Note that an excerpt of this article was published by Law360 here (subscription required)
On July 10, 2019, the SEC qualified the first offering of digital securities issued pursuant to Regulation A (Tier 2) under the Securities Act of 1933 (the “Securities Act”). Blockstack PBC, which is a blockchain-based company developing a decentralized internet system that supports applications, is seeking to raise up to $28,000,000 through the sale of Stacks tokens. This approval has been a long time coming: it reportedly took 10 months and $2 million in expenses for Blockstack to design an offering that the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) was comfortable certifying. More broadly, though, this represents a landmark for:
Regulation A (typically referred to as “Reg A+”) Tier 2, which has not disrupted the capital markets as it was expected to do when it was passed as part of the JOBS Act in 2012;
The crypto community, which raised billions of dollars from the public in ICOs before the regulatory crackdown by the SEC and other agencies, and now appears to have a compliant model for public capital raising without using a traditional IPO;
The SEC, which has faced constant pressure over the past year to approve a Reg A+ token offering in the wake of its insistence that nearly all, if not all, of the tokens being sold in ICOs were unregistered securities.
Now that the community can see what an SEC-qualified Form 1-A looks like, Reg A+ token offerings could seek to emulate the success of the unregistered ICO market of 2017, although at much lower levels than the heights of the ICO boom: Tier 2 offerings are capped at $50 million, while ICOs made hundreds of millions or even billions of dollars at times. For now, we examine the Blockstack offering and see how the company answered or otherwise dealt with the thorny questions that slowed down the approval for this offering.
What do the economics of the Blockstack offering look like?
Blockstack is seeking to raise up to $28 million in a cash offering of Stacks tokens. It is also offering Stacks for non-cash consideration through its “App Mining” program, valued for purposed of the offering at $12 million. The App Mining program is designed to grow the Blockstack network by rewarding the development of well-reviewed decentralized applications that run on the network.
Blockstack is selling Stacks for $0.30 per token with a few exceptions. Certain individuals who participated in earlier private offerings received vouchers which can be redeemed in this offering at a token price of $0.12. Voucher holders who pre-registered early can purchase tokens at a discounted price of $.12. Also, foreign individuals can purchase Stacks at a discounted price of $0.25 per token in a concurrent Regulation S offering, reflecting the fact that the Reg S Stacks offered are “restricted securities” subject to a one-year transfer lock. The transfer lock is embedded into the code of the smart contract by which the tokens are sold outside the U.S. to prevent transfer of the tokens for one year after delivery.
App Mining Program Notes
The App Mining program will distribute Stacks on a schedule after closing under Securities Act Rule 251(d)(3), which permits continuous or delayed offerings of securities under Reg A+ under certain circumstances. The program requires participants to subscribe to the offering and comply with KYC/AML requirements in order to receive token awards.
Additionally, the Stacks bought during the 60-day cash offering period will be delivered via a hard fork on the Blockstack network at the conclusion of the offering, which we discuss more below. However, the Stacks to be released through the App Mining program will be distributed pursuant to a multi-year schedule to reward app developers as they launch popular new apps on the network. Because of the delay, it is possible that the value of Stacks will greatly increase before all of these tokens are distributed. If enough Stacks are distributed through the App Mining program at a high enough valuation (i.e. well-above the current $0.30 valuation), it would be possible for Blockstack to distribute more than the $50 million in Stacks it can sell in its Reg A+ offering. Thus, Blockstack notes that it may have to cease distributions under the App Mining program if Stacks’ value becomes too high.
What do the mechanics of the offering look like?
Notwithstanding that Stacks are securities being sold to raise capital to fund the company, Blockstack has designed the tokens as “utility tokens,” that is, the only right associated with a Stacks token is the utility of currency on the Blockstack network. The tokens can be used burned as fuel to create a new digital asset or smart contract on the network; they can be used as currency to interact with or purchase goods or services from an app; and they may provide the right to participate in non-binding polling of network users. Stacks do not confer any equity, revenue, profit interest, or voting rights.
