Much of the discussion concerning offerings of crypto assets to date has concentrated on whether the offered assets are “securities” and therefore subject to the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). Let us assume that an offering does involve the offer and sale of securities. If so, the offering may be covered by Securities and Exchange Commission Regulation M. This article provides a brief introduction to the application of Regulation M to offerings of crypto asset securities (frequently called “initial coin offerings”).
Regulation M is a set of anti-manipulation provisions that are designed to protect the integrity of the securities offering process. The regulation imposes significant constraints on the conduct of persons who are subject to its provisions. The essential feature of Regulation M is a prohibition directed at persons participating in a securities offering against bidding for, purchasing, or inducing others to bid for or purchase the security that is the subject of the offering during a defined “restricted period.”
Initially, it is important to note three key features of Regulation M:
- Its provisions must be considered irrespective of whether the offered securities must be registered under the Securities Act;
- A violation can be found even in the absence of proof that the relevant activities affected the market for the subject securities; and
- It is not necessary for the SEC to prove that the relevant activities were engaged in with manipulative intent.
The initial stages of funding a cryptocurrency venture frequently involve the offer and sale of securities in private placements, such as to “accredited investors” pursuant to exemptions from Securities Act registration. However, the applicability of Regulation M does not turn on registration, but whether the offering constitutes a “distribution” as defined in Rule 100 of Regulation M. That term is functionally defined as:
“an offering of securities … that is distinguished from ordinary trading transactions by the magnitude of the offering and the presence of special selling efforts and selling methods.”
Whether a distribution is present depends on the facts and circumstances of the particular case. However, the SEC has provided guidance on assessing whether the dual “distribution” criteria are present. Factors relevant to the magnitude element include the number of shares to be sold compared to the number of outstanding shares, the public float, and the trading volume of the security. “Special selling efforts and selling methods” can be indicated by providing greater than normal sales compensation arrangements, delivery of sales documents, such as prospectuses or market letters, and conducting “road shows.”
If an offering constitutes a distribution, the issuer (including selling security holders) and all “distribution participants,” together with their “affiliated purchasers” are subject to Regulation M unless an exception or exemption is available.
The restrictions of the regulation apply during a defined restricted period that generally commences one or five business days before the pricing of the distribution, and terminates when the selling effort for the distribution ends.
An Illustrative Case
The SEC’s proceeding against Bitcoin Investment Trust (BIT) illustrates the application of Regulation M to the crypto security offering context. BIT offered and sold shares through SecondMarket to accredited investors pursuant to Rule 506(c) under the Securities Act. The shares were sold on a continuous basis in exchange for the deposit of bitcoins at the net asset value per share based on the market value of bitcoin.
BIT and SecondMarket used “special selling efforts and methods” to market BIT shares, including: providing prospective investors with a multipage PowerPoint presentation that pitched investment in BIT; maintaining a Facebook account to post information on a publicly-available webpage; discussing BIT during various television appearances; providing prospective investors with a “BIT Fact Sheet” summarizing its historical performance and describing the advantages of investing in BIT; and posting tweets on Twitter with updated information about BIT and hyperlinks to news articles and other online sources.
Because the offers and sales of BIT shares was continuous, the Regulation M “restricted period” also was continuous.
While engaged in this distribution, BIT and SecondMarket allegedly violated Rules 101 and 102 of Regulation M by concurrently implementing a shareholder redemption program whereby BIT, through SecondMarket, accepted orders to redeem, and purchased, shares from BIT shareholders. The shareholder redemption program was intended to provide a measure of liquidity to BIT shares, which were not registered with the SEC and there was no public trading market for the shares.
Because BIT and SecondMarket participated in making offers to redeem shares and purchasing shares during the restricted period of the distribution, they were found to have violated Regulation M. The SEC order notes that BIT obtained legal advice prior to implementing the shareholder redemption program, and took that into account in imposing sanctions. BIT and SecondMarket were ordered to cease and desist from future violations of Regulation M, and SecondMarket was order to pay disgorgement of fees that it had received in connection with the shareholder redemption program.
The Bitcoin Trust case is a cautionary tale for issuers in the crypto securities market. Namely, issuers and persons marketing their securities must be mindful of Regulation M, even when offers and sales of securities are conducted on a private placement basis.
As the Bitcoin Trust case indicates, a lack of liquidity can be a problem in marketing securities. In some cases, the SEC Staff has provided relief from Regulation M to permit an issuer to provide a degree of liquidity during a distribution. For example, the Staff of the SEC’s Division of Trading and Markets has issued a series of exemptions for share redemption programs for non-listed real estate investment trusts (“REITs”). The relief is typically based upon certain conditions, i.e.:
- There is no trading market for the REIT's common stock;
- The REIT will terminate its share redemption program during the distribution of its common stock in the event that a secondary market for the REIT's common stock develops;
- The REIT purchases shares of its common stock under its share redemption program at a price that does not exceed the then current public offering price of its common stock; and
- The terms of the share redemption program will be fully disclosed in the REIT's Prospectus.
Analogous relief has been granted in other limited contexts. An issuer of crypto securities seeking to conduct a shareholder redemption or other liquidity program during a distribution generally will need to seek a similar exemption from the SEC unless an exception is available.
