Laura Anthony

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    • Member Type(s): Expert
    • Title:Founding Partner
    • Organization:Legal & Compliance, LLC
    • Area of Expertise:Securities Law
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    SEC Adopts Amendments to Simplify Disclosure Requirements

    Tuesday, October 16, 2018, 5:14 AM [General]
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    n August the SEC voted to adopt amendments to certain disclosure requirements in Regulations S-K and S-X (the “S-K and S-X Amendments”) as well as conforming changes throughout the federal securities laws and related forms. The amendments are intended to simplify and update disclosure requirements that are redundant, duplicative, overlapping, outdated or superseded with the overriding goal of reducing compliance burdens on companies without reducing material information for investors. The new amendments finalize and adopt the proposed rules that had previously been issued on July 13, 2016. See my blog on the proposed rule change HERE. The final rule changes were substantially, but not entirely, as proposed.

    The Regulation S-X and S-K Amendments come as a result of the Division of Corporation Finance’s Disclosure Effectiveness Initiative and as required by Section 72002 of the FAST Act. The proposing release also requested public comment on a number of disclosure requirements that overlap with, but require information incremental to, U.S. GAAP to determine whether further changes should be made.

    The S-K and S-X Amendments cover:

    • Duplicative requirements, including duplications between financial footnote requirements and disclosures in the body of a registration statement or report;
    • Overlapping requirements which may not be completely duplicative. The S-K Amendments consider whether to delete certain disclosure requirements that are covered in GAAP or other financial reporting or integrate such disclosures into a single rule source;
    • Outdated requirements which have become obsolete due to the passage of time or changes regulations, business or technology; and
    • Superseded requirements which are inconsistent with recent legislation or updated rules and regulations.

    The amendments are set to go effective thirty (30) days after publication in the federal register. As of the date of this blog, the amendments have not been published. There have been a few blogs and some commentary as to the reason for the delay, but regardless of the reason, the delay has caused some question as to whether certain changes will need to be implemented in the upcoming 10-Q’s to be filed for companies with a September 30 quarter-end. In particular, the new amendments will require companies to present a change in shareholders’ equity as part of its quarterly financial statements, which statement was previously only required in annual reports.

    Responding to the marketplace questions, on September 25, 2018, the SEC published a new Compliance and Disclosure Interpretation (C&DI) on the matter. New question 105.09 clarifies that the amendments are effective for all filings made 30 days after publication in the federal register. However, despite this effective date, the SEC would not object if the first quarterly statement of changes in shareholder’s equity is included in a company’s Form 10-Q filed for the quarter that begins after the effective date of the amendments.

    Disclosure Location

    Some of the amendments change the location of information in a filing which can have a material impact.  Location changes involve:

    • Prominence Considerations – the location of a disclosure may provide for a certain level of prominence of the information.
    • Financial Statement Considerations – some amendments relocate disclosure from outside to inside the financial statements, thus subjecting the information to audit and internal review, internal controls over financial reporting and XBRL tagging. Furthermore, forward-looking statement safe-harbor protection is not available for information inside the financial statements. Conversely, some amendments relocate disclosures from inside to outside the financial statements.
    • Bright-line Disclosure Threshold Considerations – some amendments removed bright-line disclosure requirements.

    Redundant or Duplicative Requirements

    The Regulation S-K and S-X Amendments eliminate a laundry list of 25 redundant and duplicative disclosures. Most of these changes are technical and nuanced related to particular Regulation S-X GAAP and other financial statement disclosures—for example, foreign currency, financial statement consolidation, income tax disclosures, contingencies and interim accounting adjustments. As these eliminations are duplicative, they will not change the financial reporting or disclosure requirements.

    Overlapping Requirements

    Similar to redundant and duplicative disclosures, the SEC has identified numerous disclosure requirements that are related to, but not exactly the same as, GAAP, IFRS and other SEC disclosure obligations. The Regulation S-K and S-X Amendments delete, scale back or integrate the overlapping disclosures to eliminate the overlap.

    The proposed rule release categorized changes as either deleting a disclosure requirement or integrating a requirement with another rule. Some of the proposed changes involved a change in disclosure location, with considerations outlined above in my discussion of disclosure location.

    A complete detail of all the Regulation S-K and S-X Amendments related to overlapping disclosures is beyond the scope of this blog; however, a few items deserve discussion.

    In general, many of the changes proposed by the SEC relate to interim financial reporting. In some cases where items are fully required to be reported in a Form 8-K, annual report or management discussion and analysis (MD&A), the SEC has eliminated the same or similar requirement from interim financial statements. For example, the SEC eliminated significant business combination pro forma financial statement requirements from interim financial statements for smaller reporting companies and Regulation A filers. The pro forma financial statements are already sufficiently required by Item 9.01 of Form 8-K.  However, at this time the SEC retained the financial reporting in interim reports for a significant business disposition or discontinued operation.

    In some cases, the SEC eliminated disclosures in financial statements, leaving only the disclosure in the body of the filing. For example, the SEC eliminated segment financial information from the footnotes, leaving it only in the MD&A.

    In other cases, the SEC eliminated disclosure in the body of a document in favor of a financial statement disclosure. For example, the SEC eliminated a discussion of warrants, rights and convertible instruments from the body of a Form 10 or S-1, noting that a complete disclosure, including dilution, is required in financial statements.

    Not all of the proposed amendments were included in the final S-K and S-X Amendments. For example, rules related to the financial disclosure requirements related to repurchase and reverse repurchase agreements have overlapping provisions. However, the comments to the proposed elimination of these overlapping requirements prompted the SEC to retain the provisions as is, and refer the requirements to FASB for potential incorporation into U.S. GAAP.  Similarly, although most of the proposed amendments related to derivative accounting were included in the final rule release, the requirement to disclose where in the statement of cash flows the effect of derivative financial instruments is reported remains, again with a referral to FASB to consider incorporation with U.S. GAAP. Likewise, disclosures related to equity compensation plans remain unchanged but were referred to FASB for potential incorporation with U.S. GAAP.

    Outdated Requirements

    The SEC has identified disclosure requirement that have become obsolete as a result of time, regulatory, business or technological changes. The Regulation S-K and S-X Amendments amend and sometimes add, but not delete, disclosure as a result of outdated requirements.

    Again, most of the outdated requirements are technical (for example, income-tax disclosures) in nature and beyond the scope of this blog. Some are common sense; for example, a reference to information being available in the SEC public reference room has been amended to include only a reference to the SEC Internet address for EDGAR filings. Another common-sense change is the elimination of the requirement to post the high and low bid or trading prices for each quarter for the prior two fiscal years in an annual 10-K. The SEC reasons that the daily market and trading prices of a security are readily available on a number of websites. Moreover, these websites allow for the download and collation of trading prices over periods of time and provide much more robust information than currently contained in a 10-K.

    Superseded Requirements

    The constant change in accounting and disclosure requirements and regulations have created inconsistencies in Regulation S-K and S-X. The SEC has effectuated amendments to eliminate such inconsistencies. For example, certain provisions in Regulation S-X still refer to development-stage companies, a concept that was eliminated by FASB in June 2014.

    The SEC also took this opportunity to clean up some nonexistent or incorrect references that resulted from regulatory changes over time.

    Further Background on SEC Disclosure Effectiveness Initiative

    I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative.  The following is a recap of such initiative and proposed and actual changes.

    On June 28, 2018, the SEC adopted amendments to the definition of a “smaller reporting company” as contained in Securities Act Rule 405, Exchange Act Rule 12b-2 and Item 10(f) of Regulation S-K. See HERE.  The initial proposed amendments were published on June 27, 2016, (see HERE).

    In December 2017, the American Bar Association (“ABA”) submitted its fourth comment letter to the SEC related to the financial and business disclosure requirements in Regulation S-K. For a review of that letter and recommendations, see HERE.

    In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report made specific recommendations for change to the disclosure rules and regulations, including those related to special-interest and social issues and duplicative disclosures.  See more on the Treasury Report HERE.

    On October 11, 2017, the SEC published proposed rule amendments to modernize and simplify disclosure requirements for public companies, investment advisers, and investment companies. The proposed rule amendments implement a mandate under the Fixing America’s Surface Transportation Act (“FAST Act”).  The proposed amendments would: (i) revise forms to update, streamline and improve disclosures including eliminating risk-factor examples in form instructions and revising the description of property requirement to emphasize a materiality threshold; (ii) eliminate certain requirements for undertakings in registration statements; (iii) amend exhibit filing requirements and related confidential treatment requests; (iv) amend Management Discussion and Analysis requirements to allow for more flexibility in discussing historical periods; and (v) incorporate more technology in filings through data tagging of items and hyperlinks. See my blog HERE.. March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC.  The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format.  The new Rule goes into effect on September 1, 2017, provided however that non-accelerated filers and smaller reporting companies that submit filings in ASCII may delay compliance through September 1, 2018. See my blog HERE on the Item 601 rule changes and HERE related to SEC guidance on same.

    On November 23, 2016, the SEC issued a Report on Modernization and Simplification of Regulation S-K as required by Section 72003 of the FAST Act. A summary of the report can be read HERE.

    On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K.  Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance.  See my blog on the request for comment HERE.

    On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments).  See my blog on the proposed rule change HERE. Final amendments were approved on August 17, 2018.

    That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016.  See my two-part blog on the S-K Concept Release HERE and HERE.

    The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE.

    As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies.  For more information on that topic and for a discussion of the reporting requirements in general, see my blog HERE

    In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K.  For more information on that topic, see my blog HERE.

    In early December 2015 the FAST Act was passed into law.  The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging-growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative.  In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE. These items are all included in this year’s SEC regulatory agenda...

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    Securities Token Or Not? A Case Study – Part III

    Tuesday, October 9, 2018, 5:22 AM [General]
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    This is the third part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. In Part 1 of the series, I examined a decentralized token that had been issued without any concurrent capital raise and was able to conclude such token was not a security. Part 1 can be read HERE. In Part 2 I examined a token that was issued with the intent of being a utility token, but as a result of the clear speculative motivation for purchasers, and the lack of decentralization, concluded it was a security. Part 2 can be read HERE.

    In this Part 3 of the series, I examine the issuance of the Free Token as a dividend and its cousin the Bounty Token. Unlike the prior blogs in this series, which examined the question of whether a particular token is a security, this blog will analyze the definition of a “sale” under Section 2(a)(3) of the Securities Act of 1933, as amended (the “Securities Act”).  As part of this analysis, I will review the SEC action In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”).

    The Free Token

    Facts

    Acme Insurance is building a blockchain-based community for the development of blockchain applications to revolutionize the insurance industry. Acme Insurance intends for the community to ultimately be decentralized and the code to be entirely open-source. Acme Insurance is a regional, top-tier insurance company that hopes to grow in the national marketplace and believes that if it can start and assist in the creation of a community that fosters technological developments in the industry, it will be able to capitalize on those developments to improve its market share. It also fundamentally believes in the improvement and advancement of the industry as a whole, which is defragmented and has a very large incidence of fraud. Prior to launching the Insurance Blockchain, Acme donated 2% of its net profits to educational projects which could benefit the insurance industry and has now committed to donating that 2% to the Insurance Blockchain community.

    Acme is launching the Free Token to facilitate its plans. Acme is forming a Foundation to oversee the Insurance Blockchain project. An initial team of international developers is creating the platform. Acme has created 15 million Free Tokens, half of which it will distribute as a dividend to all Acme Insurance shareholders, on a pro rata basis. Acme has 900 shareholders. Acme will not receive any consideration for the issuance. Future Free Tokens will be issued through Proof of Work, and later Proof of Stake, mining efforts and as compensation for website maintenance, code updates, developing and other contributions to the project. All software developments will remain open-source, with no royalty or profit-sharing-type rights.

    It is anticipated that the Free Token will trade on cryptocurrency exchanges, and Acme hopes they will increase in value to motivate efforts on the project.

    Although Acme believes that ultimately the Free Token would not be considered a security, rather than test its analysis, it intends to sidestep the question and issue the token as a dividend by airdropping the token to all shareholders, without compliance with the registration and exemption requirements of the federal securities laws. Acme has asked me to confirm that it is able to do so.

    Legal Analysis

    As I’ve written about many times, Section 5 of the Securities Act stipulates that the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration.  Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the resale of a security by an existing security holder must either be registered or exempt from registration. The registration statement or offering circular is subject to review by the SEC before it can be used for the offer and sale of a security. The process can be both time-consuming and expensive.

    Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

    The registration requirements, or necessity to utilize an exemption, apply to the “offer” or “sale” of a security. Section 2(a)(3) of the Securities Act defines the terms “sale” and “offer” in pertinent part as:

    The term “sale” or “sell” shall include every contract of sale or disposition of a security or interest in a security, for value. The term “offer to sell”, “offer for sale”, or “offer” shall include every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value… Any security given or delivered with, or as a bonus on account of, any purchase of securities or any other thing, shall be conclusively presumed to constitute a part of the subject of such purchase and to have been offered and sold for value.

    Section 2(a)(3), by its own terms, hinges on the receipt of value. The issuance of a dividend to all shareholders or the issuance of broad-based stock options to all employees has long been viewed as not involving the sale of securities.  This theory is often referred to as the “no sale” theory. In a Letter of General Counsel Discussing Question of Whether a Sale of a Security is Involved in the Payment of a Dividend, Securities Act Release No. 33-929, the SEC stated that the distribution of a cash or stock dividend to an issuer’s existing shareholders does not constitute a “sale” under Section 2(3)(a) of the Securities Act, and therefore such distribution does not require a Securities Act registration statement.  This guidance was issued in 1936 and has been reiterated on multiple occasions ever since.

    Question 103.01 of the SEC Division of Corporation Finance’s Compliance and Disclosure Interpretations, published in November, 2008 confirmed the SEC’s long-standing position.  In particular:

    Question 103.01

    Question: If a company declares a dividend that is payable in either cash or securities at the election of the recipients, does the declaration of the dividend need to be registered under the Securities Act?

    Answer: No, as there is no sale of the dividend shares under the Securities Act. [Nov. 26, 2008]

    The analysis is based in part on the lack of investment decision by the recipient of the dividend.  If the recipient is not bargaining for the dividend and is not giving up anything of value, there is no risk, and therefore no sale of securities has occurred.

    Accordingly, without more, even if the Free Token is a security, Acme Insurance can issue it as a dividend without compliance with the registration or exemption requirements under the federal securities laws.

    The Bounty Token

    Facts

    To increase distribution of the Free Token, Acme will create a bounty program whereby initial users receive Free Tokens for (i) signing up to the Insurance Blockchain project; (ii) sharing certain white papers and other information documents on the project; or (iii) writing and creating educational and informational documents on the project.

    Bounty programs are also often referred to as airdrop programs, though an airdrop can be used for a dividend release as well. An airdrop involves a controlled and periodic release of “free” tokens to people that meet a specific set of requirements, such as user ranking or activity. Generally the goal of an airdrop is to promote the new cryptocurrency. Bounty programs are essentially incentivized reward mechanisms offered by companies to individuals in exchange for performing certain tasks. Bounty programs are a means of advertising and have gained in popularity in ICO campaigns. During a bounty program, an issuer provides compensation for designated tasks such as registering at a website, reading and sharing materials, or marketing and making improvements to aspects of the cryptocurrency framework. In an airdrop, however, the issuer does not assign any tasks to the recipients; they need only meet some effortless requirements.  In a bounty program, however, individuals must execute assigned tasks before receiving the tokens.

