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Regulation Enforcement of CryptoCurrency Sept-2018

The Financial Industry Regulatory Authority (“FINRA”) announced on Tuesday, September 11, 2018, its first disciplinary action for securities violations against a cryptocurrency. The disciplinary action involves Rocky Mountain Ayre, Inc. (RMTN) in connection with its issuing and selling of HempCoin, which was marketed as “the first minable coin backed by marketable securities”. Ayre bought the rights to HempCoin in 2015 and effectively securitized HempCoin by backing it with RMTN’s publicly traded common stock. HempCoin was touted as the “the world’s first currency to represent equity ownership” in a publicly traded company and promised investors that each coin was equal to 0.10 shares of RMTN common stock. Through late 2017, investors were able to mine more than 81 million HempCoin securities and subsequently buy and sell the coin on two cryptocurrency exchanges.  FINRA alleges in its complaint that Ayre defrauded investors in RMTN by making materially false statements and omissions regarding the nature of RMTN’s business. Such false statements include failing to disclose its creation and unlawful distribution of HempCoin, and misleading statements in RMTN’s financial statements. Ayre is charged with the ‘unlawful distribution of an unregistered security’, as HempCoin was not registered with the SEC nor did the issuer  use a registration exemption.

The same day as the FINRA announcement, the SEC issued two separate cease-and-desist orders. The first cease-and-desist order was issued to a cryptocurrency hedge fund, Crypto Asset Management (“CAM”) who misrepresented itself as the “first regulated crypto asset fund in the United States”. The SEC claims that the CAM has not registered with the SEC and “willfully” misrepresented itself as having the proper credentials to trade and hold securities. The second cease-and-desist order was issued to self-proclaimed “ICO Superstore” TokenLot, for failing to register with the SEC. The heads of TokenLot have agreed to pay a fine to settle the charges that they acted as an unregistered broker-dealer for the sale of tokens. Similar to most investigations, these two have already been resolved via the payment of fines. These two cases may signal that the SEC is beginning to go after companies that have failed to comply with securities laws out of negligence, rather than overt fraudulent activities.

Although the SEC has previously issued statements that Bitcoin and Ethereum are not securities, to date, the SEC has declined to issue broad or narrow classifications or taxonomies as to which cryptocurrencies are securities, and which are not. It is worth remembering, however, that, ultimately, the SEC is only a regulatory body that enforces the law. Thus, these issues will likely be left to the courts to ultimately decide.

On September 11, 2018, a New York federal judge in U.S. v. Zaslavskiy ruled that U.S. securities laws applied to prosecuting fraud allegations involving cryptocurrency. Zaslavsky was charged in November 2017 for securities fraud related to two ICOs:  ReCoin and DRC. In February 2018, Zaslavsky filed a motion to dismiss claiming that he did not commit securities fraud because ReCoin and DRC are not securities and that the U.S. securities laws are unconstitutionally vague because an ordinary person would not have known that his conduct was illegal under current securities laws. The judge denied his motion to dismiss on the grounds that ReCoin and DRC are, in fact, securities assuming the Department of Justice’s allegations are true, and the U.S. securities laws are not so vague as to be unconstitutional. The judge’s denial of Zaslavskiy’s motion to dismiss means the case will proceed to trial. Zaslavskiy is expected to argue that the relevant tokens were not investment contracts under the Howey Test.

These three announcements issued on the same day demonstrate how seriously regulators and courts are taking cryptocurrency despite their late start and lack of definitive guidance surrounding the law to date. We will keep monitoring these developments as more announcements are made.

Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected] 


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Do ICO’s Seek an Expectation of Profit Solely from the Efforts of Others?

In our most recent blog post, we discussed the second prong of the Howey test – a “common enterprise” – and the US Circuit Courts’ fragmentation on the issue and lack of uniform definition. In this third and final part of our series pulling apart the Howey Test, we’re looking at the third and fourth prongs of the Test. These final two prongs, typically read together, are (collectively) “with an expectation of profits solely from the efforts of others”. The expectation of profits element focuses on the type of return that the investor seeks on their investment. This return inquiry is easily satisfied by an increase in capital or participation in earnings on invested funds. As mentioned, however, the return or profit must depend on the “efforts of others”, which goes to the passive nature of the investment return. Remember, the Howey company was selling plots of land on its citrus grove to people who had no intention of farming the land and depended on the Howey company to produce profits. These investors were expecting a passive return with no intention of consuming the oranges produced (i.e., this was not a pre-sale for the underlying future oranges which goes to consumptive use v. speculative use).


The SEC Wants to Talk About Your Control Issues


The “solely from the efforts of others” inquiry is a fact-specific analysis of the economic realities of the transaction. In sum, the more an investor controls the business operations of the project, the less likely an investment contract exists. The critical question to ask is whether the efforts of individuals other than the investor are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”. In determining an investor’s control over the profitability of the investment, a court may look at:

  • the investor’s contribution of time and effort to the success of the project;
  • the investor’s rights under the investment agreement;
  • the investor’s access to information about the project; and
  • and the investor’s level of sophistication.

This analysis brings into focus the timing of the investment. If promoters promoted the investment and then made no further efforts after the investment, it is likely that no investment contract exists.

In the modern context of security ‘token’ sales that we have been examining, an appreciation in value via secondary market trading, in theory, should not be used as weighing in favor of the token being an investment contract. Additionally, a court may consider the adequacy of financing of the investment as well as the level of speculation and the nature of the risks in the transaction.


Getting Over Control Issues


With respect to securitized token offerings, it’s fun to talk about monetary gains, decentralization, openness, lambos, etc., but more time needs to be spent around architecting the proper token governance schemes. Because this is a fact-specific analysis, each token project must think granularly in terms of why a token is necessary; what does the token do; what is a token purchaser receiving (voting rights, effectively a license to use the network, ability to contribute to the network, etc.); how is this information being communicated (i.e., Telegram, Reddit, Twitter, Slack, Medium, YouTube, Podcasts, etc.); and how knowledgeable are the pre-functional platform investors (accredited investors, professional knowledgeable investors, ordinary public investors).

