The PPP Affiliation Rules: Thoughts on a Workaround

March 27, 2020, President Trump signed into effect the Coronavirus Aid, Relief,
and the Economic Security Act (the “CARES Act”), which includes,
among other relief provisions, the Paycheck Protection Program (the “PPP”)
aimed at providing liquidity to help small businesses maintain their existing
payroll by making certain (forgivable, in part) loans available through the
Small Business Administration (SBA). On April 2, 2020, the SBA issued its Interim Final Rules regarding the administration of the PPP,
which provides the framework under which businesses with under 500 employees
(generally) can take advantage of the PPP, if they certify that “current
economic uncertainty makes this loan request necessary”.

Venture and PE Back Entities and the Affiliate Attribution

for a large swath of the small business community, including many start-ups,
the rules around PPP eligibility present a significant roadblock to their
participation. Since the program is administered by the SBA, the SBA’s general
rules and regulations are applicable to the program. One particular aspect of
those rules, regarding how to count ‘employees’—the so called “Affiliation”
rules—is problematic in that it may require attribution and aggregation of
employees with other ‘affiliates’. In this context, it is suggested that
affiliates may have to include any investors who hold a ‘controlling interest’
in the company and any other companies in whom that investor also holds a
controlling interest.

that level of attribution, it becomes highly likely that any given investor
(often, PE, VC or even Angel) backed company will quickly exceed the 500
employee maximum level under the PPP, and, therefore, will not be eligible to
participate. With time being of the essence, and an already limited (and
rapidly dwindling) level of available PPP funds to access, it is imperative
that these businesses—often some of the US’ most promising young enterprises, including
in the biotechnology space
—proactively find a safe and compliant way to
participate in this important economic stimulus (or ‘emergency distress
relief’, depending on your perspective) program.

Defining ‘Control’

the heart of the problem here is what constitutes a ‘control investor’ under
the applicable SBA regulations. We will not attempt, in this column, to
explicate the nuances around every direct and edge case that might constitute
control. Others have done a great job summarizing and explaining the same
(including an excellent rule / example chart here). Suffice it for our purposes to say,
however, that ‘control’ can be expressed or implied as a result of any of the
following conditions:

  • Common
    Ownership – Ownership of >50% of voting equity.
  • Present
    Effect – The rules will give present effect to potential future events,
    such as the exercise of options, warrants, etc., that could affect control.
  • Common
    Management – Where sister entities share controlling executive officers and/or
    directors, for example.
  • Identity
    of Interest (Family Relationships) – Where sister entities are owned /
    controlled by close family members.
  • Identity
    of Interest (Economic Dependence) – Where a company derives 85%+ of its
    revenues over the previous 3 fiscal years from another entity.
  • Identity
    of Interest (Common Investments) – Where management / shareholder groups have
    substantial investment and economic overlap with other entities.
  • Newly
    Organized Concern – Applicable where a key stakeholder in one entity begins to
    perform work for another, and maintains substantial overlap of resource usage
    from the old entity.
  • Successor-in-Interest
    – Applicable in cases involving a consummated strategic transaction, where the
    successor may be aggregated with the predecessor entity.
  • Totality
    of Circumstances – When the facts and circumstances suggest that two companies
    are very closely intertwined, they may be deemed affiliated.

mentioned above, in the event that a control condition exists, then it is
highly likely that attribution with an investor and with the investor’s other
portfolio companies will exist, such that the employee headcount metric for any
given company could be significantly increased, resulting in PPP ineligibility.

Suggesting a ‘Workaround’ Framework


            In our view, the best and most logical outcome here is for the Treasury and the SBA to directly fix this problem—either by updating their rules and guidance, or by issuing waivers. As of this writing, we remain hopeful of the probability of that outcome.

            However, in the event that this does not happen, it may fall to business and legal advisers to consider creative ways that their clients may stay outside of the attribution rules, and still fit within the letter and spirit of the PPM framework.

            We would suggest that there are three obvious ways to potentially deal with (portions of) this issue, and they all involve the full participation of the investor community.

  • Note – For the sake of brevity and clarity,
    the following analysis is based on and assumes a Delaware domiciled for-profit
    corporation, which has adopted standard
    NVCA investment documentation
    , and which requires a simple majority of preferred holders to
    effect charter / material document modifications or waivers (that being the
    ‘Requisite Holders’).