    Legal Analysis

    Tokens issued in a bounty program generally involve the sale of securities that must either be registered or exempt from registration. The concept behind a bounty token program is not new. In the Internet bubble of the ’90s, companies were issuing free stock to gain website traffic and the SEC took notice. In a series of no-action letters, the SEC shut down the practice.

    In Vanderkam & Sanders (January 27, 1999), an unnamed operator of an Internet-based auto referral service proposed to issue free stock to anyone who registered at the company’s website or who referred others to it. Visitors would complete a simple registration form and would not be required to provide cash, property or services for their shares. The SEC ruled that “the issuance of securities in consideration of a person’s registration on or visit to an issuer’s Internet site would be an event of sale” and would be unlawful unless “the subject of a registration statement or a valid exemption from registration.”

    In Simplystocks.com (February 4, 1999), a web-based provider of financial information proposed to distribute free stock from a pool of entrants who logged in to the company’s website and provided their name, address, Social Security number, phone number and email address and then chose a log-in name and password. Visitors would receive one entry in the stock pool for each day they logged in to the website. After 180 days, the stock would be randomly allocated among the entrants in the stock pool. The SEC stated that the Simplystocks.com stock giveaway would be unlawful unless registered or exempt from registration.

    In Andrew Jones (June 8, 1999), the promoter proposed to issue free stock to the first one million people who signed up or referred others to sign up. Shares would be claimed either by sending a self-addressed stamped envelope to the company along with the person’s name, address and email address, or by visiting the company’s website and providing the same information. The company said the information provided by shareholders would be used solely for corporate purposes and would not be sold or given to others or used for advertising purposes. The SEC ruled that “the issuance of securities in consideration of a person’s registration with the issuer, whether or not through the issuer’s Internet site, would be an event of sale” and would be unlawful unless registered or exempt from registration.

                    In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”)

    On August 14, 2018 the SEC obtained a judgment against Tomahawk Exploration LLC and its principal for engaging in a fraudulent ICO.  According to the SEC, Tomahawk attempted to complete an ICO using fraudulent and misleading sales materials. However, the ICO failed to raise any money and so Tomahawk “gave away” its tokens as part of a bounty program involving online promotional services.

    The bounty program, like the ICO sales materials, were misleading on their face and clearly an effort to promote the token.  Tomahawk featured the program prominently on its ICO website, offering between 10 and 4,000 tokens for activities such as making requests to list TOM on token trading platforms, promoting tokens on blogs and other online forums, and creating professional picture file designs, YouTube videos or other promotional materials.

    The SEC Order found that Tomahawk’s issuance of tokens under the Bounty Program constituted an offer and sale of securities because the company provided tokens to investors in exchange for services designed to advance Tomahawk’s economic interests and foster a trading market for its securities. In other words, the services required in the bounty program were a valid consideration. It has long been established that value for securities can be in the form of services, cash, property, or anything that a board of directors reasonably determines as valuable. Tomahawk received value in the form of online marketing and promotion, and by the creation of a secondary public trading market for its token.  In the case of SEC vs. Sierra Brokerage Servs, Inc., the court specifically found that “where a ‘gift’ disperses corporate ownership and thereby helps to create a public trading market it is treated as a sale.”

    Although the Insurance Blockchain bounty program does not require outright promotional activity, at this point, I would still recommend that the bounty program be discontinued or comply with the registration or exemption requirements of the federal securities laws...

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    Securities Token Or Not? A Case Study – Part II

    Tuesday, October 2, 2018, 6:20 AM [General]
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    This is the second part in my three-part series laying out fact patterns and discussing whether a specific digital asset is a security, a utility, currency, commodity or some other digital asset. Although the first and easy answer is that if a digital asset is being issued today, it is most assuredly a security upon issuance that needs to comply with the federal securities laws, the answer is not always that straightforward for digital assets that have been in the marketplace for a period of time, such as Bitcoin and Ether, or for new digital assets that are carefully being constructed to fall outside the purview of a securitized token.

    In the first part of this series, we examined the Oldie Token and, under the fact pattern presented, was able to determine that the Oldie Token was not a security. Part 1 can be read HERE. In this part we will examine the Functional Token, which has not yet been issued. In our fictional fact pattern, Freight Blockchain, Inc. has created what they believe to be a true utility token, the Functional Token that would not need to comply with the federal securities laws. Based on the analysis below, I concluded that Functional Token does indeed need to comply with the federal securities laws.

    Sources Applicable to an Analysis of all Digital Assets

    In determining whether a digital asset is a security and/or needs to comply with the U.S. federal securities laws in its issuance and distribution, at least the following sources should be reviewed and considered by securities counsel. This is not a comprehensive list as facts and circumstances, and the evolving state of the U.S. and international laws, must also be considered, but it covers the basics.

    1. The Securities Act;
    2. The Exchange Act;
    3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”);
    4. Reves v. Ernst & Young, 494 U.S. 56 (1990) (“Reves”);
    5. Report of Investigation Pursuant to Section 21(a) of the Exchange Act: The DAO (July 25, 2017)(the “DAO Report”);
    6. In the Matter of Munchee Inc. (“Munchee Order”);
    7. Statement on Cryptocurrencies and Initial Coin Offerings (SEC Chairman Jay Clayton) (December 11, 2017) (“SEC Cryptocurrency Statement”);
    8. Speech by William Hinman, the Director of the SEC Division of Corporation Finance at Yahoo Finance’s All Markets Summit on June 14, 2018;
    9. SEC v. PlexCorps et al., Civil Action No. 17-cv-07007 (E.D. N.Y., filed December 1, 2017) (“PlexCorp Litigation”);
    10. In the Matter of Tomahawk Exploration LLC et al. (“Tomahawk Matter”);
    11. The Bitcoin White Paper;
    12. The Ethereum White Paper;
    13. The MUN Coin White Paper;
    14. The PlexCoin White Paper; and
    15. The White Paper and all relevant documents associated with the particular Digital Asset.

    Like the first, this blog and case study is limited to an analysis of the U.S. federal securities laws and does not include any state or international securities laws nor the applicability of any regulations promulgated under or enforced by any other U.S. regulators such as the CFTC, FinCEN or the IRS.

    The Functional Token

    Facts

    Freight Blockchain, Inc. is a software company focused in the logistics and transportation business. They have built a blockchain software application whereby the defragmented small trucking company can have access to the freight and transport needs of customers such as warehouses, stockrooms and shipping and receiving stations, without the use of a freight agent or broker. In addition to allowing for direct communication between trucking companies and potential customers, the Freight Blockchain allows for pre-screened qualified businesses in the logistics industry to advertise their goods and services on its platform. Freight Blockchain’s revenue model is based on transaction fees for the use of the Freight Blockchain.

    Freight Blockchain’s idea was well received in the trucking industry and, as a result, they were able to raise funds in traditional debt and equity offerings and through venture capital investors. The Freight Blockchain is fully built out and operational, though as with any application, it is expected that it will need consistent development modifications and improvements as it gains users.

    Partially as a result of the marketing angle and to attract users, and partially to encourage developers and the crowd to collaborate on maintenance and improvements to the Freight Blockchain, the company has decided to issue a Functional Token. Freight Blockchain created 10 million Functional Tokens for release with an upper limit of 15 million tokens. The management team of Freight Blockchain each received 100,000 Functional Tokens for deferred compensation, and the company removed the deferred compensation liability from its financial statements.

    Freight Blockchain sold the Functional Token to users of the Freight Blockchain in its initial release at $2.00 per token with the Functional Tokens to be used as currency on the Freight Blockchain. Freight Blockchain accounted for the sales as advance transaction fees and purchasers were given a transaction fee credit for the purchase. Freight Blockchain sold 5 million Functional Tokens in its initial launch, all to individuals or entities that they thought to be customers or prospective customers of the Freight Blockchain based on a check-the-box response from purchasers.  Freight Blockchain did not separately advertise the Functional Token, but rather included the offer to prepay transaction fees via the purchase of a Functional Token in its regular Freight Blockchain ads and on its website.

    Transaction fees equate to 6% of the transaction value and could vary widely depending on the customer and whether a haul is local or long-range. However, Freight Blockchain did not include either a minimum or maximum on the ability to purchase the Functional Token. A review of purchase records show that the minimum purchase was $500 and the maximum was $50,000. Although it is possible that a large customer could pay $50,000 in transaction fees in a year, it does not appear that the particular purchaser would do so and thus in hindsight, it is likely that person purchased for speculative value.

    Users of the Freight Blockchain can opt to be paid in Bitcoin, Ethereum, Functional Token or fiat currency.  Transaction fees are paid to Freight Blockchain in the same currency that the users complete their transaction with.  Following the initial release Freight Blockchain launched the Functional Token open source code on Github and began trading on several cryptocurrency exchanges. Tokens can be earned by miners and are issued as compensation for website maintenance, code updates and other contributions to the Freight Blockchain. The Functional Token works as Proof-of-Stake. Freight Blockchain did not and does not market the Functional Token as an investment opportunity.

    All changes to the Freight Blockchain platform must be approved by the Freight Blockchain management team, who maintains ultimate control over the software. No Foundation has been formed.

    Functional Token holders do not have rights generally associated with security holders.  In particular, Functional Token holders (i) have no ownership rights in Freight Blockchain; (ii) have no right to share in profits and/or losses of Freight Blockchain; (iii) claims in bankruptcy or similar proceedings with a status of an equity holder; (iv) right to convert or exchange the Functional Token for a security token or other security; or (v) right to purchase a security token.

    Legal Analysis

    As I’ve written about many times, the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration. Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the re-sale of a security by an existing security holder must either be registered or exempt from registration.

    Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

    The registration requirements, or necessity to utilize an exemption, only apply to securities and accordingly, if Functional Token is not a security, it could be issued or resold on a cryptocurrency exchange without compliance with the federal securities laws.

    The Securities Act defines the term “security” broadly to include “investment contracts.” Several tests have been used by the SEC and the courts to determine whether an offering involves an investment contract and thus a security, with the most commonly used test being the “Howey test.”  The SEC relied on the Howey test in its DAO Report in determining that certain offerings of tokens may be deemed securities. Another common test is the “Reves Test,” which I will discuss further in this analysis.

    As set forth below, I conclude that the Functional Token is a security requiring compliance with the federal securities laws. However, my conclusion is weighed by the lack of legal clarity on tokens in general and my belief that when in doubt, it is a security. Furthermore, I find an analysis of a token with the features of the Functional Token to be more difficult than a decentralized token such as the Oldie Token from Part 1 of this series.

    The Howey Test

    The US Supreme Court case of SEC v Howey, 328 U.S. 293 (1946) established the test for whether an arrangement involves an investment contract.  An investment contract is a type of security.  In Howey, the Supreme Court noted that the term “investment contract” has been used to classify those instruments that are of a “more variable character” that may be considered a form of “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” The Howey test can be expressed as three independent elements.  All three elements must be met in order for a token or cryptocurrency to be a security, including (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits predominantly from the efforts of others. For more on the Howey test, see HERE.

    (i) Investment of Money. Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. Given the broad definition of investment, Functional Token distributed to developers for mining or other services to the Functional Token project may satisfy this part of the test, but it is also possible that a court might view the individual efforts of the miners or developers differently and conclude that no investment of money has occurred. Furthermore, it is possible that the courts would interpret the initial sale of the Functional Token, even though it was characterized as advance payment for transaction fees, as an investment of money. As part of this analysis, I consider the fact that it is unlikely that a customer would advance any fees associated with the use of the Freight Blockchain but for the potential for receiving value from such advancement in excess of the amount expended.

    (ii) Common Enterprise. Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: (a) horizontal; (b) narrow vertical; and (c) broad vertical.

    1. Under the horizontal test, a common enterprise is deemed to exist where multiple investors pool funds into an investment and the profits of each investor equal a prorated portion of the total profits of the pool; see, e.g., Curran v. Merrill Lynch, 622 F.2nd 216 (6th Cir. 1980). Whether funds are pooled appears to be the key question, and thus in cases where there is no sharing of profits or pooling of funds, a common enterprise may not be deemed to exist. For example, a court has found that a discretionary trading account was not an investment contract because there was no pooling of funds.

    Under the horizontal test, the Functional Token may be considered a common enterprise — notwithstanding the absence of a pooling of funds — where the reward for work, through mining or the contribution of other services, correlates to the reward received by the miners, developers or other members of the Functional Token platform receiving Functional Token. However, since Freight Blockchain retains control over the platform and there is no sharing of profits or pooling of funds, it is also likely that there is not a common enterprise under the horizontal test.

    1. Under the narrow vertical test, the key is whether the profits of an investor are tied to the promoter. For example, a court has found that the imposition of profit limitations on investors through requiring a promoter to receive an excess return rate tied to the investors return, satisfied this test. This test generally relates to income earned by a promoter from profits derived from participants.
    2. Under the broad vertical test, the critical fact is whether the success of the investor depends on the promoter’s expertise. If there is such a reliance, then a common enterprise is deemed to exist.

    In this case, I believe a common enterprise exists in applying the vertical test.  Although miners depend on their own efforts to receive Functional Tokens, the ultimate secondary trading value of the Functional Token is inextricably tied to the success of the Freight Blockchain. Moreover, management of Freight Blockchain has maintained control over the platform and it is their expertise that will drive the success of the enterprise as a whole. If the Freight Blockchain does not gain customers and users, it is unlikely that the Functional Token will have any value to miners or those receiving the Functional Token in exchange for services.  Furthermore, I don’t believe a reasonable argument could be made that the initial purchasers of the Functional Token were purchasing for the purpose of pre-paying transaction fees, but rather were purchasing with the hope of an increased value on secondary markets, which would depend on the success of the Freight Blockchain under the control of its management.

    An alternative test, sometimes called the “risk capital test,” focuses on whether the holder of an investment may be deemed passive, and in being passive, relying on the efforts of others.  This test has four parts: (i) are any funds raised for use by a venture or enterprise; (ii) who is the target investor (i.e., is it the public generally, or a group comprised only of those with specialized interest or expertise in the area relating to the investment); (iii) how much influence do investors have on the success of the enterprise; and (iv) is the investor’s investment substantially at risk?  Under the risk capital test, I believe the Functional Token would be a security.  If Freight Blockchain is not successful, then the Functional Tokens will have no value either on a secondary market or to be used against future transaction fees.

    (iii) Expectation of Profit from the Efforts of Others.  Under this element of the test, profit refers to the type of return or income an investor seeks on their investment.   This could refer to any type of return or income earned from being the owner of a Functional Token, but for purpose of the Howey test and a securities law analysis would only include profits earned passively from the efforts of others.  In other words, it is the essentially passive nature of the return, utilizing the efforts of others, that results in an “investment contract” and determination of the existence of a security, rather than a simple contract which in itself would not be a security.

    As discussed above, the success of the Freight Blockchain and therefore value of the Functional Token depends on the efforts of the Freight Blockchain management and as such, I believe that this part of the Howey test is satisfied.

    As with the Oldie Token, the appreciation in the value of the Functional Token after issuance, due to secondary trading, should not affect the analysis of whether a Functional Token is an investment contract and thus a security.  Other rights that are not investment contracts or securities, such as loyalty points, airline points, licenses and franchise rights, can increase in value over time due to the secondary market for those assets.

