaking, “The U.S. does not currently have a functioning market in digital asset securities due to the lack of a clear and workable regulatory regime.”

This is because tokens that register as securities would not be tradeable on existing crypto exchanges, none of which are registered as a national securities exchange. But there are also no registered national securities exchanges that can trade tokens and a limited number of ATS that effectively have no meaningful secondary liquidity. But more fundamentally, the current regulations are incompatible with disintermediated trading.

On the rare occasion the SEC lets a token project legitimize through registration, that token lands in a world lacking the infrastructure necessary to trade it. Specifically, the SEC has refused to license intermediaries such as broker-dealers and exchanges. As a result, the restrictions on the secondary market trading of tokens registered as securities will severely hinder if not totally impede the operation of most crypto projects. The SEC has created a world where project founders are required to register as ice cream, while making freezers illegal. Good luck!

Crypto projects seeking to register tokens or other products will also face a daunting process. Despite the substantial time and extraordinary costs incurred by the few projects that have attempted registration, these projects have arguably been unable to operate their businesses while complying with the securities laws, or have operated their businesses at a significant disadvantage to others in the market who operate without registration and with no adverse regulatory consequences. In the sections that follow, we will provide an overview of the tokens that have attempted to register with the SEC.9

3. ICO era enforcement actions

The earliest attempts at registering tokens under the Securities Acts came as a result of settlements relating to SEC enforcement actions. Six projects that conducted ICOs starting in 2017 — CarrierEQ Inc. (dba ”Airfox”), Paragon Coin, Inc., Gladius Network, Blockchain of Things, Inc., Enigma MPC and Salt Blockchain Inc. — were each charged by the SEC with undertaking an unregistered offering and sale of securities.10 In order to settle the changes, each of the projects agreed to repay investors, to register their respective tokens as a “class of securities” under the 1934 Act by filing Form 10 and to comply with ongoing reporting obligations.

a. How have those projects fared?

At the time, the SEC hailed the settlements as “a model for companies that have issued tokens in ICOs and seek to comply with the federal securities laws” and argued the settlements represented “a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.” The SEC even declined to impose additional penalties on each of the projects to account for their respective “remedial” actions, including their commitment to register the tokens as securities.

Yet one can argue the SEC’s requirement that these companies register their tokens was not meant to provide an avenue for the projects to continue operating as reporting companies – it was intended only to euthanize them. Registration was used as a tool to assist in the rescission process pursuant to which the companies had to pay back the original token purchasers. In hindsight, it’s no surprise that despite the SEC’s initial enthusiasm, out of the six projects that were required to register their token, five are no longer operating in the US or reporting to the SEC and none of the six tokens has any meaningful utility or market.

These examples reveal that the SEC’s suggested “path to compliance” was really an ascent to the afterlife. And while some might dismiss this as worthy punishment for projects that conducted unregistered offerings, it reveals the impossibility of complying with the current SEC regime.A former SEC enforcement lawyer was even quoted at the time saying the SEC’s settlement model was “impractical.” Perhaps recognizing this fact, the SEC has largely since stopped requiring projects to register as part of settlements for unregistered offerings of securities.11

Airfox

Airfox was a Massachusetts-based start up that, between August and October 2017, raised $15 million through its ICO of “AirTokens.” The company entered into a settlement with the SEC on Nov. 16, 2018, that included the obligation to register the AirTokens by filing a Form 10 within 90 days. Nearly 4 months later, on March 15, 2019, Airfox filed its Form 10, which became automatically effective on May 14, 2019, making AirTokens the first token to be registered with the SEC on Form 10. However, Airfox’s Form 10 had to be subsequently amended four times in order to respond to SEC comments.

While Airfox initially complied with its obligation to register the AirTokens and make ongoing disclosures, the company was forced to pivot away from their token and in May 2020 was acquired by a Brazilian retailer. In a current report filed on Form 8-K, the company noted it would discontinue the development of AirTokens because “[c]urrent laws and regulatory regimes do not provide for the Company to utilize the AirTokens as envisioned by the Company…” Since then, the company has stopped operating in the US and the AirTokens have had no liquidity. The token is effectively dead.

