What is an Option?

Like warrants, options are a form of security called a derivative. As a derivative’s name suggests, these securities gain their value from an underlying asset. In the case of options, this is the underlying security

 

There are typically two primary forms of options; call options and put options. Both are governed by contracts; a call option allows the holder to buy securities at a set price while a put option allows them to sell. However, options contracts do not come for free. They can be bought for a premium, which is a non-refundable payment due upfront. Once options have been purchased, the holder has a certain amount of time during which they can exercise their options. On the other hand, options do not require the holder to purchase the shares contracts allow. When options are exercised, the price paid is referred to as the strike price.

 

In buying call options, the holder is guaranteed to buy securities at a certain price, even if the underlying security significantly increases in price. A put option works more like an insurance policy, protecting the holder’s portfolio from potential downturns. If a security was to decrease in price, the shareholder would be able to sell at a set price specified by their option contract, even if the market price was to fall lower than what the option allows it to be sold at.

 

In addition to being a way to minimize investment risks and maximize profits, options are becoming a popular incentive for employees, especially in startup companies when looking to attract employees. In addition to options that can be bought, options also refer to the ones issued to employees by their employer. This gives employees the chance, but not the obligation, to buy shares within a specified time. Employee stock options either come as an Incentive Stock Option or Nonqualified Stock Options, with the difference being the tax incentives that go along with exercising the options. 

 

Whether you have call or put options, they are a useful way to protect your portfolio from downsides or benefit from being able to purchase more shares at a discounted price. They are just one of the many forms of securities available, which should be considered carefully when making investment decisions.

 

What is TradeCheck?

Through RegA+, RegCF, and RegD, hundreds of companies across the country have been able to raise capital from both retail and accredited investors. The shares held by these investors are freely tradeable (after one year in the case of RegCF or RegD, however, buying and selling these securities requires compliance with a patchwork of regulations that can differ between different jurisdictions.

 

TradeCheck is a solution offered by KoreConX to ensure that state rules governing the resale of unlisted securities are met by providing clarity on state requirements for trading securities, automating compliance checks, and producing reports detailing transactions. TradeCheck is unique in its ability to provide transparency into transaction compliance, helping companies ensure a smooth and compliant trading process. 

 

TradeCheck can be used by all parties involved in a regulation process, including investors, issuers, and intermediaries. To use it, investors simply enter their email addresses into the platform and follow the prompts, where they will be asked to log in with their KoreID and password, and answer a security question before they can access their account. 

 

For issuers, the process begins with KoreConX walking them through the necessary state requirements, and providing a detailed report on which states transactions may be made in and for what time period. Alongside this, the inclusion of the issuer’s information in the Mergent “Securities Manuals” is also a part of this service. Ultimately, TradeCheck helps companies get clearance for all states and territories except California

 

The TradeCheck service also offers additional assurance to the investor or intermediary regarding the correctness of the disclosure available about the company, operating history, and financial statements. This is achieved by providing a third-party audit of the company’s documents to ensure that all the necessary regulations are met. The audit also helps in preventing any fraudulent activity which can result from incorrect disclosure or faulty financial information being provided to an investor. 

 

TradeCheck helps issuers and intermediaries comply with the regulations set by the broker-dealer operating their Alternative Trading System (ATS). It provides automated compliance checks and produces reports detailing transactions, providing transparency for investors in the regulatory compliance process. TradeCheck applies to many different types of securities and brings multiple benefits to investors, intermediaries, and other parties involved in the trading process. Ultimately, TradeCheck helps to reduce risk and increase investor confidence in trading securities.

Celebrity Endorsements of Investment Opportunities

When it comes to investing, celebrities are just like the rest of us. They need to do their research before putting their money into anything. Unfortunately, many stars have fallen victim to investment schemes in the past without doing the proper due diligence. However, an issue that is becoming even more prevalent is celebrities who use their influence and followings to promote securities, without including the proper disclosures, to unsuspecting fans and investors.  So, with the SEC cracking down on celebrities and companies, it’s important to know what you’re getting into when dealing with an investment opportunity tied to a celebrity endorsement.

