Regulation S

May 1, 2018

This is my opinion, not legal advice. 

 

If you are launching an ICO, either from the United States or from any other jurisdictions, you should be familiar with the Security and Exchange Commission’s (SEC) Regulation S. This is a highly simplified explanation that intentionally excludes anything not pertaining to crypto (such as debt instruments and warrants).

 

In short, Regulation S lets you sell Tokens to foreign markets without registering with the SEC; but you have to lock them up pursuant to Rule 144 for a one-year timeframe so the Tokens don’t flow back into America. The stated purpose of this Regulation—and every other regulation from the SEC—is to protect American Investors. 

 

The regulation was created in 1990 so that companies selling securities offshore did not have to register with the SEC. American companies abused the Regulation, so the SEC amended it in 1999 to “enhance investor protection.”  See https://www.sec.gov/rules/final/33-7505.htm.

 

The 1999 amendments created a requirement for US issuers selling equities offshore, but they did not change anything for foreign entities selling equities. Now the US issuers have to classify their securities as “Restricted Securities” within the meaning of Rule 144.  The holding period while the Securities are restricted from resale is called a “distribution compliance period,” which is broken down into three tiers: 0 days for tier 1, 40 days for tier 2, and 1 year for tier 3. While there is no guidance specific to ICOs, I believe they would fall into Tier 3 because of the strong possibility of funds flowing back to America once the restriction is lifted. There are other restrictions in place on foreign issuers that force them to lock their securities up for a year so there is no possibility that they could issue the securities and then have a big portion of them immediately flow into America without the SEC’s knowledge or oversight. 

 

Regulation S is not an exemption from registration; it’s an exclusion from the U.S. securities laws.  U.S. Issuers must meet three conditions to use it: 

  1. The offer or sale is made in an “offshore transaction” (outside the U.S.)

  2. No directed selling efforts are made in the U.S. by the Issuer; and 

  3. Additional resale restrictions depending on whether the Security is considered Category 1, 2, or 3.

CATEGORY 1:

There are no restrictions on resale as long as:  

  1. The issuer is a foreign company;

  2. Who reasonably believes there is no U.S. market interest in the securities;

  3. The offer and sale takes place overseas;

  4. The issuer can’t engage in any direct selling efforts targeted to American investors. 

Applicability for ICO Issuers: 

I don’t think this category applies for ICO issuers because of prong 2. The American appetite for crypto is especially strong, and crypto easily flows across borders.  

 

CATEGORY 2:

Category 2 requires a 40-day distribution compliance period for: 

  1. Foreign private debt issuers

  2. Foreign private equity issuers that are subject to the reporting requirements of the Securities Exchange Act of 1934, and 

  3. Debt offerings of U.S. issuers provided the issuers are subject to the reporting requirements of the Securities Exchange Act. 

The big difference between Category 1 and 2 is that the securities may not be offered or sold to U.S. persons, even if the person is outside the United States. Under Category 1, the securities can be offered to U.S. persons who are outside the United States. 

The 40-day restriction clock begins at the later of either the actual sale, or the close of the offering.  The issuer must have the buyer sign something to the effect that all offers and sales of the securities before the end of the 40 day lockup period are only made pursuant to the registration of the securities under the Securities Act or pursuant to an exemption. 

Applicability for ICO Issuers: 

I don’t think this category applies for ICO issuers because ICO issuers don’t meet any of the three prongs.  

 

CATEGORY 3:

Category 3 requires a one-year lock-up period. 

The offer comprises of: 

  1. Equity offerings of foreign private issuers not subject to the reporting requirements of the Securities Exchange Act, but where there is a high likelihood funds will flow back into America [in the class of securities being offered];

  2. All equity offerings of U.S. issuers; and

  3. Debt offerings of U.S. issuers not subject to the reporting requirements of the Securities Exchange Act. 

Applicability for ICO Issuers: 

Prong 1 includes foreign companies issuing ICOs and Prong 2 applies to American based ICOs.

The one-year restriction can be lifted if any of these conditions can be satisfied:

 

1. The person who bought the ICO Tokens sells it to a non-US person. 

This is impossible for an ICO issuer to track, so it would not be safe to allow free trading in hopes that they never pass to an American on the secondary market.

 

2. The American-based ICO issuer attaches a legend indicating that transfer is not allowed unless it’s in accordance with Regulation S, the Securities Act, or an available exemption.

For example, the ICO issuer registers the ICO for an IPO on a traditional stock market and becomes a reporting company or files for an exemption through Regulation D to allow for the sale to American Accredited Investors. However, there is no way to force the person who bought the ICO Token to check and make sure they are selling to an American Accredited Investor unless there was some kind of exchange that only allowed Accredited Investors on it, and did the verification process before allowing the sale. Once this is built, this could work to create liquidity, but so far, there’s no way to implement. 

 

3. The issuer (via contract or provision in its organizational documents) refuses to register any transfer not made in accordance with Regulation S, the Securities Act or an available exemption.