Hard Fork Implementation
The offering circular makes clear that the tokens will not simply be transferred via a Blockstack-directed blockchain transaction from the Blockstack wallet to investors’ wallets when the offering closes. Rather, the distribution requires a hard fork of the Blockstack network (which currently resides on the Bitcoin blockchain). A hard fork requires a critical mass of nodes on the network to accept the new protocol. The nodes are controlled by third parties. Thus, Blockstack does not actually control whether the tokens will be released. It therefore provides that investors will have the opportunity to revoke their purchase of Stacks if Blockstack “has determined in its reasonable discretion that it expects a significant number of nodes on the network not to adopt the hard fork at the cash offering closing.” Blockstack will file an offering circular supplement in compliance with Securities Act Rule 253(g)(2) (requiring amendments for substantive changes to the terms of an offering), file a Form 1-U, and post a notice on its website to notify investors of such a determination.
Although the nodes have an interest in accepting the hard fork – otherwise the network is likely to immediately become much less valuable – it is conceivable that some number of them may object to Blockstack registering Stacks as securities, which is antithetical to the widely-held position of the crypto community in the last several years. This level of third-party control over the success of a security offering is unique, reflecting the new dynamics that may start to be seen in regulated token offerings.
Unsurprising for a token offering, Blockstack is accepting U.S. dollars, as well as Bitcoin and Ether, which are often the preferred currency for individuals who invest in tokens. Recognizing the differences in accepting, handling, and custodying digital currency, Blockstack is employing separate escrow agents for cash and cryptocurrency payments. This recognition of the unique nature of cryptocurrencies requiring special care certainly would have been insisted on by the Commission. This approach is likely focused on assuring investors that their tokens will be protected if the hard fork is not approved.
At the same time, accepting cryptocurrency payments over a 60-day period, using an escrow account, and potentially returning those funds if the transaction is not consummated, can present significant risks for both investor and issuer given the volatility of cryptocurrencies. To deal with these risks, it is reasonable to assume that Blockstack and the Commission staff heavily negotiated and decided on the following approach:
Blockstack will use a third-party website, www.bitcoinaverage.com, to determine the exchange value of payments in Bitcoin and Ether. Presumably the Commission staff is satisfied of the reliability of the website.
The exchange rate is updated every three hours, which appears designed to be frequent enough to capture major price fluctuations, but not so frequent as to impinge on the offering.
In the event a cryptocurrency purchase is revoked or otherwise refunded, the refund will be paid in the same currency and same amount as originally paid in (e.g. 2 Ether for 2 Ether). This means investors are taking the risk that their crypto payment is worth less at the time of refund than at the time of subscription, and the issuer is taking the counter-risk that the crypto refund payment would be more valuable than the crypto paid at the time of subscription.
One issue not accounted for in the offering circular is ensuring compliance with the maximum value of the offering given the volatility of Bitcoin and Ether. The relevant question is when will Blockstack (or the SEC) value the currency received in exchange for Stacks. The use of bitcoinaverage.com to value purchases presumably means that Blockstack is valuing its Stacks sales at the time of purchase. But between the time of purchase (say, Day 1 of the offering) and closing (approximately 60 days later), Bitcoin and Ether payments could rise in value dramatically. That would mean Blockstack could receive greater than $40 million in value at closing even if it takes in less than $40 million during the offering. It is unclear whether Blockstack or the SEC staff have considered this possibility or how to guard against it.
The Stacks will be freely tradeable once purchased and unlocked (per the scheduled unlocking discussed below). However, Blockstack makes clear that Stacks will not be listed on any exchange, and it is unaware of any exchange or ATS that has been properly registered for a Stacks listing.
After the tokens are unlocked, there does not appear to be any limitation on peer-to-peer transfers of Stacks. In the FAQ on its website the company says: “It may be possible to sell or transfer Stacks directly to another person in a peer-to-peer transaction,” but it then recommends consulting with an attorney before doing so. Certainly, tax and securities laws issues would need to be considered before any peer-to-peer sale was consummated.