 

Celebrity Endorsement and Investment Opportunities

 

The SEC’s Office of Investor Education and Advocacy (OIEA) has warned investors not to make investment decisions based solely on celebrity endorsements. While celebrity endorsements exist for a wide variety of products and services, a celebrity endorsement does not mean that an investment is legitimate or appropriate for all investors. As the OIEA says, “It is never a good idea to make an investment decision just because someone famous says a product or service is a good investment.”

 

Celebrities can be lured into participating in a fraudulent scheme or be linked to products or services without their consent. According to the SEC, even if the endorsement and investment opportunity are genuine, the investment may not be good for you. Before investing, always do your research, including these steps:

 

  • Research the background, including registration or license status, of anyone recommending or selling an investment through the search tool on Investor.gov.
  • Learn about the company’s finances, organization, and business prospects by carefully reading any prospectus and the company’s latest financial reports, which may be available through the SEC’s EDGAR database.
  • Evaluate the investment’s potential costs and fees, risks, and benefits based on your personal investment goals, risk tolerance, investment horizon, net worth, existing investments and assets, debt, and tax considerations. 

 

Kim Kardashian and the SEC

 

The SEC’s announcement followed an investigation that found Kim Kardashian failed to disclose that she was paid $250,000 to publish a post on her Instagram account promoting EMAX tokens, a crypto asset security offered by a company called EthereumMax. The post contained a link to the EthereumMax website, which provided instructions for potential investors to purchase the tokens. Since the investigation, she has agreed to settle the charges and pay $1.26 million in cooperation. SEC Chair Gary Gensler noted that “investors are entitled to know whether the publicity of a security is unbiased,” and the SEC’s Director of Enforcement Gurbir S. Grewal added that “Ms. Kardashian’s case also serves as a reminder to celebrities and others that the law requires them to disclose to the public when and how much they are paid to promote investing in securities.”

 

This case highlights the need for transparency surrounding celebrity endorsements of investments. Federal securities laws are clear that any celebrity or other individual that promotes a security must disclose the nature, source, and amount of compensation they received in exchange for the promotion. Without this type of disclosure, investors cannot make informed investment decisions. The SEC’s investigation is ongoing, and it remains to be seen if any additional action will be taken in this case. This case serves as a reminder that celebrities and influencers are not above the law. When considering any investment opportunity, it is important to do your own research and consult with a financial advisor to ensure it is right for you. Be sure to ask questions and demand transparency if you are asked to invest in a security based on a celebrity endorsement.

SEC Charges Eight in Scheme to Fraudulently Promote Securities Offerings

On September 30, 2022, the SEC announced charges against 8 CEOs and CFOs for fraudulently promoting Regulation A+ securities offerings.  The companies named by the SEC include Elegance Brands Inc. (now Sway Energy Corp.), Emerald Health Pharmaceuticals Inc., Hightimes Holding Corp., and Cloudastructure Inc.

 

This is not a good day for those who flout the rules, but we are glad the SEC has taken decisive action.  Reg A+ is gaining great momentum in the marketplace and this type of scrutiny by the SEC is necessary to keep it clean.

 

There are so many great companies and intermediaries working hard and being compliant. This only reminds us that we must continue to be diligent and keep our eyes open so that no further damage happens in the private markets.

 

It is not enough for the broker-dealers of record to simply do KYC ID verification; you also need to keep asking the hard questions.

 

If you are an IA firm,   you are creating and delivering the branding, messaging, and content through stories, videos, blogs, webinars, etc.  Each of these activities has far-reaching regulatory consequences. You can’t just simply do whatever they tell you to do; you too must be diligent in ensuring that you are telling the truth on their behalf. 

 

We turn down clients daily because we don’t compromise our ethics, and we only operate with full compliance to all regulations..  

 

There are only two ways to operate in this world:

  • Compliantly, ethically, legally
  • Non-Compliantly, unethically, illegally, and cutting corners

 

The choice is clear.

 

Capital-raising cannot be done by only the Issuer. This caution applies to all the following participants:

  • Issuer (Management, Board Directors)
  • Investors
  • Shareholders
  • Lawyers
  • Auditors
  • FINRA Broker-Dealers
  • Investor Acquisition Firms (Marketing Firms)
  • Call Centers (Boiler Rooms)
  • Transfer Agents
  • Issuance Technology Providers
  • Funding Platforms
  • Research Providers
  • Offering Aggregators
  • Investor Relations
  • Public Relations 

 

If you see any kind of questionable behavior, exercise caution and if necessary, let the SEC know.

