Reg A vs. Reg CF: Which JOBS Act Equity Crowdfunding Regulation Is Right For You?

When the JOBS Act was passed into law in 2012, small businesses in United States were given the opportunity to finally be able to tap into the crowd – everyday people – to raise capital even if the company was a startup, early stage or otherwise not going to be able to attract private equity or venture capital money. After 80 years, the heart of the American economy, small businesses, could finally raise capital from anyone, not just wealthy or well-connected individuals or institutions, and still remain a private company.

Over the past few years, two provisions of the JOBS Act have allowed small businesses (and some large businesses!) to raise billions of dollars from investors that for decades would not have been allowed to invest. Regulation A (also called Reg A or Reg A+) and Regulation Crowdfunding, or Reg CF as many call it, changed the landscape for small businesses that needed money to grow. While most people decide which of these provisions to use based on the amount of money they are trying to raise (Reg A allows an offering of up to $75M in one year while Reg CF is limited to $5M per year) there are many factors to be considered by a company seeking capital that go far beyond the simple question of “How much do I need to raise?”

 As a securities attorney who has handled many of both types of offerings, and as a crowdfunding consultant who has helped direct the marketing and other non-legal facets of both Reg A and Reg CF offerings, I have some insights that most do not have. In this new series of articles, I’ll share many of the things companies need to consider when they choose which regulatory exemption from SEC registration to use in order to raise capital from the crowd.

 I’m going to break this down into several articles that I will post over the next few weeks to save you from having to read the War and Peace version of how to democratize capital raising all at one time!

 Also, note that Reg A involves two tiers: not-so-coincidentally named Tier I and Tier II.  because Tier I has limited use for most companies raising capital and is rarely used compared to Tier II.

 This week: The Basics.

 Who can raise capital?

 For both Reg A and Reg CF, only a company (usually a corporation or an LLC) can raise capital. Individuals cannot raise funds with either Reg A or Reg CF.

 Regulation A is only available only to companies organized in and with their principal place of business in the United States or Canada.

 Regulation CF requires the company raising funds to be organized under the laws of a state or territory of the United States or the District of Columbia. There is no “principal place of business requirement” for Reg CF which opens the door to foreign companies using the law with some restructuring.

 Who can invest in a Reg A or Reg CF offering?

 Anyone, regardless of their level of income or net worth, may invest in a Reg A or Reg CF offering. This includes anyone in other countries, as long as it is legal in their jurisdiction to invest and assuming there is no ban in the United States on that person or anyone from their country investing.

 Are their limits on how much someone can invest in a Reg A or Reg CF offering?

 There are no limits on the amount any person or entity may invest in either type of offering, if the investor is “accredited.” An accredited investor is defined in 17 CFR § 230.501(a) and there are many criteria that allow one to meet the definition, but the most common two categories are (a) any natural person whose individual net worth, or joint net worth with that person's spouse or spousal equivalent, exceeds $1,000,000 (not including the person's primary residence not included as an asset and indebtedness that is secured by the person's primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, not included as a liability or (b) any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse or spousal equivalent in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.

 For an investor who is not accredited, they may still invest in a Reg A or Reg CF offering. In both cases, the amount one may invest is limited. In the case of Reg CF, it is further limited by the amount that person has invested in other Reg CF offerings in the past 12 months.

 I’d explain the formulas behind the limitations here, but it would only confuse you and make you ask yourself why these two provisions of the JOBS Act that basically allow companies to do the same thing to not have the same formula to determine how much money a non-accredited investors is allowed to invest. The good news is that this calculation is done behind the scenes through software that makes it fairly easy for an investor to determine how much they are legally allowed to invest. The other good news is that Congress didn’t put the burden on companies using Reg A or Reg CF to check the math or verify the numbers an investor uses. Unless the company is aware the investor is not “accredited” the company is allowed by law to rely on the investor’s representations.

How much capital can a company raise?

 In any one year period, a company may raise up to $5M with Reg CF.

 In any one year period, a company using Reg A may raise up to $75M with Tier II of Regulation A, and up to $20M with Tier I. This is commonly misconstrued to mean any company raising between $1-$20M must use Tier I, which is not true. A company may raise from $1-$20M with Tier I, and from $1-$75M with Tier II.

 I’m not going to get into the details of Reg A Tier I versus Reg A Tier II in this article for one simple reason: the use of Reg A Tier I is very limited for most companies. The reason for this in a nutshell comes down to one major factor: Reg A Tier II allows a company to raise capital anywhere in the U.S. without having to comply with every state’s Blue Sky laws while Tier I is the opposite and requires the issuer to comply with those laws in every state where investors will be solicited. Compliance with state by state Blue Sky laws is extremely expensive and could easily double or triple the cost of getting a Reg A Tier I offering live. Imagine having to have your offering circulars to raise capital undergo review by each state’s securities regulators, instead of just the SEC. Imagine the legal bills of trying to come up with filings in each state that are the same, and every time one of 50 state regulators or the SEC tells you to change one random paragraph, then having to go to all the other states again to make sure that they are happy with the change one regulator 2,000 miles away required. Imagine watching your bank account get drained as you pay even more attorneys’ fees.

 Suffice to say, Reg A Tier I is an often excellent choice to raise capital if you plan to only target residents on one state (an example would be a local restaurant who wants to open more locations in the same city), it is not a great choice for a company trying to reach investors across the fruited plain.

 How much does it cost to raise capital?

 For a company that is already formed, typically it costs approximately $15,000-$25,000 in out of pocket expenses to get a Reg CF offering live. The costs after the offering is live typically involve mostly marketing expenses, which can vary dramatically from case to case.

 For a company that is already formed, typically it costs approximately $50,000-$75,000 in out of pocket expenses to get a Reg A offering live. Just like Reg CF, the costs once the offering is live typically involve marketing expenses which can vary dramatically.

These numbers are general guidelines, and the cost could be far lower, or much higher, depending on all of the circumstances.

What legal documents do I have to prepare?