    Reves and the Family Resemblance Test

    An analysis of Reves and the “family resemblance test” as formulated by the Supreme Court in Reves v. Ernst & Young, is only appropriate when determining whether a loan is a security under the Securities Laws.  Revesfocused on the term “note” rather than the term “investment contract” as such terms are included in the definition of a security under the Securities Laws.  For more on the Reves test, see HERE.

    The Functional Token as sold as pre-paid transaction fees and recorded as same on the books and records of the company. Each purchaser received a credit on their account. Accordingly, the funds received from the Functional Token sales are a liability on the books of Freight Blockchain and each purchaser is a creditor. In the event that Freight Blockchain were to fail, the purchasers of the Functional Token with remaining transaction fee credits would be creditors of the company entitled to a distribution of assets, if any.

    The first part of an analysis as to whether the Functional Tokens could be a debt security would be to consider the time in which repayment is likely. The Exchange Act and SEC specifically exclude notes with a term of less than nine months, the proceeds of which are used for a current transaction, from the definition of a “security.”  The transaction fee credit associated with Functional Tokens does not have an expiration date and based on the amounts purchased, although some will be used up in nine months, many will take much longer.

    Reves analysis involves four tests: (i) the motivation of the seller and buyer; (ii) the plan of distribution of the instrument; (iii) the reasonable expectations of the investment public; and (iv) the presence of an alternative regulatory regime.

    (i) Motivation of the seller and buyer. The first factor is described as the motivation that prompts “a reasonable seller and buyer to enter into” the transaction.  If the seller’s motivation is to raise money for his/her business and the buyer’s motivation is to earn profits, then the note is likely a security.  Even if the note is not necessarily characteristic of a security, if the investor reasonably expected that they were buying a security, and would be protected by the accompanying securities laws, the courts can determine that indeed a security has been sold.  Furthermore, Reves specifically states that if the purpose is, for example, to “facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash flow difficulties, or to advance some other commercial or consumer purpose,” it is unlikely to be deemed a security.

    Although the Freight Blockchain management was attempting to motivate users and build the commercial enterprise of the Freight Blockchain by issuing the Functional Token, I think it would be difficult to establish that the motivation of the purchaser was to pre-pay transaction fees.  Transaction fees do not fluctuate and therefore there would be no motivation to pre-pay this expense.  However, the immediate secondary trading of the Functional Token created a motivation to expend risk capital with the hope of a return on such investment.  Moreover, the Freight Blockchain transaction fees could be paid in fiat currency, and thus it would not be necessary to purchase the Functional Token to conduct business on the platform.

    (ii) Plan of distribution.  The second factor determines whether the instrument is being distributed for investment or speculation.  If the debt instrument is being offered and sold to a broad segment or the general public for investment purposes, it is a security.  Although the Functional Blockchain was not marketed as an investment, advertisements related to the Freight Blockchain and the availability of the Functional Token were widely disseminated.  Moreover, a Telegram group quickly formed regarding the Functional Token, which appeared to increase sales dramatically.

    (iii) Reasonable expectation of investing public.  An instrument will be deemed a security where the reasonable expectation of the investing public is that the securities laws (and accompanying anti-fraud provisions) apply to the investment.  Although the investing public did not believe they were purchasing a security, as described herein, it is likely that the purchase of the Functional Token was motivated by a potential return on investment as opposed to purely commercial uses.

    (iv) The presence of alternative regulatory regime.  The fourth factor is a determination whether another regulatory scheme “significantly reduces the risk of the instrument, thereby rendering the application of the Securities Act unnecessary.”  A “utility token” or cryptocurrency remains largely unregulated in the U.S. unless such token is found to be a security under the federal securities laws, or a commodity subject to the Commodity Exchange Act.  The lack of alternative regulatory regime supports the need for protection under the federal securities laws in the issuance and sale of the Functional Token.

    Speech by William Hinman

    On June 14, 2018, William Hinman, the Director of the SEC Division of Corporation Finance, gave a speech at Yahoo Finance’s All Markets Summit in which he expressed his views on when a cryptocurrency would most assuredly be a security, and laid out some factors to consider in completing an analysis under the securities laws.  An important factor in determining that a token is not, or no longer, a security is the decentralization of the underlying platform.  If a platform is decentralized, purchasers of the token would not reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts, the result of which would increase the value of the token.

    When the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.  It is this information asymmetry that I find is key to the analysis of the Functional Token, and why using both Howey’s based-on-the-efforts-of-others test and Reves’ motivation test, the Functional Token is a security.

    The Freight Blockchain management team is uniquely positioned to know whether the Freight Blockchain platform is meeting its milestones, successful, and profitable, all of which are necessary for the Functional Token to have value.  To the extent that initial purchasers hold credits for future transaction fees, those credits become worthless if the Freight Blockchain fails.  Furthermore, it is likely that the trading value of the Functional Token is inextricably tied into the success of the Freight Blockchain.  Without meaningful disclosures, such as can be found in a registration statements or proper private placement offering document, the only information that purchasers receive is found on the Freight Blockchain website, press releases and on social media such as the Telegram group.

    Moreover, a review of the social media sites, such as Telegram, clearly indicates that some are promoting the Freight Blockchain for the purpose of increasing the value of the Functional Token, presumably because they hold tokens and hope to sell at a profit.  The Functional Token was sold to anyone who sought to purchase which would include those that may not understand the risks associated with the investment, and even those that did, were not provided with any meaningful information on which to assess such risks.

    Hinman provided some guidance in determining whether a particular sale involves the sale of a security.  The primary consideration is whether a third party, such as a person, entity, or coordinated group, drives the expectation of a return on investment.  Questions to consider include:

    1. Is there a person or group that has sponsored or promoted the creation and sale of the digital asset, the efforts of whom play a significant role in the development and maintenance of the asset and its potential increase in value?
    2. Has this person or group retained a stake or other interest in the digital asset such that it would be motivated to expend efforts to cause an increase in value in the digital asset? Would purchasers reasonably believe such efforts will be undertaken and may result in a return on their investment in the digital asset?
    3. Has the promoter raised an amount of funds in excess of what may be needed to establish a functional network, and, if so, has it indicated how those funds may be used to support the value of the tokens or to increase the value of the enterprise? Does the promoter continue to expend funds from proceeds or operations to enhance the functionality and/or value of the system within which the tokens operate?
    4. Are purchasers “investing,” i.e., seeking a return? In that regard, is the instrument marketed and sold to the general public instead of to potential users of the network for a price that reasonably correlates with the market value of the good or service in the network?
    5. Does application of the Securities Act protections make sense? Is there a person or entity others are relying on that plays a key role in the profit-making of the enterprise such that disclosure of their activities and plans would be important to investors? Do informational asymmetries exist between the promoters and potential purchasers/investors in the digital asset?
    6. Do persons or entities other than the promoter exercise governance rights or meaningful influence?

    Other than that the Freight Blockchain was built and operational at the time of the issuance of the Functional Token, the answer to all of these questions supports the conclusion that the Functional Token is a security.

    License/Contract Right Considerations

    Providing access to the open-source Functional Token blockchain can be analogized to the grant of a license.  Because software licenses are typically governed by contract law, one possible analysis would be to focus on the rights associated with the license that are granted by the licensor to the licensee. For example, the licensor’s rights would include the ability to grant or distribute all, some or none of the rights attached to the use of the software code (originally the licensor’s intellectual property), as well as the right to exclude certain parties from using any of those rights.  Thus, the licensee would receive all of these rights, or a portion of these rights depending on what the licensor grants.

    In the context of a license of the Functional Token blockchain, if any, Freight Blockchain would act as the licensor of the system, which includes the right to use the Functional Token platform and earn fees for accepted developments, but which does not include most other proprietary rights, including the right to assign or sublicense the Functional Token blockchain or transfer any rights.  There are no voting rights inherent in the Functional Token or provided other members of the Functional Token community.  Of the bundle of rights, the only right is to use the Functional Token blockchain, with the hope that innovations will be rewarded.  This limitation could be used to argue that the right is more analogous to a limited contract right rather than a security.

    The DAO Report

    The SEC has advised that tokens may be securities in certain circumstances, generally when involving raising capital for the issuer or seller of the tokens.  On July 25, 2017, the SEC issued the DAO Report detailing its investigation into whether the DAO (an unincorporated “decentralized autonomous organization”), Slock.iotUG (“Slock.it”), its co-founders, and intermediaries violated the federal securities laws.  Utilizing the Howey test, the SEC determined that the tokens issued by the DAO are securities under the Securities Laws and advised that those who would use distributed ledger or blockchain-enabled means for capital raising must take appropriate steps to comply with the Securities Laws (e.g., register the offering or qualify for an exemption from registration).

    The DAO Report emphasized that whether a particular investment transaction involves the offer or sale of security is not dependent on the terminology used, but rather on the facts and circumstances, including the economic realities of the transaction. For more on the DAO Report, see HERE.

    As detailed in the DAO Report, the concept of the DAO was memorialized in a white paper (the “DAO White Paper”) authored by the Chief Technology Officer of Slock.it.  In the DAO White Paper Slock.it proposed an entity (a DAO entity) that would use smart contracts to attempt to solve governance issues it describes as inherent in traditional corporations. Slock.it organized a DAO as a crowdfunding contract to raise funds to grow a company in the crypto space. The DAO was a for-profit entity where participants would send ETH to the DAO to purchase DAO tokens, which would permit the participant to vote and entitle the participant to “rewards.” The White Paper described this as similar to “buying shares in a company and getting . . . dividends.”  The DAO was to be “decentralized” in that it would allow for voting by investors holding DAO tokens.  All funds raised were to be held at an Ethereum blockchain “address” associated with the DAO, and the DAO token holders were to vote on contract proposals, including proposals to the DAO to fund projects. Based on the vote of the DAO token holders, the DAO would use any “rewards” from the projects it funded to either fund new projects or distribute them to the DAO token holders. The DAO was intended to be “autonomous” in that project proposals were in the form of smart contracts that exist on the Ethereum blockchain and the votes were administered by the code of the DAO.

    In applying the Howey test, the SEC found that the DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it, its co-founders, and the DAO’s curators to manage the DAO and generate profits.

    The Freight Blockchain project is an actual for-profit corporation under the control of a standard board of directors and officers.   Under this analysis the Freight Blockchain management acted as promoters of the Functional Token, and continue to be motivated to increase its value, as each received Functional Tokens as compensation. Moreover, although the Functional Token can be used as currency on the Freight Blockchain, its real value is in the secondary trading market, which depends on the success of the underlying platform. Applying the Howey test and principles in the DAO Report, it is difficult to argue that the Functional Token is not a security.

    The Munchee Order

    On December 11, 2017, the SEC issued a cease-and-desist order against Munchee, Inc. (“Munchee”) to stop Munchee’s ICO and require it to return to investors the funds it collected through the sale of its MUN token. The SEC found that Munchee’s token sale constituted an offering of securities in violation of the Securities Laws.

    In applying the Howey test to the offering of the MUN token, the SEC gave little weight to the fact that Munchee characterized the MUN token as a “utility” token because of their functional use in connection with the business model of Munchee.  Instead, the SEC focused on the manner in which the offering of the MUN token was marketed.  In connection with the ICO, Munchee described how MUN tokens were expected to increase in value, especially as the result of Munchee’s future efforts. The SEC noted that Munchee made statements in its White Paper, on blogs, podcast and Facebook posts that suggested that investors would profit from purchasing MUN tokens.  In addition, Munchee endorsed statements made by other commentators that highlighted the opportunity for profit through the purchase of MUN tokens, including, for example, by linking their public post on their Facebook page about the offering (“199% GAINS on MUN token at ICO price!”) to a YouTube video in which the person featured claimed that if investors got in early enough on ICOs, they would make a profit.  Munchee also stated in a blog post that investors could count on the burning of MUN tokens by Munchee from time to time to increase value.

    In the Munchee Order, the SEC noted that in its White Paper, Munchee said that they would work to cause MUN tokens to be listed on various exchanges to ensure that a secondary trading market would exist for MUN tokens. The SEC viewed such statements as priming “purchasers’ reasonable expectations of profit” and that “[p]urchasers would reasonably believe that they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUM ‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and other materials.”

    In addition to concluding that purchasers of MUN tokens would have a reasonable expectation of profits based on Munchee’s states, the SEC concluded that those profits would be based primarily on the future efforts of Munchee.  In the Munchee Order, the SEC said:

    The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable. Munchee was to revise the Munchee App so that people could buy and sell services using MUN tokens and was to recruit “partners” such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of the MUN tokens created by the revised Munchee App and by Munchee’s ability to create an “ecosystem” – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens.

    The SEC focused on the ongoing efforts by Munchee after the token sale. However, in most cases token issuers intend to use at least a portion of the proceeds from the sale to further develop the token ecosystem. In the Functional Token context, the work done by developers, miners and other contributors to the Functional Token project is rewarded with Functional Tokens.

    The Freight Blockchain management team believed that because the Freight Blockchain was built and operational at the time of issuance of the Functional Token, and because they did not tout the potential increase in value, it would not be a security. However, I believe that, because the Functional Token immediately began to trade in a secondary market, despite how it was marketed, its purchase would logically be to realize an increase in value and because the Functional Token is not a requirement to use the Freight Blockchain, it is a security.

    Security or Utility Token A Case Study – Part I

    Tuesday, September 25, 2018, 6:40 AM [General]
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    Is it a security or is it a utility, currency, commodity or some other digital asset? That question has been continuously raised by those working with digital assets such as cryptocurrenciesvirtual coins and tokens, including by digital asset issuers and companies that run platforms for the issuance or trading of such digital assets. Although the first and easy answer is that if a digital asset is being issued today, it is most assuredly a security upon issuance that needs to comply with the federal securities laws, the answer is not always that straightforward for digital assets that have been in the marketplace for a period of time, such as bitcoin and ether, or for new digital assets that are carefully being constructed to fall outside the purview of a securitized token.

    The “STO” standing for security token offering has quickly gained favor alongside “ICO” with an industry-understood distinction. An STO is designed to be a security or financial instrument offering usually backed by stock, assets, revenues or profits in a company. An ICO may or may not be designed to be a security or financial instrument upon issuance, has utility or commodity attributes, and often involves a token offering entirely outside of the United States precluding US investors (some doing so more successfully than others, but that is another topic).

    In this three-part blog, I will lay out fact patterns and analyze whether a digital asset is a security including (i) the issued- and trading-for-years Oldie Token; (ii) the about-to-be-issued Functional Token; and (iii) the newly-issued-as-a-dividend Free Token including a discussion of the definition of a “sale” under the Securities Act and its cousin, the Bounty Token.

    Sources Applicable to an Analysis of all Digital Assets

    In determining whether a digital asset is a security and/or needs to comply with the U.S. federal securities laws in its issuance and distribution, at least the following sources should be reviewed and considered by securities counsel. This is not a comprehensive list of facts and circumstances, and the evolving state of the U.S. and international laws must also be considered, but it covers the basics.