Unfortunately, there is no bright-line rule, and there is likely not going to be one for some time. In the decade since cryptocurrency has existed, only two cryptocurrencies (Bitcoin and Ethereum) have been declared not securities.


Exploring the Other Side


We have talked in this series of posts, in some detail, about transparency from the team building the network, but next, we should finish by focuses on how traditional finance disclosures work for large, private investors.

Meltem Demirors, a prominent cryptocurrency investor, has openly talked about the notion of this “shitcoin waterfall”. The shitcoin waterfall is when an ICO raises a pre-pre-sale round from VCs at a very steep discount. Then, the project raises a pre-sale where the initial investors now have tokens that are valued at 50-100x more than the previous round. The white paper is likely then revised with “crypto-famous” investors listed as advisors, and the white paper reads like any other marketing brochure. Next, the project does an ICO followed by an exchange listing for the general public. Coinciding with the exchange listing, these early investors are dumping their heavily discounted tokens on the average consumer. Meanwhile, most ICOs fail within four months.

Should large, early investors in an ICO be subjected to disclosures about token exits? Such disclosures would help regulators evaluate whether or not these early investors are pumping and dumping coins on the average retail investors. The same is true with self-dealing issues in respect to projects and team members contributing back into their ICO for more of their tokens, thereby inflating the ICO raise. While we share in the enthusiasm and promises of cryptocurrency, current ICO practices are less than noble or open to everyone despite what is propagated at overpriced conferences. As more empirical data comes to light, the legal landscape will begin to adjust for these projects.


Series Post-Script


The broad variables discussed throughout this series of blog posts on the Howey test offers arguments on why some tokens are considered securities and the gaps in the legal knowledge that need to be overcome. As noted in Coin Center’s recent Framework for Securities Regulation of Cryptocurrency, “the Howey test happens to also be an effective guide for determining whether a token possess heightened risks to users. The more a given token’s software and community variables allow it to fit the definition of a security, the more need there may be to protect its users with regulation.”. In theory, the more decentralized and transparent the network, the less risky it is to hold the token as it functions more like a commodity as price fluctuation is due to the market rather than one entity behind the project.

The reason we started the blog series with the facts of Howey was because the facts are easily substitutable. However, there is a mental shift around digital things that must be explained to regulators and token issuers in order to advance the ecosystem. Sometimes, acting and failing to act can have the same consequences; a didactic that the SEC already knows very well in its views on disclosure. For now, an understanding of the past and careful self-regulation based on our understanding of prior law will have to do.


Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


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What is a Common Enterprise and is Bitcoin or Ethereum one?

In our most recent blog post, we discussed the first prong of the Howey test – an “investment of money” – through the lens of so-called ‘airdrops’. Moving on to the second prong – a “common enterprise” – requires us to take a step back and consider multiple angles. While courts, generally, have been quick to find a common enterprise despite the U.S. Courts fragmentation on the test, new cryptocurrency based projects, as open-source, add a level of consideration that is worth exploring.


Not Split – Fragmented

The circuits are fragmented in evaluating the “common enterprise” element, and we are left with three approaches: (1) horizontal commonality, (2) broad vertical commonality, and (3) narrow vertical commonality.

The horizontal commonality test is relatively straightforward. The test requires a pooling of funds in a common venture and a pro rata distribution of profits. The test is not worried about any promoters (which, in this context, means the issuer and its principal(s)). Thus, an investor’s assets must be joined with other investors where each investor shares the risk of loss and profits according to their investment. To date, the U.S. Circuit Courts of Appeal that follow the horizontal commonality test include the First, Second, Third (affirmed, but no opinion by the Third Circuit Court), Fourth, Sixth, and Seventh Circuits. Note – We have only include the circuit courts because these courts are one tier below the U.S. Supreme Court regarding what decisions hold the most weight in the U.S. legal system.

Vertical commonalty focuses on the vertical relationship between the investor and the promoter. Under this test, a common enterprise exists where the investor is dependent on the promoter’s efforts or expertise for investment returns. There are two approaches the vertical commonality:  (1) broad vertical commonality, and (2) narrow vertical commonality.

The only requirement under broad vertical commonality test is that “the investors are dependent upon the expertise of efforts of the investment promotor for their returns”. This test is perhaps the easiest to satisfy because there is typically always an information asymmetry between the promoter and the investor. The key question to ask, therefore, is does the investor rely on the promoter’s expertise? Both the Fifth and Eleventh Circuits follow the broad vertical commonality test.

The narrow vertical commonality test only finds support from one circuit – the Ninth Circuit. Under this test, the court only looks at whether or not the investor’s profits are linked with the profits of the promoter. Put another way, a common enterprise exists if the investor’s success or failure is directly correlated with that of the promoter’s.


Where Does That Leave Us?

When we look at Bitcoin and Ethereum, we have to ask who exactly are the ‘promoters’? One of the primary concerns in regulating securities is information asymmetries that lead to investors being taken advantage of by promoters. Remember, the Securities and Exchange Commission (SEC) has a three-part mission:  (1) protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation. Therefore, companies offering securities must tell the truth about its business, what securities they are selling, and the risks involved in investing in the company’s securities.

Evaluating Bitcoin and Ethereum under the same test, a central organization, clearly, does not exist. For Bitcoin, there was no ICO and has perhaps been sufficiently decentralized since its inception according to the SEC. For Ethereum, perhaps at the ICO stage, a central entity existed that investors relied on, making it (possibly) a security. However, we are now three years removed from that, and Ethereum has been, to all intents and purposes, deemed to be not a security. In the current state, anyone can write proposals on GitHub, fork the code, contribute upstream to Ethereum, etc. In truly permissionless, decentralized systems, has everyone become a ‘promoter’? The investment of money is not in a common enterprise, but rather an investment of money for tokens to participate in the growth of a network or base protocol. Unlike the familiar examples above, however, the issue with most ICOs is that the platforms are not built and there is a core team that is developing the software pre-release in a silo. Therefore, the investor is dependent on the team for the network to be built, and the funds from the ICO are going towards the team to continue the development of the network.

