It’s all about liquidity…
Why don’t all companies just file an S1 (for equity securities) or SF-1 (for asset-backed securities) and list their securities on NASDAQ?
Because it’s just too damn expensive and time-consuming to comply with the myriad of rules and regulations. Although the JOBS Act helped businesses with less than $1 billion in revenue dial back the onerous requirements of Sarbanes Oxley and other Acts and rules, the fact is that to handle the quarterly and annual accounting, legal, regulatory and shareholder reporting and disclosure obligations is going to exact a huge…massive…toll on a company.
Every country on the planet has seen solid growth of publicly listed companies on their exchanges over the last 20 years. Every country except one, the USA. In fact, we now have less than 50% of the number of exchange-listed, publicly traded companies today than we did 20 years ago. Why? The regulations, often born out of times of crises and as such formed via reactionary legislation, are far too expensive and restrictive.
Why don’t private securities trade like public securities do?
Private securities are generally not subject to anywhere close to the same exhaustive quarterly/annual reporting and disclosure requirements as public companies. Instead, they have various restrictions on them as to who can buy them in initial offerings and who can sell or buy in secondary transactions, and when they can sell or buy. The regs also place a cap on the total number of holders of record a company can have without having to file as a publicly “reporting company”.
Within those restrictions, people are allowed to buy and sell private securities. They could, in theory, be reasonably liquid. And entrepreneurs have in the past started “alternative exchanges” like SecondMarket and SharesPost to attempt to do this. But whereas the public markets have a well-established network of custodians (aka Etrade, Robinhood, Merrill Lynch, Pershing, etc) integrated with DTCC, NSCC, and various transfer agents in order to settle trades between distributed buyers and sellers, that simply hasn’t existed in the private markets.
Thus, without expensive legal opinions and paperwork…
- There’s no good way to know if someone really owns the private securities they are attempting to sell;
- There’s no good way for sellers and buyers to find each other, or to negotiate a price;
- There’s no good way to initiate a transaction between a seller and a buyer;
- There’s no good way to secure and settle funding of the transaction;
- There’s no good way to record the change of ownership;
- There’s no good way to ensure compliance with trading restrictions such as those under Rule 144 and Reg’s CF and S; and,
- There’s no good way to handle KYC and AML.
- Thus, private securities aren’t liquid, as the tools and infrastructure don’t exist.
*** Blockchain can solve all of these things ***
By tokenizing securities on a blockchain, combined with writing appropriate rules and restrictions into the smart contracts, they can now effectively trade on any of the hundreds of token exchanges globally. Thus potentially unleashing trillions of dollars in pent-up supply and demand to distribute and build wealth in private businesses, real estate, and every asset imaginable.
One big wrinkle in all of this is Rule 12g of the Securities Exchange Act of 1934.
People involved with securities tokens offerings (“STO’s”, aka “Smart Securities”) need to be aware of and plan for compliance with Rule 12g of the Securities Exchange Act of 1934. This is true for issuers, as well as their lawyers, brokers, exchanges and other professional advisors.
What is “12g”?
Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”) establishes the thresholds at which an issuer is required to register with the SEC if and when:
- it has more than $10 million of total assets; and
- the securities are “held of record” by either 2,000 persons or 500 persons who are not accredited, investors.
Registering – if you fall into the 12g trap, you must register as a publicly reporting company. What’s involved with that? It generally means;
- for equity securities and for asset-backed securities (including real estate), filing Form 10 with the SEC
– what’s the difference between an S-1 and a Form 10? –
In complying with Section 12(g) of the Exchange Act, a company becomes subject to the periodic and current reporting requirements of Section 13(a) of the Exchange Act. Reporting companies must file quarterly reports on Form 10-Q, annual reports on Form 10-K, and current reports on Form 8-K as well as certain director and shareholder reporting (Forms 3, 4, 5 and Schedules 13D/G ) and proxy statements for voting on matters which require shareholder approval. Reporting companies that fail to file Forms 10-Q or 10-K are subject to liability under Section 10 of the Exchange Act and Rule 10b-5 thereunder for failure to disclose material information or for any omissions.