    1. The Securities Act;
    2. The Exchange Act;
    3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”);
    4. Reves v. Ernst & Young, 494 U.S. 56 (1990) (“Reves”);
    5. Report of Investigation Pursuant to Section 21(a) of the Exchange Act: The DAO (July 25, 2017)(the “DAO Report”);
    6. In the Matter of Munchee Inc. (“Munchee Order”);
    7. Statement on Cryptocurrencies and Initial Coin Offerings (SEC Chairman Jay Clayton) (December 11, 2017) (“SEC Cryptocurrency Statement”);
    8. Speech by William Hinman, the Director of the SEC Division of Corporation Finance at Yahoo Finance’s All Markets Summit on June 14, 2018;
    9. SEC v. PlexCorps et al., Civil Action No. 17-cv-07007 (E.D. N.Y., filed December 1, 2017) (“PlexCorp Litigation”);
    10. In the Matter of Tomahawk Exploration LLC et al (“Tomahawk Matter”);
    11. The Bitcoin White Paper;
    12. The Ethereum White Paper;
    13. The MUN Coin White Paper;
    14. The PlexCoin White Paper;
    15. Any and all recent statements, speeches or enforcement proceedings by the SEC; and
    16. The White Paper and all relevant documents associated with the particular Digital Asset.

    This blog and case study is limited to an analysis of the U.S. federal securities laws and does not include any state or international securities laws nor the applicability of any regulations promulgated under or enforced by any other U.S. regulators such as the CFTCFinCEN or the IRS.

    The Oldie Token

    Facts

    The Oldie Token was a fair launch without any presale, ICO, pre-mine or distribution to the Oldie Token Team. No central company or entity was in charge of the initial launch. An international group of developers, building on the idea of John Doe, the founder of the idea on which Oldie Token is based (the “Initial Founders”), created the core code for the Oldie Token. Members of the developer community donated bitcoin, fiat currencies, coin and their time in a collaborative effort to launch, develop and maintain the Oldie Token.

    The Oldie Token Team released 10 million coins during its Proof-of-Work phase and has a total upper limit of 15 million coins. Following the initial release, a team of developers and hundreds of contributors launched the Oldie Token open-source code on Github, the Oldie Token switched from Proof-of-Work to Proof-of-Stake and began trading on several cryptocurrency exchanges. Tokens continue to be issued via mining and as compensation for on initial graphical works, website maintenance, code updates and other contributions to the Oldie Token project.

    A few years after the initial issuance of the Oldie Token, the Initial Founders formed a Foundation to direct the continued development of the Oldie Token on open source blockchain. Over time developers have made changes and upgrades to the Oldie Token code including to the wallet, programming which enables user to register names on a server linked to the blockchain and send and receive Oldie Token, data storage and messaging. The Foundation also solicits donations to spend on further development on the open sourced Oldie Token blockchain. The Foundation is based in Switzerland.

    Legal Analysis

    As I’ve written about many times, the offering or sale of a security requires registration under the Securities Act and applicable state securities laws, unless it is able to fit within an exemption from registration. Registration under the Securities Act requires the issuer of the security to file a registration statement or offering circular in the case of Regulation A+ offerings, containing specified disclosure about the issuer, its management and business, including financial information. Likewise, the resale of a security by an existing security holder must either be registered or exempt from registration. The registration statement or offering circular is subject to review by the SEC before it can be used for the offer and sale of a security. The process can be both time-consuming and expensive.

    Exemptions from registration under both the Securities Act and applicable state securities laws are generally designed for limited offerings of securities to qualified offerees, such as “accredited investors.” Broad-based solicitation without limits on the number or qualifications of offerees, or value of the offering, would make it difficult, if not impossible, to qualify for an exemption.

    The registration requirements, or necessity to utilize an exemption, only apply to securities and accordingly, if Oldie Token is not a security, it could be issued or resold without compliance with the federal securities laws.

    The Securities Act defines the term “security” broadly to include “investment contracts.” Several tests have been used by the SEC and the courts to determine whether an offering involves an investment contract and thus a security, with the most commonly used test being the “Howey test.” The SEC relied on the Howey testin its DAO Report in determining that certain offerings of tokens may be deemed securities.

    As set forth below, I conclude that the Oldie Token is not a security requiring compliance with the federal securities laws.

    The Howey Test

    The US Supreme Court case of SEC v Howey, 328 U.S. 293 (1946) established the test for whether an arrangement involves an investment contract. An investment contract is a type of security. In Howey, the Supreme Court noted that the term “investment contract” has been used to classify those instruments that are of a “more variable character” that may be considered a form of “contract, transaction, or scheme whereby an investor lays out money in a way intended to secure income or profit from its employment.” The Howey test can be expressed as three independent elements (the third element encompasses both the third and fourth prongs of the traditional Howey test). All three elements must be met in order for a token or cryptocurrency to be a security, including (i) An investment of money, (ii) in a common enterprise, (iii) with an expectation of profits predominantly from the efforts of others. For more on the Howey test, see HERE.

    (i) Investment of Money. Under Howey, and case law following it, an investment of money may include not only the provision of capital, assets and cash, but also goods, services or a promissory note. Given the broad definition of investment, Oldie Token distributed to developers for mining or other services to the Oldie Token Project may satisfy this part of the test, but it is also possible that a court might view the individual efforts of the miners or developers differently and conclude that no investment of money has occurred.

    (ii) Common Enterprise. Different circuits use different tests to analyze whether a common enterprise exists. Three approaches predominate: (a) horizontal; (b) narrow vertical; and (c) broad vertical.

    1. Under the horizontal test, a common enterprise is deemed to exist where multiple investors pool funds into an investment and the profits of each investor equal a prorated portion of the total profits of the pool. See, e.g., Curran v. Merrill Lynch, 622 F.2nd 216 (6th Cir. 1980). Whether funds are pooled appears to be the key question, and thus in cases where there is no sharing of profits or pooling of funds, a common enterprise may not be deemed to exist. For example, a court has found that a discretionary trading account was not an investment contract because there was no pooling of funds.

    Under the horizontal test, the Oldie Token may be considered a common enterprise — notwithstanding the absence of a pooling of funds — where the reward for work, through mining or the contribution of other services, correlates to the reward received by the miners, developers or other members of the Oldie Token community receiving Oldie Token. Thus, although the Foundation has some control over the protocol, the rewards in the form of Oldie Token would likely be correlated.

    1. Under the narrow vertical test, the key is whether the profits of an investor are tied to the promoter. For example, a court has found that the imposition of profit limitations on investors through requiring a promoter to receive an excess return rate tied to the investors return, satisfied this test. This test generally relates to income earned by a promoter from profits derived from participants.
    2. Under the broad vertical test, the critical fact is whether the success of the investor depends on the promoter’s expertise. If there is such a reliance, then a common enterprise is deemed to exist.

    Under either of the vertical approaches, however, a common enterprise may not exist given the decentralized nature of the Oldie Token blockchain framework. This is because those who receive Oldie Tokens depend on their own efforts (mining or otherwise), rather than on any expertise of the Foundation or the Oldie Token Team (even though the Foundation may in some cases control or influence technical permission or changes to the protocol). The key is the degree of control exerted by the Foundation; where there is less reliance on the Foundation’s expertise, there is less likelihood that the Oldie Token blockchain would be viewed as being part of a common enterprise.

    The law on what constitutes a “common enterprise” is unclear and a definitive conclusion is not possible. Nevertheless, given that at no time has the Oldie Project received any funds from the issuance of the Oldie Token, and instead relies on donations, including donations made to the Foundation, to create, support and maintain the Oldie Token blockchain, a court would not be likely to find that the common enterprise element is satisfied. This is all the more the case since there was no presale of the Oldie Token or distribution to members of the Oldie Team.

    An alternative test, sometimes called the “risk capital test,” focuses on whether the holder of an investment may be deemed passive, and in being passive, relying on the efforts of others. This test has four parts: (i) are any funds raised for use by a venture or enterprise; (ii) who is the target investor (i.e., is it the public generally, or a group comprised only of those with specialized interest or expertise in the area relating to the investment); (iii) how much influence do investors have on the success of the enterprise; and (iv) is the investor’s investment substantially at risk? The risk capital test does not seem applicable to the facts and circumstances of the Oldie Token distribution since it generally applies only in a limited number of jurisdictions, and typically is applied only in the context of “startup” capitalization for a business. Cases relating to the risk capital test generally relate to memberships in a club-like organization that does not allow commercial exploitation for profit, but only create a right of personal use.  To the contrary, our fictional Oldie Token blockchain is an open-source system which allows for exploitation of the system by the Oldie Token owner. The Oldie Token Project does not receive funds from the issuance of Oldie Token.  Moreover, the target investor in Oldie Token is the Oldie Token developer community, rather than the general investor class.

    (iii) Expectation of Profit from the Efforts of Others. Under this element of the test, profit refers to the type of return or income an investor seeks on their investment (rather than the profits that might be earned from using the Oldie Token blockchain). This could refer to any type of return or income earned from being the owner of an Oldie Token, but for purpose of the Howey test and a securities law analysis would only include profits earned passively from the efforts of others. In other words, it is the essentially passive nature of the return, utilizing the efforts of others, that results in an “investment contract” and determination of the existence of a security, rather than a simple contract which in itself would not be a security.

    In determining whether profits arise from the efforts of others, courts have been flexible including situations where there is significant or essential managerial or other efforts necessary to the success of the investment. An expectation of profits resulting from receipt of an Oldie Token primarily relates to whether the holder receives (i) rights or (ii) investment interests. While the holder of an Oldie Token may receive some form of financial incentive inherent in the Oldie Token’s current and potential value, these incentives are primarily derived through the efforts of the holder of the Oldie Token, whether obtained by mining or by providing other services, or whether developed outside of the open-source blockchain protocol.

    That is, owners of an Oldie Token can utilize, contribute to or even license their own contribution to the Oldie Token blockchain in various ways, none of which would be considered a passive investment. Owners of Oldie Token received by mining or for services would be better viewed as active participants, like franchisees or licensees. Although the Foundation may have some managerial oversight over the Oldie Token blockchain, including the distribution of the Oldie Token, the Foundation seeks the consensus of the Oldie Token community to make changes to the protocol, again making the owners active participants.

    The appreciation in the value of the Oldie Token after issuance, due to secondary trading, should not affect the analysis of whether an Oldie Token is an investment contract and thus a security. Other rights that are not investment contracts or securities, such as loyalty points, airline points, licenses and franchise rights, can increase in value over time due to the secondary market for those assets.

    The manner in which the Oldie Token is distributed to developers and miners, particularly the promotion and marketing, likely affects the “expectation of profits” analysis.  For example, we assume that since the Oldie Project’s public statements do not include words like “returns” or “profits” derived from the Oldie Token.

    Reves and the Family Resemblance Test

    An analysis of Reves and the “family resemblance test” as formulated by the Supreme Court in Reves v. Ernst & Young is only appropriate when determining whether a loan is a security under the Securities Laws. Revesfocused on the term “note” rather than the term “investment contract” as such terms are included in the definition of a security under the Securities Laws. There is nothing about the Oldie Token that suggests it could be a debt obligation or that any party has an obligation of repayment. That is also generally the case with any token or coin.  For more on the Reves test, see HERE.

    License/Contract Right Considerations

    Providing access to the open-source Oldie Token blockchain can be analogized to the grant of a license. Because software licenses are typically governed by contract law, one possible analysis would be to focus on the rights associated with the license that are granted by the licensor to the licensee. For example, the licensor’s rights would include the ability to grant or distribute all, some or none of the rights attached to the use of the software code (originally the licensor’s intellectual property), as well as the right to exclude certain parties from using any of those rights. Thus, the licensee would receive all of these rights, or a portion of these rights depending on what the licensor grants.

    In the context of a license of the Oldie Token blockchain, if any, the Foundation would act as the licensor of the system, which includes the right to use the Oldie Token blockchain, but which does not include most other proprietary rights, including the right to assign or sublicense the Oldie Token blockchain or transfer any rights, other than those created by the developer/miner (licensee) by its independent contribution to a side blockchain, albeit one which builds on the public open-source Oldie Token blockchain. There are no voting rights inherent in the Oldie Token or provided to donors or other members of the Oldie Token community (other than, of course, the Board of the Foundation); at best there is an expectation that decisions will be made by consensus, and that users may use the Oldie Token blockchain for their own purposes, independent of the Foundation. Thus, of the bundle of rights, the only right is to use the Oldie Token blockchain, like any other open-source code. This limitation could be used to argue that the right is more analogous to a limited contract right rather than a security.

    The DAO Report

    The SEC has advised that tokens may be securities in certain circumstances, generally when involving raising capital for the issuer or seller of the tokens. On July 25, 2017, the SEC issued the DAO Report detailing its investigation into whether the DAO (an unincorporated “decentralized autonomous organization”), Slock.iotUG (“Slock.it”), its co-founders, and intermediaries violated the federal securities laws. Utilizing the Howey test, the SEC determined that the tokens issued by the DAO are securities under the Securities Laws and advised that those who would use distributed ledger or blockchain-enabled means for capital raising must take appropriate steps to comply with the Securities Laws (e.g., register the offering or qualify for an exemption from registration).

    The DAO Report emphasized that whether a particular investment transaction involves the offer or sale of security is not dependent on the terminology used, but rather on the facts and circumstances, including the economic realities of the transaction. For more on the DAO Report, see HERE.

    As detailed in the DAO Report, the concept of the DAO was memorialized in a white paper (the “DAO White Paper”) authored by the Chief Technology Officer of Slock.it.  In the DAO White Paper Slock.it proposed an entity (a DAO entity) that would use smart contracts to attempt to solve governance issues it describes as inherent in traditional corporations. Slock.it organized a DAO as a crowdfunding contract to raise funds to grow a company in the crypto space. The DAO was a for-profit entity where participants would send ETH to the DAO to purchase DAO tokens, which would permit the participant to vote and entitle the participant to “rewards.” The White Paper described this as similar to “buying shares in a company and getting . . . dividends.”  The DAO was to be “decentralized” in that it would allow for voting by investors holding DAO tokens. All funds raised were to be held at an Ethereum Blockchain “address” associated with the DAO and the DAO token holders were to vote on contract proposals, including proposals to the DAO to fund projects. Based on the vote of the DAO token holders, the DAO would use any “rewards” from the projects it funded to either fund new projects or distribute them to the DAO token holders. The DAO was intended to be “autonomous” in that project proposals were in the form of smart contracts that exist on the Ethereum blockchain and the votes were administered by the code of the DAO.

    As described in the DAO Report, Slock.it was the promoter of the DAO and its tokens because it launched a website to describe and facilitate the DAO token sale, solicited media attention by posting updates on websites and online forums, communicated to the public about how to participate in the DAO token sale and retained the right to choose the “curators” that would determine what proposals to put to a vote by DAO token holders.

    In applying the Howey test, the SEC found that the DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it, its co-founders, and the DAO’s curators to manage the DAO and generate profits.

    Generally, the Oldie Project has a substantially different focus than that of the DAO. The DAO was focused on providing incentives for investment and promoting sales of the DAO token. Slock.it did this by emphasizing the DAO token’s potential for profits by distributions/dividends and appreciation in value. Oldie Tokens are not sold for other currency, fiat or virtual, but are issued for the contributions made by the miners/developers to the Oldie Token blockchain from which they benefit themselves. Moreover, the role of the Oldie Team and the Foundation is different from that of Slock.it, primarily in that, unlike Slock.it, neither the Oldie Team or the Foundation receive payment for their role and neither actively promotes the Oldie Token as an investment.