Many people in cryptocurrency are expecting the next big announcement to come from the SEC or the CFTC. We believe, however, that the next large moment of legal clarity will come, rather, from the courts via the numerous civil lawsuits developing. The U.S. Supreme Court has, to date, declined to take on this circuit court fragmentation directly. Perhaps this is because the facts and circumstances of the prior cases do not warrant a novel decision around the commonality question. However, the way we have seen cryptocurrency evolving and expect it to continue evolving, the time has come to settle the issue of what is a common enterprise.

Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


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Do Crypto Currency Airdrops pass the Howey Test?

Continuing on our journey of securities law and cryptocurrency, it’s time to start pulling apart the Howey test. In an academic paper following the Howey Test’s 64th anniversary, the test was equated to that house that the home owners have continued building new additions that are clearly additions, sometimes awkward, and “the consensus of neighbors with taste is that the house should be torn down and rebuilt from scratch.”

What better way to start than by contemplating what is an “investment of money”? In my previous post, “investment of money” is presumably an investment of anything of value. An investment is the commitment of the item of value with the expectation of receiving some additional profit. This prong seems simple enough, is rarely litigated, and not of much concern; however, of more concern to the crypto community is the concept of airdrops.

An airdrop is when a token project distributes tokens into the token recipient’s cryptocurrency wallet for no monetary contribution in exchange. Most of the time, the airdrop is for the Ethereum blockchain; however, airdrops have occurred on Stellar, NEO, Waves, and EOS (to name a few) and bitcoin holders have received airdrops via Bitcoin hard forks. Airdrops continue to be a source of token distributions for a number of reasons. For the token issuer, it is an easy way to gain a broad network of token holders. Once listed on an exchange, the token holders are free to trade thereby creating a “liquid” market and market cap for the token project as well as a source of income for the token project as an airdrop usually constitutes some minority percentage of the token supply. I say “usually” because an $8M airdrop earlier this month ran out of tokens and has since announced a token buy-back program. Airdrops, as a token generation event, appear to be a way to create demand for your token and to skirt the uncertainty around ICOs and securities laws. Unfortunately, this is not the case.


No Investments of Money and Securities Law

Like everything in cryptocurrency right now, it’s all new and there is nothing like it that regulators can compare it to. Well, you can continue thinking that; however, where airdrops, or free distributions of securities are concerned, the SEC has seen this movie before. On July 21, 1999, the SEC issued four cease-and-desist proceedings relating to the issuance of “free” stock. The SEC claimed in its press release, “Free stock is really a misnomer in these cases. While cash did not change hands, the companies that issued the stock received valuable benefits. Under these circumstances, the securities laws entitle investors to full and fair disclosure, which they did not receive in these cases.” The valuable benefits for these companies were “a fledgling public market for their shares, increasing their business, creating publicity, increasing traffic to their websites, and, in two cases, generating possible interest in projected public offerings.” The reason the valuable benefits to the company are mentioned is because Section 2(a)(3) of the Securities Act defines a “sale” to “include every contract of sale or disposition of a security or interest in a security, for value.” Therefore, these companies were selling unregistered securities to the public.

Given that tokens are airdropped into your cryptocurrency wallet and it is then your choice to trade them or use them as the network prescribes, is subjecting the token distribution to securities laws necessary? Yes, airdrop scams do exist taking the form of impersonating real airdrops, fake profiles and project name confusion, marketing gimmicks, requesting private keys. The SEC’s role is to protect the integrity of markets through full and fair to disclosure to prevent fraud. So, is subjecting airdrops to securities laws using the above history of free stocks necessary to achieve the SEC’s purpose or is another regulatory body like the FTC more equipped to handle such an issue?

However, as of now, when contemplating an airdrop as a token distribution model, securities law still applies. While the SEC is warming up to the notion that utility tokens can exist. However, the economic realities of the transaction must still be contemplated. An SEC review is substance over form. Unfortunately, giving away things for “free” is not so free.


Commentary by Stan Sater
 & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


House Hits Refresh on JOBS and Investor Confidence Act of 2018

On July 17, 2018, the U.S. House of Representatives passed a near-unanimous bill (406-4) to update the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). The JOBS Act, passed with much fanfare in 2012, was designed to help small businesses, entrepreneurs, and investors by updating and modernizing, in a number of respects, the way that capital is formed for these stakeholders. Unfortunately, in the six years since its passage, many of those constituencies have for the JOBS Act wanted in crucial ways, and have viewed its work as unfinished. Accordingly, calls for an overhaul have been steady and growing.

Which brings us to the present, and the passage of an overwhelmingly bipartisan bill from the House of Representatives, titled the JOBS and Investor Confidence Act of 2018 (the “Act”), which seeks to further reform regulations which have been viewed as holding back investments in small businesses and start-ups.

Major Takeaways for Investors and Startups

Update to “accredited investor” definition: The $1 Million ‘net worth test’ as part of the definition of “accredited investor” in the Securities Act of 1933 is amended to be adjusted for inflation every five (5) years using the Consumer Price Index for all Urban Consumers.

The Act also expands the definition of accredited investor beyond simply the net worth and income tests to include registered brokers and investment advisers as well as natural persons who have “professional knowledge” of a subject related to a particular investment, and whose education or job experience is verified by the Financial Industry Regulatory Authority (“FINRA”) or an equivalent self-regulatory organization (“SRO”).

Reg D Modification: The Act requires the SEC, within six (6) months after the Act is enacted, to amend Reg D to exclude presentations made to angel investor groups and others from the definition of ‘general solicitation’.

