Originally published on April 28, 2018
This is my opinion, not legal advice.
If you are doing an ICO, either from America or from any other jurisdiction, you should be familiar with the Security and Exchange Commission’s (SEC) Regulation S. This is a highly simplified explanation that intentionally excludes anything not pertaining to crypto, such as debt instruments and warrants.
In short, Regulation S lets you sell Tokens to Foreign markets without registering with the SEC — but you have to lock them up for a one-year timeframe so the Tokens don’t flow back into America. The stated purpose of this Regulation, and every other regulation from the SEC, is to protect American Investors.
The regulation was created in 1990 so companies selling securities offshore did not have to register with the SEC. It turned out that American companies abused the Regulation, so the SEC amended it in 1999 to “enhance investor protection.” See https://www.sec.gov/rules/final/33-7505.htm.
The 1999 amendments created a requirement for US issuers selling equities offshore, but did not change anything for foreign entities selling equities. Now the US issuers have to classify their securities as “Restricted Securities” within the meaning of Rule 144. The holding period while the Securities are restricted from resale is called a “distribution compliance period, “ which is broken down into three tiers of 0 days for tier 1, 40 days for tier 2 and 1 year for tier 3.
Regulation S is not an exemption from registration; it is an exclusion from the U.S. securities laws. U.S. Issuers must meet three conditions to use it: (i) The offer or sale is made in an “offshore transaction” (outside America) (ii) No directed selling efforts are made in the U.S. by the Issuer; and (iii) Additional resale restrictions depending on whether the Security is considered Category 1, 2, or 3.
There are no restrictions on resale so long as: 1. The issuer is a foreign company; 2. Who reasonably believes there is no U.S. market interest in the securities; 3. The offer and sale takes place overseas 4. The issuer can’t engage in any direct selling efforts targeted to American investors.
Category 2 requires a 40-day distribution compliance period for: 1. Foreign private debt issuers 2. Foreign private equity issuers that are subject to the reporting requirements of the Securities Exchange Act of 1934, and 3. Debt offerings of U.S. issuers; provided the issuers are subject to the reporting requirements of the Securities Exchange Act. The big difference between Category 1 and 2 is that the securities may not be offered or sold to U.S. persons, even if the person is outside the United States. Under Category 1, the securities can be offered to U.S. persons who are outside the United States. The 40-day restriction clock begins at the later of either the actual sale, or the close of the offering. The issuer must have the buyer sign a written document to the effect that all offers and sales of the securities before the end of the 40 day lockup period are only made pursuant to the registration of the securities under the Securities Act or pursuant to an exemption.
Category 3 requires a one-year lock-up period. The offer comprises of: 1. Equity offerings of foreign private issuers not subject to the reporting requirements of the Securities Exchange Act, but where there is a high likelihood funds will flow back into America [in the class of securities being offered]; 2. All equity offerings of U.S. issuers; and 3. Debt offerings of U.S. issuers not subject to the reporting requirements of the Securities Exchange Act.
Rule 904 offers a safe harbor that covers offshore resale of securities that were initially placed offshore or by private placement in the United States by someone other than the issuer. (An example of this could be an ICO done in America, and sold to an American Accredited Investor, pursuant to Regulation D — who then sells it to someone offshore). These people can generally resell their securities outside the United States immediately provided the offshore transaction requirement is satisfied and directed selling efforts are not used in the United States. (No practical way for an ICO issuer to enforce this, so it’s safer to lock all Tokens up). The caveat for crypto is that the transaction has to be conducted on a physical trading floor of an established foreign securities exchange, or through the facilities of a “designated offshore securities market” and requires that neither the seller nor anyone acting on its behalf know that the transaction has been prearranged with an American buyer. Crypto exchanges likely wouldn’t qualify as a foreign securities exchange, so unless the Tokens can be transferred through entities like the Toronto Stock Exchange or the London Stock Exchange; this safe harbor provides nothing useful for an ICO issuer.
Rule 905 imposes the same restrictions as Rule 144, typically used in Regulation D for American issuers, and requires a one-year lock-up period. This means any sales done pursuant to 904’s safe harbor would not “wash off” the restricted status of the securities and enable them to be freely sold into the United States by the purchaser. This rule does not extend to the Securities of a foreign private issuer.
REPORTING OF REGULATION S TRANSACTIONS
An American securities issuer used to be required to report all Regulation S sales on Form 8-K within 15 days of occurrence, but that requirement was dropped in 1999. Now issuers do need to report on Forms 10-Q, 10-QSB, 10-K or 10-KSB, as applicable. Form 10-K is typically known as the “Annual Report to Shareholders” and must be filed with the SEC for companies with more than $10 million in assets and a class of equity securities that is held by more than 2000 owners, regardless of whether the securities are publicly or privately traded. It has to include the company history, organizational structure, executive compensation, equity, subsidiaries, and audited financial statement. Form 10-Q is a quarterly filing required by publicly traded companies (on the traditional stock market). So as long as the ICO doesn’t
have more than 2000 Token Holders, it doesn’t need to file these things.
ADVANTAGES OF REGULATION S
American Token issuers can sell security tokens around the world to any number of purchasers, and do not have to ensure each of them meet the American Accredited Investor standards.