            What We Believe Can be
Solved For by Action…

            Solving for any of the control
issues detailed above is almost certainly going to require manipulation of
existing provisions in companies’ Certificates of Incorporation and possibly
Bylaws (collectively, the “Charter”), as well as certain
collateral shareholders rights agreements (inclusive, broadly, of the typical
Investors Rights Agreement, Right of First Refusal (“ROFR”) and
Co-Sale, and Voting Agreement). Collectively, these documents contain a number
of provisions that are, generally, prophylactically protective of investors’
rights, that may cause attribution control issues. Specifically, investors are
often granted dedicated board seats and certain investor protective provisions
(veto rights) over certain key material company transactions. Depending on the
existing deal in place, investors may also have conversion rights that give
them effective voting control (under the ‘Present Effect’ prong), which are
likely baked into the Charter documents.

            Individually or collectively, these rights almost certain cement a ‘control’ relationship, that would put any such company squarely in the attribution dead-zone described above.

            We believe, however, that a mix of
the following techniques could be effective in rebutting a number of
these presupposed conditions.

            Charter Amendments

            The most obvious and robust place to start unwinding disqualifying ‘control conditions’ is in the company’s Certificate of Incorporation (and any corresponding provisions in the company’s Bylaws, if any). In the standard NVCA form, this will also certainly involve direct amendments to the Board of Directors composition / voting section, as well as the Preferred Stock Protective Provisions Section (both usually contained in Section 3 of the NVCA model form of Amended and Restated Certificate of Incorporation).

            What we would suggest is that an abrogation of the rights contained in those Sections may be directly necessary in order to comply with certain of the control conditions detailed in the rules. Each situation could, of course, be slightly different, so a universal approach is likely impossible, but the principals around what would need to be changed should be fairly universal.

            Or, what if a more universalist approach, is possible? For example, what if, a company and investors representing the Requisite Holders could agree to some form of the following new, ‘temporary’ Article in a standard Certificate:

            FOURTEENTH:        For purposes of the rules of the US Department of the Treasury and the Small Business Administration (to the extent applicable) (the “Rules”), in connection with any loan obtained by the Company under the Paycheck Protection Program (PPP), for so long as any principal or interest may be outstanding under such loan, all holders of [Series A Preferred Stock] agree that the provisions contained in Article FOURTH, Section B of this Certificate related to preferential voting by such holders on any matters, including, but not limited to matters related to the Board of Directors and any special protective provisions shall be fully suspended, and that such holders shall, in lieu of such rights, be entitled to vote on any or all such matters on a theoretical as-converted to common stock basis only. This provision shall be automatically abrogated, and shall be of no further force or effect, upon the earlier of (i) the repayment, forgiveness, novation or other extinguishment of such loan and the Company’s obligations with respect thereto, or (ii) any modification of the Rules that would no longer necessitate the same, as a condition of participation by the Company in the program(s) underlying such loan.

            The benefits of this approach are obvious. It is relatively simple and easy to implement. But would it be respected by any examining authorities, and be sufficiently ‘unambiguous’ not to fall foul of the law of unintended consequences on other matters? These may not be answerable without some leap of faith (which, of course, will put a lump in legal counsel’s throat). But we would suggest that, if the now fairly standard Certificate provision dealing with Section 500 of the California Corporations Code (dealing with certain repurchases) is working in Delaware Certificates, then there is no obvious reason why some version of this approach should not also work.


            Waivers are the fastest and easiest way to deal with required corporation actions. The model NVCA Certificate provides a simple and easy to use waiver provision for use by the preferred Requisite Holders (See Article FOURTH, Section B.8.). In theory, this provision could be used, in a blanket fashion, to obtain well designed and thorough waivers from preferred holders to address one or more blocking control conditions (including all those mentioned above). Another benefit of waivers is that they are much easier to update, modify, repeal, etc., in the event that the same is required by any regulatory authority, and/or the underlying conditions for their need have ceased to exist.

            However, effecting by waiver everything which is necessary to mitigate away control condition risk seems unlikely. For one thing, it may not be obvious how the regulatory authorities (or a Delaware court, for that matter), would treat a ‘waiver’ of an otherwise obviously codified right in the Certificate (such as a Board seat nominating right), and such an approach seems like a recipe for corporate governance ambiguity. Further, it is not obvious how the regulatory authorities would view a waiver, that may otherwise have legal revocability, in light of the ‘Present Effect’ and ‘Totality of Circumstances’ prongs; and may choose to look through the same.