Paragon

Paragon Coin Inc. (“Paragon”) was a Delaware company that raised $12 million from their 2017 ICO of “PRG Tokens” as part of a scheme to integrate blockchain technology to the cannabis industry. Paragon also entered into a settlement with the SEC on the same date and on substantially the same terms as Airfox, including the requirement to register the PRG Tokens on Form 10 within 90 days.

On March 29, 2019, more than 4 months after the settlement, Paragon Coin filed its first and only Form 10 registration, which became automatically effective 60 days after. However, the company failed to answer an SEC letter with dozens of follow-up questions, or amend the registration or provide any additional disclosures.

According to reports, in April 2020 Paragon announced that it was filing for bankruptcy and ceasing operations, noting that its “plans were impossible to achieve due to several legal mistakes”.

On March 9 of this year, the SEC officially revoked the registration of the PRG tokens. There is also no market in the PRG Tokens. This project is dead.

Gladius

Gladius Network LLC (“Gladius”) was a Nevada company that was developing a network that allowed participants to rent out spare bandwidth and storage space. The company raised ~$12.7 million pursuant to its 2017 ICO of “GLA Tokens.”

On February 20, 2019, Gladius also entered into a settlement with the SEC that required it to register the GLA Tokens on Form 10 within 90 days. The Gladius settlement order included an additional provision stating that the company may later choose to file a Form 15 to de-register the GLA Tokens.12

The reference to Form 15 supports the view that a crypto asset may initially be offered and sold as part of an investment contract but later (e.g., as a result of sufficient decentralization) no longer be part of any investment contract.

However in Gladius’ case, the company didn’t even file any Form 10 registration statement as agreed to in the SEC settlement, nor did it reportedly pay back any of the tokenholders, opting to dissolve instead. This project is dead.

Blockchain of Things, Inc.

Blockchain of Things, Inc. (“BCOT”) was a NY-based corporation that, from December 2017 through July 2018, raised more than $12 million from its sales of “BCOT Tokens.”

On December 18, 2019, the company entered into a settlement with the SEC pursuant to which it agreed to register the BCOT Tokens under Form 10 within 120 days. In June 2020, BCOT filed its initial Form 10 registration, which it had to subsequently amend.

While BCOT temporarily complied with its ongoing reporting obligations, in March of 2023, it announced that it was ceasing operations and liquidating. In connection with the wind down, the company filed a Form 15 to de-register the BCTO Tokens, which is the first and only time tokens have been de-registered, albeit in the contest of a dissolution not a project decentralizing. This project is dead.

Enigma MPC

Enigma MPC (“Enigma”) is a Delaware corporation that raised ~$45 million by selling “ENG Tokens” in the summer and fall of 2017. On February 19, 2020, the company entered into a settlement with the SEC that required the company to register the ENG Tokens using Form 10.

Like others before it, the company initially complied with the settlement obligations and filed a Form 10 registration statement, which it subsequently amended three times in response to SEC comments. However, the company stopped making any disclosures after May 31, 2021, and is currently in an administrative proceeding for being delinquent on its reporting. The ENG Token has virtually no liquidity. This project appears to be comatose at best.

Salt Blockchain Inc.

Salt Blockchain Inc. (“Salt”) is a Colorado based corporation that operates a lending business that allows borrowers to obtain US-denominated loans collateralized by digital assets. During a period beginning in August 2017 and ending in August 2019, Salt raised ~$47 million from its sale of “Salt Tokens.”

On Sept. 30, 2020, Salt entered into a settlement with the SEC that included an obligation to file a registration statement on Form 10 within 120 days. In May 2021, Salt filed its initial Form 10, which was subsequently amended four times in response to SEC comments.