Special Purpose Crowdfunding Vehicles: Crowdfunding investors can now form “crowdfunding vehicles” advised by investment advisors to invest as a group rather than as disparate, individual shareholders.

Analysis / Impact

These changes would be significant steps forward for the startup space (Note: the Act must, of course, still be passed by the Senate, signed into law and implemented). With fast-moving and highly technical investment opportunities like cryptocurrency, the definition of “professional knowledge” is changing. It is nice to see a shift toward an understanding that professional knowledge is inherently valuable and can give well-informed individuals access to early investments into start-ups, and businesses at all stages of the capital formation life cycle.

The Reg D modification seems to be an extension of the shifting view in securities regulation away from focusing on ‘offers’ and, instead, focusing on ‘sales’. The clarification that activities such as demo days and pitch events do not constitute general solicitation under Reg D would seem to be a recognition of a reality that already exists in those environments and brings lower level ‘testing the waters’ activities into the sunshine. The new exemption is provided so long as:  the event advertising does not reference or specify offerings of securities and the event sponsor is not offering investment advice to event participants nor is engaging in investment negotiations, charging fees, or receiving certain compensation; and the information provided does not extend beyond the type and amount of securities being offered, the amount of securities already subscribed for, and the issuer’s intended use of the securities offering proceeds. With the growth of incubators and accelerator programs, the ambiguity between general solicitation and pitches has been questioned numerous times. The clarity offered in the Act finally adds some guardrails to that grey area.

Finally, the Special Purpose Crowdfunding Vehicle seeks to address one of the most significant issues with equity offerings under Reg CF (although, from the author’s perspective, many more still exist!). Currently, using crowdfunding platforms like Angelist, accredited investor groups often form a special purpose vehicle using Reg D to invest jointly in a company. The obvious benefit to the issue is that there is only one shareholder on the cap table rather than thousands. The cost and difficulty in getting shareholder approval from thousands of disparate investors every time shareholder consent is required has kept many companies from utilizing Reg CF.

With respect to non-accredited investors, the Act addresses this issue by allowing small investors to form a special purpose vehicle guided by a sophisticated investor who, additionally, has a fiduciary duty to represent their interests and negotiate on the small investor groups’ behalf. Similarly to accredited investors forming special purpose vehicles under Reg D, a special purpose vehicle for crowdfunding would represent one shareholder on the issuing company’s cap table. Although it seems to be a hopeful aspect that qualified intermediaries will actually find it lucrative to act in this capacity and will wish to do so (which will remain to be seen), nevertheless, this addition provided by the Act may allow companies that are shying away from Reg CF to use it more going forward.

We will be following this Act closely as we continue advising our start-up and investor clients on these and other developments in unlocking innovation and growth in small businesses.

Commentary by Stan Sater  Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]



What is the Howey Test? How To Tell if a Coin Passes The Test

In our last blog post, we discussed the SEC’s position that Ethereum was ‘not a security’. With the commentary from the SEC, it’s worth re-visiting the four-prongs of the Howey test and the meaning of a security. Section 2(a)(1) of the Securities Act of 1933 contains a statutory definition of the term “security”. The definition includes a non-exhaustive list of various financial instruments including many traditional financial interests and something nebulously called an “investment contract”.

If the financial instrument falls outside of the standard and commonly understood categorization of equity, debt, or derivatives instrument, then the analysis turns on whether or not an “investment contract” exists. As a result of the inherent uncertainty that accompanies this definition, a determination rubric was developed through the common law by the Supreme Court and has since become known as the “Howey Test”. Under the Howey Test, an investment contract is (1) an investment of money; (2) made in a common enterprise; (3) with an expectation of profits; (4) to be derived from the efforts of others. If these prongs are met, then, according to the Supreme Court “it is immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value”.


What was Howey Doing?


In 1946, the Howey Company came up with an interesting scheme to profit from its citrus grove (yes, this all started over oranges). The Company planted the oranges on the property, kept half of the property for itself, and sold interests in the other half to the public to fund additional company development. Howey’s service company then offered the land purchasers a service contract to maintain the land they bought. Thus, the purchasers could simply be passive investors in the growth of the citrus grove while Howey did all the work to grow the value of the grove. Even though some purchasers chose not to accept Howey’s full offer to enter into a service contract too, the Court said that the mere offer was enough to constitute an unregistered, non-exempt securities offer as an “investment contract”. (So, what about token airdrops? That’s a story for future blog post…)


Pulling Apart the Prongs


The first prong of the test – an investment of money – is fairly straightforward. Under Howey and succeeding case law, an investment of money may be deemed to include capital, assets, cash, goods, services, or promissory notes (or, presumably, anything of value).

The second prong – a common enterprise – is, however, not as straightforward. The Supreme Court has yet to define a “common enterprise”. Consequently, federal courts of appeal have varying interpretations of the term. In total, we have three approaches that exist to examine the term under Howey. The first approach is horizontal commonality. Here, a common enterprise exists where multiple investors pool funds and the profits of each investor correlates with the other investors. As the case law has developed, it appears that there is no common enterprise where there is no sharing of profits or pooling of funds. The second approach is narrow vertical commonality, which finds a common enterprise if there is a correlation between the investor’s profits and the promoter’s. Finally, broad vertical commonality finds a common enterprise where “the investors are dependent upon the expertise or efforts of the investment promoter for their returns”.

The vertical approach is relatively easy to satisfy as we are only concerned with the fact that the investor depends on the promotor because the promoter often has more knowledge about the project than the investor and stands to benefit (in some sense) based off of their expertise putting them in alignment with the investors’ profit seeking goals. The horizontal approach is slightly more difficult to apply, as it depends on the coordination of multiple investors; however, for token sales (to refer to a modern and hot topic), it depends on the distributions of the tokens and who or what is receiving any proceeds from sale of tokens.