 See, e.g., Tashea, J., “Blockchain-based initial coin offerings are all the rage, but the legal terrain is uncertain,” ABA Journal, Vol. 104, no. 3, (March 2018), p. 56-62, available at http://www.abajournal.com/magazine/article/blockchain_initial_coin_offerings_legal.
 17 CFR 242.100-105.
 Because Regulation M addresses market activity other than the offer and sale of the securities being offered, it is sometimes assumed that the regulation does not apply to securities with no existing trading market, e.g., initial public offerings and, by extension, initial coin offerings. That is incorrect. Activity occurring during initial offerings of a security can trigger the regulation’s restrictions. See, e.g., SEC, “Commission guidance regarding prohibited conduct in connection with IPO allocations,” Securities Exchange Act Release No. 51500 (April 7, 2005), 70 FR 19672, https://www.gpo.gov/fdsys/pkg/FR-2005-04-13/pdf/05-7366.pdf; SEC, “Amendments to Regulation M: anti-manipulation rules concerning securities offerings,” Securities Exchange Act Release No. 50831 (December 9, 2004), 69 FR 75774, 75776-75777, https://www.gpo.gov/fdsys/pkg/FR-2004-12-17/pdf/04-27434.pdf; SEC, Division of Market Regulation, “Prohibited solicitations and ‘tie-in’ arrangements for aftermarket purchases,” Staff Legal Bulletin No. 10 (August 25, 2000), https://www.sec.gov/interps/legal/slbmr10.htm.
 The regulation applies to “securities,” which includes “investment contracts” falling within the definitions in Section 2(a)(1) of the Securities Act, 15 USC 77b(a)(1), and Section 3(a)(10) of the Exchange Act, 15 USC 78c(a)(10).
 See SEC, Division of Market Regulation, “Frequently asked questions about Regulation M,” Staff Legal Bulletin No. 9 (rev. September 10, 2010), available at https://www.sec.gov/interps/legal/mrslb9.htm (“Staff Legal Bulletin No. 9”):
“Q: Can a private placement of securities be a distribution under Regulation M?
A: Yes, if the offering satisfies the "magnitude" and "special selling efforts and selling methods" criteria of the definition of distribution.”
 See generally, “Review of antimanipulation regulation of securities offerings,” Securities Exchange Act Release No. 33924 (April 19, 1994), 59 FR 21681, 21684-21685 (“Concept Release”). See also Bitcoin Investment Trust, et al., Securities Exchange Act Release No. 78282 (July 11, 2016) (“Bitcoin Trust”), https://www.sec.gov/litigation/admin/2016/34-78282.pdf.
 See Bitcoin Trust at 5.
 These terms are defined in Rule 100 of Regulation M. Distribution participants and their affiliated purchasers are covered by Rule 101 of Regulation M, and the issuer and its affiliated purchasers are covered by Rule 102. See generally Staff Legal Bulletin No. 9, footnote 5 above.
 “Restricted period” and “business day” are defined in Rule 100 of Regulation M.
 See footnote 6 above. See also SEC, “SecondMarket, Inc. and Bitcoin Investment Trust (BIT) Settle Charges Relating to Unlawful Redemptions of BIT Shares during a Continuous Distribution,” https://www.sec.gov/litigation/admin/2016/34-78282-s.pdf.
 SecondMarket was registered as a broker-dealer with the SEC, and was the only entity that could place orders to create and redeem BIT shares. Bitcoin Trust at 2.
 Bitcoin Trust at 3. BIT’s sales also satisfied the “magnitude” element of the “distribution” definition.
 Bitcoin Trust at 6.
 Id. at 4, 6.
 Id. at 4.
 Id. at 6.
 Id. at 6-7.
 It may be noted, however, that Rules 101(b)(10) and 102(b)(7) except transactions in securities eligible for resale under Rule 144A(d)(3) under the Securities Act from the restrictions of Rules 101 and 102.
 See, e.g., SEC Staff No-action Letter, “Class Relief for Real Estate Investment Trust Share Redemption Programs; Regulation M Rule 102” (October 22, 2007), https://www.sec.gov/divisions/marketreg/mr-noaction/2007/reitsrpclassrelief102207-102.pdf.
 See, e.g., “Order Granting FS Investment Corporation II a Limited Exemption from Rule 102(a) of Regulation M pursuant to Rule 102(e),” Securities Exchange Act Release No. 67163 (June 7, 2012) [externally managed, non-diversified, closed-end management investment company; exemption has conditions similar to REIT exemptions], https://www.sec.gov/rules/exorders/2012/34-67163.pdf; “Order Granting Limited Exemptions from Rule 10b-17(b)(1)(v)(A) and (B) and Rules 101 and 102 of Regulation M to Xtrackers High Yield Corporate Bond – Interest Rate Hedged ETF Pursuant to Exchange Act Rule 10b-17(b)(2) and Rules 101(d) and 102(e) of Regulation M,” Securities Exchange Act Release No. 82760 (February 22, 2018), https://www.sec.gov/rules/exorders/2018/34-82760.pdf [registered open-end investment company; exemption based upon a variety of representations and conditions].
 See Rule 102(b) and (d). It is not known whether BIT attempted to emulate the REIT or other relief in implementing its shareholder redemption program.