While Salt is an exception amongst the group given that it is still operating in the US, the Salt Token itself seems to have been largely deprecated and has almost non-existent liquidity. Despite this, the company has not filed a Form 15 to deregister the token, meaning they are subject to the burden of ongoing disclosure despite the token having no real utility.

Reg A offerings

The next wave of attempts at “compliant” token offerings were done as “mini-IPOs” under Regulation A promulgated under the 1933 Act (“Reg A”). Reg A offerings are technically exempted offerings as opposed to registered offerings, yet relevant to the discussion as they provide a potential alternative for regulated token distributions. As we will see, however, Reg A did not turn out to be a viable path either.

Reg A was updated by the JOBS Act in 2012 to provide an alternative for small companies to raise from unaccredited investors using “slimmed down” disclosures as compared to a traditional IPO on Form S-1. Those wishing to conduct a Reg A offering must draft an Offering Statement including the information required on Form 1-A, file it with the SEC and address any comments before getting “qualified.”13

If the issuer is conducting an “ongoing offering,” it must continuously update the Offering Statement to ensure it always contains all material information about the company, the platform, and the tokens. In cases where there are fundamental changes to information in the qualified Offering Statement, the SEC will review and approve the amendment. As described below, this obligation to update the Offering Statement on an ongoing basis can cause significant friction for crypto projects which typically iterate on product quickly and therefore will need to constantly amend their disclosures.

Reg A issuers also have ongoing reporting requirements. Although these disclosure obligations are less burdensome than those required after a fully registered offering, they nonetheless result in material ongoing costs to the token issuers. In addition, a significant challenge for Reg A token offerings is the lack of secondary markets, as the tokens must trade on SEC registered trading venues, none of which are workable options today.

When the Reg A offerings of Hiro Systems PBC (f/k/a Blockstack PBC, “Hiro”) and YouNow (each described below) were qualified in 2019, some argued that Reg A was a ”potential solution” to regulated token distributions.14 However, as described in more detail below, Reg A offerings did not turn out to be a viable option, partly due to the prohibitively high costs, the restrictions with trading the tokens, and the burden of disclosure obligations. This pathway has also led to a dead-end.

With four years of hindsight, the assessment from those same commentators was stark. The lead lawyer for both Hiro and YouNow recently noted that “To date, the SEC still has not adopted a single rule with which to govern crypto, has not amended a single disclosure or registration form to reflect the unique aspects of crypto, and has not created a workable process by which digital asset issuers can register their tokens for public sale or trade those tokens in a liquid secondary market.”

Hiro

On July 10, 2019, the SEC qualified the first Reg A token issuance. Hiro’s $40 million offering of “Stacks Tokens” structured as a “Tier 2” Reg A offering reportedly cost the company $2.8 million in fees and took over 10 months to prepare.

In addition to being the first, the most remarkable aspect of Hiro’s Offering Circular was that it laid out the company’s long-term plans for decentralization, noting that its “ultimate goal is that the evolution and development of the Blockstack network become independent of [Hiro].” Therefore, Hiro noted that while it was treating the Stack Tokens as securities “for the foreseeable future,” its Board would be “responsible for regularly considering and ultimately determining whether the Stacks Tokens no longer constitute securities.”

In other words, Hiro had registered the Stacks Tokens as securities out of an “abundance of caution,” but from day one aspired for the tokens to “morph” into non-securities, at which point Hiro would no longer be responsible for their registration.

In keeping with this framework, in January 2021, Hiro’s Board voted to “no longer treat the Stacks Tokens as investment contracts that are securities under the federal securities laws.”15

As a result, Hiro would no longer be required to file reports pursuant to Reg A. In making this critical determination, Hiro’s management and Board relied on a legal opinion from Wilson Sonsini, a summary of which was made publicly available.

Despite Hiro’s self-declaration that the Stacks Tokens were no longer securities, the SEC never formally weighed in. And it’s not clear the SEC agrees with Hiro’s position. In its latest annual report, Hiro disclosed that it “is responding to an inquiry from the Division of Enforcement” related to its decision to no longer treat the Stacks Tokens as securities.

