UNITED STATES SECURITIES LAW DEEP DIVE

Gordon Einstein, Esq.

Blockchain & Crypto Partner – CKR Law – www.ckrlaw.com

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SECTION 1 – Securities Regulation Background and Context • The US Constitutional Order

• Historical context for securities regulation in the US • Historical US Securities (Non-)Regulation

• Wall Street Crash of 1929

• Franklin Roosevelt’s “New Deal”

• “New Deal” US Securities Regulation 1933/40

• “Post-New Deal” US Securities Regulation

• Commodities, the CEA, and the CFTC

• US Securities and Exchange Commission (SEC)

The US Constitutional Order

• US Constitution = key to understanding US securities regulation.

• Origins of the US constitutional order • From Colonies to “States” • From Confederation to Federation

• Key US Constitution principles • The US Constitution is the supreme law of the US. • Creates federal government layer, with limited jurisdiction. • Creates 3 branches of federal government: Legislative, Judicial, and Executive. • Jurisdiction can be exclusive to the state(s), shared, or exclusive to the federal

government. • The US Supreme Court (USSC) is the ultimate arbiter of constitutional law.

Historical US Securities (Non-)Regulation

• Securities regulation was matter of state law, not federal.

• Kansas implemented first securities regulation law in 1911. However, states usually had no securities regulation, or inconsistent regulation. Could not enforce across state lines.

• Holes in system allowed for rampant abuse. • Fraud/“Blue Sky”

• Pump and dump and other market manipulation

• Insider trading

• Disclosures did not exist or were minimal. No standardization.

• The “Roaring 20s” – rampant stock market speculation.

Wall Street Crash of 1929

• Begins on October 24, 1929, after London Stock Exchange failed

• 12 year Great Depression starts – millions unemployed, farms fail

• Smoot–Hawley Tariff Act of 1930 leads to trade wars

• Germany’s Weimar Republic defaults on WW1 reparations in 1932

• Weimar Republic falls to Nazis in 1933/1934. War is coming.

• US Senate’s Pecora Commission (1932/1934) uncovers widespread securities markets abuse. Both in the sale of securities, and in subsequent “after market” activity.

Franklin Roosevelt’s “New Deal”

• Many laws quickly passed in response to the Great Depression.

• USSC finds Congress does actually have the power to regulate the national securities markets (etc.) on a federal level under the “Commerce clause” (US Const. Art. I, Sec. 8, Clause 3).

• "To regulate Commerce with foreign Nations, and among the several States…“

• Based on Pecora Commission findings and subsequent recommendations of committee headed by Professor later USSC Associate Justice), Felix Frankfurter (Congress passed several key US securities regulation statutes.

“New Deal” US Securities Regulation 1933/40 TITLE COVERAGE

SECURITIES ACT OF 1933 The "truth in securities" law Aka, the ’33 Act

The initial sale of securities by the issuer (IPOs, etc.). Registration and disclosure requirements. Registration exemptions and exceptions. Securities fraud.

Glass–Steagall (repealed!) Previously separated commercial banking and investment banking. Repealed by Gramm–Leach–Bliley Act in 1999.

SECURITIES EXCHANGE ACT OF 1934 Aka, the ’34 Act

Secondary trading of securities following the initial issuer sale, especially Publically Traded Securities (companies) on Exchanges. OTC markets. Market regulation/market manipulation. Broker/Dealer rules and “self regulating organizations” (SROs, e.g., FINRA). Securities fraud. Proxies. Tender offers. *** Creation and powers of the US Securities and Exchange Commission (SEC) ***

Trust Indenture Act of 1939 Regulates bond issues. Disclosures, indenture agreements, trustees.

Investment Company Act of 1940 Regulates “retail investment products” such as mutual funds.

Investment Advisors Act of 1940 Regulates investment advisors.

“Post-New Deal” US Securities Regulation TITLE COVERAGE

National Securities Markets Improvement Act (NSMIA) (1996)

Greatly limited state “blue sky” security laws and transferred power to SEC so as to create truly national regulatory structure and securities market. States mostly may only receive “notice”.