As to the third prong – an expectation of profits – the Supreme Court, in United Housing Foundation, Inc. v. Forman, stated that profits were “capital appreciation resulting from the development of the initial investment…or a participation in earnings resulting from the use of investors’ funds”. It is the return an investor seeks on their investment. In looking at the meaning of investment, the Forman Court determined that an investment depended on the investor. The Court differentiated between “consumption” and “investment” noting that an investment occurs when “the investor is ‘attracted solely by the prospects of a return on investment’” (emphasis added). Therefore, an investment exists if the investor decided to invest not for use but some return on investment.

The third prong is meant to be read together with the fourth prong – derived solely from the efforts of others. Under this prong, the success or failure of the enterprise must be significantly correlated with the efforts of the promoters. While the word “solely” seems to limit the breadth of possibilities, courts have broadened it to include essential or significant managerial or other efforts that are necessary for the enterprise to succeed. As the case law has developed, the simple four-pronged approach quickly becomes very intricate and nuanced.


Re-Examining the Test


The Howey Court’s definition of a security “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”. Further keeping with such a broad definition, form over substance with an emphasis on the economic realities of the transaction, is stressed. This principal has been evident in the SEC’s approach to regulation, across a broad spectrum of policy areas, since its establishment.

The SEC’s analytical approach is clearly on a case by case basis. Applying these lessons in the modern context, in the decade since the launch of Bitcoin, for example, only two cryptocurrencies have been declared not securities: Bitcoin and Ethereum (Note: do not neglect the CFTC, FINRA, other federal or state regulatory bodies).

To date, it is easy to conclude that a majority of Initial Coin Offerings (ICOs) are securities simply by saying that:  the investor invested Bitcoin or Ethereum into an entity formed to develop the promised platform that is not yet operational at the time of “investment” and the investor is relying on the development team of the entity to develop the platform; and, therefore, the investor is investing in a security. Thusly, each of the prongs of the Howey test could be concluded to apply. However, nuance matters, and never more so than in the increasingly complex world of digital currency adjacent offerings. If, for example, projects are open source and available on GitHub, then, in theory, anyone can comment or contribute to the project moving them from passive to more active investors. Of course, not every cryptocurrency purchaser knows how to code or has used GitHub. Nonetheless, it is clear to see that cracks can be formed in the SEC’s rather narrow approach to its “broad” securities test.

Further, the governance models used in Bitcoin and Ethereum are simply two governance models at the protocol level in an ecosystem which is still rapidly developing and iterating (for example, EOS, DFINITY, Augur, and other structural considerations like on-chain versus off-chain governance, Proof-of-Work, Proof-of-Stake, Delegated Proof-of-Stake, etc.). Further, the governance models for various projects are going to adapt if the project is to survive over time. The initial design of the network is important but is subject to change. After all, software is not static.

With the explosion of varying governance and economic models at the protocol level, is “common enterprise” and “derived solely from the effort of others” relevant? Is the Howey test really malleable enough to consider the governance and economic designs that are coming? We will be following these issues closely as we continue to see new projects emerge and existing models iterate.

Coupled with the SEC’s remarks, Justice Breyer’s remarks are a giant step forward for the crypto community. While these remarks are not binding law, it does show a shift in the regulators’ and justice department’s sympathies toward cryptocurrency as a legitimate form of value.

Commentary by Stan Sater  &  
Yuri Eliezer, Esq. & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]



Is Ethereum a Security according to the SEC?

One day after the SEC town hall in Atlanta, Georgia, William Hinman, Director for the Division of Corporation Finance of the SEC, gave a landmark speech declaring that Ethereum was ‘not a security’. These important statements follow on previous statements from SEC Chairman Jay Clayton, whose comments at a hearing in front of the House Appropriations Committee on April 26, 2018, gave the crypto community some relief by declaring that Bitcoin was ‘not a security’. With his recent comments, Director Hinman expressly answered another key question for the community. While his remarks are not law, they came with much needed insight into how regulators are continuing to evaluate crypto.

Perhaps not surprisingly, at least to those who follow such matters in the community, Hinman’s remarks about Ethereum seemed to run right through the Howey Test. For those unfamiliar, the Howey test is a four-pronged test long used by the SEC that contemplates whether or not a particular instrument constitutes an “investment contract”, which is a type of security. Under the four-pronged test, an investment contract is (1) an investment of money; (2) made in a common enterprise; (3) with an expectation of profits; (4) to be derived from the efforts of others. Using this test (reaffirmed by Hinman), it does not matter if the token is labeled as a “utility token”, as the analysis relies on ‘substance over form’ and the economic realities underlying a transaction.


  1. The classification of a digital token is not static. A token’s treatment under US law may change over time.
  2. “[I]f the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”. Note, although the SEC calls it “decentralized”, most may otherwise refer to this as “functionality”. Accordingly, Network Decentralization does not equal SEC Decentralization.
  3. As most knowledgeable lawyers in the space do (like us!), separate the sale of the token from the token itself. Apply securities laws when it fits.
  4. Hinman’s remarks pose some interesting questions for industry participants. One thing is clear, you cannot go this process alone. Engage with experienced lawyers in the space who truly understand (and care) about the technology and are capable of navigating the applicable laws.


Still Left with Questions

How do we know if a network is sufficiently decentralized? The answer, as with many aspects of this area of the law, at least for now, is that we do not exactly know, and facts and circumstances always matter. However, it would probably not be difficult to start by weighing the differences between the promises made in any particular white paper and the parts of the platform that are already functional. The existing consumptive purpose for a token should reduce if not take away any speculative purpose for the token.

The SEC has yet to address whether or not a digital token can change to a ‘non-security’ during a pre-sale phase, if some functionality of the ultimate underlying platform is built. This point is particularly important because purchasers of digital tokens under the guise of securities laws subject to securities lock-ups need to know if they can use securities protections or if the sale (or use!) of their token ceases to be a sale of securities. The SEC stated concerns in its Atlanta town hall event about flowbacks (in the Reg S context) and complying with other requirements of private placement offerings. Again, Director Hinman’s remarks are directly related to federal securities laws. He did not address the need to understand or comply with other federal, state, and non-US laws and regulation related to money transmissions, banking, commodities, and tax.


