By Scott R. Chichester CPA
President of Madison Park Advisors Corp
The name comes from the acronym RAWSPD* “Reg A with Simultaneous Property Dividend”.
The Current State of Affairs: During the past year, financial services firms have been assessing the disruption caused by cryptocurrencies and the phenomena of “Initial Coin Offerings” (ICOs). With Spain and Russia having announced the development of their own cryptocurrencies and Japan contemplating a similar initiative, it is clear that cryptocurrencies are here to stay.
The question is how to regulate cryptocurrencies? Different U.S. regulators treat cryptocurrencies differently. The U.S. Securities and Exchange Commission (SEC) says that “some” cryptocurrencies are securities, the IRS says that they are property subject to capital gains treatment on resale and the CFTC has called them “exempt currencies”.
Not surprisingly, the investment community sees ICOs or the distribution of “tokens” as a completely new way to raise capital. But, the regulatory uncertainty concerning ICOs leads to great confusion for entrepreneurial companies seeking capital by means of an ICO.
This whitepaper presents a simple means for operating companies to use current laws, rules and regulations to raise capital and distribute a cryptocurrency.
The Basic Premise: The simplicity of the structure is as follows:
- Previous to the registration, the Company creates its cryptocurrency tokens.
- The Company declares a dividend distributing the token, pro rata, to shareholders as of a future record date.
- The Company files a Regulation A offering of stock via filing of Form 1/A.
This is a path. It is not the only path. However, the Raw Spud has many merits.
MERITS TO THE ISSUER
- Risk mitigation. One benefit of the Raw Spud is that rather than bypass the SEC’s review and consideration, the registration process calls for full disclosure and a dialogue with the SEC. The purpose of the SEC review and comment period on registration statements is full disclosure for the investor. The SEC is NOT legally blessing anything and reserves every right to prosecute after any registration, however, as mentioned earlier, in practice, it should enable (i) a dialogue with the SEC about the cryptocurrency token, (ii) the SEC to ask questions, and (iii) the SEC to require disclosures that will keep potential stockholders adequately informed. To date, most ICOs have been direct token offerings and have bypassed the SEC altogether.
Risk beyond the regulators. There is not only risk from the SEC, but I have also noticed that there are lawyers who are now trying to create class action civil lawsuits for those who have lost money investing in ICOs. Honest and robust disclosure, as in a Reg A filing with the SEC, would mitigate the risk of these type of lawsuits
- Access to Hedge Funds Quite a number of hedge funds require investments only in a public company. Companies that file Form 1/A are eligible for a Form 15c-211 application to obtain a ticker symbol for their stock which will be publicly traded. This opens up the issuer to a whole new cadre of institutional investors.
- Tax benefits to the issuer. The IRS has been clear and unequivocal: cryptocurrencies are property that are subject to taxation on any gain on resale. In the case of a new cryptocurrency, the cost basis would be near zero. The issuer would only be able to apply the legal and development costs to the cost basis. Thus, in a direct token offering, nearly all the capital raised would be subject to taxation at the combined federal and state corporate tax rate of approximately 25%. Thus, on a $20 million raise, we are talking about nearly $5 million off the top in tax liability.
Utilizing the Raw Spud, the sale of common stock and the issuance of the property dividend are not taxable events for the issuer. This can make a massive difference in the capital raised.
Note: Tax issue for the stock purchaser. One tax implication of the Raw Spud, is that the purchaser of the stock will have to pay tax on the market value of the property dividend received. However, this tax can be mitigated. For one, upon issuance of the dividend the market value may not be totally clear yet. Additionally, the stock purchaser may be eligible for a Discount for Lack of Marketability (DLOM) which would further mitigate the market value the stock purchaser assigns to the dividend.
MERITS TO THE PURCHASER
- Full Disclosure. Primarily, the investor gets full disclosure. The details and metrics of the cryptocurrency are known. Additionally, since the securities law requires significant disclosures about the owners of the stock, the existing laws would exclude bad actors.
- Immediate liquidity. Since Reg A stock is free trading, the purchaser gets immediate liquidity.
- Stock and Asset. The purchaser obtains free trading stock with knowledge that it includes a future distribution of property.
MERITS FOR THE SEC
- An acknowledgment of what the SEC is up against:
With cryptocurrencies less than 10 years old and just becoming mainstream in the last 2 years, the capital raising space has been massively disrupted. It is my opinion that the investment community must be honest with itself and acknowledge that the sharks and scamsters are circling. So, the need for regulators to create guard rails is understandable and warranted. Use of the Raw Spud acknowledges this fact. By declaring the cryptocurrency dividend prior to the Regulation A registration, it binds the registrant to securities law and full disclosure about not only the Company itself, but also the details about the cryptocurrency and the proposed dividend. Since the SEC Form 1/A requires an SEC review and comment period, the SEC now is given the opportunity to ask more about the cryptocurrency and proposed dividend. Thus, while the issuer is not conceding that the cryptocurrency is a security, via the dividend declaration prior to registration, it has put the cryptocurrency within the purview of the SEC and gives the SEC the ability to improve the disclosure that will be provided to investors regarding this offering by the registrant (including information about the cryptocurrency dividend).
So, what does this effectively do?
- For one, any previous bad actors would not be allowed to be promoters.
- Insiders would be known. Any officers, directors, or more than 5% stockholders would have to be disclosed.
- Those receiving the dividend would also be stockholders so would have full stockholders’ rights as written in statute and tried in the courts over many years.