In order to start raising capital with a Reg CF offering, a company must file a document called Form C with the SEC which contains certain required legal disclosures, risks factors, company information, information about the securities you are selling, financial statements and more. Note that some funding portals – who are a sort of mini-broker-dealer – will offer to draft and file the Form C for you to save money. Before taking this extremely risky chance, consider the risks of allowing non-lawyers to draft legal documents for you that investors will be relying upon. Your company, and perhaps the principals and directors of your company, will be on the hook for whatever is contained in that Form C filing.  There are potential criminal penalties for those whose names are signed to these documents if they are not prepared correctly. Securities laws are complicated and paying a seasoned securities lawyer with Reg CF experience to draft and file this important document for you is something most prudent companies do.

 In order to start raising capital with a Reg A offering, a company must file a document called Form 1-A with the SEC. Typically, this is a far more extensive document than Reg CF’s Form C, even though it contains much of the same basic disclosure requirements. In reality, Form 1-A is basically a shorter form of a prospectus used by companies that hold an IPO. Form 1-A undergoes a review process with the SEC and must be “qualified” before you can go live and start raising capital.

 What financial and accounting requirements must I meet to file my proposed offering with the SEC?
This can get complicated, so I’ll give you the basics which apply in most situations.

Reg A is simple. With Tier II, all offerings must include up to two years of financial statements audited by an independent CPA. If your company is less than two years old, you must have audited financial statements from inception to the present.

 Reg CF is a bit more complex, and what financial statements must be included in your SEC filing depends on how much you plan to raise, and whether this is your company’s first Reg CF offering or not and whether the date of the offering is more or less than 120 days after the end of your company’s prior fiscal year.

 The basic rules are:

 If you are planning to raise less than $124,000, you may disclose internally created financial statements for the past two fiscal years certified as accurate by your management.

 If you are planning to raise between $124,000 and $618,000, you must disclose independent CPA reviewed financial statements for the past two fiscal years.

If you two are planning to raise between $618,000 and $1,235,000 and this is the first time your company has used Reg CF, you must disclose independent CPA reviewed financial statements for the past two fiscal years. If you have previously used Reg CF, you must disclose independent CPA audited financial statements for the past two fiscal years.

 If you two are planning to more than $1,235,000, you must disclose independent CPA audited financial statements for the past two fiscal years.

 Also, for Reg CF, if your company has audited financial statements available for the relevant time period, you must disclose those.

 After you start raising capital, are there any ongoing filings to make with the SEC?

 For both Reg A and Reg CF, there are ongoing reporting requirements. While none of these are as expensive or burdensome as those required of fully registered public companies, they are very important to remain compliant with federal securities laws. The main reports to be filed are discussed below, although other reports may be required.

 Reg CF only has one major ongoing SEC reporting requirement. An issuer that sold securities in a Regulation CF offering is required to provide an annual report on Form C-AR no later than 120 days after the end of its fiscal year and must post the report the company’s website. The annual report requires similar financial information to what is required in the Form C offering statement that is initially filed to start a Reg CF offering, but the financial statements do not need to be audited or reviewed by an independent CPA. This filing requirement ends when one of five events occurs:
(1) the issuer is required to file reports under Exchange Act Sections 13(a) or 15(d);

(2) the issuer has filed at least one annual report and has fewer than 300 holders of record;

(3) the issuer has filed at least three annual reports and has total assets that do not exceed $10 million;

(4) the issuer or another party purchases or repurchases all of the securities issued pursuant to Regulation Crowdfunding, including any payment in full of debt securities or any complete redemption of redeemable securities; or

(5) the issuer liquidates or dissolves in accordance with state law.

 At that point, the issuer may file notice on Form C-TR reporting that it will no longer provide annual reports.

 For Reg A, Tier II, there are more reports to file to remain compliant. Similar to Reg CF’s annual report on Form C-AR, Reg A issuers file an annual report on Form 1-K within 120 calendar days of the issuer’s fiscal year end. Form 1-K requires two years of audited financial statements. It also requires an update of information from the issuer to information previously filed. It also requires disclosures relating to the issuer’s business operations for the prior three fiscal years (or, if in existence for less than three years, since inception) as well as related party transactions, beneficial ownership of the issuer’s securities, executive officers and directors, including certain executive compensation information, management’s discussion and analysis of the issuer’s liquidity, capital resources, and results of operations.

And requires an update of information from the issuer requires issuers to update information previously filed and to provide disclosures relating to the issuer’s business operations for the prior three fiscal years (or, if in existence for less than three years, since inception) as well as related party transactions, beneficial ownership of the issuer’s securities, executive officers and directors, including certain executive compensation information, management’s discussion and analysis of the issuer’s liquidity, capital resources, and results of operations.

Additionally, Reg A Tier II requires a semiannual report to be filed on Form 1-SA within 90 calendar days after the end of the first six months of the issuer’s fiscal year. Form 1-SA requires issuers to provide disclosure primarily relating to the issuer’s interim financial statements and management’s discussion and analysis of the issuer’s liquidity, capital resources, and results of operations.

Reg A also requires an issuer to file a “current report” on Form 1-U within four business days of the occurrence of one (or more) of the following events: fundamental changes; bankruptcy or receivership; material modification to the rights of securityholders; changes in the issuer’s certifying accountant; non-reliance on previous financial statements or a related audit report or completed interim review; changes in control of the issuer; departure of the principal executive officer, principal financial officer, or principal accounting officer; and unregistered sales of 10% or more of outstanding equity securities.

 How fast can I get an offering live?

 This is a hard question to answer because there are so many variables. One variable – how long it takes your company to get its financial statements done - almost always takes longer than expected and without those statements, you cannot file with the SEC under Reg CF or Reg A.

Some companies do not have their books in order, or their books are not to GAAP (Generally Accepted Accounting Principles) so there can be delays getting the basic financial statement requirement complete which holds up the entire process.

 But realistically, I tell my law firm clients that it is about a 3 month process to get a Reg CF offering live from the time I am hired, and a 4-6 month process to get a Reg A offering live. That being said, there are times I have been able to get an offering live on a shorter timeline, and times it took longer than those estimates.

 Coming next week: Part 2 of the 6 part series: How Does a Company Receive The Capital It Raises? Also, this article is not and should not be considered legal advice. Yes, I am a securities lawyer but no, you did not hire me to provide you with legal advice. In all cases, consult with your own lawyer as every legal situation is unique and do not rely on my educational and informative article as legal advice.