Sarbanes-Oxley Act of 2002 (SOX) Response to Enron and Worldcom frauds. Imposed complex new corporate governance rules, process and financial controls and audits. Crossed over into traditional state law areas. Disincentive to go public in the US.

Dodd–Frank Wall Street Reform and Consumer Protection Act (2010)

Response to 2008 financial crisis. Truly massive law which affects almost all aspects of financial markets regulation.

Jumpstart Our Business Startups Act (JOBS Act) (2012)

Crowdfunding-oriented improvements. Reg “A+”. General solicitation under Reg D Rule 506. Easier IPO registration for “emerging growth companies”.

Commodities, the CEA, and the CFTC

• The Commodity Exchange Act (CEA) was passed in 1936 as part of the New Deal.

• The US Commodity Futures Trading Commission (CFTC) was (much later) created by the Commodity Futures Trading Commission Act of 1974.

• The CFTC regulates non-security “futures” and “options” markets. And not just futures/options on “commodities” like oil or corn. Most non-security financial “derivatives” are under CFTC (not SEC) jurisdiction.

• The CFTC has no jurisdiction over “spot markets” and “forward contracts”.

• The SEC and the CFTC have occasionally engaged in agency “turf wars”.

• Preview – many cryptocurrencies and tokens are more like commodities than securities!

US Securities and Exchange Commission (SEC) • Created by the ’34 Act (not the ’33 Act!). • The SEC is an “independent agency” of the US federal government,

organized as a “commission”. It is not a “committee” nor a “department”. • The SEC is charged with forming policy and regulating the US securities

markets. • Pursuant to the ’34 Act, the ’33 Act (as amended), et seq., the SEC has

“delegated authority” from the US Congress to make and enforce “rules” and “regulations”, which have the full force of US federal law.

• BUT – the SEC may neither (i) act beyond the scope of its delegated authority, nor (ii) act in an unconstitutional manner.

• US federal courts can and do “overrule” the SEC. The US Congress can also “amend” the law (see next slide).

SECTION 2 – Overview of the Securities Act of 1933 • ’33 Act Key Concepts

• ’33 Act §2(b) – A “Big Picture” Approach

• ’33 Act – Key Sections – Part 1

• ’33 Act – Key Sections – Part 2

• ‘33 Act – Some Important §2(a) Definitions

• ‘33 Act – More Important §2(a) Definitions

‘33 Act – Key Concepts

• Many terms are defined in §2(a) of the ’33 Act and have non-obvious meanings.

• Concerns the “initial distribution” or “issue” of a “security” by the “issuer” (or agents of the issuer, such as its “underwriters”).

• Default rule is that all such sales or offers to sell securities to a US “person” must be “registered” with the SEC.

• Registration involves filing a “registration statement” and “prospectus” which must be approved by the SEC. This process is expensive and slow.

• A policy goal of the ’33 Act is “full disclosure” of all “material information”, not a “merit evaluation”.

• This default rule that all sales of securities must be registered has several useful “exemptions”.

• IMPORTANT – the ’33 Act only covers sales and offers of sale of a “security” (including “securities fraud”). I.e., its coverage is limited…

’33 Act §2(b) – A “Big Picture” Approach

• The SEC’s mandate is not JUST to protect investors. The US Congress added §2(b) to the ’33 Act in 1996. Now, the SEC is directed to have a “big picture” approach.

• “Whenever… the Commission is engaged in rulemaking...(it) SHALL… consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.”

• In legal English it is important to distinguish “shall” vs. “may”.

• Note – nothing limits these considerations to the securities markets.

• Query – is the SEC abiding by §2(b) when is chills the ICO market?

’33 Act – Key Sections – Part 1 SECTION SUMMARY

§2 “Definitions” – very important. Details in following slide(s).

§5 BASIC RULE OF ’33 ACT - prohibits the sale or offering for sale of any security where there is no registration statement in effect. Luckily, the ’33 Act contains many “exempted securities” and “exempted transactions”.

§3 “Exempted Securities” - provides that the provisions of the ’33 Act (all of it) shall not apply to certain “classes of securities”. • §3(a) “exempted securities” include a long list of certain types of securities (e.g., §3(a)(2)

any security issued by a US state). • §3(b) provides for “additional exemptions” which the SEC may create by “rule or

regulation”. These mostly relate to small, non-public offerings of securities. • §3(c) exemption relating to “securities issued by a small business investment company”.