In an express effort to impede speculation (and likely satisfy the Commission), Blockstack is locking its tokens using smart contracts in two different ways. There is a time lock on the Stacks sold in the U.S., during which time the tokens cannot be burned, transferred, or even used on the network. Blockstack explains that the time lock is designed to prevent speculation. However, while a sale prohibition would target speculation, it is hard to see how preventing purchasers from recognizing the utility of the tokens on the Blockstack network as intended targets speculation. Perhaps the Commission was concerned that unscrupulous investors could speculate indirectly with yet-to-be developed applications.
In any event, Blockstack intends for the Stacks to unlock over an almost two-year period at a rate of 1/24th of each investors’ holdings per month. The actual schedule will be determined by the rate at which blocks are processed on the Blockstack blockchain (which is Bitcoin for now, but a native blockchain is under development), meaning the unlocking could be faster or slower. Again, as with the hard fork acceptance by network nodes (which impacts whether the tokens can be delivered), the rate of unlocking is also out of Blockstack’s control.
The second lock is the transfer lock applied to foreign sales under Regulation S because those Stacks are “restricted securities.” Those securities cannot be transferred for one year after sale because the transfer lock prevents the tokens from being recorded on the network during that one year. The smart contract will then automatically unlock the tokens at the one-year mark.
Although small subscriptions can be completed through the Blockstack website, bulk purchases of more than $200,000 in Stacks requires direct contact with Blockstack. The Commission may have wanted additional comfort that Blockstack knew the identities of large purchasers to further protect smaller investors from potential speculation and bad actors. Blockstack explains that it reserves the right to only partially accept large orders to ensure sufficient decentralization of the network. Although that approach may lead to the company selling fewer Stacks than reflected by demand (and thereby making less money in the offering), it makes sense given Blockstack’s mission is creating a decentralized network and internet.
Blockstack Believes Stacks Will Eventually Not Be Securities
In the early days of cryptocurrencies, the community generally treated all digital assets as something other than securities. As token issuers began raising significant capital in 2016 and 2017, the SEC issued a series of formal and informal guidance and brought numerous enforcement actions to make clear its belief that tokens issued in ICOs likely were securities. Although many in the crypto community have acquiesced to the SEC’s position (at least as a means of avoiding regulatory scrutiny) and comply with the securities laws when issuing a new token, the question of whether such tokens are, in fact, securities continues to rage. This tension of playing by the SEC’s rulebook, while questioning the SEC’s legal position is highlighted by Blockstack’s circular: Blockstack devotes an entire section of its circular to addressing the question of whether Stacks must continue to be a security simply because Blockstack chose to treat them as securities for purposes of this offering.
Having to treat Stacks as securities when the Blockstack network is functional (i.e. it has operating decentralized applications, or Dapps, that will accept Stacks) raises some serious questions about the ramifications of using a security as a utility token:
If a token holder uses a token to access applications or services on the blockchain while the token is still a security, is the token holder selling a security?
Can a recipient of Stacks through a Dapp do anything with it? Can it re-sell the token without worrying about securities registration?
If an application provider advertises that it accepts Stacks, is it soliciting purchases of securities?
If an application provider pays third parties in the security token, as well as solicits purchases, is the application provider a securities dealer?
The answers to these thorny questions become moot if Stacks is not a security. Thus, Blockstack asserts that it will engage in an ongoing determination of whether Stacks tokens are securities:
At the present time, based on the guidance cited above, we expect this determination to turn on whether the Blockstack network is sufficiently decentralized; this will, in turn, depend on whether purchasers of Stacks Tokens reasonably expect Blockstack to carry out essential managerial or entrepreneurial efforts, and whether Blockstack retains a degree of power over the governance of the network such that its material non-public information may be of special relevance to the future of the Blockstack network, as compared to other network participants. Under current guidance, Blockstack would expect to take the position that if the answers to these questions are that purchasers do not have that expectation, and Blockstack does not have that power, the Stacks Tokens will no longer constitute a security.
Even amid an offering that is registered with the SEC Blockstack declares that it may unilaterally decide at some point in the future that Stacks are no longer securities. The offering circular states that if Blockstack makes such a determination, it will make a public announcement at least six months before taking any action. Left unanswered is what action Blockstack plans to take, or what action it may be required to take under the securities laws.