Bonus! Bitcoin and Cryptocurrency Get Referenced by SCOTUS

Now, after Director Hinman’s remarks, Supreme Court Justice Stephen Breyer, albeit in a dissenting opinion, gave the first Supreme Court opinion reference to Bitcoin and cryptocurrency. Breyer wrote: “Moreover, what we view as money has changed over time. Cowrie shells once were such a medium but no longer are…our currency originally included gold coins and bullion, but, after 1934, gold could not be used as a medium of exchange…[P]erhaps one day employees will be paid in Bitcoin or some other type of cryptocurrency.”.

Coupled with the SEC’s remarks, Justice Breyer’s remarks are a giant step forward for the crypto community. While these remarks are not binding law, it does show a shift in the regulators’ and justice department’s sympathies toward cryptocurrency as a legitimate form of value.


Commentary by Stan Sater  & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]



SEC Commissioners Town Hall Visit at Georgia State University

On June 13, 2018, the five SEC commissioners and selected staff visited the campus of Georgia State University (College of Law) Atlanta for an interactive event with the public outside of the Beltway. The SEC event, one of several held and planned in 2018 is in keeping with the SEC’s recent efforts to be more engaging and open to the public, especially on topics of cutting edge interest.

The event began with a town hall-style discussion, which included all five commissioners and addressed several topics. Following the town hall, each Commissioner and various staff headed smaller breakout groups. Interestingly (if not altogether surprisingly) the most heavily attended session was the blockchain and ICO session.

The ICO panel consisted of SEC Commissioner Kara M. Stein and SEC staff members Valerie Szczepanik (informally dubbed the ‘crypto czar’), Amy Starr, and Josh Dickman. Quickly addressing the general public sentiment hoping for new regulation in the ICO space, the panelists reiterated the SEC’s stance, to date, on using the existing framework of securities laws to guide how crypto is treated. As previously stated by the SEC, issuing tokens on the basis of some future promise—including future utility on a future platform—is a security.

With the reiteration of this general presumption, the panelists discussed how issuers might work within existing registration and exemption frameworks, in order to manage compliant digital coin offerings. One of the more interesting discussion points was around the possible use of Reg. A+ in such contexts, whereby digital coin offerings can, in theory, be allowed to proceed, subject to the required SEC review and approval before the offering commences. While Reg. A+ is arguably the most flexible option to do an ICO, given its benefits, it would, by the very nature of its use, mean that any digital coin offering commenced thereunder would be ‘a security’ for regulatory purposes. Although the SEC has yet to approve a Reg. A+ offering in the ICO context, the panelists stated that this does not mean that they will never approve a Reg. A+ offering, or that they are not actively reviewing such offerings submitted to them. Accordingly, the session gave the impression that the door is open to such qualification, if/when the right use case is presented.

With respect to uses of Regulation S in the digital coin offering context, the SEC raised concerns over the issue of ‘flowbacks’. Along with a Regulation D exempt offering, many ICO issuers are simultaneously using Reg S in order to offer and sell digital coins to non-US residents, as Reg S provides a safe harbor from registration under the Securities Act for offerings made outside the US. However, Reg S participants are under certain resale restrictions, which includes directly selling to anyone in the US prior to the expiration of a lock-up period of 12 months.

Flowbacks are said to occur when foreign investors in a US offering, which is otherwise exempt under Reg S, sell their shares to people living inside the US. In a nutshell, the problem is that crypto assets exist in a distributed/global environment and there is a robust secondary trading market for these tokens which has developed in several places. Unfortunately, other than raising flowbacks as a concern, there was no additional guidance on best practices to avoid or handle this problem that was communicated by the SEC during the session. Accordingly, ICO issuers are advised to be aware of such SEC concerns and structure their Reg S offerings to put lock-up safeguards in place.

Despite the promise of an intimate and less formal gathering, the SEC generally shied away from commenting on specific projects and tokens, or providing concrete industry guidance. Nevertheless, an impression was given that the SEC is continuing to ramp up its competency and focus in the ICO space, and was forceful in its recommendation that issuers are counsel contact the agency with questions, concerns, comments and suggestions in this evolving market.

Commentary by Stan Sater  & Jeffrey Bekiares, Esq.  Jeff is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


Capital Raising for Small Businesses and Free Lancers: Legal and Practical Aspects

When starting your own business, it is important to keep in mind what makes your company investable, where is your financial support is coming from, and the legal and tax implications in raising capital. You can either go the DIY route or hire a professional who can assist you in cutting through the red tape.

You also need to know the difference between seed funding, traditional and alternative lenders, angel investors, and venture capital to ensure you get the most out of your capital campaign. This presentation provides a great overview of all of this as well as how to design a winning campaign for your new business.

Capital Raising For Small Businesses And Free Lancers


If you are interested in more detail related to your situation it is best to speak with an attorney.

Jeffrey Bekiares is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


How to Make a Successful Crowdfunding Campaign – Video

Here is a video link to Dun & Bradstreet’s hangout session from January 22, featuring Jeffrey Bekiares. This session features insights into what makes a successful crowdfunding campaign–including rewards and equity based. Jeff’s perspective focuses equity crowdfunding and crafting the right approach to a winning campaign. Equity crowdfunding is similar to rewards in many ways, in that it takes preparation, sharp A/V elements, crowd identification and a solid outreach plan to succeed. It also differs, however in important ways. Specifically, equity crowdfunding requires legal compliance strategies and a longer lead time. Access the video to learn more.



If you are interested in more detail related to your situation it is best to speak with an attorney.

