The rise in the use of digital assets has presented regulators around the world with a number of unique challenges. Regulators and law makers in different jurisdictions are considering their options to more effectively regulate these novel assets in ways that protect consumers and the market, but also foster innovation to support the benefits this technology could bring.
Our digital asset regulatory experts in the UK, Germany and the US have each provided their views regarding current developments in their respective jurisdictions. In this article, we focus in on the US. Over the past year, pressure continued to mount for the US government to enact regulation governing the use of digital assets in capital raising transactions.
The mounting pressure to regulate the use of digital assets in capital raising transactions is partly due to reforms in other countries that explicitly provide legal structures for digital asset offerings. Because the U.S. has enacted no such measures, both domestic and international entities have been left without a clear roadmap for compliant digital asset fundraising in America. U.S. regulators have instead continued to apply decades-old regulations and case law to these emerging technologies. Paths to raise capital legally in the U.S. with digital assets do exist through either registered or exempt traditional securities offerings.
"The lack of a digital asset-specific U.S. regulatory framework has meant that regulation continues to occur principally through enforcement activity."
However, the lack of a digital asset-specific U.S. regulatory framework has meant that regulation continues to occur principally through enforcement activity. It seems unlikely this situation will change any time soon, but several developments provide hope for a solution that could allow the U.S. to remain competitive in the digital asset fundraising space.
Compliant Fundraising & Enforcement under Current Law
A. Regulation A
Amended Regulation A of the Securities Act of 1933 (“Reg. A+”) provides a two-tiered exemption scheme under which offerings can be “qualified” as exempt from the U.S. securities laws. Tier 2 of the Reg. A+ exemption allows an issuer to raise up to $50 million per year from both accredited and non-accredited investors.1 In July 2019, the SEC qualified the first digital asset offering under Reg. A+ for Blockstack PBC (“Blockstack”), which conducted a $28 million offering to fund the growth and functionality of its network. Blockstack stated that it decided to conduct the offering under existing U.S. law because it “wanted to open our token offering to the general public… without excluding the U.S.”, in hopes of “maturing the broader crypto industry.” The day after qualifying the Blockstack offering, the SEC qualified video-streaming platform YouNow’s Reg. A+ issuance of 178 million “Props” Tokens that would be used to reward application users and content creators.
B. Significant Enforcement Actions
Reg. A+ provides an important option for compliant digital asset offerings in the United States, but most would-be issuers seek to raise more than Reg. A+’s $50 million threshold (or the $75 million it will increase to later in 2021). And while the SEC contends that its application of the securities laws to digital assets has been coherent and definitive, many in the digital asset community believe the agency’s approach has left no clear and easily-utilized fundraising options.
Despite this uncertain environment, digital asset issuers have continued to raise funds, resulting in a flurry of enforcement activity as discussed during our Emerging Themes webinar on 19 January 2021. Most notably, the SEC sued messaging platform Telegram Group Inc. (“Telegram”) in September 2019 to stop its $1.7 billion offering of digital assets called Grams. The SEC alleged that Telegram’s offering, structured as a two-part transaction known as a Simple Agreement for Future Tokens (“SAFT”2), was actually one integrated and unregistered securities offering. The U.S. District Court for the Southern District of New York (“SDNY”) accepted the SEC’s argument that the offering was a scheme to unlawfully distribute Grams to the secondary public market, and issued an order prohibiting sale or distribution of Grams, and ordering Telegram to disgorge $1.2 billion raised in the offering and pay an $18.5 million civil penalty.
The agency filed a similar suit against Kik Interactive, Inc. (“Kik”) for what it claimed was an illegal issuance of “Kin” digital assets in a $100 million offering. The SDNY again agreed with the SEC’s claim that Kik sold digital assets to investors without registering their offer and sale as required by the U.S. securities laws. The court permanently enjoined Kik from publicly offering Kin, ordering it to notify the agency before any future issuance or sale of digital assets and to pay a $5 million penalty.3 Both Telegram and Kik filed a Form D with the SEC that claimed a Rule 506(c) exemption from registering their offering of rights to receive future tokens. But in both cases the SDNY looked to the “economic realities” of the transactions, and accepted the SEC’s argument that the two transactions should be viewed as one integrated offering to which the exemption could not apply.4 These results have furthered the market perception that U.S. regulators are hostile toward digital assets.
Reasons for hope
Recent events provide some cause for optimism that the U.S. could be on the cusp of a new era for digital asset fundraising. While SAFT transactions were rejected in both the Telegram and Kik cases, Protocol Labs’ Filecoin offering, the first project ever to utilize the SAFT structure, recently completed its SAFT’s digital asset offering step in October 2020 and has so far avoided SEC scrutiny. There is hope that the presumed success of Filecoin’s SAFT can be a roadmap for other issuers, though the substantial period (more than three years) between investors’ initial outlay of cash and their receipt of digital assets could make it a less attractive option. Whether the SEC remains indifferent to the offering is also a critical question. But apart from any developments regarding Filecoin, SEC guidance released in late 2020 may soften the legal regime around SAFT offerings by providing new exemptions that allow related offerings to avoid integration under some circumstances.
"Recent events provide some cause for optimism that the U.S. could be on the cusp of a new era for digital asset fundraising."
1. A SAFT’s two parts are an initial offering of rights to receive tokens / digital assets in the future, which is claimed to be exempt from registration because the rights agreements are offered solely to accredited investors. This is followed in the future by a digital asset offering, by which time the digital asserts are envisioned to have utility in a developed network and so to no longer be purchased for their investment potential.
2. The SEC did not seek the sizable penalty against Kik that it sought in the Telegram case, which caused Telegram to abandon both its plans for Grams and their underlying blockchain. While unclear, this may have been due to the relative size of the offerings, the issuers’ relative risk profiles from an AML perspective, or Kin’s already having been issued and used in the market.
3. Rule 506(c) provides an exemption from registering a securities offering that will only be offered and sold to accredited investors.
4. Under the “integration doctrine,” single offerings which are artificially divided into multiple offerings to take advantage of Securities Act exemptions that apply to the multiple offerings, but would not be available to a single, combined offering, will be deemed integrated back into a single offering for regulatory purposes under certain conditions.
While new U.S. regulation similar to that implemented in Germany and contemplated in the U.K. would provide certainty for both private parties and the government, hope alone cannot make it a reality and it rests with the branches of government to chart such a course.
U.S. President-elect Biden will reportedly name former CFTC chairman Gary Gensler to head the SEC. Gensler is a leader with both a history of successfully imposing regulation on unregulated spaces and good familiarity with digital assets. Recently departed SEC Chairman Jay Clayton ably oversaw the agency’s initial response to digital assets, but his measured approach to the instruments was viewed as hostile by sectors of the crypto / digital asset community. Some of President-Elect Biden’s most prominent advisors on financial policy have backgrounds that suggest they would be more welcoming – even enthusiastic – about the technology. And legislators have already begun efforts to fill the regulatory void with proposed reforms governing the digital asset space. Two complementary bills, the Securities Clarity Act and the Digital Commodity Exchange Act, were recently introduced in the U.S. Congress, and seek to clarify the legal status of digital assets and their trading platforms.
While the precise regulatory environment that will prevail remains unknown, the multiplicity of potential avenues for reform is a positive development.