And this is not a purely speculative pronouncement or mere reservation of rights. Blockstack states that it anticipates this transformation from security to non-security occurring within a year of launching the Blockstack blockchain with its own, independent miners.
Alternatively, Blockstack discusses the possibility that Stacks transforms from a Blockstack-issued security to “a new security and new token which Blockstack has not issued, claims no responsibility over, and will not support with upgrades.” This transformation could occur if third party upgrades and hard forks gain traction without Blockstack approval, creating “a new network different than the one described in this offering circular.” This possibility raises more questions than it answers. Who would be considered the issuer of this new security? Would anyone have any reporting obligations? Is it permissible for these unnamed “third parties” to convert Stacks into a new security without Blockstack’s or holders’ permission? What rights would the Stacks holders have with respect to this new security?
It is certainly notable that this possibility was raised in a qualified Reg A circular. As far as we know, it is possible that the SEC, not Blockstack, wanted this possibility to be disclosed to the public. It is also possible that the SEC did not object to its disclosure.
Interesting Risk Factors Unique to a Token Offering?
Risk factors are an important part of any offering disclosure. The first Reg A token offering, open to non-accredited investors, would naturally require robust risk disclosures, including those unique to digital assets and blockchain generally. And although we can’t know for certain which risk factors originated with the SEC staff and which originated with Blockstack, it’s likely that at least some of these risk factors were Commission staff-directed.
Blockstack described the following risk factors relating to Stacks:
It may have been difficult for a technology company to highlight this risk, but Blockstack notes a potential loss of tokens due to software bugs in the digital wallet software.
Irreversibility of transactions, which is a risk for any cryptocurrency;
Loss of control by Blockstack of the network given decentralization of the platform.
Untested use of Reg A rules and regulations with regard to cryptoassets;
Hard fork required for issuance of tokens may not achieve consensus;
Limited utility for the tokens at present;
Escrow risk- Blockstack notes that the company is risking a decrease in value of the cryptocurrency it accepts during the escrow period, which would result in it issuing tokens at an effective valuation higher than the consideration it receives. But it curiously does not note a similar escrow risk for investors. If the value of their cryptocurrencies increases during the escrow period, the investors will receive fewer tokens than the value of the cryptocurrencies they paid in as measured at closing.
Potential lack of access to financial institutions: as with the cannabis industry, this is a problem across the cryptocurrency industry. Most financial institutions are hesitant to bank or serve cryptocurrency companies.
Blockstack discussed these Risk Factors tied to blockchain technology generally:
Recognized hacking vulnerabilities;
Blockchain vulnerabilities and different kinds of attacks (e.g. 51% attacks);
Volatility of digital asset prices,
Planned migration from Bitcoin blockchain to future Blockstack native blockchain, including risks from Blockstack’s lack of control of the Bitcoin blockchain and risks from the migration;
Loss of tokens if investors do not maintain their private keys.
Which Questions did the SEC and Blockstack Leave Unanswered?
The circular is enormously helpful in answering many questions about how a Reg A token offering could be structured in an SEC-staff approved manner. And the SEC staff was certainly thorough in its approval process, given the time and effort involved in getting final approval. However, the parties chose to leave several important questions unanswered at this time. For each of these questions, Blockstack disclosed its position, but noted that the SEC could ultimately take a different position.
Mining: Blockstack notes that its mining activities will need to comply with laws governing securities, meaning the automatic distribution of Stacks as a reward for miners adding blocks to the blockchain should, in some form or fashion, recognize that Stacks are currently recognized as a security. Blockstack notes further that its Reg A+ offering is likely insufficient to cover the number of tokens necessary to reward miners going forward, which is to say additional Stacks may need to be created (and possibly registered) once the Reg A+ Stacks are all distributed.
Miners: Blockstack does not believe that broker-dealer laws should apply to miners but notes that a regulator may disagree.