    The Munchee Order

    On December 11, 2017, the SEC issued a cease-and-desist order against Munchee, Inc. (“Munchee”) to stop Munchee’s ICO and require it to return to investors the funds it collected through the sale of its MUN token.  The SEC found that Munchee’s token sale constituted an offering of securities in violation of the Securities Laws.

    In applying the Howey test to the offering of the MUN token, the SEC gave little weight to the fact that Munchee characterized the MUN token as a “utility” token because of their functional use in connection with the business model of Munchee.  Instead, the SEC focused on the manner in which the offering of the MUN token was marketed. In connection with the ICO, Munchee described how MUN tokens were expected to increase in value, especially as the result of Munchee’s future efforts. The SEC noted that Munchee made statements in its White Paper, on blogs, podcast and Facebook posts that suggested that investors would profit from purchasing MUN tokens. In addition, Munchee endorsed statements made by other commentators that highlighted the opportunity for profit through the purchase of MUN tokens, including, for example, by linking their public post on their Facebook page about the offering (“199% GAINS on MUN token at ICO price!”) to a YouTube video in which the person featured claimed that if investors got in early enough on ICOs they would make a profit. Munchee also stated in a blog post that investors could count on the burning of MUN tokens by Munchee from time to time to increase value.

    In the Munchee Order the SEC noted that in its White Paper, Munchee said that they would work to cause MUN tokens to be listed on various exchanges to ensure that a secondary trading market would exist for MUN tokens.  The SEC viewed such statements as priming “purchasers’ reasonable expectations of profit” and that “[p]urchasers would reasonably believe that they could profit by holding or trading MUN tokens, whether or not they ever used the Munchee App or otherwise participated in the MUM ‘ecosystem,’ based on Munchee’s statements in its MUN White Paper and other materials.”

    In addition to concluding that purchasers of MUN tokens would have a reasonable expectation of profits based on Munchee’s states, the SEC concluded that those profits would be based primarily on the future efforts of Munchee.  In the Munchee Order, the SEC said:

    The proceeds of the MUN token offering were intended to be used by Munchee to build an “ecosystem” that would create demand for MUN tokens and make MUN tokens more valuable.  Munchee was to revise the Munchee App so that people could buy and sell services using MUN tokens and was to recruit “partners” such as restaurants willing to sell meals for MUN tokens. The investors reasonably expected they would profit from any rise in the value of the MUN tokens created by the revised Munchee App and by Munchee’s ability to create an “ecosystem” – for example, the system described in the offering where restaurants would want to use MUN tokens to buy advertising from Munchee or to pay rewards to app users, and where app users would want to use MUN tokens to pay for restaurant meals and would want to write reviews to obtain MUN tokens.

    The SEC focused on the ongoing efforts by Munchee after the token sale.  However, in most cases token issuers intend to use at least a portion of the proceeds from the sale to further develop the token ecosystem. In the Oldie Token context, the work done by developers and miners, and other contributors to the Oldie Token project is rewarded with Oldie Tokens. I do not think that the SEC intended by its statements in the Munchee Order to require an issuer of cryptocurrencies to refrain from any ongoing development and promotional activities for its blockchain once it issues a cryptocurrency coin.

    I believe that had the Munchee ecosystem been built and usable at the time of sale and had Munchee not marketed and promoted the MUN tokens in a manner that focused on the future profit and investment potential of MUN tokens and had instead focused on how the MUN token would be used in Munchee’s ecosystem and why the token was an important component of using and accessing the ecosystem, the SEC may not have found the token to be a security.

    The SEC noted that Munchee focused on people interested in investing and making profits, not current users of the Munchee app or “people who, for example, might have wanted MUN tokens to buy advertising or increase their ‘tier’ as a reviewer on the Munchee App.” This is different from the Oldie Team and Foundation’s focus on miners/developers and members of the Oldie Token community who can contribute to the development of the Oldie Project (ecosystem) and not on the profits that may be derived from holding and investing in Oldie Token.

    Realistically, in most cases, the developers and team involved in the creation of the cryptocurrency coin, such as is the case  for the Oldie Team, will continue to play some form of role in supporting and developing the blockchain. This, in and of itself, is not a fatal fact. However, if the cryptocurrency has little or no functionality at the time of sale, as was the case with Munchee, the SEC may view this as indicative that the initial purchasers are passive investors hoping to make a profit as opposed to those desiring to participate in the development of the blockchain or to gain access to the products or services that will ultimately be provided through the blockchain’s ecosystem.

    SEC Cryptocurrency Statement

    Concurrently with the release of the Munchee Order, the SEC’s Chairman, Jay Clayton, released a statement on cryptocurrencies and ICOs that provides some additional insights into the SEC’s mindset in reviewing cryptocurrencies. He stated that “I believe that initial coin offerings – whether they represent offerings of securities or not – can be effective ways for entrepreneurs and others to raise funding, including for innovative projects.” He also reemphasized in his statement that “replacing a traditional corporate interest recorded in a central ledger with an enterprise interest recorded through a block chain entry on a distributed ledger may change the form of the transaction, but it does not change the substance.”

                SEC v. PlexCorps

    On December 1, 2017, the SEC’s newly created Cyber Unit filed a civil enforcement action in federal court against PlexCorps in connection with its ICO or the cryptocurrency “PlexCoin.” On December 4, 2017, the court granted the SEC’s request for an emergency freeze on PlexCorps assets. The PlexCoin White Paper written by PlexCorp characterizes PlexCoin as “the new Bitcoin.” It states that it is comparable to bitcoin but with faster confirmation speeds. However, in the PlexCorps White Paper, PlexCoin promised an investment return of 1,354% for presale purchasers. The SEC viewed these as fraudulent misrepresentations designed to promote the purchase of over $15 million in PlexCoins.

    Although the PlexCorp litigation and the facts of the case have some similarities with that of the Oldie Token Project, there are significant differences, most notably the manner in which Oldie Token has been promoted, as a tool for the developer community and those who use the Oldie Token blockchain for their own business purposes, apart from the Oldie Team and the Foundation. I do not think this changes the analysis or warrants the finding that the Oldie Token blockchain as directed by the Oldie Team and the Foundation would be deemed a security.

    Conclusion

    Based on this analysis, I would be comfortable concluding that the Oldie Token is not a security requiring compliance with the federal securities laws. In the next chapter in this three-part blog series, I will set forth facts and analyze how a new token could be created and issued without being a security, and facts and circumstances which sway the argument in the other direction...

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    SEC Strategic Plan

    Tuesday, September 18, 2018, 8:28 AM [General]
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    On June 19, 2018, the SEC published a draft Strategic Plan and requested public comment on the Plan. The Strategic Plan would guide the SEC’s priorities through fiscal year 2022. The Plan reiterates the theme of serving the interests of Main Street investors, but also recognizes the changing technological world with a priority of becoming more innovative, responsive and resilient to market developments and trends. The Plan also broadly focuses on improving SEC staff’s performance using data and analytics.

    The Strategic Plan begins with a broad overview about the SEC itself, a topic I go back to and reiterate on occasion, such as HERE. The SEC’s mission has remained unchanged over the years, including to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. In addition, according to the Strategic Plan, the SEC:

    • Engages and interacts with the investing public directly on a daily basis through a variety of channels, including investor roundtables and education programs and alerts on SEC.gov;
    • Oversees approximately $82 trillion in securities trading annually on U.S. equity markets;
    • Oversees approximately $40 trillion in the U.S. fixed-income market;
    • Selectively reviews the disclosures and financial statements of approximately 4,300 exchange-listed public companies with an aggregate market capitalization of $30 trillion;
    • Oversees the activities of over 26,000 registered market participants, including investment advisors, mutual funds, exchange-traded funds, broker-dealers, municipal advisors, and transfer agents, who employ at least 940,000 individuals in the United States;
    • Oversees 21 national securities exchanges, 10 credit-rating agencies, 7 active registered clearing agencies, the Public Company Accounting Oversight Board (PCAOB), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), the Securities Investor Protection Corporation (SIPC), and the Financial Accounting Standards Board (FASB); and
    • Provides critical market services through information technology systems, such as the more than 50 million pages of disclosure documents available on the EDGAR system.

    The Strategic Plan describes three main goals: (i) focusing on the long-term interests of Main Street investors; (ii) recognizing significant developments and trends in evolving capital markets and adjusting efforts to ensure the effective allocation of resources; and (iii) elevate the SEC’s performance by enhancing analytical capabilities and human-capital development.

                    Long-term Interests of Main Street Investors

    The American workforce is getting older and living longer. Moreover, many companies no longer manage retirement plans, instead leaving individuals to manage their own 401(k)’s and similar plans. The SEC is concerned that investors do not understand the difference between a stockbroker and an investment advisor or what the responsibilities are for investment advisor.

    Furthermore, the SEC is concerned that fewer companies are going public, or are going public later, leaving fewer investment opportunities for Main Street investors. The slow IPO market has been a consistent theme with the SEC and market participants over the past year. See HERE, for example, a summary of Commissioner Piwowar’s speech and HERE for this summary of a U.S. Department of Treasury report.

    The SEC identified five initiatives to further their first strategic goal.

    1. Enhance the SEC’s understanding of how retail and institutional investors access capital markets.
    2. Enhance the SEC’s outreach, education and consultation efforts, including taking into account the diversity of businesses and investors.
    3. Pursue enforcement and examination proceedings focused on identifying and addressing misconduct that impacts retail investors. This effort includes uncovering new methods to administer scams and Ponzi schemes and the continued focus on penny stocks.
    4. Modernize the delivery and content of disclosures so that investors can access readable, usable and timely information. The SEC will continue to examine business and accounting disclosures and make appropriate changes and to upgrade the EDGAR system to make it more usable to retail investors.
    5. Identify ways to increase the number and type of long-term, cost-effective investment options available to retain investors, including by increasing the number of IPO’s and public companies.

    Developments and Trends in Capital Markets; Effective Allocation of Resources

    Technology has fundamentally changed the way consumers interact with the securities markets. Investors rely less on traditional personalized advisory services and instead are increasingly seeking advice and pursuing trades using data analytics and executed via algorithms on electronic platformsThis trend is expected to not only continue but to grow and expand with the advent of blockchain technology. Although these changes are beneficial, there are also increased risks, especially related to cybersecurity.

    In addition, with the increase in technology there is a global marketplace that interconnects geographical areas and time zones on a 24-hour cycle. Information from one market impacts others, and capital flows across markets, both geographically and in asset type, in amounts that would have been unimaginable only a few decades ago. These changes add challenges to the SEC, especially related to global market participants that may be outside the jurisdiction of the SEC’s authority. The Strategic Plan specifically refers to the recent advent of ICO’s and those that plan offerings to avoid the US federal securities laws. The SEC will need to increase its coordination with other US regulatory bodies and with foreign regulators.

    The SEC identified four initiatives to further their second strategic goal of recognizing significant developments and trends in evolving capital markets and adjusting their efforts to ensure the effective allocation of resources:

    1. Expand market knowledge and oversight capabilities to identify, understand, analyze and respond effectively to market developments, including related to market operations, clearing and settlement, and electronic trading.
    2. Identify and correct existing SEC rules and approaches that are outdated, including by monitoring new rules which may not be functioning as intended.
    3. Examine cyber and infrastructure strategies related to risks faced by capital markets and market participants. In addition to focusing on its own direct risks, the SEC must also ensure that market participates are effectively managing their cybersecurity risks.
    4. Promote SEC preparedness and emergency response capabilities, including through training and testing.

    Enhance Analytical Capabilities and Human Capital Development

    The SEC’s success, as with all agencies and companies, depends on using resources wisely. The SEC has a goal of improving its own workforce and finding ways to utilize data and technology to improve productivity and efficiency.

    The SEC has identified five initiatives to further this third strategic goal:

    1. Focus on the SEC’s workforce to increase capabilities and promote diversity and equality.
    2. Expand the use of risk and data analytics, including through developing a data management program that is available on an SEC-wide basis but that provides privacy protections for sensitive information.
    3. Enhance analytics of market and industry data to prevent, detect and prosecute improper behavior.
    4. Enhance the SEC’s internal control and risk management capabilities related to cybersecurity.
    5. Promote collaboration among SEC offices...

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    FINRA Examines Fintech Including Blockchain

    Tuesday, September 11, 2018, 8:39 AM [General]
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    On July 30, 2018, the Financial Industry Regulatory Authority (FINRA) published a Special Notice seeking public comments on how FINRA can support fintech developments including those related to data aggregation services, supervisory processes, including with the use of artificial intelligence, and the development of a taxonomy-based, machine-readable rulebook. The Special Notice, and fintech in general, necessarily includes blockchain technology, a topic FINRA has been examining for a few years now. Last July, FINRA held a Blockchain Symposium to assess the use of distributed ledger technology (DLT) in the financial industry, and earlier in January 2017 FINRA issued a report entitled “Distributed Ledger Technology: Implications of Blockchain for the Securities Industry” on the topic (see HERE).

    Also, on July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens. FINRA informs members that it is monitoring the digital asset marketplace and as part of its efforts and wants all firms to notify FINRA if it or its associated persons engage in any activities related to digital assets. FINRA has requested that it be kept updated on firms’ digital asset matters through July 31, 2019.

    FINRA Special Notice on Financial Technology Innovation

    Clearly financial technology innovation (“fintech”) offers benefits to investors and the financial marketplace as a whole, but also creates challenges for regulators to adapt rules and supervision that support the innovations while continuing to satisfy their goals of investor protection. In addition to blockchain, technological advances have been affecting how financial service providers conduct their business and interact with clients for years. For example, fintech applications related to digital advice including robo-advisors and algorithmic trading platforms, and the use of social media in wealth management, have been hot topics of several years now. Furthermore, the use of artificial intelligence, natural language processing and social media have impacted market research and analytical coverage on a wide scale.

    FINRA’s special notice provides a succinct summary of the actions FINRA has taken to date involving fintech developments, including:

    • Created an external website dedicated to fintech-related matters (see HERE).
    • Formed Fintech Industry Committee with large and small member firms, non-member fintech service providers and SEC and NASAA representation. Topics of focus for the committee include: (i) the potential impact of innovation on FINRA’s investor protection and market integrity objectives; (ii) challenges to the adoption of fintech-based products or services; (iii) opportunities to improve interactions with FINRA; and (iv) FINRA fintech-related initiatives.
    • Have held 4 blockchain and/or fintech symposiums;
    • Fintech representation at the annual FINRA conference;
    • Issued reports and investor alerts related to blockchain, cryptocurrencies digital investment advice and other fintech matters;
    • Working with other domestic and foreign regulators to share insights and address fintech-related issues.

    The special report generally seeks comments that can help identify FINRA rules or administrative processes that could be modified or improved to support fintech innovation while still protecting investors and market integrity. In addition to the general request for comments, FINRA specifically requests comments on (i) the provision of data aggregation services through compiling information from different financial accounts into a single place for investors; (ii) supervisory processes concerning the use of artificial intelligence; and (iii) the development of a taxonomy-based, machine-readable rulebook.

