Can Equity Ownership Exist on the Blockchain?
Can Equity Ownership Exist on the Blockchain?
Yes. How useful is it, though? Read on to find out.
I started Brogan Law to provide top quality legal services to individuals and entities with legal questions related to cryptocurrency. Cryptocurrency law is still new, and our clients recognize the value of a nimble and energetic law firm that shares their startup mentality. To help my clients maintain a strong strategic posture, this newsletter discusses topics in law that are relevant to the cryptocurrency industry. While this letter touches on legal issues, nothing here is legal advice. For any inquiries email aaron@broganlaw.xyz.
Enforcement News
The long march of Gary Gensler’s cryptocurrency enforcement continues this week, as the DAO-led Mango Markets settled SEC charges that its distribution of the governance token MNGO was an unregistered sale of securities. At the same time, the entities Mango Labs LLC and the Blockworks Foundation settled charges that they had acted as unregistered brokers in the sale of MNGO token. In their press release, the SEC affirmed that it does not consider a DAO structure protective where the underlying activity is transgressive:
“Since the inception of our crypto enforcement program, our view has been that the label ‘DAO’ does not change the reality of who is behind a project, what activities they engage in, or whether their activities need to be registered. Nor does engaging in intermediation of securities with the aid of automated or open source software change the nature of such activities” said Jorge G. Tenreiro, Acting Chief of the Crypto Assets and Cyber Unit.
As a part of the settlement agreement, Mango Markets agreed to ask exchanges to delist the MNGO token and destroy those in its possession. It seems the SEC is now seeking to unwind cryptocurrency tokens in their entirety—a dark omen. More enforcement actions may come out Monday, as well, as the SEC has historically released many notices on or around September 30. Those could shed more light on the implications of this aggressive approach.
Tokenized Equity
But we’re not talking about that this week. Much the opposite, this newsletter is concerned with affirmatively legal approaches to distributing equity. We spoke briefly last week about the exemptions to registered securities offerings like Regulation D, Regulation CF, and Regulation A. These are familiar to many, but their application to crypto remains somewhat speculative. First, though, how do they work?
Regulation D: Often called “private placements”, Reg D offerings are the most common kind of exempt security offering. The criteria for offering tokens under this exemption differs depending on the applicable rule, Rule 506(b), Rule 506(c) or Rule 504. Rule 506(b) and (c) cover sales to investors. Under 506(b) sales without general solicitation (advertising to investors) are permitted for up to 35 non-accredited investors[1]. Rule 506(c) permits solicitation and does not cap the number of investors, but requires that they are accredited. Rule 504 allows solicited sale to unaccredited investors, but only up to $10 million in a year. Under any of the rules, these securities will be “restricted” after sale, meaning they cannot be sold on secondary markets without being registered or exempted. In order to offer securities under the Reg D exemption, firms must file Form D with the SEC.
Regulation S: Reg S allows sales of securities to offshore investors. It is applied differently depending on a number of distinct categories of sale involving the nationality of the seller and buyer. Generally, sellers cannot solicit United States persons to invest in Reg S sales, but may solicit and sell unlimited equity to offshore investors. Depending on the structure of the sale, there is a “distribution compliance” period after the sale during which the securities cannot be resold to a US person. After that period has passed, however, these securities can be resold into the United States. Once sold into the US, however, they are still considered restricted securities.
Regulation CF: Reg CF or “regulation crowdfunding” was created by the 2012 JOBS act to facilitate public fundraising for small businesses. Reg CF permits fundraising up to $5 million annually from non-accredited investors under certain limitations. Tokens sold through this exemption must be offered through a registered intermediary like a broker-dealer or funding portal. The total amount raised from any individual investor is capped variably based on their income and net worth, but can be no more than $124,000. Resale of securities sold under Reg CF is limited for a year except under certain conditions, like when the buyer is an accredited investor. Entities selling securities under Reg CF must file Form C.
Regulation A and A+: Reg A and A+ allow offerings of up to $20 or $75 million annually under certain conditions. Offerings under these exemptions include distributing an “offering circular” which is reviewed by the SEC and also possibly by the state where the securities are sold. There are financial disclosure requirements as well. The specific path taken in these regulatory exemptions can be a touch baroque. Generally, these securities are unrestricted and do not have a lockup period post sale, but Rule 144 restricting sales by insiders does apply.
