The online document generator helps startups raise capital with customizable market standard terms and optional digital token provisions.
By David L. Concannon, Yvette D. Valdez, Stephen P. Wink, Miles P. Jennings, and Shaun Musuka
In collaboration with ConsenSys and OpenLaw, Latham & Watkins recently launched the Automated Convertible Note Generator, a complimentary tool designed to assist startups with capital raises. The Automated Convertible Note is a potential solution for capital formation that also addresses future token sales in a manner compliant with US securities and commodities regulations.
Token presale agreements, such as the Simple Agreement for Future Tokens (SAFT), have become a popular type of financing instrument among startups in the blockchain and cryptocurrency sector. Although these agreements aim to solve securities law issues applicable to pre-functional token sales, many iterations of these agreements may raise significant additional concerns under US securities and commodities laws. This blog post will summarize these concerns, while a more in-depth analysis of the pertinent regulatory issues and proposed solutions is available here.
US Securities Law Issues With Current Token Presale Agreements
Token presale agreements are regularly structured as securities offerings and marketed as investment opportunities, with the planned use of proceeds typically relating to the development of the issuer’s network or platform. This approach creates a strong correlation between the sale of the tokens and the development of the network, and may support a finding that federal securities laws should apply to the subsequent offer and sale of such tokens under the Howey test. In addition, the settlement of these instruments often contemplates token delivery at network launch, coinciding with the delivery of tokens for consumptive use. As a result, an issuer may face more difficulty in arguing that its token launch is not a securities offering. If any of an issuer’s tokens delivered pursuant to a token presale agreement are deemed to be securities, the token-based network may be rendered unusable.
US Commodities Law Issues With Current Token Presale Agreements
Given that cryptocurrencies are commodities, a presale of tokens through an instrument that provides the purchaser with a right to receive tokens in the future may be a forward contract for the sale of a commodity or a commodity option. If an exemption is unavailable, either scenario would make the presale subject to regulation as a “swap” by the Commodity Futures Trading Commission (CFTC).
Potential Solution: ConsenSys Automated Convertible Note
The Automated Convertible Note permits issuers to provide investors with a broader range of protections and to address investor demand for exposure to tokens, taking into account the applicable securities and commodities laws. To achieve these outcomes, the Automated Convertible Note:
- Gives noteholders certain voting rights with respect to the creation and distribution of tokens. Noteholders may also seek additional protections to prevent potential uses of the issuer’s token-based network that circumvent noteholders’ token-related economic and participation rights.
- Replaces conversion and exchange rights featured in other token presale instruments with appropriately limited rights to participate in the future token sale of the issuer (i.e., a Token Purchase Option) while providing for the more traditional economic rights of securityholders. This structural adjustment should assist in distinguishing the subsequent token distribution from the securities offering.
- Enables the noteholder, upon consummation of a token sale by the issuer, to elect for the convertible note to: (i) be repaid at a pre-negotiated multiple of the convertible note’s aggregate principal amount; (ii) remain outstanding or; (iii) be converted into preferred stock of the issuer.
- Delivers, from a commodities law perspective, an alternative to the traditional presale agreement structures that provide for (by way of option or fixed agreement) the future delivery of tokens (or conversion thereof) at a fixed price should a token sale occur. Parties are offered a right to purchase tokens at the best market price at the time of the sale (i.e., without a pre-agreement of the price). This purchase option is arguably not a swap, but rather a most favored nation clause, which does not carry the regulatory risk of a typical commodity option or commodity forward contract. While no regulatory certainty from the CFTC currently exists, the token purchase option may provide a clear path to navigating commodities law concerns in such instruments.
- Offers built-in protections for token purchasers who will also participate on the network as part of their business and who intend to benefit from an available CFTC exemption for trade options that relieves transacting parties from many of the regulatory requirements applicable to swaps.
- Provides investors with a more traditional security, meaning the various rights they purchase are less ambiguous and drafting appropriate disclosures regarding the material aspects of the investment is easier.
To access the complimentary online tool, please visit the ConsenSys website.
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