Lessons To Be Learned From The SEC’s Recent Penalties for ICO Companies

“Learn from the mistakes of others” - Ancient Philosopher Kendall Almerico

The Securities and Exchange Commission recently brought their regulatory hammer down on several ICO-related companies. After months of public statements from officials and rumors of numerous subpoenas and investigations, the SEC sent a strong and undeniable message to companies that have held unregulated initial coin offerings, and to those who are considering it.

Don’t do it.

There are lessons to be learned from these recent regulatory actions. These lessons confirm what I have been preaching in my securities law practice to all of the coin/token/crypto companies I have been talking to or representing: Follow the existing securities laws to raise capital selling tokens or be prepared to suffer some extreme consequences. In this article, I will dig into the story of Carrier EQ, also known as AirFox, whose story is a perfect illustration of the dangers a company faces when they hold an ICO without following securities laws.

I am going to get into a lot of specific facts because what AirFox did is so common in the ICO world, so we can all learn from their mistakes. I will also explain in layman’s’ terms what happened to AirFox as the SEC reviewed their offering, in an effort to provide a “heads-up” to companies that still believe they can get away with holding an ICO in the United States without going through the SEC. It appears that AirFox did not receive very good advice in their ICO, and despite all the recent warnings and negative publicity, I still have ICO companies contacting me wanting to use these same methods (“But I’m selling a utility token!”) that got AirFox in trouble.

Two things are obvious after this SEC enforcement action:

1. You cannot call what you are selling a “utility token” and have securities laws magically not apply to your offering (see Lesson 7 below), and

2. Unless you can definitively prove what you are selling is not a security, you need to follow securities laws in your offering.

The AirFox ICO

AirFox is a U.S. company that sells mobile technology that allows prepaid mobile phone customers to earn free or discounted airtime or data by interacting with ads on their smartphones. From August to October 2017,[1] AirFox offered and sold blockchain-issued digital tokens called AirTokens in an ICO where the company raised about $15 million to create a new international business and ecosystem. AirFox told potential ICO investors that the new ecosystem would include the same functionality of AirFox’s existing U.S. business (allowing prepaid mobile users to earn airtime or data by interacting with ads) and would also add new features such as the ability to transfer AirTokens between users, peer-to-peer lending, credit scoring, and eventually using AirTokens to buy and sell goods and services other than mobile data. In the ICO, AirFox stated that AirTokens would potentially increase in value as a result of AirFox’s efforts, and that AirFox would provide investors with liquidity by making AirTokens tradeable in secondary markets.

Any advisor who even has a basic understanding of securities law would look at this and say “Hey, AirFox, you are selling securities. You are selling tokens to the general public, that you are alluding to an increase in value, to finance a new business.” Apparently, AirFox’s “crypto advisors”[2] and lawyers (if they had any) did not bother to Google “what is a security?”[3]

The SEC Penalties

On November 16, 2018, the SEC instituted “cease and-desist proceedings” against AirFox. This means, in laymen’s terms, that the SEC told AirFox to “Stop Breaking The Law!” because the SEC is about to come in, and effectively shut their company down with penalties. As a result, AirFox reached a settlement with the SEC so they could have some hope of continuing in business. The settlement requires AirFox to:

· Pay a $250,000 fine,

· Inform each person that purchased AirTokens of their right to get their money back if they still own the tokens or if they can show they sold them for a loss,

· Issue and post a press release on the company’s website notifying the public of the SEC’s order, containing a link to the order, and containing a link to a “Claim Form” for investors to get their money back,

· File the appropriate paperwork with the SEC to register the AirTokens as a class of securities — this means the AirFox now must follow all securities regulations and ongoing reporting requirements as to these tokens — an extremely expensive requirement, and

· Deal with a lot of other ongoing reporting requirements related to these penalties to keep the SEC informed.

In essence, the SEC made AirFox pay a large fine, forced them to return up to $15 million back to investors, publicly admit on online and in the press that they broke the law, and be subject to a ton of time-consuming and expensive paperwork (disclosing information like audited financial records that investors typically need to decide if a stock is a good investment ).

How many companies that held an unregistered ICO could financially stay viable with the imposition of such penalties? My suspicion is that there are very few.

What do we learn from the AirFox settlement?

1. The SEC is going to follow the Howey test[4] at least as a baseline to determine if a token sold in an ICO is a security. AirTokens were “securities” under the Howey test because people buying the tokens would have had a reasonable expectation of obtaining a future profit based upon AirFox’s efforts, including AirFox revising its app, creating an ecosystem, and adding new functionality using the proceeds from the sale of AirTokens.

Lesson: If your token offering cannot pass muster with a well-known 76-year old Supreme Court ruling, you are selling securities.

2. If you sell tokens that are securities, you have to either (a) register the securities with the SEC or (b) qualify for one of the well-known exemptions from registration such as Regulation D or Regulation A when you sell the tokens. In other words, follow existing securities laws. AirFox, like many ICO companies, did neither of these things, which is illegal.

Lesson: This isn’t rocket science. Either file an S-1 and register your token offering or be sure you qualify under one of the exemptions from registration (like Regulation A) before you sell any tokens to anyone.

3. The SEC is going to read your “white paper”[5] and review everything[6] related to your token offering. With AirFox, the SEC specifically noted that “in September 2017, AirFox explained to prospective investors in a blog post that the ‘AirFox browser is still considered ‘beta’ quality and will continue to be improved over the coming months as we execute on the AirToken plan.’” This blog post helped the SEC satisfy one of the Howey prongs of what constitutes a security: Money from the token sale was being used in a common enterprise for the company raising capital to build their business.

Lesson: Follow securities laws in all offering documents, marketing materials, media interviews, and everything whatsoever associated with the token offering.

4. AirFox’s white paper informed investors that 50% of the proceeds of the offering would be used for engineering and research and development expenses. In AirFox’s whitepaper, the company proposed a potential timeline of development milestones which covered from August 2017 through the second quarter of 2018.[7] Again, the company’s own documentation showed they were selling securities under Howey, by explaining that the company was going to use the funds from the token sale to fulfill their business plan.

Lesson: If you are using the funds from the token offering to build your business, follow your business plan, or build your ecosystem the tokens will be uses in, you are probably selling securities.

