The enfant terrible of the digital token world, the Simple Agreement for Future Tokens, or SAFT, continues to grab headlines. In the recent Telegram case, the federal district court for the Southern District of New York enjoined Telegram Group Inc. from proceeding with its long-planned token generation event, finding not only that the issuance of their tokens, Telegram Open Network, would violate the registration requirements of the Securities Act of 1933 but that the initial placement of SAFTs constituted an illegal unregistered offering of securities. On June 26, 2020, the court approved a settlement between the United States Securities and Exchange Commission and Telegram that included an $18.5-million civil penalty, the return of some $1.22 billion to investors and a three-year requirement to notify the SEC before issuing digital assets. That settlement extinguished the appeal, leaving the decision as the final legal determination. The SEC has made similar arguments in the case of the Canadian startup Kik last year. Nonetheless, billions of dollars of SAFTs have been issued by other issuers of which many remain outstanding and are subject to potential secondary market trading.
Although there have been variations, in a quintessential SAFT offering, an issuer raises funds to finance the development of a platform that will be driven by tokens by selling to investors a SAFT that represents the right to receive an allotment of tokens once the platform is launched. The purchase price is paid upon receipt of the SAFT, and the number of tokens to be delivered in settlement is determined on the date of the token generation event, usually at a discount to the public purchase price. For many issuers, numerous delays in launching the platform have caused SAFT holders to look for pre-launch exits, and as anticipated launch dates approach, other investors look for ways of buying tokens at discounted prices. Thus, there is a natural supply and demand for secondary transfers of SAFTs. However, such secondary sales are complicated by a number of contractual and regulatory factors, which are discussed in turn below.
Secondary sales of SAFTs vs. secondary forward contracts
Most SAFTs are subject to contractual transfer restrictions that prohibit the assignment of the SAFT contract or any rights thereunder to a third party without the prior written consent of the issuer. While it may be feasible to acquire the issuer’s consent to transfer a SAFT, many SAFT holders may feel constrained by relationship considerations from signaling to the issuer that they are seeking to exit their investment. Similarly, SAFT issuers may be disinclined from consenting to such transfers to avoid: (1) any implication that they are encouraging the growth of a secondary market; (2) the complexities of policing transfer restrictions; and (3) the cost of reviewing and approving transfers, and may only agree to transfers to affiliates. Some transfer restrictions contain exceptions for partnerships or funds that wish to distribute assets pro rata to their partners or investors. To the extent such entities were the initial investors in a SAFT, distributions to their investors, whether old or new, may be possible within the contractual restrictions.
Alternatively, SAFT holders may gain liquidity by entering into a forward contract with a secondary investor for the tokens underlying the SAFT — a “secondary forward contract.” Whether this approach is permissible or not depends in large part on how strict the transfer restrictions are defined in the SAFT. Questions that would need to be answered include, but are not limited to: (1) Do the transfer restrictions apply to transfers of the underlying tokens or only the SAFT itself? and (2) Do the transfer restrictions encompass indirect transfers or transfers of the economic rights under a SAFT? Assuming counsel can get comfortable that a secondary forward contract is permissible under the SAFT’s transfer restrictions, a number of difficult regulatory issues then arise.
Regulatory issues with secondary forward contracts
A secondary forward contract can be understood as a physically settled contingent prepaid forward contract obligating the seller to deliver certain tokens, if and when issued, to the buyer in exchange for the payment of an upfront purchase price. The regulatory treatment of this type of prepaid forward contract will depend in large part on the legal characterization of the underlying tokens: Are they securities, commodities or “something else?”
Tokens as securities
Whether a digital token is a security under the U.S. securities laws has been the central issue facing initial coin offerings and SAFTs since inception and has been the primary subject of many court cases and regulatory writings, including the SEC’s Report of Investigation on the DAO, numerous SEC enforcement actions and the SEC’s Framework for “Investment Contract” Analysis of Digital Assets. The legal analysis of whether a digital token is a security hinges on the application of the Howey Test.
Much has been written on this question, however, we will not review the application of the Howey Test to digital assets here. But note that many SAFTs were based on the legal theory that, although the SAFT itself was a security which would be sold to investors in a private placement exempt from the registration requirements of the Securities Act, the tokens, once generated, would not be securities. However, in a number of cases, the SEC and courts have found that the tokens underlying SAFTs were securities.
Assuming that the tokens, when generated and issued, are securities, the question becomes: How do the securities laws apply to the forward sale of such tokens by the holder of a SAFT to a third-party buyer? We may assume that the SAFT holder is on-selling “restricted securities” — i.e., securities that were acquired in a transaction or chain of transactions not involving a public offering.
Conventional analysis would proceed as follows: Under the Securities Act, every offer and sale of a security requires registration with the SEC unless a valid exemption from registration is available. Section 4(a)(1) exempts transactions “by a person other than an issuer, underwriter, or dealer.” A person is an “underwriter” under section 2(a)(11) of the Securities Act if they acquire securities with a view to “distribution” or are participating in a “distribution,” which, as a practical matter, can be understood to mean an offering that is not a private offering. A securities holder who wishes to resell them privately under section 4(a)(1), therefore, must sell in a transaction that is sufficiently “private” to avoid being considered an underwriter. The SEC and securities lawyers have come to accept a practice of imposing various restrictions on sale as permitting a resale to be eligible under section 4(a)(1). This practice is referred to as “Section 4(1-1/2).” Alternatively, a safe harbor from “underwriter” status is provided by rule 144 for public resales by holders of securities who have held securities for a minimum holding period and meet certain other requirements. Analyzed this way, a secondary forward contract would simply need to comply with the well-developed private resale restrictions under Section 4(1-1/2). ).
