Clarifying Reg S Category 3 and US Flowback

It's not as simple as "sell offshore and wait 1 year"

In what I hope to be a rare departure, I will rehash some prior content for a quick PSA motivated partially by the fact that yesterday I met with the third new client in a week that held the same mistaken belief around offshore tokens flowing back into the US after 1 year. To be clear: tokens sold pursuant a Reg S category 3 offering (i.e. tokens distributed by domestic issuers and US-controlled offshore issuers) are not always free to flow back into the US after 1 year.

The Problem

• Category 3 prohibits offers or sales of an equity security to US persons made “prior to the expiration of a one-year distribution compliance period.” “Distribution compliance period” is defined as “a period that begins when the securities were first offered to persons other than distributors in reliance upon this Regulation S or the date of closing of the offering, whichever is later.”  In other words, the one-year distribution compliance period for tokens does not begin until the “closing of the offering.” 
• To the extent a network issues tokens as a consensus/engagement reward, and/or operates subject to an inflationary model, then the offering continues and is not “closed.”  Accordingly, the vast majority of permissionless token offerings (where tokens are prudentially presumed to be securities) are likely to qualify as continuous offerings for purposes of Reg S compliance. The result is that the Reg S distribution compliance period is likely to be deemed indefinite (a la the SEC’s allegations that Ripple’s XRP offering was continuous from 2013-present).
• Reinforcing the above position, CEX partners, market makers, and liquidity providers are all likely to be deemed distribution participants of the issuer under Rule 902(d) which broadly defines “distributor” as “any… person who participates, pursuant to a contractual arrangement, in the distribution of the securities offered or sold in reliance on this Regulation S.” Rule 902(f)(1) provides: “All offers and sales by a distributor of an unsold allotment or subscription shall be deemed to be made during the distribution compliance period.”
• Tokens sold via an offshore CEX pursuant to a listing or exchange partnership agreement, which subsequently remix back through the CEX (whether through an omnibus account or an issuer/market maker account) and are then redistributed in a secondary sale by the CEX may be factually indistinguishable from primary sales due to token fungibility/traceability issues.
• Moreover, all category 3 tokens which secondarily resell via the offshore CEX (i.e. even where a CEX/issuer/market maker wallet is not involved) may be deemed to be an offer by a distributor (the CEX) “during the distribution compliance period” irrespective of how long a token was originally held prior to resale, due to the offering being continuous.
• The result is that tokens sold via offshore CEXs, under the above facts, may continue to be subject to US flowback restrictions, even where an original (or secondary) purchaser held the token for more than one year.
• Even more problematic, from a practical perspective:
  • Reg S category 3 requires:
    • that all primary purchasers certify they are not US persons. Many CEXs will not agree to this requirement, even though they IP block the US; and
    • that all primary purchasers certify that they will not resell purchased tokens except in compliance with Reg S, a US registration or an exemption from US registration. Most offshore CEXs will not agree to dictate user conduct post-purchase, especially where US securities laws are at issue.
  • Any category 3 offering lacking these certifications is non-compliant with Reg S ab initio, irrespective of how long a purchaser ultimately holds the token prior to reselling.

Potential Solutions

This is not to say that category 3 sales via CEXs are impossible. They can be compliantly designed, but it is not as simple as “sell offshore and wait a year.”

One alternative that offers issuers greater control over category 3 compliance involves the avoidance of exchange partners instead effecting direct distributions to offshore holders (whether though airdrops or direct sales). In such a scenario, the issuer would be able to directly subject the purchase or claiming of a token to the requisite non-US person and US resale restrictions and (ideally) subject tokens to a programmatic 1-year lock, after which point the tokens would be freely tradeable offshore via Reg S or onshore via Rule 144 (assuming the holder is not an issuer-affiliate).

Beware 12(g)

Ultimately, unless it becomes crystal clear in the US that secondary sales of crypto assets are not investment contracts, issuers in category 3 offerings should generally restrict US resales, even where otherwise permitted by Rule 144. Per Section 12(g) of the Exchange Act, tokens deemed to be securities may be subject to registration with the SEC where held by as few as 300 US residents (see my 12g post for more info).