Application of state regulations: Blockstack does not believe that the New York BitLicense applies to this offering. It is not going to seek a BitLicense. It is in talks with NYDFS regarding federal law preemption of the BitLicense requirement for a Reg A offering. But it notes that ultimately NYDFS could reject Blockstack’s position.
Future transformation to non-security: As discussed above, Blockstack believes that one day Stacks may transform from securities to non-securities. However, it notes that Stacks may then be regulated under a different regime (for example as a commodity or money services business).
Transfer agent: Blockstack does not believe that it or its miners need to register as a transfer agent, but a regulator may disagree.
Clearing agency: Blockstack does not believe that it or its miners need to register as a clearing agency, but a regulator may disagree.
Exchange: Blockstack does not intend to register the network as an exchange or ATS because each transaction will be individually negotiated and implemented. But it notes that a regulator may disagree.
Money Transmitter or MSB: Blockstack is not intending to register as a money transmitter or money services business, but it notes that a regulator may disagree.
“Reporting Company”: Blockstack states that it is not an Exchange Act “reporting company” under Reg A, even though it is not using a transfer agent as required for complying with Exchange Act Rule 12g5-1. Blockstack argues that the blockchain automatically performs the activities performed manually by a transfer agent. But the SEC may ultimately disagree.
Investment Company: Blockstack takes the position that it is not an investment company, even though it holds a large number of security tokens because it believes it is reasonable to treat the Stacks Tokens in its possession as non-securities for purposes of the Investment Company Act. This position rests on the argument that any returns Blockstack might receive based on those tokens would be based on its own efforts and not the efforts of others. As a result, the tokens would not be “investment contracts” and not securities. But a regulator may disagree with Blockstack’s position.
Regulation M: Blockstack argues that Reg M is not implicated by selling Stacks at the same time Stacks-holders are burning them for use on the network because burning is materially different than buying back. To use a token on the network (for example, to pay the fee to use an application) involves “burning” the token so that it cannot be spent again. The burning process involves “send[ing] them to a ‘blackhole’ address with independently verifiable mathematical proof that no one, including Blockstack, can access.” Blockstack believes that its verifiable lack of access to the tokens that are spent and burned inoculates it from Regulation M. But a regulator may disagree with this position.
These are major issues that, in many respects, go to core investor protections. The Reg A+ pre-approval process is certainly designed to answer such serious questions before an offering goes live, but there may simply be too many serious issues on which the SEC (and other regulators) have not yet taken a formal position that waiting for answers to all of them would render Reg A+ useless for now. This highlights the regulatory uncertainty that all token issuers (and others involved in token offerings) are living with right now. But what can investors expect with respect to resolution of these issues in the future? If the SEC ultimately disagrees with Blockstack’s positions on one or more of these issues, as Blockstack notes remains a possibility, would the SEC commence enforcement action against it? Will the SEC attempt to answer more of these questions before a similar Reg A+ offering gets pre-approved?
The Ball Keeps Rolling: YouNow’s Reg A+ Offering
The day after qualifying the Blockstack offering, the SEC qualified another Reg A+ token offering: YouNow’s issuance of the token Props. YouNow is not raising money with Props, but wanted to ensure that distributing its utility tokens to non-accredited investors would comply with the securities laws. Props were sold in an earlier offering pursuant to Simple Agreements for Future Tokens (so-called “SAFTs”) to accredited investors under Regulation D. The circular notes that the SAFT tokens began being distributed in March 2019 and are subject to a vesting schedule. As those tokens vest, they will enter the Props market and potentially drive the price down for the Reg A tokens. We note that, as with Stacks, there are thorny issues associated with using a security as a utility token.
Achieving regulatory certainty for the cryptocurrency industry will take time as regulators grasp the implications of new technology. The Blockstack and YouNow Reg A+ offerings provide additional clarity, at least for the requirements necessary for selling security tokens to non-accredited investors under Reg A+. But our analysis of Blockstack’s circular demonstrates that significant uncertainty remains. We imagine that many investors and issuers may have continuing uncertainty.