 

SEC News Release 30 September 2022

https://www.sec.gov/litigation/litreleases/2022/lr25541.htm

 

Stay tuned for more updates from the SEC.

Benefits of Digital Securities for Investors and Issuers

With the emergence and development of blockchain technology, digital securities have seen wider adoption by investors and investment firms. Arising from the need for protection against fraud and as a way for investors to ensure asset ownership, digital securities are a digital representation of traditional securities and follow the same regulatory rules. Since their first appearance, digital securities now include any debt, equity, or asset that is registered and transferred electronically using blockchain technology. 

Digital securities are made possible by blockchain, also known as “distributed ledger technology”. Distributed ledger technology is a database where transactions are continually appended and verified by multiple participants, ensuring that each transaction has a “witness” to validate its legitimacy. By the nature of the system, it is more difficult for hackers to manipulate, as copies of the ledger are decentralized or located across multiple different locations. Changes to one copy would be impossible, as the others would recognize it as invalid.

Distributed ledger technology allows digital securities to be incredibly secure. Ownership is easily recorded and verified through the distributed ledger, a huge benefit over traditional securities. Any transfer of digital securities is also recorded and with each copy of the transaction stored separately, multiple witnesses of the transaction exist to corroborate it. 

Traditional or digital

With traditional securities, investors can lose their certificate of ownership or companies can delete key files detailing who their investors are. Without a certificate, proving how many shares an investor owns would be incredibly challenging. In contrast, digital security ownership is immutable. Investors are protected and always able to prove their ownership since the record cannot be deleted or altered. Additionally, investors can view all information related to the shares they’ve purchased, such as their voting rights and their ability to share and manage their portfolios with both accuracy and confidence. 

Since the record is unchangeable, it also serves as a risk management mechanism for companies, as the risk of a faulty or fraudulent transaction occurring is removed. Digital securities are also greatly beneficial to the company when preparing for any capital activity since the company’s records are transparent and readily available. With traditional securities, the company would typically hire an advisor to review all company documents. If the company has issued digital securities, this cost is eliminated, as it is already in an immutable form.  

Smart contracts made possible

The use of digital securities also makes smart contracts possible, which have preprogrammed protocols for the exchange of this kind of securities. Without the time-consuming paper process, companies can utilize digital securities to raise funds from a larger pool of investors, such as the case with crowdfunding. Rather than keeping manual records of each transaction, the smart contract automatically tracks and calculates funds and distributes securities to investors. 

Companies looking to provide their investors with the ability to trade digital securities must be aware that they are required to follow the same rules set by the SEC for the sale and exchange of traditional securities, such as registering the offering with the SEC. This ensures that potential investors are provided with information compliant with securities regulation worldwide. According to the SEC, investors must receive ongoing disclosures from the issuer so they can make informed decisions regarding ownership of their securities. Companies that are not compliant with the SEC can face severe penalties and may be required to reimburse investors who purchased the unregistered offerings. 

Besides the companies offering securities, broker-dealers must also register with the Financial Industry Regulatory Authority (FINRA). Similarly, platforms on which digital securities can be traded must register as an Alternative Trading System operator with the SEC. Both broker-dealers and ATS operators can face severe penalties if not properly registered. 

Secondary market (ATS) also benefits

Possibly the greatest benefit of digital securities is that it allows for smoother secondary market transactions. With records of ownership clear and unchangeable, an investor can easily bring their shares to a secondary market. Transactions are more efficient and parties have easy access to all necessary information regarding the securities being traded, removing the friction in traditional securities. 

At KoreConX, the KoreChain platform is a fully permissioned blockchain, allowing for companies to issue fully compliant digital securities. Records are updated in real-time as transactions occur, eliminating errors that would occur when transferring information from another source. The platform securely manages transactions, providing investors with support and portfolio management capabilities. Additionally, the KoreChain is not tied to cryptocurrencies, so it is a less attractive target for potential crypto thieves. KoreChain allows companies to manage their offerings and company data with the highest level of accuracy and transparency.