            Accordingly, although useful (and, in the case of non-Charter documents, perhaps perfectly adequate), we would suggest that the Charter Amendment approach is an obviously more robust and defensible approach, if possible to actuate.

            Business Structuring / Recusals

            It is somewhat less clear whether provisions that provide conditions of control that are contained within collateral company documents (such as, e.g., the IRA, Voting Agreement and ROFR Co-Sale), as opposed to the Certificate and Bylaws, would also have to be amended, or whether waiver would be sufficient; especially since these documents are a matter of contractual private relationships, not public record. However, in the interests of caution, we would suggest that corresponding amendments and/or waivers also be cascaded down to these documents. Afterall, there is no point in committing to this strategy and amending a company’s Charter only to fumble the ball on technicalities at the five yard line. Accordingly, we would recommend corresponding changes / waivers to these documents as well.

            Further, in order to deal with certain remaining prongs of the control relationship tests, we would suggest that intelligent business structuring and recusal strategies can be actuated (and documented) in order to solve for issues presented by the ‘Common Management’, ‘Identity of Interest – Family Common Investments’, and ‘Newly Organized Concern’ prongs. For example, careful investor divestiture of interest in certain entities (choosing carefully, obviously), recusal or resignation from certain boards / management roles for sister entities and/or a rethinking of certain strategic plans of portfolio companies may all be useful techniques to deal with issues in these verticals.

            What May Not be Solved For…

            Some of the control conditions above will simply have to mechanically ‘not be the case’, as they can’t practically be solved for in legal documentation alone. Those would include, self-evidently, the ‘Common Ownership’, ‘Identity of Interest – Family Relationships’, ‘Identity of Interest – Economic Dependence’ and ‘Successor in Interest’ tests. Accordingly, not every business is going to be eligible here, no matter what is undertaken.

            Further, the ‘Present Effect’ rule
presents a possibly serious problem here as well. Charter amendments and
waivers are clever, but, if they contain obvious snap-back provisions that make
them, essentially, perfunctory in nature, then it is likely that any examining
authority would view them with a jaundiced ‘substance over form’ eye. We would
suggest that any changes that have true substantive effect, and are not
reversable for the life of the PPP loan should be respected as satisfying the
spirit of the program, and, thus, out of reach of the Present Effect prong,
but, admittedly, this is, perhaps, a tautological conclusion.

            Lastly, the ‘Totality of Circumstances’ test (a perpetual law school and legal profession favorite!) is never going to be completely solvable. If it walks like a duck and quacks like a duck, it’s a duck. However, what we would suggest is that if this prong is to be solved for, it will have to come from the Treasury / SBA itself in public guidance (i.e., something akin to a ‘no action letter’, for properly structured workarounds). Doing so would send a strong signal to the business and legal community that the government is not hostile to this process, and, in fact, encourages its use.

Investor ‘Buy-in’; the Big Unknown

is no practical way to implement the foregoing without buy-in from the investor
community. None.

investors are not willing to work with their portfolio companies to actuate a
mixture of the foregoing strategies (as different use cases require), then the
possibility of the same is a purely academic exercise. And many of these
choices may be difficult and imperfect, under the heat of the moment on a
compressed timeframe. For example, how can an investor reasonably and
responsibly choose, in, say, 72-hrs, which of its portfolio companies has the
‘best chance’ to succeed and should pursue the PPP program, and in which of
those it should simply resign its Board seat? … Investors will have to pivot to
a mindset of trust, greater good and long-term thinking to effectively hedge
risk in such matters.

we would suggest that this is likely in the best interests of basically all
investor portfolio companies and the investors themselves. For most
businesses, there would appear to be very little downside to participation in
the PPP. In fact, for most, it may be a crucial survival lifeline, at a
minimum, and possibly even a booster rocket to spur growth and innovation
(which the US always, always needs more of, in the best and worst
of times). If the alternative is the failure of one or multiple investor
portfolio companies, then we would suggest that the waiver or abrogation of
certain investor rights, temporarily, is a trifling matter to accept.