=> see this LexisNexis article on “everything you need to know about reporting”
Why is this important?
Historically, since private securities were pretty much illiquid and impossible to trade, there was little risk of having more than 500 non-accredited investors (or 2,000 total investors) of record. But if Reg D, S or CF securities are tokenized, then it makes them a heck of a lot more likely to trade. And in the event that the securities start trading, then hitting 12g is much more of a risk.
Does it apply to me?
If the tokens are considered equity securities or asset-backed securities, then 12g applies (I save the discussion about debt securities for a future article).
Okay, but I’m not issuing equity or asset-backed securities.
Exchange Act of 1934 Rule 3a11-1 – The term equity security is hereby defined to include any stock or similar security, certificate of interest or participation in any profit-sharing agreement…limited partnership interest, interest in a joint venture, or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any other security which the (SEC) shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security.
=> This language is obviously very broad and can be interpreted by the SEC in potentially surprising (and costly) ways.
Can using a custodian help avoid 12g registration requirements?
Yes. But no, not for that reason.
§ 240.12g5-1 Definition of securities “held of record”.
(a) For the purpose of determining whether an issuer is subject to the provisions of sections12(g) and 15(d) of the Act, securities shall be deemed to be “held of record” by each person who is identified as the owner of such securities on records of security holders maintained by or on behalf of the issuer, subject to the following:
(3) Securities identified as held of record by one or more persons as trustees, executors, guardians, custodians or in other fiduciary capacities with respect to a single trust, estate or account shall be included as held of record by one person.
“Security holders” of a company are those listed on its books and records (or those of the company’s transfer agent). Many shareholders of publicly traded companies are not individually counted as record holders because they hold their shares at a custodian such as Schwab, Robinhood, Northern Trust, Citibank, etc. In this case, the custodian is counted as a single record holder of the issuer, even if many of the custodian’s clients are the ultimate beneficial owners of the issuer’s shares. Although the JOBS Act increases the record holder thresholds, it does not affect the distinction between “record holders” and “beneficial owners” who hold their shares at a custodian. In other words, the JOBS Act does not “look through” custodians and other record holders to the count ultimate beneficial owners of securities for purposes of determining whether the 12g threshold is reached.
(b) Notwithstanding paragraph (a) of this section:
(3) If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of section 12(g) or 15(d) of the Act, the beneficial owners of such securities shall be deemed to be the record owners thereof.
So why use a custodian in a tokenized world?
- For investors, a custodian enables them to hold digital assets safely in cold storage and provides the convenience of having all investments appear on a single statement (just as they would with traditional securities). It also provides for easy holding in different types of accounts, including JTWROS/JTIC, IRA, HSA, college savings, and asset protection trusts, and simplifies asset management and estate planning.
- For issuers, a custodian makes payments of interest, dividends, royalties, principal, etc. incredibly easy, with both fiat and cryptocurrency on-and-offramps. The cap-table is simplified, saving on time and costs of managing investor lists and communications, And it enables easier listing and trading on exchanges to provide liquidity options for its investors.
- For exchanges and OTC desks, a custodian enables frictionless, cost-free, instant settlement of transactions.
! But a custodian is NOT to be used as a mechanism to primarily avoid Rule 12g.
For all the opportunities that tokenization of securities brings issuers, investors and the markets, it is critical to remain aware and respectful of the rules. Some regulations provide an opportunity to get funded, create wealth and build businesses. Others present a very real threat, potentially to the very existence of the company. Rule 12g and the costs associated with registration and reporting requirements presents such a threat. Offerings and secondary trading must be constructed and conducted with this in mind.
Final thought: these issues are INCREDIBLY complicated matters of law. You absolutely must engage and rely only on the advice of qualified securities attorneys before taking any action. Countless books can be and have been written on each of the many parts of these regulations. I am not an attorney, so this article is not intended to be a guide, advice, recommendation, or an exhaustive presentation of all the applicable information.