5. In its ICO, AirFox raised approximately $15 million by selling 1.06 billion AirTokens to more than 2,500 investors. The number of investors is important: A company selling securities is required to register their equity securities under “Rule 12(g)”[8] if the class of securities was held of record by more than 2,000 persons and more than 500 of those persons were not accredited investors. In other words, if you sell securities to 2,001 total investors, or 501 non-accredited investors, you have to be registered with the SEC.[9] With more than 2,500 investors, AirFox would be subject to these expensive registration requirements, if their tokens were considered to be securities.

Lesson: Watch the number of investors in your offering. Even when you are selling tokens that are clearly securities, you must pay attention to the rules surrounding how many investors you are allowed based on the laws applicable to your offering.

6. AirTokens were available for purchase by individuals in the United States and worldwide through websites controlled by AirFox. The company is based in the United States. The websites selling the tokens in the U.S. were controlled by the company. This all subjected AirFox to the jurisdiction of the SEC.

Lesson: If your company does business in the U.S., or wants to touch the U.S. investor market, you need to follow U.S. securities laws. If you are not a U.S. company[10], and do not sell or market at all to U.S. investors, most of this article may not apply to you at all.

7. The terms of AirFox’s the ICO required purchasers to agree that they were “buying AirTokens for their utility as a medium of exchange for mobile airtime, and not as an investment or a security.” In other words, AirFox assumed they could agree with their token purchasers that they were selling a “utility token” and not a security. It doesn’t work that way. Calling something a “utility token” and saying it “is not a security” is meaningless to the SEC. As the SEC notes “at the time of the ICO, this functionality was not available. Rather, the AirFox App was a prototype that only enabled users to earn and redeem loyalty points, which could be exchanged for mobile airtime. According to the company, the prototype was “really just for the ICO and just for investment purposes so people know . . . how it’s going to work” and “[did not] have any real users” at the time of the ICO. Despite the reference to AirTokens as a medium of exchange, at the time of the ICO, investors purchased AirTokens based upon anticipation that the value of the tokens would rise through AirFox’s future managerial and entrepreneurial efforts.”

This quotation from the SEC is important for two reasons:

· It makes it clear that the AirTokens violate the Howey test. Investors purchased AirTokens anticipating that the value of the tokens would rise through AirFox’s future managerial and entrepreneurial efforts. That is, almost literally, the definition of a security contract from Howey — someone investing in a company where the company’s efforts will increase the value of the investment.

· More importantly, the SEC seems to have cracked the door open a little. The SEC specifically set out several reasons why the AirTokens are securities and not “utility tokens” …but what if those reasons did not exist? What if this ICO had taken place later, and the following facts had been in existence:

(a) At the time of the ICO, the tokens’ functionality was available,

(b) The app was a not a prototype but was fully functional,

(c) The app had real users at the time of the ICO,

(d) The tokens were being used onlyas a medium of exchange at the time of the ICO, and

(e) Purchasers of the tokens had no anticipation that the value of the tokens would rise through the company’s future managerial and entrepreneurial efforts, because the tokens were not allowed to be traded on an exchange or otherwise.

While the marketplace for such tokens would not likely yield nearly $15 million in purchasers like in AirFox’s ICO, it seems that the SEC mightentertain characterizing tokens in the scenario[11] above as not being subject to securities laws.

Lesson: You can’t call what you are selling a “utility token” and have securities laws magically not apply to you. What you call your tokens is irrelevant to the SEC’s legal analysis.

8. AirFox’s whitepaper described an ecosystem to be created by the company where AirTokens would serve as a medium of exchange and that the company would maintain the value of AirTokens by purchasing mobile data and other goods and services with fiat currency that could be then purchased by holders of AirTokens and that the company would buy and sell AirTokens as needed to facilitate the purchase and sale of goods and services with AirTokens. In other words, the investors in the tokens would, again, be relying on the future efforts of AirFox, clearly one of the Howey prongs that make the AirTokens clearly securities under the law.

Lesson: If you are relying on the future efforts of the company selling the tokens to give the tokens value, the tokens have failed one portion of the Howey test.

9. Prior to the ICO, AirFox communicated to prospective investors that it planned to list the tokens on token exchanges to ensure secondary market trading. Obviously, liquidity in any investment is a huge part of the investment decision by a purchaser, and AirFox made it clear (a very common trait in unregulated ICOs) that their tokens would be traded on crypto exchanges, so buyers could sell them and potentially make a profit. This satisfies the “investment” arm of the Howey test. If investors have a reasonable expectation of profit from being the tokens, the tokens are very likely securities.

In fact, in the middle of the ICO, AirFox announced that it was reducing the token supply from 150 billion to 1.5 billion without changing the anticipated market cap “to alleviate concerns raised by many current and potential token holders and token exchanges who prefer each individual token to be worth more.”

Imagine a tradition initial public offering of stock, where the IPO company suddenly changed the number of shares of stock available but kept the valuation of the company the same. “Hey, those shares you first-in buyers got for $20 are now worth $2000 each because we decided to sell 1/100thof the number of shares.” This kind of market manipulation would likely end of with a few people in federal prison.

Lesson 1: If you tell purchasers of your token that the tokens are going to be traded and that you are going to do things to make the tokens more valuable for these investors, you are selling securities, without any question.

Lesson 2: Changing the material terms of a securities offering in the middle of it = bad idea.

10. The SEC noted the following interesting bit of information. Following the ICO, AirFox attempted to list AirTokens on a major digital token trading platform, and answered an application question that asked, “Why would the value increase over time?” AirFox’s response was “As time lapses the features and utility of AirToken will go up as we continue to build the platform. As of today, the people are able to download our browser to earn and purchase AirTokens to redeem mobile data and airtime across 500 wireless carriers. Over the next two years, the utility of the token will expand and therefore, more people across the world will need to have AirTokens in their possession to participate on our platform and ecosystem.”

Lesson: The SEC reads and reviews everything, including interactions a company has with third-party companies.

11. AirFox offered and sold AirTokens in a general solicitation to potential investors. This means AirFox advertised the ICO to the general public and solicited investments from anyone willing to send them money. In the securities world, general solicitation is limited to certain types of securities under certain exemptions, and allowing any investor to purchase securities, regardless of their accredited status, is not allowed in most cases.

Lesson: If you are going to advertise your token offering (and how else would you get the word out and find investors?) you need to follow securities laws and regulations related to general solicitation.