would also suggest that, if pressed, most investors will accept the foregoing
logic (with the admittedly very large caveat assumption, of course, that
their own fund charter documents will even permit them to do so). In fact, we
would suggest that the investor (PE, VC and Angel communities) will likely
embrace at least some of the solutions to this dilemma (the foregoing, and
others that will undoubtedly be forwarded in the days to come), in light of the
unappetizing alternatives that are very much in play here.

said that, it is impossible to predict in advance. As an admitted digression,
but by way of example, we have been arguing to anyone who would listen for 8+
years now that it is time to do away with Legal Opinion delivery in Series A
rounds, as nothing but a pointless, expensive waste of scarce time and
resources, but we are still swimming upstream against larger law firms on that
fight! Here is to hoping that times may be changing in creative and
cost-effective legal practice.

it Work? The Fine Print…

foregoing is a suggested framework for businesses and legal practitioners to
begin to think about how venture backed small businesses, who would otherwise
be eligible to participate in the PPP, may be able to take advantage of the
program without violating the letter or the spirit of the program.

as with many matters that are new and cutting edge, and with rough contours
(and, as of the date of this writing, this one has a lot), the question
of whether or not this framework will work—from a business and/or legal
perspective—is unknowable. Accordingly, we are not offering this
framework as a ‘silver bullet’ of any kind, or offering any legal advice to any
party, with respect hereto. The truth is, we just don’t know.

we are hopeful that this framework will spark a conversation around creative
ways to address these roadblocks, which may, or may not, include some mixture
of the foregoing techniques. We posit that it is likely that a framework that
is workable for investors, businesses, counsel, the SBA and the US Treasury will
be rolled-out, and likely in the next 3-4 weeks, at most. The stakes are
too high for these parties not to work together.

would suggest that the most robust (and still most likely) solution to this
issue is for the Treasury and SBA to issue the necessary amendments, waivers or
modifications of the regulatory framework. However, if this does not occur,
then we fully expect that industry will find one or more solutions to fit
quality, investor backed small businesses into the definitional framework of
the PPP.


the days and weeks to come, if we do not see a systemic fix to these
issues—which, at present, are working to exclude a huge and hugely important
sector of the US small business ecosystem—we will be developing and rolling out
suggested documents for our clients who may be able to take advantage of these
techniques. At such time, we will also make those documents publicly available,
to the extent that it is prudent and helpful to do so.

the meantime, we welcome all inquiries from businesses who may potentially
benefit by participation in the PPP and are looking for forward pathways, and,
of course, any and all constructive criticism from industry on the usability of
the foregoing framework.

*     *     *

Dated April 7,

Written by
Jeff Bekiares, Ed Khalili and Stan Sater

If you are a business that has questions about the Paycheck Protection Program (PPP) and how the laws impact your business, contact our Founders Legal team at [email protected], [email protected], or [email protected].

Data Processing Addendums for California

Earlier this month, the California Consumer Privacy Act became effective with many companies scrambling to become compliant with the law. While there are many ambiguities in the law and the California Attorney General is still finalizing his draft regulations, companies are continuing to create their legal frameworks to comply with the law nonetheless. Part of this compliance framework is the data processing addendum (“DPA”).


The data processing addendum concept was introduced when the General Data Protection Regulation (“GDPR”) was passed into law in Europe in 2016. Since the GDPR became effective in May 2018, the DPA concept has been ingrained in the contractual framework for data processing activities done on behalf of others. While DPAs are generally required under Article 28 of the GDPR, a DPA is not necessarily required by the CCPA, but there is a growing understanding of its benefits for data processing contracts between businesses, service providers, and third-parties.


Notably, the contract requirements come from the combination of the definitions of “service provider,” “third party,” and “business purpose.” A “service provider” “processes personal information on behalf of a business…for a business purpose pursuant to a written contract…and the contract prohibits the entity from retaining, using, or disclosing” it for a purpose other than the specified business purpose(s). “Business purpose” means “the use of personal information for the business’s or a service provider’s operational purposes, or other notified purposes.” Finally, a “third party” is defined by what it is not. A “third party” is not (1) a business that “collects” personal information from a consumer; or (2) a service provider with the contractual restrictions described above and, in this paragraph, (or any other “person” with the same such contractual restrictions). Additionally, a third party will not be considered a third party if it is included in the written contract between the business and the service provider. Therefore, despite being two separate defined terms, the definitions of service provider and third party should be read together.