This says that the tokens could be traded freely on the secondary market as long as they weren’t being sold to Americans. The ICO Issuer would have to put something in their bylaws that would create a safeguard against Americans buying on the secondary market. There is no practical way to implement this, but in theory the ICO issuer could allow free trading of the tokens during the one-year period on an exchange that absolutely blocked Americans.

 

4. If the laws of the foreign jurisdiction prevent the issuer from refusing to register transfers, other procedures have to be implemented to prevent impermissible transfers.

This one has no practical application. 

 

5. Since equity securities (aka ICO Tokens as per the SEC’s statements) have the highest potential for abuse, the SEC adopted amendments in 1999 to require purchasers of equity securities in Category 3 to agree to resell the securities, only in accordance with the registration or exemption through Regulation S. Purchasers are required to have notice of the resale restrictions at the time they make the purchase.

This means ICO issuer needs to include in their Offering Memorandum that there is a one-year restriction on resale.

 

6. Purchasers of the equity securities are required to certify that they are not U.S. persons and are not acquiring the securities for the account or benefit of a U.S. person. If they are a U.S. person, they must certify that the transaction did not require registration under the Securities Act. (Note, the SEC has said this is necessary to prevent “sham” transactions where issuers park securities offshore with an affiliate or Shell Company that is actually owned by the U.S. persons.) 

So to qualify here, the international ICO purchaser could sell his or her ICO Tokens to a non-U.S. person, or get some kind of certainty (like a legal opinion letter) that the transaction doesn’t require SEC approval. Again, this is impossible for the ICO issuer to control, so it’s impractical to allow for these transactions to take place, undoubtedly the result would be free flowing of ICO Tokens into America, and possible legal consequences from the SEC against the ICO issuer for allowing this to happen.  

 

7. This category also requires an issuer, by contract, or a provision in its bylaws, articles, charter, or comparable document, to refuse to register any transfer of securities unless made in accordance with the registration or exemptive provisions of the Securities Act, or in accordance with Regulation S. This requirement imposes monitoring similar to unregistered private placements. 

Again, this is impractical in terms of Tokens because they are so liquid, and the issuing company has no control over the transferring of them. It’s not like the Tokens are shares of the company, and the company has records of its shareholders. That’s the big reason why applying all these securities laws on tokens makes no sense. 

 

Category 3 was not extended to reporting foreign issuers that have their principal market in the USA. A reporting foreign issuer means a company listed on a stock market – this caveat has no benefit for crypto companies, as they are not listed on the traditional stock markets. 

 

RULE 904:

Rule 904 offers a safe harbor that covers offshore resale of securities that were initially placed offshore or by private placement in the United States by someone other than the issuer. (An example of this could be an ICO done in America, and sold to an American Accredited Investor, pursuant to Regulation D – who then sells it to someone offshore). These people can generally resell their securities outside the United States immediately, provided the offshore transaction requirement is satisfied and directed selling efforts are not used in the United States. (No practical way for an ICO issuer to enforce this, so it’s safer to lock all Tokens up). The caveat for crypto is that the transaction has to be conducted on a physical trading floor of an established foreign securities exchange, or through the facilities of a “designated offshore securities market” and requires that neither the seller nor anyone acting on its behalf know that the transaction has been prearranged with an American buyer.  Crypto exchanges likely wouldn’t qualify as a foreign securities exchange, so unless Tokens can be transferred through entities like the Toronto Stock Exchange or the London Stock Exchange, this safe harbor provides nothing useful for an ICO issuer. 

 

RULE 905: 

Rule 905 imposes the same restrictions as Rule 144, typically used in Regulation D for American issuers, and requires a one-year lock-up period.  This means any sales done pursuant to 904’s safe harbor would not “wash off” the restricted status of the securities and enable them to be freely sold into the United States by the purchaser.  This rule does not extend to the Securities of a foreign private issuer. 

 

REPORTING OF REGULATION S TRANSACTIONS

An American securities issuer used to be required to report all Regulation S sales on Form 8-K within 15 days of occurrence, but that requirement was dropped in 1999. Now issuers do need to report on Forms 10-Q, 10-QSB, 10-K or 10-KSB, as applicable. Form 10-K is typically known as the “Annual Report to Shareholders” and must be filed with the SEC for companies with more than $10 million in assets and a class of equity securities that is held by more than 2000 owners, regardless of whether the securities are publicly or privately traded. It has to include the company history, organizational structure, executive compensation, equity, subsidiaries, and audited financial statement. Form 10-Q is a quarterly filing required by publicly traded companies (on the traditional stock market).  So as long as the ICO doesn’t have more than 2000 Token Holders, it doesn’t need to file these things. 

 

ADVANTAGES OF REGULATION S

Despite having to lock the securities for a year, American Token issuers can still sell security tokens around the world to any number of purchasers, and do not have to ensure each of them meet the American Accredited Investor standards. The only sore point is they have to wait a year to allow purchasers to resell them, or if a crypto exchange did become designated as a “Regulated Securities Exchange” they could be sold there before the expiration of the one-year. 

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