The various securities exemptions offer entities a great deal of potential liquidity with relatively limited cost and regulatory burden. Last week I told you that an initial public offering could cost $20,000,000, with ongoing obligations in the millions annually. In comparison, one estimate suggests that an exempt offering might cost less than a million.
While these exemptions have great promise to facilitate fundraising by small companies, they are hampered by significant liquidity problem on secondary markets. While there may not be legal restrictions on all secondary sales of exempt securities, there are nonetheless strong practical barriers to establishing liquid market. Low volumes and complex compliance, coupled with a lack of market makers, make sytematized sales of these assets prohibitively difficult. Academics have generally identified this as the core problem of private fundraising, because “from an investor’s perspective dividends are the only realizable financial gains given the absence of well-established secondary markets.”
Without a mechanism to easily facilitate resale, these primary markets are fundamentally limited. Who wants to buy an equity they might never be able to sell? While some entities have tried to remedy this by launching “Alternative Trading Systems” (ATSs), SEC registered exchanges that can deal in secondaries[2], none has yet found success. In a vicious cycle, this limits primary sales, which in turn suppresses volumes of outstanding equity and thus limits future liquidity on secondary markets.
Some have proposed that the blockchain can solve this secondary market liquidity problem (by being very liquid). Indeed, these “Reg-” exemptions can generally apply to offerings of “tokenized equity”, shares of a company that are represented as tokens on the blockchain. The SEC tends to be more concerned with substance than form, so an issuance of tokens that met the requirements of one of these exemptions may be permissible. To prove the point, the blockchain company INX successfully made a public offering using tokenized equity in 2023. In 2017 Delaware even expressly permitted blockchain as a medium to maintain corporate records.
That said, there are also some limitations to the promise of tokenized equity as an asset class. For one, even where it could theoretically act as a bearer-bond type substitute for equity ownership, thus aligning with the code-is-law ethos of cryptocurrency and facilitating significant liquidity, that is not the practical reality. In order to comply with the regulatory web of exempt offerings, resale restrictions, etc., tokens must either be managed by a central intermediary or structured to imitate one through code. In the Ethereum token standard, ERC-884, which was developed to comply with Delaware law for tokenized equity, whitelists must be maintained to permit token smart contracts to comply with law. This means that, off-chain, someone either has to be actively managing the tokens, or passively managing them by creating, checking, and updating lists. In addition, there generally must be lists of token holders and their holdings so that if tokens are lost or destroyed their ownership of the company can be restored.
This is consistent with an ever present theme among academic literature on this topic: in order for on chain regulated securities to work, they must be paired with enforceable legal rights existing off-chain. Practically, any serious investor would require this. Even if an entity created a smart contract such that the purchaser’s rights could not conceivably be impaired on-chain, without some written legal agreement there would be nothing to prevent an entity from offering new, legally-recognized, shares off-chain and diluting the tokenized equity to dust. For some in crypto, this might be an acceptable risk, but for the public at large, it is a barrier to adoption.
This practical reliance on off-chain maintenance and legal structures diminishes the value of the blockchain for facilitating liquidity. While it is easy to trade crypto on decentralized exchanges (DEXs), it is far more difficult to do so with compliance focused tokenized equity. Even on the major centralized crypto exchanges like Coinbase, there may be regulatory barriers. Without access to these crucial markets, it is difficult for any tokenized equity to gain traction and increase in price, so even if investors can sell them, their return might be diminished compared to more liquid public equities or traditional wild-west style cryptocurrencies.
That said, it is possible to imagine controls that facilitate a market far more liquid than the ones presently in place. Just because nobody has figured it out yet doesn’t mean it is impossible. At Brogan Law, we think about new legal structures for cryptocurrency every day, so the future may yet be bright for tokenized equity. If it happens before next Sunday, you’ll read about it here. Until next time.
[1] An accredited investor is a technical calculation based on income and net worth. In other words, the SEC’s term for a rich person.
[2] National security exchanges like the New York Stock Exchange or NASDAQ cannot list exempt securities.
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