12. Through a “bounty” campaign, AirFox provided “free” AirTokens to people (crypto advisors) who helped the company’s marketing efforts. AirFox entered into an agreement with a crypto advisor who had previously led similar ICO promotions by other companies. This crypto advisor received a percentage of the AirTokens issued in the ICO in exchange for his services, recruited other people to translate AirFox’s whitepaper into multiple languages and to tout AirTokens in their own internet message board posts, articles, YouTube videos, and social media posts. More than 400 individuals promoted the AirToken initial coin offering as part of the bounty campaign. These individuals also received AirTokens in exchange for their services.

While the SEC did not specifically address this point in their ruling, I would not be surprised to see some regulatory or legal investigation undertaken against these crypto advisors. Depending on several factors that there is not enough publicly available information to know for certain, it is possible these crypto advisors may have conducted illegal broker-dealer activities subject to various regulations. The advertising and marketing of securities is highly regulated and based upon the representations made by those who were paid “bounties” by AirFox, it is also possible that some of these individuals did not follow existing laws and regulations as to how such advertising should be conducted.

Lesson: Follow all securities laws and regulations related to marketing, and only deal with advisors who understand and follow securities laws. When interviewing advisors, ask them about their experience in token offerings that were done in compliance with SEC regulations, not their experience with unregulated ICOs.

13. AirFox aimed its marketing efforts for the ICO at digital token investors rather than the anticipated users of AirTokens.

· AirFox promoted the offering in forums aimed at people investing in Bitcoin and other digital assets, that attract viewers in the United States even though the AirFox App was not intended to be used by individuals in the United States.

· AirFox’s principals were interviewed by individuals focused on digital token investing.

· In a blog post, AirFox wrote that an AirToken presale was directed at “sophisticated crypto investors, angel investors and early backers” of the AirToken project and in a pre-sale, prior to the public offering, AirFox made AirTokens available to early investors at a discount.

AirFox made no effort to market the ICO to the anticipated users of AirFox tokens — individuals with prepaid phones in developing countries. Instead, AirFox marketed the ICO to investors who “viewed AirTokens as a speculative, tradeable investment vehicle that might appreciate based on AirFox’s managerial and entrepreneurial efforts.”

Lesson: If you are going to claim you are selling “utility tokens” in an offering, you should sell those tokens to the ultimate users of the tokens. If you do not, you are likely selling securities to speculating investors, and your argument of selling “utility tokens” falls apart very quickly.

Conclusion (The Final Lesson)

I’ve been talking to (and in some cases, actually representing) token and crypto companies ever since the DAO decision when the floodgates opened to companies realizing that the only safe way in the U.S. to issue a digital asset, token or coin is to follow securities laws. It’s not that hard. Every mistake AirFox made was avoidable, and everything they did to violate well-established securities laws could have been avoided if they had received good advice. Selling investments to U.S. citizens is one of the most highly regulated industries in the world. To think a company can avoid following these well-established laws and regulations just because of a new technology, and because “everyone else is doing it,” is ridiculous.

Can I start openly selling cocaine online to anyone who wants to buy it because I keep the records of the sales on a distributed ledger and track each kilo on a blockchain? No, and nobody would be so stupid to try.[12]

This is not that difficult. The final lesson is: If you want to sell tokens without following securities laws to the U.S. market, you need to be 100% certain they are not securities, and that is going to be very difficult to do in most cases. If you and your advisors are not 100% certain that what you plan to sell is not a securitiy, get advice from reputable securities counsel before you do anything.

Once more thing: if you find yourself creating arguments to get around parts of the Howey Test rather than being able to definitively prove your tokens do not fit the Howey definition of a security, then the SEC is most likely going to disagree with you, and deem your tokens to be securities.

[1]It is important to note these dates. One month before the AirFox ICO, in July 2017, the SEC announced that it viewed the tokens offered by The DAO, an ICO that raised more than $150 million in 2016, as securities. This ruling was widely reported and sent shockwaves through the “unregulated” ICO industry. It would be hard to imagine that those advising AirFox were not aware of the DAO ruling when they started their ICO one month later.

[2]Some “crypto advisors” are persons (nearly always without a law degree) who advertise that they have “helped companies raise millions” in other ICOs (none of which followed U.S. securities laws). They often have influence in the ICO community and on ICO review websites where, in many cases, the review of an unregistered ICO is based on how much money you pay the website.

[3]Or, their advisors Googled it, read the Howey test, and decided “Let’s make like an ostrich and ignore the obvious.” Advisors to ICO companies should not take the attitude of “but everyone else is doing it and raising millions of dollars so it must be okay” or, my favorite, “there are no rules for ICOs, these are unregulated!”

[4]SEC v. W. J. Howey Co., 328 U.S. 293 (1946). The “Howey Test” is the U.S. Supreme Court’s definition of what a security is and has been the law for 76 years. In a nutshell, the four-part Howey Test determines that a transaction represents an investment contract if a person (a) invests his money (b) in a common enterprise and is (c) led to expect profits (d) solely from the efforts of the promoter or a third party.

[5]A “white paper” in the ICO world is a document that explains the business and the offering. In most cases, these documents are heavy on technical language regarding the tokens and blockchain but offer little to no guidance on the financial health of the business and rarely disclose all the risks of investing in the offering. In many cases, these “white papers” are not even close to what a securities lawyer would draft for any securities offering. But, many ICO companies apparently are advised to believe their white paper, with its page of legal disclaimers copied from other white papers found online, will magically protect them from any securities laws repercussions.

[6]The SEC will look at a company’s white paper, any other offering documents, websites, social media, media interviews, and any other online or offline matter related to the offering. If it is publicly available, the SEC is going to review it. Even if it is not publicly available, the SEC may subpoena it. In the AirFox case, the SEC noted that AirFox talked about prospects for development of the AirToken ecosystem on blogs, social media, online videos, and online forums and even gave a specific example of quotes from AirFox’s principals making claims in a YouTube video.

[7]These are typical White Paper 101 inclusions in an ICO. A breakdown of what the funds will be used for (which is actually a normal part of a securities law compliant offering document) and a timeline. While there is nothing wrong with these disclosures, the problem is that these white papers rarely discuss the risks involved with the offering, and almost never disclose anything about the financial condition of the company — staples of a compliant securities offering.