The written contract required by the CCPA is meant to bring down some of the business’s obligations to its service providers so that it may comply with its obligations to California consumers who exercise their rights as provided by the CCPA. Specifically, a service provider must contractually agree that it is prohibited from (i) “selling” (as defined by the CCPA) the personal information it acquires from the business and (ii) retaining, using or disclosing the personal information outside of the direct business relationship with the business or for any other purpose than what is specified in the contract. Further, the service provider must “certify” that it understands its contractual restrictions and will comply with them.


If you are a business or service provider, updating all of your service provider contracts could be cumbersome and costly. Rather, the addition of a DPA to your contract playbook could cut down on time-consuming negotiations while clearly establishing relationships that comply with new data protection regimes.


January 10, 2020


Written by Stan Sater and Jeff Bekiares


*    *    *

If you are a business that has questions about CCPA compliance or applicability issues, contact our Founders Legal team at [email protected] or [email protected]



SEC Tells Telegram to Hit Pause On Its Token Issuance

This past Friday (October 11, 2019), the Securities and Exchange Commission filed an emergency action and temporary restraining order against Telegram, a messaging app similar to WhatsApp. The emergency action is an attempt by the SEC to stop Telegram’s unregistered offering of its digital asset, “Grams.” As the SEC outlines, Telegram failed to adhere to the requirements of an exempt offering using Regulation D, the investment agreements to purchase Grams and the Grams tokens themselves are securities, and the investors and Telegram would flood the U.S. markets with billions of Grams. Telegram will now work with the SEC and further assess whether it needs to further delay the launch of TON.

In the complaint, the SEC takes the position that both the Grams Purchase Agreement to purchase the tokens and the tokens themselves are securities. The SEC noted that “Telegram has taken the position that the Gram Purchase Agreements were investment contracts i.e., securities, and placed a restrictive legend on the Gram Purchase Agreements…Telegram, however, claimed that Grams, the heart of the Gram Purchase Agreements, without which the agreements have no value or purpose, were not securities but rather currency.” The SEC continues, “Grams are investment contracts. Based on Telegram’s own promotional materials and other acts, a reasonable purchaser of Grams would view their investments as sharing a common interest with other purchasers of Grams as well as sharing a common interest with Defendants in profiting from the success of Grams. The fortunes of each Gram purchaser were tied to one another and to the success of the overall venture, including the development of a TON ‘ecosystem’ integration with Messenger, and implementation of the new TON blockchain. Investors’ profits were also tied to Telegram’s profits based on Telegram’s significant holdings of Grams.”

The SEC’s complaint goes on to state that the Grams would have no utility or use upon the distribution of the Grams other than speculation. Much of the complaint focuses on the materials and discussions of Telegram insiders promoting the tokens as well as the undertaking that Telegram was promising to support the tokens and the continued development of the ecosystem after the launch. While the SEC’s complaint does not cycle through the factors of the Howey test, a key focus of the Howey analysis is what was offered or promised to potential purchasers to determine whether the promoter held out an investment opportunity. Such a determination requires “an objective inquiry into the character of the instrument or transaction offered based on what the purchasers were ‘led to expect,’” which includes the terms of the offer, the plan of distribution, economic inducements promised to the purchasers, and an analysis into the promotional materials used for the transaction.

Further, alluded to in the complaint by the SEC is that Grams’ investors are dependent on the managerial efforts of Telegram. One of Howey’s progeny cases, which is not mentioned in the complaint, but which shares similarities with Telegram’s role in the transaction, is the Second Circuit’s decision in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc. In that case, the Second Circuit held that investors in certificates of deposit expected profits from Merrill Lynch’s managerial efforts because Merrill Lynch promised to create and operate a secondary market for the certificates. Investors thereby “bought an opportunity to participate in the CD Program and its secondary market. And, they are paying for the security of knowing that they may liquidate at a moment’s notice free from concern as to loss of income or capital.” As the SEC points out in the current complaint, Telegram issued a two-page teaser to investors to expect a listing of Grams on the major cryptocurrency exchanges. A Telegram executive and Vice President of Business Development also projected to list Grams on his trading platform allowing Gram holders to trade Grams with no restrictions. Additionally, 52% of the supply of Grams would be “retained by the TON Reserve to protect the nascent cryptocurrency from speculative trading.” Similar to Merrill Lynch in the Gary Plastic case, but not argued by the SEC, Telegram appears to have promised to create a secondary market for Grams to immediately be sold with no restrictions and guaranteed some price stability for investors that wish to liquidate their positions.