Since digital securities face the same regulatory rules as traditional ones, investors are protected by the SEC against fraudulent offerings. This, together with the security and transparency that blockchain allows, creates a form of investment that is better for investors and issuers alike. Since the process is simplified and errors are decreased without redundant paperwork, issuers have the potential to raise capital more efficiently. They will also be better prepared for future capital activity. For investors, a more secure form of security protects them from potential fraud and losses on their investments. With digital securities still in their infancy, it will be exciting to see how this method of investment changes the industry. 

Foreign Investors Key Considerations for Your Next Deal

This post was originally written by our KorePartners at Crowdfunding Lawyers. View the original post here

 

When discussing fundraising for your deals, most of our attention has previously focused on U.S. citizens investing their own money. That’s to be expected, but it’s important not to overlook another potential funding source: foreign investors. This article will explore what you should know about working with foreign investors in the U.S. and their potential impact on your deal.

Foreign Investors in the U.S.

Foreign investors are those individuals or companies outside of the United States who invest their money into U.S.-based businesses. And foreign money can be great. But, of course, there are advantages and disadvantages to know here and some pretty important restrictions.

How Foreign Investments Work

Before we dive into how these investments work or the pros and cons of foreign investments, we should touch on the restrictions put in place by the U.S. government. You’ll find that they’re twofold. First, there are restrictions set out by the country’s government in which you’re raising funds that you need to consider, as well as those applied by the U.S. government. Second, there are also regulations regarding how much money can be raised from foreign investors.

Foreign Investment Regulations

Each country has its own rules regarding investments. It is your responsibility to investigate what those are and how they may impact you, your investors, and the money that you raise. Some factors to consider include how much money you’re raising and the level of involvement between citizens of foreign countries.

It’s important to stay in legal compliance within all countries, which means you need to know the true cost of remaining completely legally compliant within each’s borders. In some cases, you may find that it is simply too expensive to develop a feasible plan. For example, suppose you’re raising a small amount of capital in a foreign country to transfer to the United States, and you’re not being fraudulent. In that case, complying with local securities laws might be somewhat cumbersome.

Too often, those raising funds focus more on securities laws here in the United States rather than in the other country, but this can hamstring you.

Limitations on Who Can Invest

In addition to the laws governing investments in the other country, you’ll also need to consider our domestic Office of Foreign Assets Control, or OFAC, here in the U.S. This organization determines which foreigners can invest and which ones should be blocked. In some cases, the OFAC focuses on the individual or the nation in question. In other instances, their review centers on the foreign country and the investment amount.

For instance, if an investor has 15% of greater assets in North Korea, Iran, Syria, and some other countries, they cannot invest here in the U.S. Again, you will need to check the OFAC website to see who is on the blocked persons list.

This is all part of getting to know your investors. It’s an enormous risk, but it can be potentially rewarding. You don’t want to take any money from people that you shouldn’t be because it can lead to problems beyond the scope of securities law.

Of course, these rules are implemented with good reason. They help ensure that you’re not taking money from a terrorist, helping someone launder money, for instance.

U.S. Securities Laws

We’ve touched on these briefly, but they bear deeper scrutiny. U.S. securities laws have a significant role to play when it comes to foreign investors. For instance, we have a law called “Regulation Asks,” which states that the securities laws for foreign investors don’t apply because they’re foreigners to the SEC. Regulation S states that if you investors are outside the country, most securities laws do not apply.

With that being said, if you commit fraud in any way, dealing with foreign investors will not prevent the SEC or any other authorities from investigating you and your investors. So it’s important to avoid the assumption that Regulation S protects criminal behavior – you should always do the right thing.

However, this brings up an important point. Since securities laws may not apply the same way to foreign investors that they do to U.S. investors, are you still required to provide disclosure? Absolutely, yes. The best path forward is to comply with Reg D as much as possible because then at least you’re providing proper disclosure to your investors and not taking advantage of the vulnerable out there.

Potential U.S. Tax Implications for Foreign Investment Deals

The tax situation is never simple, and adding foreign investors to the mix can muddy the waters a great deal. The tax consequences here can be substantial because when you add foreign investors to the mix and operate as an LLC, there’s pass-through taxation.