    Data Aggregation

    Many investors have started using data aggregation services that compile their financial data from different financial institutions, including broker-dealers, into one place, often using a dashboard on an Internet-based platform, in order to offer a variety of services such as financial planning, portfolio analysis, budgeting, and other types of financial analysis or advice. In order to compile the data, personal information, including passwords, must be provided to these service providers. Generally, the system is automated such that a program or computer code utilizes the passwords to access various financial institutions and obtain data that is then presented to the investor. In this case the aggregation service provider and financial institution to not have a contractual relationship.

    As an alternative, some financial institutions now offer services called “application programming interface” (API) in which there is a direct transfer of data from the financial institution to the aggregator. The consumer client sets the access authorization and level. In this case there is a contract between the aggregator and the financial institution including provisions related to responsibilities and technical requirements to safeguard data and privacy.

    Broker-dealers can be on both sides of these transactions. That is, the broker-dealer may be one of the financial institutions from which data is being aggregated and broker-dealers can act as the aggregation service provider as well. FINRA is exploring ways to address this increasing consumer option including through the development of standards and protocols. FINRA has provided a notice to members with some guidance on data aggregation services, including that consolidated reports are communications with the public subject to anti-fraud parameters. FINRA also provided some guidance on supervisory and internal control systems; however, with the increase use of these services, more robust rules and guidance may be necessary. Blockchain, including the use of smart contracts, could be utilized in data aggregation services.

    Supervision Related to Artificial Intelligence

    There is a growing interest in applying artificial intelligence, including machine learning and natural language processing, to financial markets and broker-dealer processes and services. Artificial intelligence is used in areas such as anti-money laundering/know-your-customer compliance, trading, data management and customer service.

    With the growth of artificial intelligence comes concerns about how the processes fit within existing FINRA regulations, and the need for new regulations. For example, FINRA is examining how a firm can adequately supervise algorithmic trading, including suitability requirements for specific customer transactions. However, more information is needed and the Special Report indicates that FINRA needs to develop a better understanding of artificial intelligence applications in the industry.  Smart contracts built on the blockchain are a form of artificial intelligence.

    FINRA specifically requests comments on the following:

    • For what purposes are members using, or considering, artificial intelligence tools—including chat bots and robotic process automation (RPA) tools—in their brokerage businesses and what benefits will it serve?
    • Do firms’ governance practices for the development and ongoing operation of artificial intelligence tools differ from those used for tools or processes that use more conventional operational techniques?
    • What forms of quality assurance do firms use in developing artificial intelligence?
    • What are the greatest regulatory challenges in adapting artificial intelligence, including those related to supervision?
    • Are there specific regulatory issues that the use of artificial intelligence tools in the context of algorithmic trading strategies raises?

    Development of Taxonomy-based, Machine-readable Rulebook

    The UK Financial Conduct Authority (FCA) and the Bank of England (BoE) have launched an initiative to examine how to simplify regulatory compliance through the digitization of rulebooks, making them “machine-readable” – in other words, the creation of a rulebook that is structured in such a way as to make it more easily processed by a computer such as a rulebook built on the blockchain using smart contracts. FINRA is reviewing the possibility of machine-readable rulebooks for compliance policies, procedures and transaction databases.

    According to the FCA and BoE, such efforts have the potential to “fundamentally change how the financial services industry understands, interprets, and then reports regulatory information,” through the mapping of regulatory obligations. The reduction of compliance costs and elimination of human error would benefit both firms and regulators.

    Obviously, such a dramatic change in the industry will not happen overnight, but as FINRA indicates, it has to start with a first step. As such, FINRA is considering the feasibility and desirability of developing a type of machine-readable rulebook through the creation of an embedded taxonomy (i.e., a method for classification and categorization) within its rules.

    FINRA specifically seeks comments on:

    • Who will benefit the most and who will utilize a machine-readable rulebook?
    • In what way will it make compliance more efficient and effective?
    • Is there a risk of “over-reliance”?
    • What are the benefits of developing machine-readable rulebooks that interact with other US-based and foreign regulators’ machine-readable rulebooks?
    • What role should vendors and regulated firms play in the adoption, development and ongoing taxonomy maintenance?

    Regulatory Notice 18-20

    The market for digital assets such as cryptocurrencies, tokens and coins continues to grow significantly and as such, fraud in their issuance and secondary trading continues to be a focus for regulators including FINRA. On July 6, 2018, FINRA sent Regulatory Notice 18-20 to its members asking all FINRA member firms to notify FINRA if they engage in activities related to digital assets such as cryptocurrencies, virtual coins and tokens and to continue to update FINRA on such activities through July 31, 2019. FINRA informed members that it is monitoring the digital asset marketplace and, as part of its efforts, wants all firms to advise FINRA if it or its associated persons engage in any activities related to digital assets.

    Member firms are specifically requested to notify FINRA of any of the following activities:

    • Purchases, sales or execution of transactions in digital assets;
    • Purchases, sales or execution of transactions in a pooled fund investing in digital assets;
    • The creation of, management of, or provision of advisory services for a pooled fund investing in digital assets;
    • Purchases, sales or execution of transaction in derivatives tied to digital assets;
    • Participation in an initial or secondary offering of digital assets including ICOs and pre-ICOs;
    • Creation or management of a platform for the secondary trading of digital assets;
    • Custody or similar arrangement involving digital assets;
    • Acceptance of cryptocurrencies from a customer;
    • Mining of cryptocurrencies;
    • Recommending, soliciting or accepting orders in cryptocurrencies or any digital assets;
    • Displaying indications of interest or quotations in cryptocurrencies or any digital assets;
    • Providing or facilitating clearance and settlement services for cryptocurrencies or any digital assets;
    • Recording cryptocurrencies or any digital assets using distributed ledger technology; or
    • Any use of blockchain technology.

    The Regulatory Notice also explicitly reminds member firms to be cognizant of all applicable federal and state laws, rules and regulations, including FINRA and SEC rules and regulations. Furthermore, any material change in the business operations of a member firm requires the submittal of a CMA.  Involvement in cryptocurrencies, digital assets or blockchain would be considered a material change.

    FinCEN and the SEC Weigh In

    In a speech at a blockchain conference on August 9, 2018, FinCEN director Kenneth A. Blanco was less than positive on the state of compliance of money transmitter businesses such as cryptocurrency exchanges. For more information on FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.  In particular, Blanco states that the industry lacks adequate anti-money laundering (AML) controls and that most businesses do not even attempt to put better measures into place until after they are reviewed or investigated by a regulatory authority. Furthermore, the victims of improper AML procedures are not investors with money to lose, but rather families who lose loved ones to opioid addictions or terrorist acts, as both of these utilize cryptocurrencies in their operations.

    Mr. Blanco’s remarks follow similar comments by SEC assistant director Amy Hartman, who also advised companies planning on an ICO to engage competent securities counsel...

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    SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part II

    Tuesday, September 4, 2018, 8:48 AM [General]
    0 (0 Ratings)

    On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law. Section 507 of the Act directed the SEC to increase the threshold under Rule 701 of the Securities Act, for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000. In addition, the threshold is to be inflation-adjusted every five years. The Act required that the amendment be completed within 60 days and on July 18, 2018, the SEC complied and published the amendments. The amendments were effective immediately upon publication in the federal register.

    On the same day, the SEC issued a concept release on potential further amendments to both Rule 701 and SEC Form S-8. The SEC is seeking public comment on ways to modernize the rules related to compensatory plans acknowledging the significant changes in both types of compensatory offerings and workforce composition in the past few decades.

    Part I of this blog series discussed the Rule Change and Rule 701 in general. This Part 2 discusses the Concept Release.

    Concept Release on Rule 701 and Form S-8

    As the SEC notes in its press release announcing the rule change and concept release, equity compensation can be an important component of the employment relationship. In addition to preserving cash for the company’s operations, equity compensation aligns the interests of the employer with the employee and helps facilitate recruitment and retention.

    Where Rule 701 allows non-reporting companies to sell securities to their employees, Securities Act Form S-8 provides a simplified registration form for reporting companies to use to issue and register securities pursuant to employee stock option or purchase agreements.  Since Rule 701 and Form S-8 were last amended, forms of equity compensation have continued to evolve, and new types of contractual relationships between companies and the individuals who work for them have emerged.

    The Concept Release focuses on soliciting comments related to:

    • “Gig economy” relationships, in light of issuers using Internet platforms to provide workers the opportunity to sell goods and services, to better understand how they work and determine what attributes of these relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption;
    • Whether the SEC should further revise the disclosure content and timing requirements of Rule 701(e); and
    • Whether the use of Form S-8 to register the offering of securities pursuant to employee benefit plans should be further streamlined.

    Rule 701 Eligibility

    As mentioned in my summary above, Rule 701 allows for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors under written compensatory plans. Furthermore, under the rule consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

    However, with the rise in technology and the Internet, there has been the concurrent increase in new and different types of employment relationships including short-term, part-time or freelance arrangements. Huge companies have developed using this “gig economy” structure including in areas of ride sharing, lodging, food delivery, household repairs, dog sitting, marketing, web development, logo design, and tech support as just a few examples.

    Individuals can have relationships with multiple companies and careers based on a particular service as opposed to a particular employer. These individuals may not fit within the parameters of an “employee” or consultant or advisor for purposes of Rule 701 eligibility. However, despite the non-traditional relationship, the company would have the same motivations to provide equity compensation including cash preservation, aligning company and workforce interests and facilitating recruitment and retention.

    The SEC Concept Release solicits comment regarding these “gig economy” relationships to better understand how they work and determine what attributes of these relationships potentially may provide a basis for extending eligibility for the Rule 701 exemption. The concept release drills down on the issue with 21 questions on this subject alone.

    In addition to the high-level questions related to how employees, consultants and advisors should be defined and the impact on investors and going public transactions of a larger eligibility pool, the SEC seeks input on the working of the gig economy in general such as whether an individual actually performs services for a company, or just customers and end users with the company just being a platform to obtain these customers and end users. Thought must be given to the level of control a company has over the individual and level of participation of the individual with the company in determining if such individuals should be included in an expanded eligibility regulation.

    Rule 701(e) Disclosure Requirements

    Although the SEC has amended Rule 701(e) to increase the threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000, it has not amended how the rule operates. In particular, the rule requires that all investors, including prior investors, receive disclosures as soon as the aggregate amount of sales reaches the $10,000,000 mark or the exemption is lost. Disclosures must be delivered within a reasonable period of time before the date of sale. The rule does not specify the manner of delivery of the disclosure. Accordingly, a company must carefully monitor issuances and ensure that disclosure goes out to all recipients of Rule 701 securities prior to actually reaching the threshold.

    The SEC seeks comment on whether the rule should continue to operate such that prior investors must receive disclosure before the threshold amount is exceeded. Moreover, the SEC questions whether the consequence of failing to do so should continue to be the loss of the exemption for the entire offering. As an alternative, the SEC could create a mechanism for a company to post information made available to all investors concurrently.

    Rule 701 requires that the disclosure match the financial statement requirements in Regulation A. Under Regulation A, financial statements go stale after 180 days; accordingly, once the threshold is reached, disclosures must be updated to remain current. The SEC seeks comment on this aspect of the rule as well.

    Additionally, the SEC seeks comment on the timing and manner of delivery of disclosures, including issues of confidentiality of the disclosure materials.

    Rule 701 Issuance Caps

    The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption. The SEC seeks comment on the current caps including whether the $1,000,000 figure should be increased, including eliminating the cap altogether and whether the 15% figure should have an annual cap in dollar amount.

    Form S-8

    Form S-8 was originally adopted in 1953 as a simplified form for the registration of securities to be issued pursuant to employee stock purchase plans. Form S-8 requires certain disclosures that can be incorporated by reference to Securities Act and Securities Exchange Act periodic reports and registration statements. A Form S-8 is effective immediately upon filing, though like any filing with the SEC, may be subject to review and comment.

    A Form S-8 may only be used to register securities issued or to be issued to natural persons who are employees, consultants or advisors to a company, pursuant to a written plan. The definition of a “consultant” is consistent with Rule 701. The types of written plans vary and can include different types of employee benefit plans, Internal Revenue Code 401(k) plans, other retirement saving plans, employee stock option plans, nonqualified deferred compensation plans, incentive plans, restricted stock plans, and direct contracts for services with individual employees, consultants or advisors. The form can register new issuances or the resale of restricted securities.

    The form may not be used for capital-raising purposes. In particular, no securities may be issued through a Form S-8 to consultants either (i) as compensation for any service that directly or indirectly promotes or maintains a market for the registrant’s securities, or (ii) as conduits for a distribution to the general public.

    To be eligible to use Form S-8, a company must be subject to the periodic reporting requirements of Section 13 or 15(d) of the Exchange Act and must have filed all reports required to be filed in the preceding 12 months. A shell company cannot use Form S-8; however, a company is eligible 60 days after ceasing to be a shell company and the filing of Form 10 information related to operations.

    The filing fee for a Form S-8 is calculated the same way as filing fees for at-the-market offering registration statements.

    Request for Comment

    The questions in the concept release focus on how to reduce costs and further streamline the form.

    The SEC asks for input on whether the definition of a consultant under Rule 701 and Form S-8 should remain the same, including if the scope of eligible securities recipients under Rule 701 is expanded to include individuals participating in the “gig economy.”

    The SEC asks several questions related to the administrative burdens associated with Form S-8 and how the form and its processing could be further simplified, such as by, for example, allowing the registration of all shares under compensatory plans as opposed to a specific number of shares.

    Finally, the SEC requests comment on general matters related to Form S-8 including whether it should be eliminated and Rule 701 expanded to reporting companies. My personal view is that would not work as Form S-8 shares are registered and thus freely tradeable and Rule 701 shares are restricted.

    Commissioner Kara M. Stein’s Public Statement on the Rule Change and Concept Release

    Commissioner Stein issued a statement related to the Rule 701 amendments and Concept Release in which she expressed her mild pessimism about the SEC actions. Ms. Stein notes that compensatory securities issuances are not always beneficial and that the SEC should be considering whether more companies should be able to use Rule 701 and S-8 as a gating question rather than just thinking about how to expand their use. As such, she is very interested in the responses to the Concept Release.

    Although she voted in favor of the rule change, she notes that “[W]hile I am still uncertain of all of the costs and benefits of such an increase, Congress did not give us discretion. Accordingly, I will support this recommendation...

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    SEC Amends Rule 701 And Issues A Concept Release On Rule 701 And Form S-8 – Part I

    Tuesday, August 28, 2018, 8:48 AM [General]
    0 (0 Ratings)

    On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act (the “Act”) into law. Section 507 of the Act directed the SEC to increase the threshold under Rule 701 of the Securities Act, for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000. In addition, the threshold is to be inflation-adjusted every five years. The Act required that the amendment be completed within 60 days and on July 18, 2018, the SEC complied and published the amendments. The amendments were effective immediately upon publication in the federal register.

    On the same day, the SEC issued a concept release on potential further amendments to both Rule 701 and SEC Form S-8. The SEC is seeking public comment on ways to modernize the rules related to compensatory plans acknowledging the significant changes in both types of compensatory offerings and workforce composition in the past few decades.

    This Part I of the blog will focus on the rule change and Rule 701 in general.