[8]17 CFR 240.12g-1

[9]There are notable exceptions to this rule under certain exemptions from registration, including under Regulation A, as amended in the JOBS Act.

[10]Without getting too technical, if you are a New York City based company, with offices and employees in Manhattan, who sets up a shell company in the Virgin Islands that has no office or employees and you run that company out of New York, you are not being clever and avoiding the fact that the SEC is probably still going to consider you a U.S. company. All you have done is sent up a red flag.

[11]There are other factors to consider, as Howey is just part of the analysis as to whether something is, or is not, a security. But, for illustrative purposes, this section of the SEC’s analysis is very helpful for companies considering a token sale, because it illustrates a potential path to a token not being subject to securities laws, and the possible ability in very narrow circumstances to sell a token outside of securities laws.

[12]Okay, someone might be dumb enough to try. Never underestimate the stupidity of some people. The TV show America’s Dumbest Criminals filled three years of episodes with people who might have tried this. For the record, if a stupid criminal tries this, and says it was my idea, please remember that they are, as noted, a stupid criminal and do not believe them.

Disclaimer (because I am wearing my lawyer hat): Kendall Almerico is a securities lawyer who represents companies raising capital in JOBS Act offerings (Regulation A in particular) and companies that want to sell tokenized securities in a compliant manner through a security token offering. This article does not contain legal advice and should not be relied upon bu anyone for legal advice. It is simply the opinions of Kendall Almerico interpreting certain matters that were recently in the news. Do not rely on this article for legal advice as every situation is different. In all cases, consult your own attorney or advisors.

There, I said it.

Everything you wanted to know about crypto offerings but were afraid to ask

With Securities and Exchange Commission Chair Jay Clayton making the public announcement last July he believes every ICO he’s seen is a security, every company in the cryptocurrency, blockchain and token world was put on notice that raising capital by selling coins or tokens was entering a different phase in the United States. As a result, securities lawyers like myself, have been flooded with calls and requests for our services.

I was interviewed by one of my favorite journalists, Tony Zerucha at Bankless Times, about how ICOs, token offerings and the like can be legally done these days and you can (and should) read the entire published article here. For those who want the CliffNotes version, here you go:

• Any U.S. company that wants to raise capital by selling coins, tokens or cryptocurrency, and any company that wants to access the 325 million potential investors who live in the United States, must follow securities laws at this point. With my work in the JOBS Act legal realm, I have been been talking to dozens of crypto companies. Because the grand majority will use one of two JOBS Act provisions: Regulation D, rule 506(c) (if they limit the offering to accredited investors), or Regulation A+ if they want to access the entire U.S. population, those of us who specialize in JOBS Act offerings and equity crowdfunding have become quite popular.
• I've lost count of the number of companies I have had to turn down at this point because they already have done something that is not compliant or legal. The first step is to make sure each company has not already screwed up what they want to do because they were not well informed as to how they should proceed. I ask some pretty simple questions to start, and you would be surprised at how few companies have the right answers.
• I start with the basics. I ask every company to explain to me in a sentence why they need a token and how blockchain is integral to their business. If I had a Bitcoin for every company that came to me with a concept that used the term “blockchain” or “token” without even knowing what it meant or how it was going to be used, I’d be a Bitcoin billionaire. Or maybe a Bitcoin millionaire, depending on the fluctuating exchange rates.
• You would be amazed at how many people cannot answer this question in one hour, much less one sentence. Some businesses do not need a blockchain, or a token. For example, I do a pretty good job of running a law firm without a blockchain. A pilot does not need a coin to fly an airplane. A chef does not need a utility token to cook a perfect steak. I realize that blockchain technology is revolutionary in many ways for many things. But, you can’t just throw the term “blockchain” into every business model. If a company is not able to explain in simple terms why they need blockchain in their business, they probably don’t need blockchain, and probably should not be doing a coin offering.
• I hate it when I hear, “Kendall, our pre-sale is next week. Would you take a look at our white paper and be sure we are okay?” If they are already online soliciting for their sale, there is a good chance they’ve already violated a law or two. And if they already have anything scheduled in terms of a sale, it’s probably too late for any securities lawyer to help unless they are willing to pump the brakes.
• I also hear this one a lot: “We’re okay because we’ve hired” followed by ‘a top ‘ICO’ ‘Blockchain’ or ‘Crypto’ consultant on our Board of Advisors.”  I ask these companies if their advisor is a securities attorney who has experience with the JOBS Act and securities token offerings, and then I look at my iPhone to see if the call has been disconnected because there is always dead silence. Ninety-five per cent of these “crypto experts” have absolutely no idea how to do a securities law-compliant token offering in the United States, and many charged these companies a lot of money to give them bad advice.
• I received a ton of emails, most of them spam, over the past few years with the newest hottest ICO offers, and I saw the news about the crazy amount of money being raised. I think most securities lawyers saw these ICOs raising millions with no disclosures, no investor protections, no financial statements and no real information revealed other than hype and the repeated use of the term “blockchain.” Not only were these obviously sales of securities, many of them were just blatant scams that couldn’t pass a sniff test in allergy season. No, I can’t say that seeing the SEC jump in and state regulators filing enforcement actions and class action suits being filed was at all surprising.
• A company needs to assume that what they are selling is a security, because the SEC is certainly going to assume that. You can’t call something a “utility token” and assume you can get away with not following securities laws. It does not matter what you call it, if it cannot pass the Howey Test, or if you are selling it with the idea that the purchaser may be buying something that will increase in value over time, you should treat it like a security. There are well defined exemptions that allow U.S. companies to sell securities without registering, so follow those laws in your token sale, and the capital raise portion should be legal.
• To me, Reg A+ is the holy grail for token security offerings. Everyone can invest, not just rich people. The tokens sold can immediately be listed on an Alternative Trading System (ATS) and are liquid and tradable. I love that the SEC must qualify a Reg A+ offering before it can be sold. This means if you have any problems in your offering, there is a likelihood it is going to be flagged by someone at the SEC before you start selling, rather than after when something goes wrong like with Reg D or Reg S. It is not cheap to do, but nowhere near as expensive as an S-1 and full registration with the SEC. You will have ongoing reporting requirements and a company is limited to raising $50 million per year. While most companies would be thrilled with raising $50 million per year, this limitation would prevent some companies from using Reg A+ if their capital needs are higher. That said, a Reg A+ raise can be done in conjunction with a Reg D offering, if it’s structured correctly, to raise more that the limit.
• The big questions are: What happens after someone purchases the token or coin? Can they sell it outside of an ATS? How? Can they use it as a currency? Can they use it as a utility token? There is a huge amount of uncertainty as to how the courts and regulators are going to treat security coins and tokens after they are in the hand of investors. This is one reason why I like Reg A+ so much. As soon as the offering closes, the Reg A+ securities tokens may be listed on a secondary trading platform and be bought or sold. This immediate liquidity is a huge selling point. There are rules and restrictions that limits sales under Reg D and Reg S, so this is not possible with either of those exemptions.
• My experience is that the SEC is very open to this new method of raising capital, as long as you follow securities laws and protect investors. The SEC is well aware that if they shut down all crypto offerings, another country will become the leader in this area, and billions of dollars of capital will flow out of the U.S. They do not want this to happen, so they are working with securities lawyers and their counterparts at the CFTC, Department of Treasury, FinCen and others to try to find solutions. Yes, you have a target on your back if you do a crypto offering. But, as long as you have a justifiable legal basis in securities law for what you plan to do, the chances are the SEC is not going to stand in your way.