§4 “Exempted Transactions” – provides that (just) §5 will not apply to certain transactions. I.e., certain transactions do not need to be registered with the SEC because they are exempt. NOTE that the rest of the ’33 Act will apply to such securities. So… no fraud allowed.

§§6 - 8 Describes the filing requirements and filing fees, content requirements, and effectiveness of a “Registration Statement”.

’33 Act – Key Sections – Part 2 SECTION SUMMARY

§10 “Prospectus” – describes the detailed information which must be included in the prospectus relating to the offering. This is where standardized “full disclosure” kicks in.

§§8A - 9 “Cease-and-Desist Proceedings” and “Court Review of Orders” – grants the SEC the power to intercede and order parties which may be breaking the law, or about to break the law, to stop, including the right to seek sanctions and fines. Also, §20 relates to “Injunctions and Prosecutions of Offenses”.

§11 – 17 (etc.)

Broadly relate to possible civil liabilities, remedies and causes of action associated with false registration statements, violating §5, committing fraud, etc.

‘33 Act – Some Important §2(a) Definitions SECTION SUMMARY

§2(a)(1) “Security” – all of the obvious categories (stock, bond, etc.) but also an “Investment Contract”. IMPORTANT!

§2(a)(2) “Person” – basically, everyone you can think of. Individuals, companies, trusts, etc.

§2(a)(3)

“Sale” or “Sell” (of a security) – any disposition of a security or interest in a security, including any related “offer to sell”.

§2(a)(4) “Issuer” – any person who issues (initially distributes) or proposes to issue any security.

§2(a)(5) “Commission” – the US Securities and Exchange Commission (SEC).

§2(a)(6) “Territory” – Puerto Rico, Virgin Islands, other insular possessions of the US.

§2(a)(7) “Interstate Commerce” – any trade or communication (i) between US states OR (ii) with any foreign country. Only excludes (maybe) intrastate trade and commerce.

§2(a)(8) “Registration Statement” – as used elsewhere in the ’33 Act.

§2(a)(10) “Prospectus” – as used elsewhere in the ’33 Act.

‘33 Act – More Important §2(a) Definitions SECTION SUMMARY

§2(a)(11) “Underwriter” – any person who participates in the initial distribution of securities, other than the issuer. Excludes persons buying for own account or for commission from underwriter or dealer.

§2(a)(12) “Dealer” – any person in the business of dealing or trading in securities which that the dealer owns. Compare with “broker”, which makes profit on commission, not on the spread. Note that “broker” is not defined in the ’33 Act.

§2(a)(15) “Accredited Investor” – 2 classes of investors deemed not need the protection of a full registration statement and prospectus. This relates to certain Exempt Transactions. • §2(a)(15)(i) group includes banks, ICA 40 Investment Companies, Small Business

Investment Companies, etc. • §2(a)(15)(ii) authorizes SEC to make rules and regulations defining who else can qualify as

an accredited investor based on factors such as (i) net worth, (ii) financial sophistication, etc.

§2(a)(16)

“Emerging Growth Companies” – companies which meet certain criteria (e.g., less than $1 billion in yearly gross revenue) and so have lower compliance requirements.

SECTION 3 – ’33 Act - Part 1 Meaning of “Security” and “Investment Contract”

• What is a “Security”?

• Howey - What is an “Investment Contract”?

• The “Howey Test”

• The “Gordon Securities Test”

• Is It a “Security” or a “Pencil”?

What is a “Security”?

• Recall that most securities regulation deals with offer or sale of “securities”, including fraudulent offers or sales of (non-)securities.

• If a transaction does not involve a security, then the ’33 Act, et seq., does NOT apply and the SEC does NOT have jurisdiction.

• Recall that ’33 Act §2(a)(1) defines “security”. Definition boils down to a long list of enumerated traditional and non-traditional security types (stocks, bonds, profit sharing agreements, investment contracts, etc.).

• Note – substance over form doctrine.