    Rule 701 – Exemption for Offers and Sales to Employees of Non-reporting Entities

    Rule 701 of the Securities Act provides an exemption from the registration requirements for the issuance of securities under written compensatory benefit plans. Rule 701 is a specialized exemption for private or non-reporting entities and may not be relied upon by companies that are subject to the reporting requirements of the Securities Exchange Act of 1934, as amended (“Exchange Act”). Rule 701 is available for both domestic companies and foreign private issuers. The Rule 701 exemption is only available to the issuing company and may not be relied upon for the resale of securities, whether by an affiliate or non-affiliate.

    As required by Section 507 of the Act, the SEC has increased Rule 701’s threshold for providing additional disclosures to employees from aggregate sales of $5,000,000 during any 12-month period to $10,000,000.

    Refresher on Rule 701

    Under the Securities Act, every offer and sale of securities must be registered or subject to an exemption from registration. Rule 701 exempts the offers and sales of securities under a written compensatory plan. The plan can provide for issuances to employees, directors, officers, general partners, trustees, or consultants and advisors. Under the rule, consultants and advisors may only receive securities under the exemption if: (i) they are a natural person (i.e., no entities); (ii) they provide bona fide services to the issuer, its parent or subsidiaries; and (iii) the services are not in connection with the offer or sale of securities in a capital-raising transaction, and do not directly or indirectly promote or maintain a market in the company’s securities.

    Securities issued under Rule 701 are restricted securities for purposes of Rule 144; however, 90 days after a company becomes subject to the Exchange Act reporting requirements, securities issued under a 701 plan become available for resale. In addition, non-affiliates may sell Rule 701 securities after the 90-day period without regard to the current public information or holding period requirements of Rule 144.

    The amount of securities sold in reliance on Rule 701 may not exceed, in any 12-month period, the greater of: (i) $1,000,000; (ii) 15% of the total assets of the issuer; or (iii) 15% of the outstanding amount of the class of securities being offered and sold in reliance on the exemption.

    These measures are calculated on an aggregate basis for a company and not based on separate plans or employment arrangements. For option grants, the aggregate sales price is determined when the option grant is made, not when the option becomes exercisable. For deferred compensation plans, the amount is calculated at the time of the recipient’s irrevocable election to defer. Rule 701 issuances do not integrate with the offer and sales of any other securities under the Securities Act, whether registered or exempt.

    Rule 701(e) contains specific disclosure obligations scaled to the amount of securities sold. In particular, for all issuances under Rule 701, a company must provide a copy of the plan itself to the share recipient. Where the aggregate sales price or amount of securities sold during any consecutive 12 month period exceeds $10 million (formerly $5 million), the company provides the following disclosures to investors within a reasonable period of time before the date of the sale: (i) a copy of the plan itself (ii) risk factors; (iii) financial statement(s) as required under Regulation A; (iv) if the award is an option or warrant, the company must deliver disclosure before exercise or conversion; and (v) for deferred compensation, the company must deliver the disclosure to investors a reasonable time before the date of the irrevocable election to defer is made.

    When a company grants a restricted stock award, the date of sale is the date of grant of the award and thus the disclosure must be provided a reasonable time before the date of grant. Unlike an option or warrant, the employee does not need to take additional action to convert or exercise a restricted stock award; rather, the award vests and the stock becomes irrevocably granted to the employee by the satisfaction of conditions (such as time of employment). Accordingly, Rule 7(e)(6) requiring disclosure be delivered prior to the exercise of an option or warrant would not apply.

    Rule 701 requires that the same financial statements required in Regulation A be provided as disclosure to share recipients. Rule 701 was not amended or modified when the new Regulation A/A+ rules came into effect on June 19, 2015, leaving open the question as to which of the different Regulation A+ financial statement requirements need be used in a Rule 701 disclosure. The SEC subsequently issued a C&DI to clarify that a company can elect to provide the financial statements required under either Tier 1 or Tier 2 of Regulation A, regardless of the value of securities being offered or issued under Rule 701.

    The Rule 144 holding period begins for the recipient “when the person who will receive the securities is deemed to have paid for the securities and thereby assumed the full risk of economic loss with respect to them.” For negotiated employment agreements, the holding period begins on the date the investment risk passes to the employee, which generally is the date of the agreement. For restricted awards that vest over time and are conditioned solely on continued employment or satisfaction of other conditions not tied to the employee’s performance, the holding period begins on the date of the agreement. Like any other derivative security, if the employee is required to pay additional consideration for the securities (such as through exercise of a warrant or option), a new holding period would begin on the date of that payment (i.e., the date of the new investment decision).

    As with all other Securities Act registration exemptions, the company is still subject to the antifraud, civil liability and other provisions of the federal securities laws. In addition, Rule 701 is not available for plans or schemes to circumvent the purpose of the rule, which is for compensatory purposes, and not to raise capital. Moreover, Rule 701 is not available to exempt any transaction that is in technical compliance with this section but is part of a plan or scheme to evade the registration provisions of the Securities Act.

    In 2016 the SEC issued several C&DI related to Rule 701, focusing on merger and acquisition transactions, including reverse mergers. In a merger transaction where the acquirer assumes derivative securities of the target (such as options and warrants) and, as such, they become economically equivalent derivative securities of the acquirer, no exemption need be relied upon for the assumption and transfer of the obligation to the acquirer as long as the derivative securities (again, such as employee options and warrants) were properly issued under Rule 701 and the transfer to the acquirer does not require the consent of the holders of the derivative securities.

    In other words, if a company issued options or warrants to its employees under a Rule 701 plan and that company is later acquired, such as through a reverse merger with a public shell company, the options or warrants could become obligations of the public company, without further registration or reliance on a registration exemption. As long as the options or warrants were properly issued under Rule 701 in the first place, the later exercise and conversion into other securities of the acquiring company, such as common stock, would also be exempt from registration. Moreover, where the acquiring company is subject to the Securities Exchange Act reporting requirements, the Exchange Act reports would satisfy any disclosure requirements under Rule 701(e).

    Securities issued under Rule 701 would aggregate with securities issued under the same rule after a merger or acquisition. Rule 701 issuances by the target and acquirer aggregate for all purposes, including determining issuance limits under the rule and disclosure obligations to share recipients. Assuming the $1,000,000 limit, if the target company had issued Rule 701 securities up to $500,000, the combined post-merger entity would only be able to issue an additional $500,000 in that 12-month period. However, the combined companies could use a post-merger balance sheet in determining total assets for purposes of calculating allowable continued issuances under Rule 701. Likewise, the combined companies can use post-merger financial statements to satisfy the disclosure obligations required under Rule 701.

    Rule 701 does not preempt state law and accordingly, in addition to complying with Rule 701, the company also must comply with any applicable state law relating to the issuance.

    Other Exemptions for Compensatory Issuances

    Although Rule 701 is the most commonly used exemption for the issuance of compensatory securities, companies may also directly rely on Securities Act Section 4(a)(2) or the “no sale” theory, which would not require specific disclosures. The “no sale” theory relates to the issuance of compensatory grants made by employers to broad groups of employees pursuant to broad-based stock bonus plans without Securities Act registration under the theory that the awards are not an offer or sale of securities under the Securities Act. Where securities are awarded to employees at no direct cost through broad-based bonus plans, the SEC has taken the position generally that there has been no sale since employees do not individually bargain to contribute cash or other tangible or definable consideration to such plans. To the contrary, where securities are awarded to or acquired by employees pursuant to individual employment arrangements, such arrangements involve separately bargained consideration, and a sale of the securities has occurred.

    Application of Exchange Act Section 12(g) to Employee Compensation Plans; Determining Holders of Record

    A company that is not a bank, bank holding company or savings and loan holding company is required to register under Section 12(g) of the Exchange Act if, as of the last day of its most recent fiscal year-end, it has more than $10 million in assets and securities that are held of record by more than 2,000 persons, or 500 persons that are not accredited. The same thresholds apply to termination of registration and suspension of reporting obligations.

    Section 12(g) establishes a non-exclusive safe harbor that companies may follow to exclude persons who received securities pursuant to employee compensation plans when calculating the shareholders of record for purposes of triggering the registration requirements.  Exchange Act Section 12(g)(5) provides that the definition of “held of record” shall not include securities held by persons who received them pursuant to an “employee compensation plan” in exempt transactions. By its express terms, this new statutory exclusion applies solely for purposes of determining whether an issuer is required to register a class of equity securities under the Exchange Act and does not apply to a determination of whether such registration may be terminated or suspended.

    The statute establishes an exclusion for security holders who received their stock in unregistered employee stock compensation plans, and provides a safe harbor for determining whether holders of their securities received them pursuant to an employee compensation plan in exempt transactions.

    In its Section 12(g) rules, the SEC incorporates Rule 701(c) and the guidance under that rule for issuers to rely on in their Section 12(g) analysis. The proposed safe harbor allows an issuer to conclude that shares were issued pursuant to an employee compensation plan in an unregistered transaction as long as all the conditions of Rule 701(c) are met, even if other requirements of Rule 701, such as 701(b) (volume limitations) or 701(d) (disclosure delivery requirements), are not met.

    Under the definition of “held of record,” for purposes of Section 12(g), an issuer may exclude securities that are either:

    • held by persons who received the securities pursuant to an employee compensation plan in transactions exempt from, or not subject to, the registration requirements of Section 5 of the Securities Act or that did not involve a sale within the meaning of Section 2(a)(3) of the Securities Act; or
    • held by persons who received the securities in a transaction exempt from, or not subject to, the registration requirements of Section 5 from the issuer, a predecessor of the issuer or an acquired company, as long as the persons were eligible to receive securities pursuant to Rule 701(c) at the time the excludable securities were originally issued to them.

    The SEC also excludes securities issued under the “no sale” exemption to registration theory from the “held of record” definition, including shares issued as a dividend to employees. That is, the SEC is excluding securities that did not involve a sale within the meaning of Section 2(a)(3), as well as exempt securities issued under Section 3 of the Securities Act. Examples of securities issued under Section 3 include exchange securities under sections 3(a)(9) and 3(a)(10)...

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    SEC Adopts Inline XBRL

    Tuesday, August 21, 2018, 8:54 AM [General]
    0 (0 Ratings)

    On June 28, 2018, the SEC adopted amendments to the XBRL requirements to require the use of Inline XBRL for financial statement information and fund risk/return summaries. Inline XBRL involves embedding XBRL data directly into the filing so that the disclosure document is both human-readable and machine-readable. Accordingly, no separate XBRL filings are required. The amendments also eliminate the requirement for companies to post XBRL data on their websites.

    In 2009 the SEC adopted rules requiring companies to provide the information from the financial statements accompanying their registration statements and periodic and current reports in machine-readable format using XBRL by submitting it to the SEC as exhibits to their filings and posting it on their websites, if any. Since that time, however, many industry participants have expressed concerns regarding the quality of, extent of use of, and cost to create XBRL data. In fact, the SEC itself has discovered quality issues with the data in XBRL. As with all regulatory requirements, XBRL has its proponents and supporters as well.

    Pressure from both the naysayers and proponents, as well as the clear inefficiency of duplicative postings, drove the current amendments.

    The requirement for companies and funds to post XBRL data on their websites will be eliminated upon the effective date of the amendments. The Inline XBRL requirements will become effective on a phased schedule as follows:

    • Large accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2019.
    • Accelerated filers that use U.S. GAAP will be required to comply beginning with fiscal periods ending on or after June 15, 2020.
    • All other filers will be required to comply beginning with fiscal periods ending on or after June 15, 2021.
    • Filers will be required to comply beginning with their first Form 10-Q filed for a fiscal period ending on or after the applicable compliance date.

    In its press release announcing the amendments, the SEC cited the following potential benefits:

    • Is expected to reduce, over time, XBRL preparation time and effort by eliminating duplication and facilitating the review of XBRL data.
    • Gives the preparer full control over the presentation of XBRL disclosures within the HTML filing.
    • Is expected to reduce the likelihood of inconsistencies between HTML and XBRL filings and improve the quality of XBRL data.
    • Enhances the usability of structured disclosures for investors through greater accessibility and transparency of the data and enhanced capabilities for data users, who would no longer have to view the XBRL data separately from the text of the documents.

    Statement of Commissioner Hester M. Peirce

    Commissioner Hester Peirce dissented from the amendments and made a statement related to her dissenting position. Although Ms. Peirce supports a shift to Inline XBRL in general and supports the elimination of website-posting requirements, she doesn’t in general support the use of Inline XBRL for smaller public companies or funds due to the costs associated with switching to this technology.

    Commissioner Peirce, who is consistently pro-business and very thoughtful in her role as a regulator, states:

    As regulators, we have broad authority—authority we do not hesitate to use—to reach into the day-to-day operations of the companies we oversee. Our rules can radically change the way companies conduct their business, organize their workflow, and allocate resources. Today's rule will require the adoption of very specific technology to be used in a very specific way on an ambitious timeline. When we issue such a mandate, it has wide-ranging effects on the industry, including knock-on effects on vendors, investors, and others who interact with the relevant filers. By mandating the use of inline XBRL, we are privileging one form of technology over present and potential future competitors. When we take this step, therefore, we must be very certain that we are choosing the right technology at the right time for the right purpose in the right set of companies.

    She notes that companies have been able to voluntarily use Inline XBRL under a pilot program, but the uptake on that use has been minimal, with only 1.8% of all eligible filers using the technology and most of those being accelerated or large accelerated filers. She further points out that the benefit of XBRL at all for smaller companies is questionable, with few investors utilizing its technology, adding, “[B]efore requiring small filers to invest considerable resources in implementing inline XBRL, we should be sure that the data is actually useful to their investors.”

    The costs and burdens on funds will be even greater, with investors bearing the cost burden without real benefit. In fact, Ms. Peirce suggests that the users of fund XBRL risk/return data are primarily data aggregators who sell the information...

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    The OTCQB Has Added Additional Quantitative Listing Standards

    Tuesday, August 14, 2018, 8:43 AM [General]
    0 (0 Ratings)

    On May 20, 2018, the OTC Markets Group published the OTCQB Standards version 3.0 incorporating amendments to the OTCQB initial and ongoing listing standards to add further quantitative shareholder and public float requirements. The new standards went into effect on May 20, 2018 for new listing applications. Existing OTCQB traded companies have until May 20, 2020 to comply with the new requirements.

    The amended listing standards now require that an applicant company:

    1. Have at least 50 beneficial shareholders holding at least one round lot (100 shares) each;
    2. Have a freely tradeable public float of at least 10% of the total issued and outstanding shares of the tradeable class of securities. OTC Markets may allow an exemption from this requirement for companies with a public float above 5% of total issued and outstanding and whose market value of public float is above $2 million or for a company that has a separate class of securities trading on a national exchange. Any exemption must be applied for in writing and will be granted at OTC Markets Group’s sole and absolute discretion.

    Previously in October 2017, OTC Markets amended its OTCQB rules to increase the annual listing fee from $10,000 to $12,000. Prior to that on July 31, 2017, the OTC Markets Group enacted amendments to the OTCQB standards related to the processing and reporting of change in control events. For a review of the change of control standards, see HERE.

    A review of OTCQB Listing Standards

    The OTC Markets divide issuers into three (3) levels of quotation marketplaces: OTCQX, OTCQB and OTC Pink Open Market. The OTC Pink Open Market, which involves the highest-risk, highly speculative securities, is further divided into three tiers: Current Information, Limited Information and No Information. The OTCQB is considered the venture-market tier designed for entrepreneurial and development-stage U.S. and international companies. To apply to the OTCQB, a company must submit a completed application and quotation agreement and pay the application fee.