As I said in the interview, the days are gone of some random millennial plagiarizing a white paper found on Google while their tech geek buddy sets up a website to promote and accept Bitcoin for an ICO followed by millions of dollars magically appearing, unless those people want to risk going to jail or being sued.

Anyone who wants to do this right in the U.S. is going to need experienced securities counsel. They are very likely going to need a licensed broker-dealer. They are going to need a secondary trading platform. They are probably going to need accountants and maybe auditors. Doing this right is not going to be cheap. But, then again, getting sued or arrested and having your business shut down is far more expensive than simply doing this legally and compliantly from the beginning.

Read the entire interview here, to learn more:

Do You Need A Broker-Dealer For Regulation A?

In my role helping companies raise up to $50 million in new capital using equity crowdfunding, I am frequently asked if a company that wishes to pursue a Regulation A+ capital raise must hire a broker-dealer for the offering. I have written an in-depth article about this on Medium, which you can read here (if you like to read stuff lawyers write and enjoy footnotes and long-winded legal analysis). On the other hand, if you want the simple Cliff Notes version, keep reading below!

The simple answer to the title question above is that moving forward with a Regulation A+ offering without a broker-dealer attached is a dangerous move for an issuer, even though it technically can be done. However, if an issuer wants to sleep well at night and not worry that one of the 50+ state securities regulators or the SEC will come knocking on their door, then bite the bullet and hire a broker-dealer who is licensed in all 50 states and by FINRA for your Regulation A+ offering.

The big issue related to hiring a broker-dealer for most issuers is the cost. A broker-dealer will likely have up front due diligence costs, and will charge a percentage of the funds raised in the offering as a commission. This raises this important question: Will an issuer save money by not hiring a broker-dealer? 

Up front, maybe. In the long run, probably not. As illustrated below, in order to go forward on a Regulation A+ offering without a broker-dealer, an issuer may have to register as a “dealer” in many states and at the federal level, which will cost thousands in legal and filing fees. Assuming everything is done correctly and runs smoothly, registering with all of these entities could involve hefty up-front costs, and in most cases far more than the broker-dealer would have charged for due diligence. More importantly, if anything is done wrong in that registration process in any of the venues, or if any state or federal securities regulator thinks something was done wrong, then there will be huge costs to fight the enforcement actions that could arise all over the country.

Why do companies even consider taking on all of this risk by not hiring a broker-dealer?

Regulation A+ of the JOBS Act is silent as to whether an issuer must hire a broker-dealer in order to sell unregistered securities to the general public under this JOBS Act exemption. Given this silence, most legal authorities agree that the law and SEC rules related to Regulation A+ do not, on their own, require an issuer to hire a FINRA licensed broker-dealer to sell their unregistered securities.  Therefore, some issuers feel this is enough of a justification to go at it without a broker-dealer.

What these companies are missing is that the text of Regulation A+ and the SEC regulations related to the statute are not the sole consideration in this matter given that securities are being sold. Other state and federal laws and regulations that regulate who may sell securities may prevent an issuer from selling their own Regulation A+ securities without a licensed broker-dealer in some jurisdictions. The JOBS Act waiver of state Blue Sky review does not necessarily prevent the states from regulating who can sell Regulation A+ securities in their state. Because each state has its own set of laws related to who is allowed to sell securities, who must be registered to do so, and under what circumstances securities can be sold by that entity, there are valid concerns that a state regulator could impose significant penalties on an issuer who chooses to sell its Regulation A+ securities within that state, without a broker-dealer licensed in that state.

So, you ask, what is the worst case scenario if a company decides to try to save a few dollars, and sell their Regulation A+ securities on their own? Let me give you the scenario that would keep me awake at night, and the one that typically compels me to advise my clients to hire a broker-dealer and not go at it alone:

Let’s say the company sells its Regulation A+ securities to a little old lady in Florida, without using a broker-dealer registered in Florida. The company does not do well, or the stock is listed on an exchange and the price drops. Little old lady hires a lawyer, and wants her money back. She also contacts the state securities regulators in Florida, and tells them about this mean and awful company that took her retirement savings away from her.

The lawsuit and the state securities regulators review will probably show that the company did not comply with every aspect of Florida securities law, in particular, by not hiring a broker-dealer (which would have rendered the case moot).

Do you think a Florida jury is going to side with a company that violated state law and sold stock to the little old lady? Do you think securities regulators are going to help the little old lady, or the company that violated its state’s securities laws?

The result could be rescission of the agreement to sell the stock – meaning the little old lady gets her money back. There could also be rescission ordered for all investors in the state, meaning a huge financial problem for the issuer who has to give money back to everyone who invested, not just the little old lady. On top of that, fines and penalties could be ordered. And, to make matters worse, a court or the state regulators could extend the penalties against the officers and directors of the company personally, particularly if they were involved in selling activities themselves.

Ouch.

All avoidable by simply hiring a broker-dealer.