There is still much to speculate whether Telegram will settle with the SEC or pursue a similar path to that of Kik. The facts and issues behind the Kik case heavily overlap on the surface with those of Telegram. Nonetheless, this lawsuit will be one to watch as the SEC’s regulation by enforcement continues.

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]



Equity Compensation in the Gig Economy

Last week, Uber sent a letter to the Securities and Exchange Commission (the “SEC”) seeking an amendment to Rule 701 promulgated under the Securities Act of 1933. Rule 701, which was recently modified in July 2018, allows non-reporting companies (i.e. startups and other privately held companies) to issue securities for compensatory purposes to eligible recipients (including employees, consultants, advisors, etc.) without registering such issuances with the SEC. In the letter, Uber stated its preference for the term “entrepreneurial economy” over the commonly used term “gig economy”. Presenting itself as a company that has “empowered millions of individuals around the world to take control of their lives through [their] technology platform”, Uber provides brief recommendations to expand the scope of Rule 701 to allow them to issue equity to its drivers.

Under the revised Rule 701(e), an issuing company must release financial statements, risk factors and other disclosures if the aggregate sales price or amount of securities sold by the company under Rule 701 during any consecutive, rolling 12-month period exceeds $10 million.

Aware that Rule 701 has not been updated since 1999 and the changing nature of business, SEC Chairman Jay Clayton stated in a press release, “The rule as amended, and the concept release, are responsive to the fact that the American economy is rapidly evolving, including through the development of both new compensatory instruments and novel worker relationships – often referred to as the ‘gig economy.’ We must do all we can to ensure our regulatory framework reflects changes in our marketplace, including our labor markets.”

It is well known that Uber has consistently and continually identified its drivers as independent contractors rather than employees not only in the press but also in court. Most recently, the United States District Court for the Eastern District of Pennsylvania held that Uber drivers were independent contractors. As Rule 701 is currently constituted and interpreted, it allows for issuances of restricted stock to ‘consultants’ as an eligible class of persons, but not to ‘independent contractors’. For obvious reasons, this interpretation doesn’t work within Uber’s framework, as it is cross-purposes with its essential argument that its workforce, is comprised of independent contractors. Thus, its recent letter to the SEC is an attempt to open the Rule 701 framework to be more inclusive as to eligible persons (among other matters).

Interestingly, Uber competitor Juno previously tried offering restricted stock units to its independent contractor drivers that would be redeemable when Juno went public or was sold, which it was sold to Gett in 2017. However, Juno ended the program due to implementation difficulties, a clear example of the complexity and expense which can be involved in internal company securities issuances.

Fellow “gig economy” company, Airbnb also sent a request to the SEC on September 21, 2018 to allow it to issue company stock to its hosts. Additionally, it offered suggestions to expand Rule 701(c) to include “persons with substantial, but non-traditional relationships with the issuer”.

Given the growth of the sharing economy, such changes to Rule 701 would seem to be a positive step toward the democratization of equity ownership; allowing more people to participate in the wealth generated from these companies when (and if!) they do go public.

It is unclear if the Uber and Airbnb requests are a peace offering to drivers and hosts or signaling that the dominant “gig economy” companies are truly maturing as they look into the IPO route. Regardless, other platforms based on the “gig economy” relying on alternative contractual relationships between companies and individuals who work with them could follow similar incentive packages, which could include other options like unit appreciation rights plans or restricted stock units, to attract necessary platform employees.

How the SEC will react to these entreaties is not yet certain. Clearly, the SEC is warm to the idea of updating and modernizing key Securities Act transaction exemptions to take current market realities into account, and the seemingly logical (but limited) expansion of eligible persons under Rule 701 is an appealing step in that direction. However, it would also represent another channel of securities distributions that essentially fly below the radar of regulatory and public scrutiny; and, in a world where the long-term trend away from IPOs seems to be unidirectional, the SEC may not wish to allow for more shade to darken the picture frame.

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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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  & 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]