We believe a partial solution may exist in the SEC releasing Reg A+ guidance specific to digital tokens. Recall that in late 2017 and 2018, the SEC brought numerous enforcement actions against unregistered ICO issuers. If one digested all the settlement orders that arose from those actions, one could form a picture of the SEC’s approach to Section 5 claims against ICOs. But in an attempt to show progress, in November 2018 the SEC issued a “Path to Compliance” for unregistered ICO issuers attempting to comply with Section 5, tying together in one place its approach in many different enforcement actions.
Similarly, one could have gotten a picture of the SEC’s approach to analyzing digital assets under Howey by reviewing the DAO Report, In re Munchee, and the various formal and informal guidance released, and enforcement actions brought between 2017 and early 2019. Then in April 2019, the SEC released a “Framework for ‘Investment Contract’ Analysis of Digital Assets” to provide a plain English description of the application of Howey to digital assets that reflected those precedents.
Although reading the tea leaves of the Blockstack and YouNow circulars can offer a picture of the SEC’s position on Reg A+ compliance for digital tokens, perhaps a “Path to Compliance” for Reg A+ is likewise warranted. And if it answered some of the questions we highlight in this article, then we may start making real progress towards regulatory certainty.
 And set aside an additional $12M to reward Stacks miners. See generally https://blog.blockstack.org/blockstack-token-sale-sec-qualified/. Therefore, the total dollar amount of this Reg A+ offering was $40 million.
 Compare “Regulation A+ Offerings – A New Era at the SEC” (January 15, 2014; available here) with “Market Trends 2017/18: The Jobs Act” at 9 (“As of April 2018, the Regulation A+ initial public offering (IPO) financing structure is expanding (albeit slower than may have been anticipated)…”.
 Unless otherwise noted all facts are taken from Blockstack’s Form 1-A available at: https://stackstoken.com/static/offering-circular-20190711.pdf.
 It is curious (and unexplained) that Blockstack uses the term “Mining” in its app-incentive program, which has nothing to do with “mining” in blockchain parlance meaning the cryptographic process of adding blocks to the blockchain. The potential confusion is compounded because the “App Mining” program rewards app developers with Stacks and the network will likewise reward traditional blockchain miners on the Blockstack network when its blockchain is launched.
 Which would not be permitted per Rule 251(a). The App Mining Program will use the $.30 offering price as the token value for 3 months. Future variations in the price, based on sufficient market activity, will be recognized through an amendment to the circular filed with the SEC.
 Blockstack says that a hard fork is necessary because certain characteristics associated with Stacks tokens in the genesis block (which was created in November 2018) will not be compatible with the blockchain once the tokens are distributed. For example, the genesis block contained a Smart Contract for token distribution that was not in effect, but at closing, the Smart Contract will go into effect.
 As discussed later, large purchases of Stacks are required to be made directly with the company, which would likely negotiate directly with the purchaser on the exchange rate. This would limit the ability of an investor to try to arbitrage during the three-hour exchange rate-update window.
 Depending upon exchange fluctuations, at closing the value of offering proceeds could even exceed the $50 million maximum for a Tier 2 offering.
 The company does not address the possibility of an over-the-counter market developing for Stacks.
 It notes that its decision may involve some consultation with regulators, but that the decision is ultimately for the Blockstack board of directors to make.
 As noted above, the escrow risk associated with potentially receiving above the maximum value of the offering (in this case, $40 million) due to a rise in the value of Bitcoin and/or Ether, is not addressed in the circular.
 This Risk Factor probably should have been discussed as a Blockstack-specific risk factor.
 This issue has gotten a lot of attention. See, e.g., “Can Crypto Miners Be Considered Broker Dealers” (May 2, 2019) available at https://www.forbes.com/sites/nisaamoils/2019/05/02/can-crypto-miners-be-considered-broker-dealers/#41235dd740de.
 Alternatively, could the SEC decide that these unanswered questions pose a serious problem with the offering and issue an order suspending the exemption pursuant to Rule 258?
 Indeed, the Director of the SEC’s Division of Corporation Finance, William Hinman, addressed issues that potential Reg A+ token offering issuers consider. Even turning his speech into more formal guidance could be helpful.