You will also have to deal with increased IRS scrutiny. The IRS is extremely worried about what your foreign investors will do – will they take their earnings and leave without paying taxes? Ultimately, you are responsible for their actions. This can mean that if a typical deal requires approximately 30% in withholdings, you should withhold the proper amounts from your investors’ earnings and pay it to the IRS on their behalf.

We also have FIRPTA, the Foreign Investment in Real Estate Property Tax Act of 1980. It requires you to withhold 15% from investors’ returns, although you should check with your tax specialists on the sale of real estate for any distributions that will go to foreign investors.

Avoiding Tax Complications with Foreign Investors

There are a lot of potential downsides to working with foreign investors. So how can you avoid them? Just don’t take on any. How do you avoid them, though?

It just comes down to requiring foreign investors to create their corporation or LLC within the U.S. This ensures that you’re able to let them into the deal, and you no longer have to worry about taking 45% of their returns and transmitting them to the IRS. You’ll also be able to deduct all of their expenses and losses against their income since they won’t be considered “pass-through” entities.

In addition, you can set up a separate bank account for each investor, and ensure that they only receive payments through that account. That way, you can keep track of who has paid what and make sure that everyone pays their fair share.

So, while it might seem like a good idea to work with foreign investors, you need to think twice before doing so. If you do decide to go ahead with it, you’ll need to consider these issues carefully and consult with a skilled attorney.

The Canadian Exemption

While the rules we’ve discussed here apply to investors from most nations, there is an exemption for Canadian investors under certain circumstances. The U.S. maintains a treaty with Canada that states these investors are not subject to the tax withholdings we just talked about. That means Canadian investors can be taken on without too much worry, at least about tax withholdings, with one caveat – you must have a limited partnership and cannot use an LLC or C corp or any other business formation option.

If you wish to work with Canadians, you’ll need to set up a limited partnership to receive their investment. If you choose to do so, make sure you understand all the risks involved with doing so.

The Big Questions to Consider When Taking on Foreign Investors

We’ve covered a lot of ground here in a short time. So, to sum up, let’s go over the big questions you’ll need to answer when you consider taking on foreign investors within your deal.

  • Are they from a country subject to sanctions, like North Korea, Syria, Iran, or Russia? Note that this list changes from time to time as sanctions are placed and lifted. Always check the OFAC list to ensure that your investors are clear about bringing their money into the U.S.
  • Are you following the securities laws of the other country? Are you doing enough business in that country that you need to be concerned about these laws?
  • Are you complying with U.S. tax rules as they pertain to your deal? For example, are you withholding the proper amount and remitting it to the IRS? If not, you’ll be held responsible unless your partners are American entities or have an exemption.

Do you understand all the risks involved in dealing with foreign investors? Do you know where to find information about each country? Is your legal team familiar with international law? These are all things you’ll need to think through before you sign off on any deals and it’s important to consult with an experienced attorney to help guide you

How Do I Get Foreign Investors Involved in My Deal?

If you want to attract foreign investors, you’ll need to make sure that you’re meeting their needs. To start with, you’ll need to understand why they would invest in your project. What are their goals? What are their motivations?

You’ll then need to determine if you can meet those goals and motivations. Can you provide them with something unique? Something that’s hard to find elsewhere? A good place to start is by looking at what you offer and comparing it to what others offer.

Once you’ve determined that you can meet their needs, you’ll need to figure out how to get them involved. There are two ways to approach this. One is to simply ask them to invest directly. They will likely require some sort of equity stake in your company. In exchange, they’ll receive a return on investment (ROI) based on the success of your venture.

Alternatively, you may choose to take a more traditional route. You can form a limited liability company or corporation, and invite them to join as shareholders. Their shares will be treated as income-generating assets, which means they’ll pay taxes on their share of profits. This is also known as “passive” investing.

In either case, you’ll need to know the law in both countries so that you don’t run afoul of local regulations. We’ve already touched on this briefly, but it bears repeating. Be aware that you may be required to register as a broker-dealer, and comply with all applicable federal and state securities laws.

What Happens After I Take On Foreign Investors?