I’m not alone in my concerns here. Kat Cook is the Chief Compliance Officer for Keystone Capital Corporation, a FINRA licensed broker-dealer with experience in Regulation A+ arena and other areas of the rapidly emerging FinTech industry. Cook believes that this threat is very real of having to rescind all subscriptions agreements and return capital raised if a state securities regulator finds that local laws were not complied with. “Compliance with Reg A+ means that the issuer should hire a very knowledgeable JOBS Act securities attorney and retain a supporting broker-dealer to help…or prepare to give the funds raised back to the investors,” warns Cook.

If you want far more in-depth analysis and some state law citations that let you dig deep into this, click here https://medium.com/@KendallAlmerico/do-you-need-a-broker-dealer-for-regulation-a-7308535d9b19 and read my Medium article.

Kendall Almerico is an attorney based in Washington DC whose practice involves JOBS Act related securities offerings such as those involving Regulation A+ or Regulation CF. This article should not be considered as legal advice, and the opinions expresses in the article are personal opinions of Mr. Almerico and should not be relied upon by anyone as legal advice. Other lawyers may have different opinions. The topics covered in this article are very complex, and any company considering using Regulation A+ or selling securities in any manner should seek the advice of competent and experienced legal counsel before making any decisions related to the matters set out in this article.

How Will Donald Trump's Presidency Affect Crowdfunding?

Image credit: Joe Raedle | Getty Images

Originally published at Entrepreneur.com on January 10, 2017

Donald Trump will soon be inaugurated as the country’s 45th president and will potentially impact the burgeoning crowdfunding industry in a "yuge" way. Before I share my thoughts as one of the country’s top crowdfunding attorneys, let me tell you what five industry leaders believe the Trump presidency will mean for crowdfunding.

Disclaimer: This is NOT a political article. For those on the right, please don’t send me red baseball caps embroidered with “Make Crowdfunding Great Again.” For those on the left, please do not label me or the crowdfunding leaders in this article as “deplorable” or worse.

Indiegogo has been at the forefront of rewards crowdfunding since the very beginning. Indiegogo’s co-founder and Chief Business Officer, Slava Rubin, had this to say: "It's obviously impossible to know exactly how the next four years will play out since the new administration hasn't moved into the White House yet. Trump's platform included easing up on banking regulations -- which the stock market has reacted well to -- and it will be interesting to see how that translates for equity crowdfunding. The one year anniversary of Title III is coming up this May, so that will be a good time to examine what kind of progress has been made under the new administration."

RocketHub was one of the world's pioneering crowdfunding portals and has developed into a global community for entrepreneurial growth through a partnership with luxury lifestyle network ELEQT. RocketHub's CEO Ruud Smeets shared his take on the Trump presidency.

“Any abrupt change in the political landscape is a challenge and can have ripple effects throughout one's business," Smeets said. "Having a strong support 'crowd' can be a great benefit to any entrepreneur, especially in times of change. The emerging Trump presidency may create more volatility, but it also holds the promise of potentially bringing less regulation and more freedom for innovation and entrepreneurship. That would be good news for alternative funding options like crowdfunding, which still is a highly regulated market space with certain barriers to growth. It remains to be seen though how Trump’s plans on healthcare, international trade, isolationism and any attendant currency effects will affect small business ownership as a whole.”

Roy Morejon, whose firm Command Partners has been one of the most prolific and successful PR and marketing agencies in the crowdfunding space said the initial effects of a Trump presidency seem to be positive for the crowdfunding industry. Recent meetings with top technology leaders from Apple, Microsoft, Amazon, Facebook, Intel and Tesla seemed to be productive with innovation and jobs being a top priority.

"With Trump's business background, American innovation and job creation should flourish," Morejon said. "At our crowdfunding marketing agency, we're seeing a flurry of activity in the equity crowdfunding space in hopes that Trump will alleviate some of the red tape with some of the current crowdfunding regulations.”

Ruth Hedges is one of the pioneers of the JOBS Act and executive producer of the Global Crowdfunding Convention, the largest and longest running crowdfunding convention in the country. Here are her thoughts on the Trump presidency related to crowdfunding: "As America enters uncharted waters with social safety net programs and medical insurance for 20 million people threatened with destruction, we'll need to call on crowdfunding to provide help to those people who will surely suffer, because crowdfunding is not red or blue, black or white, Christian, Muslim or Jew. It is not left or right, but showcases the best of our humanity. And it demonstrates the potential to bring together people from all backgrounds and beliefs to work for our common good as Americans."

Craig Denlinger is one of the go-to auditors for financial reports needed to comply with equity crowdfunding laws. His firm, Artesian CPA, has provided the SEC financial filings for several companies using Regulation A+ to raise capital. Denlinger said "while it is difficult to decipher between what Trump says and what Trump intends, I anticipate that Trump will be a positive force for the crowdfunding community based on his words and actions to this point. With the incumbent SEC Chair Mary Jo White set for early retirement next month, Trump is poised to appoint a more regulation-averse head of the agency looking to scale back on barriers to innovation and job creation. Trump’s planned federal hiring freeze and quotes such as 'eliminating two regulations for every one created' or 'rank all regulations and cut those least important' further confirm this belief.”

The experts have spoken. Here is my two cents.

The “crowd” is a dynamic group that effects change one dollar at a time. With its support, Pebble Watch raised $32,000,000+ in two Kickstarter rounds, BrewDog raised more than $40,000,000 through several equity crowdfunding offerings, and countless other ideas and businesses have been afforded the opportunity to succeed. Crowdfunding brings people together in a way that is truly American because political affiliation isn't a factor in the equation. Each project or offering can be a melting pot of Democrats, Republicans and maybe even Whigs -- anyone can support a business they like regardless of gender, race or religion. Even Congress managed to find common ground to pass the JOBS Act with bipartisan support.

Because navigating the legal maze of rules and regulations is presently the biggest thing hampering equity crowdfunding, President Trump will have a positive influence on the industry if he delivers on his promise to reduce regulations. Reducing regulations will slash attorney fees and compliance costs for companies wishing to use equity crowdfunding. I truly hope the Trump administration will remove unnecessary red tape and open the door for even more democratization of the capital formation process through equity crowdfunding.

And, if the new administration wants to create a new unpaid cabinet position of “Secretary of Crowdfunding” to help them reduce the barriers to entry for small businesses, I happen to know a lawyer/writer/entrepreneur who lives in D.C. and might be available to fill that role.