While the SEC staff guidance has stated that the analysis of whether a digital asset represents an investment contract (and thus, a security) may change over time, it has failed to provide any bright line rule or further clarification as to the mechanics of tokens “morphing” from securities to non-securities. Therefore, until the SEC clarifies the point of “transformation,” other token issuers considering a Reg A token distribution will face similar uncertainty as to the status of their tokens as securities.

Hiro’s Offering Circular also acknowledged the limitations on the secondary market for registered tokens, noting that “there may not be a trading market available for the Stacks Tokens, or any digital token exchange on which holders of Stacks Tokens may transfer or resell their Stacks Tokens… As a result, the tokens may initially only be traded on very limited range of venues, including US registered exchanges or regulated alternative trading systems for which a Form ATS has been properly submitted to the SEC.” The disclosure continues by noting that “As far as we are aware, there are currently no national securities exchanges or exchanges that have been approved by the [FINRA] or registered under Form ATS with the SEC… to support the trading of Stacks Tokens on the secondary market.”

YouNow - Props

Also in July 2019, just a few days after the qualification of Hiro’s Reg A offering, the SEC qualified the Reg A Offering Circular of YouNow, Inc. (“YouNow”), which allowed the company to distribute up to $50 million worth of Props Tokens (“Props”) as part of its loyalty rewards program.

Despite reportedly spending over 2 years working with the SEC to get the Props offering qualified, in August 2021, YouNow announced that “given the regulatory constraints” they no longer had a “viable future.” In particular, YouNow pointed to its obligation to update disclosures on an ongoing basis and the lack of a secondary market for its tokens as the reasons it was shutting down, explaining that:

“Props Tokens’ status as qualified securities significantly limits our ability to respond to changing market conditions in a commercially feasible manner. The Reg A+ continuous offering environment in which we operate requires us to make public filings and often get prior regulatory approval for product changes. As a result, we are unable to follow anything remotely like proper product development of “launch, measure, iterate” and struggle to launch new key functionalities we develop (like staking or per-app tokens). In addition, although we submitted to the regulation of Props Tokens as qualified securities, no U.S. exchange has been able to list crypto assets such as the Props Token, which has hindered holders wishing to trade them.”

According to YouNow, these regulatory restrictions meant that the company had “not been able to develop Props Tokens in ways that could lead to commercial success, and there is no reasonable prospect of that happening in the future, given the regulatory framework.”As described by CoinDesk at the time, “The news certainly puts a damper on the viability of Reg A for token founders looking to build the next-generation web powered by crypto.

Ceres

Since the SEC’s qualification of Hiro and YouNow in the summer of 2019, there has only been one other Reg A token offering qualified by the SEC. After responding to elevent rounds of SEC comment letters and amending their Offering Circular five times over a period of over two years, Ceres Coin LLC (“CERES”) had its Reg A offering qualified on March, 2021.16

As described in its Offering Circular, CERES intends to develop a private blockchain to enables participants in the cannabis industry to transact more efficiently. However, the company has yet to finalize the development of the private blockchain or issue any tokens and has to date recorded no revenue.

5. The History of Attempted Registrations Show it is Not Currently a Viable Path

Recounting the history of crypto projects that have tried to register their tokens with the SEC is like taking a walk through a cemetery. As we have shown in the case studies above, the projects that attempted to come into compliance with the SEC’s registration requirements expended great effort and resources yet ultimately most of them failed, and those that persist do so in a state of uncertainty and comparative disadvantage.

The failure of projects that have attempted to register is due in large part to the SEC’s reluctance to provide a workable framework through rulemaking, exemptive relief, guidance and industry engagement. Instead, the agency’s preferred approach has been to engage in a highly publicized campaign of regulation by enforcement. A prime example of the agency’s dangerous approach to the industry is their recent decision to threaten Coinbase with a wells notice, reportedly over the exchange’s failure to register. The SEC chose to take this path despite Coinbase repeatedly asking for clarity on how it could register, including by filing a public rulemaking petition and meeting with the staff over 30 times in the preceding nine months.