Now that you’ve got investors, you’ll need a plan for managing them. How do you keep them happy while still keeping your own interests protected? You’ll need to set expectations early on. Make sure everyone understands what they’re getting into.

One thing to remember is that you’re dealing with people who have different levels of experience. Some may be new to investing, while others may have been around the block many times before. It’s important to make sure that everyone understands the risks involved.

As you go through the process, you’ll also want to make sure that you have a clear understanding of the terms of the agreement. For example, you should know whether you’re going to issue stock, sell debt, or use other financing methods. As we mentioned earlier, you’ll need to be prepared to deal with taxes. If you’re issuing stock, you’ll need to decide whether you’re going to treat the shares as long-term capital gains or short-term capital losses.

Finally, you’ll want to make sure that your business plan takes these things into account. You’ll need to consider how you’re going to finance the project, how you’re going to manage risk, and how you’re going to handle any potential legal issues.

In Conclusion

In the end, working with foreign investors is a tricky situation, but with proper guidance from both experienced tax and legal professionals, it can be profitable for both you and your investors.

Securities in Real Estate – A Beginner’s Guide!

This blog was originally written by our KorePartners at Crowdfunding Lawyers. View the original post here

 

Over the past few decades, real estate investing has seen a dramatic shift from individual private investors to syndications of commercial, multifamily and development projects. This has contributed to the substantial growth of the global real estate securities markets. This shift has been largely due to the increasing adoption of the modern real estate syndication structures amid growing investor demand for passive income.

Real estate developments and multifamily opportunities generally require enormous resources and large amounts of capital for acquisitions of and operations. Investors get excited for real estate investing when they expect above-stock-market returns through passive income investing. The passive income can come from rental operations and capital gains on sale. Such investments are generally securities, which are regulated by the Securities Exchange Commission (SEC) and State securities regulators.

Private securities may take the form corporate shares, bonds, or futures/derivatives, and even promissory notes with private lenders may be categorized as securities. To make things even more confusing, some real estate investments are considered securities and others are not.

At a high level, the test for whether an investment contract is a security is referred to as the Howey Test and it considers whether the investment structure includes:

  • Investment of cash or assets
  • From a group (i.e., more than 1) of similar-interest passive investors
  • With an expectation of profits
  • From the efforts of others (e.g., management)

All securities are investments but not all investments are securities.

When should you care?

The starting point for analyzing whether securities law governs an investment real estate transaction is applying the “economic realities” test originally described by the US Supreme Court in the 1936 case SEC v. W.J. Howey. To apply this test, summarized above, it is important to consider if multiple people will put resources into a venture with an assumption that benefit will be procured through the efforts of another person.

Since a joint land venture might have different levels of investors, lenders, and stake holders, the Howey Test should be applied independently for each stake holder. As an example, there may be a first lien lender, a second position lien lender at materially different interest terms, a preferred investor that receives a designated rate of return, and common investors that receive the profit.

In the example above, the lenders would not be investing in securities because there is no commonality between them. It’s a similar evaluation of the preferred investor, assuming there is only one. Common investors expecting to receive profit would be purchasing securities and the sponsor would be responsible for complying with securities regulations (e.g., qualifying for an exemption from registration yet) for this group.

However, we can tweak one variable and each transaction can be considered a separate securities transaction. If there are multiple lenders sharing the same position loan or multiple preferred investors, then those are separate securities transactions similar to the common interest investors.

Let’s give illustration of how a single transaction may actually be BOTH a securities transaction and a non-securities investment. Let’s use an example of private loan for the acquisition of real estate. If it is a single source loan (one lender on note), the receipt of loan proceeds by the property owner would not be construed as a securities transaction. However, if the lender pooled together funds from multiple private lenders or investors for the purposes of making the loan, then the pooling of funds would still be considered a securities transaction. The property owner would have no obligations to maintain the securities exemption but the lender who is pooling investors would.

To put it in layman’s terms, whether a real estate venture is a regulated security depends on whether the investors depend on another’s efforts to earn a return. Unfortunately, since the application of the Howey Test actually depends on numerous guidelines and regulatory interpretations, court decisions frequently neglect to offer significant guidance. Likewise, the SEC will issue “no action letters,” which is the SEC’s response when asked for guidance on whether they would take action given a set of circumstances. There are thousands of these letters to consider, but they are also very fact-dependent, and therefore don’t always provide as clear a beacon as we would like.