    Eligibility Requirements

    To be eligible to be quoted on the OTCQB, all companies will be required to:

    • Meet a minimum closing bid price on OTC Markets of $0.01 for each of the last 30 calendar days and as of the day the OTCQB application is approved;
    • In the event that there is no prior public market and a 15c2-11 application has recently been approved by FINRA allowing a quotation at $0.01 or greater, or if the company is traded on a Qualified Foreign Exchange at a price greater than $0.01, OTC Markets can waive the bid requirement at its sole discretion. In this case, the company’s stock must trade above the $0.01 for each of the 30 calendar days immediately subsequent to the company first being quoted on the OTCQB;
    • Have at least 50 beneficial shareholders, each owning at least 100 shares;
    • Have a freely tradeable public float of at least 10% of the total shares issued and outstanding of the class of security to be traded on the OTCQB. OTC Markets may allow an exemption from this requirement for companies with a public float above 5% of total issued and outstanding and whose market value of public float is above $2 million or for a company that has a separate class of securities trading on a national exchange. Any exemption must be applied for in writing and will be granted at OTC Markets Group’s sole and absolute discretion;
    • Have current disclosure by meeting one of the following: (a) being subject to the reporting requirements of the Securities Exchange Act of 1934 and be current in such reporting obligations; (b) being a Regulation A reporting company and be current in such reporting obligations; (c) if an international issuer, be eligible to rely on the registration exemption found in Exchange Act Rule 12g-2(b) and be current and compliant in such requirements; (d) be a bank current in its reporting obligations to its bank regulator; or (e) be current in the OTC Markets Alternative Reporting Standards;
    • Have U.S. GAAP audited financials prepared by a PCAOB qualified auditor, including an audit opinion that is not adverse, disclaimed or qualified. International reporting companies or companies trading on a qualified foreign exchange may have audited financial statements prepared in accordance with IFRS.  Regulation A reporting companies are exempt from the requirement that the initial audits be prepared by a PCAOB auditor; however, subsequent financial statements are required to have a PCAOPB audit;
    • Be duly organized, validly existing and in good standing under the laws of each jurisdiction in which it is organized and does business;
    • Not be subject to any bankruptcy or reorganization proceedings;
    • Submit an application and pay an application and annual fee;
    • Maintain a current and accurate company profile on the OTC Markets website;
    • Use an SEC registered transfer agent and authorize the transfer agent to provide information to OTC Markets about the company’s securities, including but not limited to shares authorized, shares issued and outstanding, and share issuance history; and
    • Submit an OTCQB Annual Certification confirming the accuracy of the current company profile and providing information on officers, directors and controlling shareholders.
    • For companies that are relying on the Alternative Reporting Standard (i.e., not reporting to the SEC), meet minimum corporate governance requirements, including (i) have a board of directors that includes at least two independent directors; and (ii) have an audit committee comprised of a majority of independent directors. A company may request the ability to phase in compliance with this requirement if: (a) at least one member of the board of directors and audit committee are independent at the time of the application; and (b) at least two members of the board and a majority of the audit committee are independent within the later of 90 days after the company begins trading on the OTCQB or by the time of the company’s next annual meeting and in no event later than one year from joining the OTCQB.

    All companies are required to post their initial disclosure on the OTC Markets website and make an initial certification.  The initial disclosure includes:

    • Confirmation that the company is current in its SEC reporting obligations, whether subject to the Exchange Act reporting requirements or Regulation A reporting requirements, and has filed all reports with the SEC on the EDGAR system that all financial statements have been prepared in accordance with U.S. GAAP, and that the auditor opinion is not adverse, disclaimed or qualified;
    • Bank Reporting Companies must have filed all financial reports required to be filed with their banking regulator for the prior two years, including audited financial statements;
    • International Companies – (i) Companies subject to the Exchange Act reporting requirements must be current in such reports; (ii) A company that is not an SEC Reporting company must be current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and shall have posted in English through the OTC Disclosure & News Service or an Integrated Newswire, the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b) for the preceding 24 months (or from inception if less than 24 months); and all financial statements have been prepared in accordance with U.S. GAAP and that the auditor opinion is not adverse, disclaimed or qualified;
    • Alternative Reporting Companies must have filed, through the OTC Disclosure and News Services, an information and disclosure statement meeting the requirements of the OTCQX and OTCQB disclosure guidelines. If the company was an SEC Reporting Company immediately prior to joining OTCQB and has a current 10-K or 20-F on file with the SEC, or was a Regulation A Reporting Company immediately prior to joining OTCQB and has a current 1-K on file with the SEC, the company is not required to file an information statement through the OTC Disclosure & News Service, but subsequent to joining OTCQB must file all annual, quarterly, interim and current reports required pursuant to the OTCQX and OTCQB Disclosure Guidelines; and
    • Verified Company Profile – verification that the company profile is current, complete and accurate.

    In addition, all companies will be required to file an initial and annual certification on the OTC Markets website, signed by the CEO and/or CFO, stating:

    • The company’s reporting standing (i.e., whether SEC reporting, Regulation A reporting, Alternative Standards Reporting, bank reporting or international reporting) and briefly describing the registration status or the applicable exemption from SEC registration of the company;
    • If the company is an international company and relying on 12g3-2(b), that it is current in such obligations;
    • That the company is current in its reporting obligations as of the most recent fiscal year end and any subsequent reporting periods and that such information has been filed either on EDGAR or the OTC Disclosure & News Service, as applicable;
    • That the company profile on the OTC Markets website is current and complete and includes the total shares outstanding, authorized and in the public float as of that date;
    • The number of beneficial shareholders holding at least 100 shares and the number of shares in the public float as of the least practicable date;
    • That the company is duly organized, validly existing and in good standing under the laws of each state or jurisdiction in which the company is organized and conducts business;
    • Identifies the law firm and/or attorneys that assist the company in preparing its annual report or 10-K. Include the firm and attorney name if outside counsel, or name and title if internal counsel. If no attorney assisted in putting together the disclosure, the company must identify the person or persons who prepared the disclosure and their relationship to the company;
    • Identifies any third-party providers engaged by the company, its officers, directors or controlling shareholders, during the prior fiscal year and up to the date of the certification, to provide investor relations services, public relations services, stock promotion services or related services;
    • Names and shareholdings of all officers and directors and shareholders that beneficially own 5% or more of the total outstanding shares, including beneficial ownership of entity shareholders.

    An application to OTCQB can be delayed or denied at OTC Markets’ sole discretion if they determine that admission would be likely to impair the reputation or integrity of OTC Markets group or be detrimental to the interests of investors.

    Requirements for Bank Reporting Companies

    Bank reporting companies must meet all the same requirements as all other OTCQB companies except for the SEC reporting requirements.  Instead, bank reporting companies are required to post their previous two years’ and ongoing yearly disclosures that were and are filed with the company’s bank regulator, on the OTC Markets website.

    International Companies

    In addition to the same requirements for all issuers as set forth above, foreign issuers must be listed on a Qualified Foreign Exchange and be compliant with SEC Rule 12g3-2(b). Moreover, a foreign entity must submit a letter of introduction from a qualified OTCQB Sponsor which states that the OTCQB Sponsor has a reasonable belief that the company is in compliance with SEC Rule 12g3-2(b), is listed on a Qualified Foreign Exchange, and has posted required disclosure on the OTC Markets website. A foreign entity must post two years’ historical and ongoing quarterly and annual reports, in English, on the OTC Markets website which comply with SEC Rule 12g3-2(b). I am a qualified OTCQB Sponsor and assist multiple international companies with this process.

    Application Review Process

    OTC Markets will review all applications and may request additional information on any of the information submitted. In addition, OTC Markets can require that a company provide a further undertaking, such as submission of personal information forms for any executive officer, director or 5%-or-greater beneficial owner. OTC Markets can request that third parties provide confirmations or information as well.  OTC Markets can, and likely will, conduct independent due diligence including through the review of publicly available information.

    OTC Markets can deny an application if it determines, upon its sole and absolute discretion, that the admission of the company would be likely to impair the reputation or integrity of OTC Markets or be detrimental to the interests of investors.

    Upon approval of an application, the company’s securities will be designated as OTCQB on the OTC Markets websites, market data products and broker-dealer platforms.

    Ongoing Requirements

    • All companies are required to remain in compliance with the OTCQB standards, including the ongoing disclosure obligations;
    • S. OTCQB companies will be required to remain current and timely in their SEC reporting obligations, including either Exchange Act reports, Regulation A+ reports or Alternative Reporting Standard and including all audited financial statement requirements;
    • A foreign company that is not an SEC Reporting Company must remain current and fully compliant in its obligations under Exchange Act Rule 12g3-2(b), if applicable, and in any event shall, on an ongoing basis, post in English through the OTC Disclosure & News Service or an Integrated Newswire the information required to be made publicly available pursuant to Exchange Act Rule 12g3-2(b);
    • Audited financial statements must be prepared in accordance with U.S. GAAP or, for international reporting companies or alternative reporting companies listed on a qualified foreign exchange, IFRS and all must contain an audit opinion that is not adverse, disclaimed or qualified. Audits must be completed by a PCAOB qualified auditor.
    • Banks must remain current in their banking reporting requirements and file copies of their reports on the OTC Markets website no later than 45 days following the end of a quarter or 90 days following the end of the fiscal year;
    • All OTC Markets postings and reports must be filed within 45 days following the end of a quarter or 90 days following the end of the fiscal year for US Exchange Act issuers and Alternative Reporting Standard filers, as required by Regulation A+ for Regulation A+ reporting issuers, and immediately after their submission to their primary regulator for international companies; where applicable, file a notice of late filing allowing for 5 extra days on a quarterly report and 15 extra days on an annual or semiannual report;
    • All OTCQB companies will be required to post annual certifications on the OTC Markets website signed by either the CEO or CFO no later than 30 days following the company’s annual report due date;
    • All companies are required to comply with all federal, state, and international securities laws and must cooperate with all securities regulatory agencies;
    • Must pay the annual fee within 30 days of prior to the beginning of each new annual service period;
    • All companies must respond to OTC Markets inquiries and requests;
    • All companies must maintain an updated verified company profile on the OTC Markets website and must submit a Company Update Form at least once every six months;
    • OTCQB is a recognized securities manual for purposes of blue sky secondary market exceptions. A precondition to relying upon the manual’s exemption is the maintenance of current updated disclosure information as required by OTC Markets;
    • All companies must make a press release and possibly other public disclosure (such as a Form 8-K) to inform the public of any news or information which might be reasonably expected to materially affect the market of its securities;
    • An OTCQB company must act promptly to dispel unfounded rumors which result in unusual market activity or price variations;
    • All companies must file interim disclosures in the event the company undergoes a reverse merger or change of control and make new updated certifications and disclosure related to the new business and control persons;
    • All OTCQB companies are subject to the OTC Markets Stock Promotion Policy, as such policy may be amended from time to time. In the event that OTC Markets determines, upon its sole discretion, that a company is the subject of promotional activities that encourage trading, OTC Markets may require the company to provide additional public information related to shareholdings of officers, directors and control persons and confirmation of shares outstanding, and any share issuance in the prior two years. OTC Markets may also require submission of a Personal Information Form for any executive officer, director or 5%-or-greater shareholder;
    • OTCQB companies must quickly issue press releases to the public to disclose any news or information which might reasonably be expected to materially affect the market for its securities.
    • Not be subject to bankruptcy or reorganization proceedings;
    • Be duly organized and in good standing under the laws of each jurisdiction in which the company is organized or does business;
    • Have at least 50 beneficial shareholders, each owning at least 100 shares;
    • Have a freely tradeable public float of at least 10% of the total shares issued and outstanding of the class of security to be traded on the OTCQB. OTC Markets may allow an exemption from this requirement for companies with a public float above 5% of total issued and outstanding and whose market value of public float is above $2 million or for a company that has a separate class of securities trading on a national exchange. Any exemption must be applied for in writing and will be granted at OTC Markets Group’s sole and absolute discretion;
    • Companies relying on the Alternative Reporting Standard must comply with the ongoing corporate governance requirements subject to a notice and one-year grace period if the company falls into noncompliance;
    • All OTCQB companies must meet the minimum bid price of $.01 per share at the close of business of at least one of the previous thirty (30) consecutive calendar days; in the event that the price falls below $.01, the company will begin a grace period of 90 calendar days to maintain a closing bid price of $.01 for ten consecutive trading days; and
    • Use an SEC registered transfer agent and authorize the transfer agent to provide information to OTC Markets about the company’s securities, including but not limited to shares authorized, shares issued and outstanding, and share issuance history.

    Officers and directors of the company are responsible for compliance with the ongoing requirements and the content of all information.  Entities that do not meet the requirements of either OTCQX or OTCQB will be quoted on the OTC Pink.

    Procedures for Change in Control Events

    A “change in control event” is defined to mean a transaction resulting in: (i) a change in the majority ownership or effective control of a company; (ii) material changes to the company’s management team or board of directors; or (iii) in conjunction with either of the above, a material change in the nature of the company’s business operations.

    Under Section 2.4, a company will be responsible for notifying OTC Markets upon the completion of a transaction resulting in a change of control. Regardless of notification, OTC Markets may also make a discretionary determination that a change of control event has occurred.

    Upon a change of control event, a company will be required to submit a OTCQB Change in Control Notification together with a new OTCQB Application and application fee ($2,500) within 20 calendar days. OTC Markets will review the notice and application and may request additional information. The failure to respond or fully comply with such requests may result in removal from the OTCQB.

    Furthermore, immediately following a change in control event, a company would be required to file a new OTCQB Certification and updated company profile page.

    Fees

    Newly applying entities must pay an initial application fee of $2,500, which fee is waived for existing OTCQB entities. All OTCQB companies will be required to pay an annual fee of $12,000. Companies may opt to make two semiannual installments of $6,500. Fees are nonrefundable.

    Removal/Suspension from OTCQB

    A company may be removed from the OTCQB if, at any time, it fails to meet the eligibility and continued quotation requirements subject to a notice and opportunity to cure. Companies that are delinquent in filing and reporting requirements are subject to a 45-day cure period.  Companies with a bid price deficiency shall have a 90-day cure period. However, in the event the company’s bid price falls below $0.001 at any time for five consecutive trading days, the company will be immediately removed from the OTCQB. All other deficiencies are subject to a 30-day cure period. OTC Markets may provide additional cure periods, but in no event may audited financial statements be older than 18 months.

    Companies are granted a cure period of 30 calendar days for failure to maintain the minimum ongoing beneficial shareholder amount and public float requirements. A company may apply in writing to OTC Markets Group for an extension of the 30-day cure period by submitting a plan to cure the deficiency, which extension may be granted by OTC Markets Group in its sole and absolute discretion.

    In addition, OTC Markets Group may remove the company’s securities from trading on OTCQB immediately and at any time, without notice, if OTC Markets Group, upon its sole and absolute discretion, believes the continued inclusion of the company’s securities would impair the reputation or integrity of OTC Markets Group or be detrimental to the interests of investors.

    In addition, OTC Markets can temporarily suspend trading on the OTCQB pending investigation or further due diligence review.

    A company may voluntarily withdraw from the OTCQB with 24 hours’ notice...

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