Jeffrey Bekiares is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


Making a Successful Equity Crowdfunding Campaign in 2015 – Tips

As businesses prepare for fundraising 2015, more and more will wade into the pool of equity crowdfunding. For small and emerging businesses, equity crowdfunding offers the attractive prospect of raising risk capital and growing a loyal customer base. But it is also a difficult process to navigate. Below we discuss three critical elements of this process for businesses to address.

Behind the Page

Construction of a successful equity crowdfunding campaign takes hard work, dedication and time. As the old maxim goes: preparation, preparation, preparation! We recommend that companies prepare for an equity crowdfunding campaign at least 3 months prior to the online launch of the company’s crowdfunding page. This time generally includes:

  • Identifying your crowd (from a user/customer base analysis),
  •  Preparing your channels strategy for reaching that audience (traditional media, social media, events, etc.),
  • Producing your critical elements (pitch video, audio, slides), and
  • Securing your legal footing (remember, equity crowdfunding is much more legally complicated than a traditional rewards/donation based campaign).
  • The foregoing work takes place “behind the page”. The ultimate supporters of the campaign may never actually see all the work that goes behind the page, but they may never see the campaign at all without it.
On the Page

The list of operative equity crowdfunding sites is likely to continue expanding in 2015. (See Equity Crowdfunding Sites). Currently, only accredited investor (SEC Rule 506(c)) and intrastate only platforms are operational. However, this list is itself expanding, and the list of successes is growing. Companies should choose a platform they are comfortable with according to its user profile and the ease of use.

Once a platform is selected, companies should use all of the time they need to build an elegant, functional and informative page. The video should be kept to 3 minutes (maximum) and include a clear collaborative call to action. Ease of use is key. The more complicated the pitch is “on the page”, the more likely the company is to lose potential supporters.

Beyond the Page

Companies may fail to reach their goal in an equity crowdfunding campaign for any number of reasons. Often these reasons relate a failure by the company to think “beyond the page”. Companies tend to follow belief that crowdfunding is an online-only phenomenon. This is a fallacy. The page only creates an organization space and channel; not a substantive connection.

To supplement the material on their crowdfunding page, companies should also plan as much outreach as possible (and as legally permissible) outside of their crowdfunding page to reach their target audience. This outreach should include some combination of the following elements:

  • Digital Marketing;
  • E-mail Marketing;
  • Launch Party;
  • Public and Private Events; and
  • Investor Meet-ups.

By engaging in as many contact points as possible “beyond the page”, companies increase the likelihood that they will reach their target audience and, in turn, the funding goals for their campaign.

It should be noted, however, that many of the foregoing strategies have securities laws implications that are unique to the equity crowdfunding space. It is therefore important to abide by all such laws and consult an experienced professional prior to the launch of any campaign.

If you are interested in more detail related to your situation it is best to speak with an attorney.

Jeffrey Bekiares is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


Equity Crowdfunding in 2015

It’s a good time for small and emerging businesses to think about what the landscape for capital raising will look for the rest of 2015. The traditional channels will likely be unchanged: bank loans (if you can get them), angel investors (if you are a tech company based in San Francisco), or venture capital (if you invented a perpetual motion machine). For the remainder of the 99% of small and medium sized enterprises that don’t check one of the boxes above, what other options might emerge in 2015?

Equity (or, more broadly, securities) based crowdfunding will likely emerge in 2015 as a go-to choice for small and emerging businesses to raise capital. Unlike traditional “rewards” or “donation” based crowdfunding, equity crowdfunding is structured for businesses to sell interests (securities) in the enterprise itself to the crowd at large through a mini-public offering. At the end of a successful offering, the business has raised the capital it needs to start-up or expand, and the public now owns an interest in the fortunes (or failures) of that business going forward. Although equity crowdfunding already exists in the United States, it has been underused, and undervalued (for an example of an intrastate crowdfunding exemption, see Georgia’s here: Invest Georgia Exemption). We expect 2015 to be a breakout year as awareness and marketplace acceptance expands more rapidly.

The Trends

Why do we see this happening in 2015? Well, for many businesses (start-up or growth stage), equity crowdfunding may be their only source of access to capital. This includes a massive amount of SMEs in the United States who are either too young, or too industry or geographically challenged to attract capital from other sources, but who nevertheless have a great idea and a loyal customer or affinity base.

Furthermore, the regulatory trend is toward expansion and permissiveness of crowdfunding. In 2012, it was only permitted in two States (Georgia and Kansas). In early 2015, the list of States which have enacted (or have considered) intrastate crowdfunding exemptions will be upwards of 15 (including, now, Texas), and is growing geometrically (see NASAA’s excellent resource center here: Intrastate Crowdfunding Resources. That means that businesses in these States can use equity crowdfunding now, they do not have to wait on federal rules under the JOBS Act from the SEC that are now years late. Eventually, when the SEC does release final rules under the JOBS Act, national equity crowdfunding will be legal and available as well. This trend will continue ahead.

The Benefits

The benefits to SMEs wishing to conduct an equity crowdfunding are numerous, and include the following:

  • Access to capital that might be otherwise unavailable.
  • The Company drives the terms of the capital raise.
  • Engagement of customer/affinity base on a going forward basis.
  • Low or zero cost to rewards fulfillment following completion of the campaign.
The Drawbacks

SMEs wishing to conduct an equity crowdfunding should, of course, consider the limitations of such a campaign as well, including the following:

  • Currently, only legal in certain States, and not on a national/interstate basis (yet).
  • Low maximum raise thresholds (generally $1M).
  • Requires legal compliance structuring (unlike rewards/donation based crowdfunding).
  • Backers will own a security in the company following completion of the campaign.
The Takeaway

Equity crowdfunding—like other methods of capital raising—can be challenging and time consuming. However, for those SME’s with a natural customer or affinity group that they can tap into for support, equity crowdfunding will likely be the cheapest and easiest source of capital that they can access, and will offer the collateral benefits associated with completing a successful crowdfund.