This leaves the investment sponsor with few alternatives:

  • Hope they don’t get caught and accept investments without guidance
  • Hire an experienced securities attorney (e.g., Crowdfunding Lawyers) to evaluate and assist in the development of the investment program

Difference between a non-securities real estate transaction and a securities offering 

Real estate investments are often not securities when evaluated under the Howey Test for a variety of reasons.

Owners of a condo association are not purchasing securities although each member may have a similar passive interest in the building. Condo association members are generally expecting to reside at the property or rent out their portion rather than seeking profit from the activities of the leaders of the association.

The acquisition of rental properties is generally not a security when acquired by an individual since there is not commonality with other investors. However, if two or more investors acquire the property together, they may be purchasing a security if pooling their money to be managed by someone else.

When it comes to multifamily acquisitions, most often there are securities being offered to a multitude of qualified investors on similar terms, with the investment being managed by the investment’s sponsor. These syndications are securities and require either securities registration or exemption from registration under the appropriate securities exemption. Regulation D of the Securities Act of 1933 is the most commonly relied upon securities registration exemption but there are other exemptions from registration that should be considered when developing a capitalization plan.

Another common securities structure includes tenants in common (TIC) investment opportunities, which are often promoted in connection with 1031 tax-deferred exchanges. A straight-forward analysis of TIC investments includes: direct property owners with a non-divisible interest in a property along with other owners, a manager responsible for daily operations, and a TIC agreement binding the property owners’ activities to certain voting approvals.

Many people ask if having an investment opportunity with fewer than 35, 10, 5, or even 2 individuals is not a security. However, there is no specific number of financial backers that disqualify an investment from being a security as long as all prongs of the Howey Test are met. Even a solitary piece of venture property, deeded to two individuals, can be categorized as a securities offering if the conditions bring it inside the applicable lawful definitions under government or state law.

Compliance, Avoidance and Hope

Although conforming to securities requirements has become simpler and there has been a recent broadening of exemptions available to securities issuers, it continues to be a highly technical area of the law. Some investment sponsors seek to avoid securities requirements by giving every investor critical autonomy and control. In some cases of joint ventures, franchises, or general partnerships which generally require active participation and unlimited liability to the investors. There are some reliable strategies to structure an opportunity so that it is not a security, but a cost/benefit analysis is important to determine if, as an investor or promoter, the benefits are worth the risks.

When an offering structure is within the gray area between security and non-security, regulatory agencies can and often will step in with an investigation or audit to ensure compliance. Hence, investment offerings designed to avoid securities requirements by shifting independence and control to investors may undermine the project’s success and create unnecessary scrutiny for the participants.

What are Options?

Like warrants, options are a form of security called a derivative. As a derivative’s name suggests, these securities gain their value from an underlying asset. In the case of options, this is the underlying security

 

There are typically two primary forms of options; call options and put options. Both are governed by contracts; a call option allows the holder to buy securities at a set price while a put option allows them to sell. However, options contracts do not come for free. They can be bought for a premium, which is a non-refundable payment due upfront. Once options have been purchased, the holder has a certain amount of time during which they can exercise their options. On the other hand, options do not require the holder to purchase the shares contracts allow. When options are exercised, the price paid is referred to as the strike price.

 

In buying call options, the holder is guaranteed to buy securities at a certain price, even if the underlying security significantly increases in price. A put option works more like an insurance policy, protecting the holder’s portfolio from potential downturns. If a security was to decrease in price, the shareholder would be able to sell at a set price specified by their option contract, even if the market price was to fall lower than what the option allows it to be sold at.

 

In addition to being a way to minimize investment risks and maximize profits, options are becoming a popular incentive for employees, especially in startup companies when looking to attract employees. In addition to options that can be bought, options also refer to the ones issued to employees by their employer. This gives employees the chance, but not the obligation, to buy shares within a specified time. Employee stock options either come as an Incentive Stock Option or Nonqualified Stock Options, with the difference being the tax incentives that go along with exercising the options. 