- As a result of the SEC staff’s review and comment on the registration statement, investors should get full disclosure about the Company and the property dividend.
- A real win for the Jobs Act
The most significant change to the JOBS Act was the change to Regulation A effective June 19, 2015. The revised regulation made it easier for companies to raise capital and changed the amount capable of being raised under Regulation A from $5 million to $50 million. This change has made a moderate impact to date. The SEC reports that in the first 16 months since its effective date, 81 issuers had been qualified under Regulation A. Compare that to over 1,350 new cryptocurrencies in the last several years – and it is plain that Reg A is being underutilized. If the market embraces the Raw Spud, it could turn Reg A and the JOBS Act into a home run for the SEC.
Indeed, it is no secret that 2017 ICO activity has surpassed traditional venture capital. Through November, the ICO market had raised $3.6 billion in year-to-date capital. Much of this was done outside the United States. The purpose of the JOBS act was literally “Jump Start Our Business Start-ups”. Well, here is the opportunity to energize the U.S. capital markets. If the investment community, and the SEC alike, can embrace Reg A, it could completely revolutionize not only the ability of smaller enterprises to raise capital, but will completely revitalize the near non-existent small or regional broker-dealer market.
A COMPARISON OF THE THREE MAJOR WAYS TO DISTRIBUTE A TOKEN
|Raw Spud||Direct Token Offering||SAFT|
|Can sell to a large amount of non-accredited investors?||
|Company can sell direct to purchasers without broker-dealer?||
|Proceeds of sale taxable in the U.S.?||No||Yes||Yes|
|Purchasers can use Bitcoin and Ether to make the purchase?||Yes||Yes||Yes|
|Is stock free-trading?||Yes||n/a||No|
As can be seen above, the Raw Spud has many of the same benefits of a direct token offering and has a far superior reach than the SAFT, The SAFT cannot be offered to a broad range of non-accredited investors. Additionally, of the 3 paths to distributing a token, only the Raw Spud will be free trading upon issuance.
The Nevada Factor:
One detail of the Raw Spud is that the dividend must be issued from a Nevada Corporation. The reason for this lies in Nevada Corporate law. Most states only allow the declaration of a dividend if it is done out of “Earnings and Surplus” or positive retained earnings. Not so with Nevada law. The exact Nevada Statute is (NRS 78.288). It reads, in part, as follows:
NRS 78.288 Distributions to stockholders.
1. Except as otherwise provided in subsection 2 and the articles of incorporation, a board of directors may authorize and the corporation may make distributions to its stockholders, including distributions on shares that are partially paid.
2. No distribution may be made if, after giving it effect:
(a) The corporation would not be able to pay its debts as they become due in the usual course of business; or
(b) Except as otherwise specifically allowed by the articles of incorporation, the corporation’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the corporation were to be dissolved at the time of distribution, to satisfy the preferential rights upon dissolution of stockholders whose preferential rights are superior to those receiving the distribution.
3. The board of directors may base a determination that a distribution is not prohibited pursuant to subsection 2 on:
(a) Financial statements prepared on the basis of accounting practices that are reasonable in the circumstances;
(b) A fair valuation, including, but not limited to, unrealized appreciation and depreciation; or
(c) Any other method that is reasonable in the circumstances.
As you can see Nevada gives the board of directors broad discretion in issuing a dividend which is far different from most states.
ADDRESSING FEDERAL SECURITIES LAW
Howey Test. The ICO market has brought The Howey Test to the forefront of the discussion. The Howey case famously laid out the 4 factors for something to be declared an “investment contract” and therefore “a security”. Believe it or not, I am leaving the “security” or “not security” issue alone here. After researching it ad nauseum, it is clear that the consensus amongst the legal community is “it’s a facts and circumstances” situation. Each set of facts and circumstances is likely to be different
THE BEAUTY OF THE RAW SPUD IS THAT IT WILL MAKE THE RAGING DEBATE ABOUT WHETHER A TOKEN IS A “SECURITY” OR “NOT A SECURITY” AN IRRELEVANT POINT. THE REASON FOR THIS IS BASED ON CERTAIN SEC GUIDANCE, WHICH POINTS TO THE FACT THAT A DIVIDEND WOULD BE EXEMPT FROM REGISTRATION, EVEN IF THAT DIVIDEND WERE DEEMED TO BE A SECURITY.
Indeed, the guidance found in the following SEC references, supports this legal position:
- SEC Release 33-929
- CDI 103.01 (text below)
Consider Q&A 103.01 of the CDI, addressing Securities Act Section 2(a)(3) to illustrate this proposition, which states:
“Question: If a company declares a dividend that is payable in either cash or securities at the election of the recipients, does the declaration of the dividend need to be registered under the Securities Act?
Answer: No, as there is no sale of the dividend shares under the Securities Act. [Nov. 26, 2008]
The “Raw Spud” is the first path to token distribution that actually allows the SEC to become part of the discussion during the process – instead of after the fact. The SEC will always want to stop the public from being scammed or abused. But what if the issuer is:
1. a company in earnest
- has done serious due diligence regarding the dividend and has a legal opinion stating that it is exempt from registration whether deemed a security or not
- willing to have an open dialogue about the details of the cryptocurrency
- diligent in its disclosure about both the company and the pending dividend?
I still believe the SEC and the investment community can meet in the middle to establish an orderly way to both take advantage of this new and exciting facet of the capital markets and adequately protect investors.
*RAWSPD AND RAW SPUD are service marks owned by Scott Chichester and Madison Park Advisors Corp