• Definition of “security” includes “investment contract”. Why is that there and what does it mean?

Howey - What is an “Investment Contract”?

• US securities regulation designed to be flexible because cannot anticipate future innovations (e.g., “tokens”).

• “Investment contract” is a “catch all” term intended to incorporate prior US state law, hence undefined in the ’33 Act.

• USSC finally came up with a test for what is an “investment contract” in Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946). READ IT.

• Case involved sale of citrus orchards, and associated maintenance and profit sharing agreement. Was this an “investment contract” and hence a “security” under the ’33 Act? I.e., did it need to be “registered”?

The “Howey Test”

USSC ruled that if ALL FOUR of the following elements are present, then financial arrangement in question is an “investment contract”.

“For purposes of the Securities Act, an investment contract (undefined by the Act) means a contract, transaction, or scheme whereby a person…

1. invests his money

2. in a common enterprise

3. and is led to expect profits (GE - emphasis added)

4. solely from the efforts of the promoter or a third party.”

The “Gordon Securities Test”

My personal (completely untested) position is that if a putative investment contract has NONE of the following legal claims on the underlying business, enterprise, platform, etc., then there cannot possibly be a security involved.

The elements are:

1. A claim on the PROFITS (e.g., dividends);

2. A claim on CASH FLOWS (e.g., interest payments);

3. A claim on ASSETS (e.g., in case of dissolution or sale);

4. A claim on GOVERNANCE (e.g., shareholder voting rights).

Is It a “Security” or a “Pencil”?

In edge cases, when the SEC or the US courts are trying to determine whether or not an “object” is an investment contract/security, by far, the determining factors are the (i) understanding of the parties, and (ii) how the “object” is marketed.

• What happens when you sell a pencil as a pencil?

• What happens when you sell a tokenized pencil as a tokenized pencil?

• What happens when you offer tokened pencils for sale, before they are actually manufactured, via an IPO (an “Initial Pencil Offering”)?

• Discuss.

’33 Act - Part 2 - Registration Exemptions

• The “Accredited Investor” • Registration Exemptions In General • §3(a) - “Exempted Securities” • §3(b) and §4(a)(2) – The Basis for Reg D • Reg D - Rules 501 – 503 & Rules 507 - 508 • Rule 504 and Rule 505 Exempt Transactions • Rule 506, And Its Variants • Rule 506(b) vs. Rule 506(c) • Regulation A/A+ Exemption • Rule 144 – Restricted Stock

The “Accredited Investor”

• Recall that ’33 Act §2(a)(15) defines “accredited investor”.

• Idea is that such investors are in a position to engage in their own information discovery regarding an investment opportunity. This can lead to an “exempted transaction”.

ANY of the following can be true (short version):

1. Annual income of $200,000 (or $300,000 joint income), for the last two years with expectation of earning the same or higher income.

2. Net worth exceeding $1 million, either individually or jointly with spouse.

3. Investor is a general partner, executive officer, or director of the issuer.

4. Certain defined entities (e.g., private biz dev co. with assets exceeding $5 million).

5. Investor who can demonstrate sufficient his professional knowledge of unregistered securities.

6. Registered brokers and investment advisors automatically qualify.

Registration Exemptions In General

THREE ways to avoid registration under the ’33 Act:

1. Don’t sell or offer for sale a security as defined in §2(a)(1) – this includes not engaging in securities fraud;

2. Sell or offer for sale an “Exempted Security” as defined in §3.

3. Engage in an “Exempted Transaction” as defined in §4.

NOTE that exemptions are either directly described in the ’33 Act, OR may (indirectly) exist pursuant to an SEC “Rule” or “Regulation” created under authority of the ‘33 Act.

§3(a) - “Exempted Securities”

• §3(a)(11) – issuer and purchasers all reside within the same US State. No limit on number of investors.

• Rules 147/147A – SEC “safe harbor” implementations of §3(a)(11) intrastate offering exemption.

• There are many more exempted security types under §3(a). However, most of these types will not be applicable.

§3(b) and §4(a)(2) – The Basis for Reg D

• §3(b) – the SEC “may” exempt from §5 registration certain “small issues”. It also “shall” exempt from §5 registration certain specifically defined “additional issues”.