In the forthcoming Part III of this series, we will further analyze why the applicable disclosure regime is not fit for purpose when applied to crypto, focusing on Form S-1. Part IV will then underscore how the SEC’s current position represents in practice a ban of the industry that exceeds the agency’s authority.

Special thanks to Mike Selig for his review.

Footnotes

  1. Chair Gensler has acknowledged that “We’re not a merit-based regulator primarily, we’re primarily a disclosure-based regulator and that’s the basic bargain. The public gets to decide what risk they want to take.” See A Fireside Chat with SEC Chair Gary Gensler. ↩

  2. We believe most token offerings would not qualify as securities offerings and in the event that they do, the “investment contract” transaction should not be confused with the token, which is the underlying object of that transaction. See Lewis Cohen et at, The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are not Securities, as well as our amicus briefs in the Ripple and Wahi cases. ↩

  3. Reg. A offerings are technically not a registered, but an exempted, offerings. However, we include them in our analysis as they are an alternative path to offering tokens to the public. ↩

  4. In a Regulation Crowdfunding offering, issuers will only be able to issue up to $5m worth of tokens in a twelve month period. ↩

  5. The issuer will have limited ability to make “offers” before the registration statement is effective ↩

  6. $10 million of assets and has at least 500 non-accredited or 2,000 total holders of record of those equity securities. ↩

  7. Projects that qualify an offering under Reg. A will be exempt from 1934 Act reporting requirements so long as they comply with Reg. A’s own reporting requirements, which are a similar but streamlined version. ↩

  8. Securities issued as Reg CF offerings must trade on Crowdfunding Platform. ↩

  9. We are limiting our discussion to crypto-native tokens that have attempted to register and not discussing the registration tokenized securities such as the INX Token or certain tokenized funds, as those offerings raise different issues. ↩

  10. Importantly, none of the charges included allegations of fraud. ↩

  11. See, e.g., the SEC’s settlement with Block.one, which raised $4.1 billion, which is orders of magnitude more than the ICO issuers that were required to register. ↩

  12. Specifically, the Gladius order noted: “If Respondent plans to file a Form 15 to terminate its registration pursuant to Rule 12g-4 under the Securities Exchange Act of 1934 on the grounds that the GLA Token no longer constitutes a “class of securities” under Rule 12g-4 because the GLA Token is no longer a “security” under Section 3(a)(10) of the 1934 Act, Respondent will notify the Commission staff at least thirty (30) days prior to such filing. Upon such notification, the Commission staff may make reasonable requests for further information, and Respondent agrees to provide such information, as applicable.” ↩

  13. There are two “tiers” of Reg A offerings: Tier 1, which is capped at $20 million in a 12-month period; and Tier 2, which is capped at $75 million in a 12-month period. Amongst other differences, issuers in Tier 2 offerings are not required to register or qualify their offerings with state securities regulators, which can provide meaningful relief for projects looking to offer their tokens to all Americans. ↩

  14. A WSJ article at the time framed it in these terms: “The Securities and Exchange Commission on Wednesday cleared blockchain startup [Hiro] to sell bitcoin-like digital tokens, a first-of-its-kind offering that could give young cryptocurrency businesses a new fundraising template.” ↩

  15. Hiro is no longer in the position of providing, and will no longer be able to provide, essential managerial services to the Stacks Blockchain. Management concluded further that if Hiro is no longer in the position of providing, and will no longer be able to provide, essential managerial services to the Stacks Blockchain, then it is no longer necessary for Hiro to treat the Stacks Tokens as investment contracts that are securities under the federal securities laws. ↩

  16. Chair Gensler’s nomination was pending before the full Senate in March 2021, and he was confirmed by the Senate in April 2021. While there is only one SEC Chair at a time, Acting Chairs traditionally keep nominees for SEC Chair abreast of key decisions leading up to their confirmation and avoid taking major actions without the tacit approval of the incoming Chair. ↩