An interesting question is whether sellers offer to sell and deliver those particular tokens, which they will receive upon settlement of the SAFT or, instead, offer generic tokens of the same class for sale. If the sellers were able to sell the tokens they received in settlement of the SAFT during a valid public sale at or around the time of settlement of the forward contract and use the proceeds to purchase new “clean” tokens — i.e., a “double print” — to be delivered under the forward contract, then arguably the seller is not offering restricted securities under the forward contract.
A potential and significant roadblock, however, is the legal analysis applied by the Southern District of New York in the Telegram case. The court found that the initial placements of the SAFTs were not valid private placements and that the investors in those SAFTs were statutory underwriters with respect to the sale of the underlying tokens to the ultimate buyers once the token generation event occurs. This raises the question of whether the status of such investors as underwriters would also apply to such investors acquiring tokens through secondary forward contracts prior to the token generation event. If so, resales by such investors that are not registered under the Securities Act might be subject to SEC enforcement actions or eventual claims for rescission by disappointed buyers under section 12(a)(1) of the Securities Act.
The court’s interpretation may also create additional pitfalls for the unwary secondary forward contract participant. For example, rule 101 of Regulation M prohibits underwriters, among others, from bidding for, purchasing, or attempting to induce any other person to bid for or purchase a covered security for a specified period of time. Under the court’s interpretation, investors reselling tokens received in settlement of the SAFT as underwriters would be required to comply with the requirements of rule 101 of Regulation M. Such investors would also need to consider whether their resale activity constitutes “broker” activity as defined in section 3(4) of the Securities and Exchange Act of 1934. Non-compliance with Regulation M and the broker registration requirements of the Exchange Act is punishable by both fine and sanction.
Tokens as commodities
Assuming the underlying tokens acquired through secondary forward contracts are “commodities” within the meaning of the Commodities Exchange Act, then the Commodity Futures Trading Commission may have regulatory authority over secondary forward contracts, depending on whether the contract falls within the CFTC’s existing transactional jurisdictional buckets.
Since its enforcement action against CoinFlip in September 2015, the CFTC has consistently taken the position in other enforcement actions, interpretive guidance and public statements that virtual currencies are “commodities,” as that term is defined in the CEA. The CFTC addressed the scope of the term “virtual currency” in its March 2020 Final Interpretive Guidance on Retail Commodity Transactions Involving Certain Digital Assets. There, the CFTC declined to create a bright-line definition but instead adopted a broad interpretation:
“Virtual or digital currency: Encompasses any digital representation of value that functions as a medium of exchange, and any other digital unit of account that is used as a form of a currency (i.e., transferred from one party to another as a medium of exchange); may be manifested through units, tokens, or coins, among other things; and may be distributed by way of digital ‘smart contracts,’ among other structures.”
Assuming counsel concludes that the tokens underlying a secondary forward contract are “commodities,” then how should the secondary forward contract be analyzed under the CEA? As a first principle, the CFTC’s regulatory jurisdiction is limited to certain transactional buckets.
Generally, these buckets include futures contracts, options on futures contracts and swaps, although the CFTC does have limited anti-fraud and anti-manipulation authority over spot contracts on commodities. One would like to think that a forward sale of tokens should be no different from any commercial sale of a commodity — for example, a manufacturer of a sweet beverage buying corn syrup where the delivery is delayed for some period of time.
Surely, these are not regulated by the CFTC. However, the analysis is much more nuanced. Such commercial forward contracts are unregulated only by virtue of specific, limited exclusions under the CEA.
Under these exclusions, a forward contract is a commercial merchandizing contract between commercial parties contemplating deferred delivery of a non-financial commodity (such as an agricultural, energy or metals commodity) where delivery routinely occurs. These types of forward contracts are explicitly excluded from regulation as futures contracts. In addition, forward contracts on “non-financial commodities” (and on securities) are excluded from the definition of “swap” so long as the parties intend to physically settle the transactions. Thus, there are at least two possible reasons that the tokens underlying a secondary forward contract might not benefit from these exclusions: (1) they may be considered financial commodities and (2) investors or speculators may not be considered commercial merchants. Without an exclusion, a secondary forward contract would likely be deemed a “swap” by the CFTC.
The most immediate consequence of this determination is that swaps may only be entered into between eligible contract participants, or ECPs. For individuals, this means having at least $10 million of gross assets invested on a discretionary basis or $5 million if the swap is to hedge an existing position. A swap entered into by parties who are not ECPs would be in violation of the CEA and CFTC regulation, and both parties could face penalties and sanctions. In addition, swaps are subject to certain reporting requirements. Thus, if secondary forward contracts are swaps, the number of potential qualified counterparties for such transactions may be limited.
Tokens as “something else”
The lines between different types of digital assets can be complex and confusing. Industry commentators have pointed out technical distinctions between tokens, coins, digital currencies and virtual currencies. Some commentators have argued that certain tokens may be “utility tokens” with the implication that they are neither securities nor commodities. While it is possible that some tokens underlying SAFTs may fall between the jurisdictional cracks of the SEC and CFTC and, therefore, not be subject to any federal regulatory scrutiny, this appears highly unlikely.
The views, thoughts and opinions expressed here are the authors alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
This article was co-authored by Daniel Budofsky, Laura Watts, Riaz A. Karamali, Cassie Lentchner, James Chudy and Ryan Brewer.