• §4(a)(2) – completely exempts from §5 registration requirement “transactions by an issuer not involving any public offering.”

• These two ’33 Act sections form the basis for SEC’s “Regulation D” (Reg D) “private placement” Rules 501 through 508.

Reg D - Rules 501 – 503 & Rules 507 - 508

These rules apply to ALL Reg D offerings.

• Rule 501 - definitions that apply to all of Reg D.

• Rule 502 – conditions for using Reg D such as: 1. All sales which occur within a certain period will be treated as “integrated”; 2. Specifies what information and disclosures must be provided; 3. There must be no "general solicitation“ (not always true!); 4. That the securities being sold contain restrictions on their resale.

• Rule 503 - requires issuers to file a Form D with the SEC when they make an offering under Regulation D.

• Rule 507 - penalizes issuers who do not file the Form D.

• Rule 508 - provides SEC enforcement guidelines related to Reg D issuers.

Rule 504 and Rule 505 Exempt Transactions

• Rules 504 exempt transactions are based upon §3(b). §3(b) contemplates sales of $5 million or less of securities within any 12 month period.

• The issuer may not be blank check company or subject to ’34 Act reporting requirements.

• No advertising or general solicitation (with exceptions).

• The issuer need NOT restrict securities resale rights, so long as certain conditions are met.

• Minimal or no disclosure requirements.

• No limit on number of accredited or unaccredited investors.

• BUT – subject to state “blue sky” laws.

Rule 506, And Its Variants

Rule 506 is based upon §4(a)(2), i.e., non-public offerings.

There are two variants: Rule 506(b) and Rule 506(c). They differ as to whether the issue will be advertised or offered via a “general solicitation”.

In both cases:

1. The issuer may raise an unlimited amount of capital;

2. The issuer must be available to answer questions by prospective purchasers;

3. The issuer (may) need to provide certain financial information / statements / disclosures; and

4. Purchasers (may) receive “restricted securities”, which may not be freely traded on the “secondary market” after the offering. But see Rule 144.

Rule 506(b) vs. Rule 506(c)

In the case of Rule 506(b):

1. No “general solicitation” or advertising of the securities allowed.

2. The sale may be to an unlimited number of accredited investors.

3. There may be no more than 35 other purchasers, who must all be “sophisticated”, or have a sophisticated “purchaser representative”. “Sophisticated” = able to evaluate the investment opportunity.

In the case of (the new) Rule 506(c), pursuant to the JOBS Act:

1. General solicitation and advertising is ALLOWED.

2. BUT – only accredited investors may participate and the issuer must take reasonable steps to determine to validate this.

Regulation A/A+ Exemption

• The US attempt at “equity crowdfunding” for small and medium size companies. Original “Reg A” was pretty useless.

• Improved “Reg A+” came into effect on July 19, 2015, based on the JOBS Act.

• Now, there are two tiers of Reg A+ offerings. 1. Tier 1 - offerings of up to $20 million in a 12-month period; and 2. Tier 2 - offerings of up to $50 million in a 12-month period.

• Differences relate to who can invest, what forms of advertising are allowed, and ongoing compliance requirements.

• My opinion is that Tier 1 is still useless since need to qualify on a state by state basis. Tier 2 is pretty good. The cap may also be increased.

Rule 144 – Restricted Stock

• Recall that all public offerings of securities must be registered unless there is an exemption. This would generally apply to resales of “restricted securities” or “control securities” acquired directly from the issuer.

• “Restricted Securities” usually result from Reg D (Rule 506) sales and can be identified by the “legend” on the “stock certificate”.

• “Control Securities” usually are those held by an “affiliate” of the issuing company.

• Rule 144 provides a non-exclusive “safe harbor” where non-public company stock may be resold after 1 year without registration.

SECTION 4 - The 1934 Securities Exchange Act • Imposes complex reporting and compliance requirements on

“publically traded companies”.

• If 500+ unaccredited US persons hold “equity securities”, then publically traded.

• If 2000+ US persons (accredited or not) hold “equity securities”, then publically traded.

• These numbers may increase, but still… ouch.

• Discuss how this applies to secondary market tokens.