Unlike a simple rewards based crowdfund (like on Kickstarter or Indiegogo), equity crowdfunding involves the offering and sales of securities. Accordingly, any business that is considering conducting an equity crowdfunding campaign should consult a qualified securities attorney to make sure that the necessary compliance boxes are checked in advance. Finally, all the hallmarks of a great crowdfunding campaign should be assembled (video, copy, images, disclosure documents, etc.), and a strategic plan for execution should be formed. After that, it’s up to the crowd!

If you are interested in more detail related to your situation it is best to speak with an attorney.

Jeffrey Bekiares is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]



Equity Crowdfunding and SEC Rules


As I prepare to deliver remarks at the NASAA Corporation Finance Training Conference in St. Louis this weekend, it has provided a cause for reflection on over three years marking the rise of what I would term as “quasi-public offerings”. Trends in corporation finance laws at both the State and Federal levels have been loosening the regulatory grip on small and emerging business capital formation, and, in the process re-making over 80+ years of venerable securities laws. The rise of “quasi-public offerings” is a big part of this story.

What is a “Quasi-Public Offering”

A long accepted trope in the securities laws industry is that an offering of securities must be either “public” in that it is a transaction registered with the proper regulatory authorities (State and Federal, for a typical interstate offering), or “private” in that it is an unregistered offering that is only open to select persons, who, generally, have a prior existing relationship with the company issuing securities.

But the ever increasing costs of conducting a public-offering, coupled with the meteoric rise in the popularity of crowdfunding as an aspect of a holistic capital formation plan have led to a chorus of voices, at all levels, calling for a more sensible and affordable route to public capital raising. The responses to these calls have been variable by State, and also at the Federal level. What is emerging, however, are regulatory seems in the legal fabric that are allowing businesses (primarily small and medium sized enterprises) to raise capital from the broader public without registering the transaction, provided that certain important regulatory safeguards are abided. Collectively, these emerging exemptions are what I have termed as “quasi-public offerings”. These channels have taken on various forms, including the following discussed below.

Intrastate Crowdfunding

In 2011, with little fanfare, few spectators, and essentially no press concern, the securities administrator in the State of Kansas quietly enacted a new exemption from the registration requirements for public offerings of securities within its borders. The “Invest Kansas Exemption” (IKE), as originally enacted, permitted capital raises in Kansas of up to $1,000,000 by means of general solicitation (to both accredited and non-accredited investors) without registration and with minimal regulatory compliance features. Whether the administrator knew it at the time or not, Kansas had, in effect passed the United States’ very first securities based  “crowdfunding” exemption.

Today, over three years later, fully 14 State jurisdictions have adopted some form of intrastate crowdfunding (by legislative or regulatory means), meaning small public capital raises involving only business and only investors from that specific State. This trend of expansion is continuing apace. Why? Because State regulators are becoming increasingly comfortable that these types of small “quasi-public offerings” can be a safe and effective manner for capital starved businesses to build important community based organizations that can establish and thrive without the necessity for scarce outside capital. I expect this trend to accelerate.1

Accredited Investor Crowdfunding – Rule 506(c)

In late 2013, the Securities and Exchange Commission put in force the first major set of “quasi-public offering” regulations on the Federal level—those relating to the new Rule 506(c) registration exemption (See 17 CFR 230.506(c)). The new Rule 506(c) permits offers to be made on an interstate basis to everyone, provided that the ultimate purchaser base is restricted to “accredited investors” only. This new Rule essentially establishes “accredited investor” crowdfunding, and creates a “quasi-public offering”, albeit with an ultimately restrictive purchaser base.

With a year of data in the books, it is clear that this Rule is working. Use of the Rule is trending upward, and it is emerging as the quasi-public offering of first instance for companies looking for capital beyond what intrastate crowdfunding can provide, and, specifically, in fields (such as technology and e-commerce) in which accredited investors are well versed. The fact that this represents a shift from a focus on who is being offered securities, to who is being sold securities is an extremely important fact, and, in my view, the most significant philosophical addition that Rule 506(c) has made to the body of securities laws.2

Regulation A+

Regulation A+ is an extension of and expansion on an existing securities registration exemption called, you guessed it, “Regulation A”. Reg A permits offerings up to $5M, with scaled (reduced) disclosure requirements in the registration statement. Although Reg A has been around for a long period of time, it is underused and much maligned, primarily because the disclosure requirements are still time consuming and expensive, and, more importantly, it does not preempt State law review. As proposed by the SEC, however, Reg A+ would create a new “quasi-public offering” category for raises up to $50M, which would enjoy scaled disclosure and Federal preemption. It remains to be seen how the SEC will ultimately treat the definition of “qualified purchaser” in these offerings, and whether the Federal preemption issue will be satisfactorily resolved, but, nevertheless, many commentators believe that this Section of the JOBS Act of 2012 holds the most potential for meaningful securities offering reform.3

Follow the Trends; But Remain Cautious

I applaud the forward leaning regulators who are greeting some or all of these techniques with a welcoming—if prudently cautious—point of view. I believe that each of the foregoing has the potential to unlock capital for worthy businesses, and be done in a safe manner which protects the interests of the investing public.

Quasi-public offerings are, as discussed ever too briefly above, a new and evolving area of the securities laws. They hold the promise of broader and more cost effective access to capital for small and emerging enterprises. They are, however, also fraught with uncertainty, and a deceiving level of complexity. Any company consider conducting a capital raise—including using any of the techniques described above—should consult competent securities counsel prior to taking any action.


If you are interested in more detail related to your situation it is best to speak with an attorney.

Jeffrey Bekiares is a securities lawyer with over 8+ years of experience, and is co-founder at both Founders Legal and SparkMarket. He can be reached at [email protected]


1 For a summary of laws/regulations enacted as of July, 2014, see:

2 For helpful and interesting statistic on the use of new Rule 506(c) after approximately 1 year, see:

3 For a good, concise (but now somewhat dated) explanation of Reg A+ as proposed, see