 

Whether you have call or put options, they are a useful way to protect your portfolio from downsides or benefit from being able to purchase more shares at a discounted price. They are just one of the many forms of securities available, which should be considered carefully when making investment decisions.

What is KYC?

In 2007, the SEC approved the founding of the non-profit Financial Industry Regulatory Authority (FINRA). FINRA was created in the wake of a failing economy to consolidate the regulation of securities firms operating in the United States. The authority’s responsibilities include “rule writing, firm examination, enforcement, arbitration, and mediation functions, plus all functions previously overseen solely by NASD, including market regulation under contract for NASDAQ, the American Stock Exchange, the International Securities Exchange, and the Chicago Climate Exchange.”

The mission is to safeguard the investing public against fraud and bad practices. To fulfill this mission, FINRA added two rules in 2012: Rule 2090 (KYC or Know Your Client) and Rule 2111 (Suitability). 

KYC works in conjunction with suitability to protect both the client and the broker-dealer and help maintain fair dealings between the parties. The Know Your Client rule is a regulatory requirement for those responsible for opening and maintaining new accounts. This rule requires broker-dealers to access the client’s finances, verify their identity, and use reasonable effort to understand the risk tolerance and facts about their financial position. 

KYC is an important rule as it governs the relationship between customer and broker-dealer and safeguards the proceedings. At the heart of this rule is the process that verifies the customer’s identity (or any other account owners) and assesses their risk level. Part of FINRA’s goal is to eliminate financial crime, which means that when a broker is accessing a potential customer, they are looking for evidence of money laundering or similar crimes. This process goes both ways as FINRA allows a customer to verify the identity of brokers in good standing with the organization.

KYC also goes hand-in-hand with the Anti-Money Laundering (AML) rule, which seeks to identify suspicious behavior, outlined under FINRA rule 3310. Crimes such as terrorist financing, market manipulation, and securities fraud are illegal acts that KYC, AML, and other rules aim to prevent.

Another part of the Know Your Client rule is the requirement of a broker-dealer to use reasonable effort to understand a client’s risk tolerance, investment knowledge, and financial position. For example, accredited investors can make Regulation CF and A+ investments without facing restrictions, while the everyday investor is limited based on their net worth and income. 

When making recommendations for a client, a broker-dealer must comply with Rule 2111, the suitability rule, which means that they must have reasonable grounds for this suggestion based on a review of the client’s financial situation.

Compliance with these rules is maintained by following policies and best practices that govern risk management, customer acceptance, and transaction monitoring. Due diligence is done to know a client needs to be recorded, retained, and maintained so that broker-dealers can continuously monitor for suspicious or illegal activity. In 2020, FINRA processed 79.7 billion market events every day and imposed $57 million in fines. 

Warrants for RegA+

For private companies looking to raise capital through exemptions such as Regulation A+, Regulation CF, or Regulation D, there are many forms of securities that they may be able to issue to investors. Lately, there has been much buzz around warrants for RegA+ offerings and we are seeing them issued to investors as an equivalent to a perk. With the growing interest in this type of security, let’s explore what a warrant for RegA+ is. 

 

When a shareholder purchases a warrant, they are entering into a contract with the issuer. They purchase securities at a set price but are given the right to buy more securities at a fixed price. For example, if an investor was to buy a security at $1 apiece, but their warrant allows the shareholder to buy securities at a future point for $2 instead. If the company was to significantly increase in value, and securities were valued at $5 instead of the initial $1 they were purchased at, the warrant could be exercised and new securities can be purchased for the price specified in the contract. Such securities are typically sought after by investors who think the company they’ve invested in will significantly increase in value, allowing them to increase their ownership in the company without having to buy securities at a new, higher price. Typically, warrants have an expiration date, but they can be exercised anytime on or before that date. 

 

Warrants for RegA+ work no differently. 

 

For companies offering warrants to shareholders, many will choose to enlist a warrant agent to oversee the management of warrants. Much like a transfer agent, warrant agents maintain a record of who owns warrants as well as the exercising of the warrants. When there is a significant number of warrant holders, warrant agents maintain the administrative duties of ensuring warrant holders can exercise their rights and are issued additional securities when they are looking to do so. Just as KoreConX is an SEC-registered transfer agent, KoreConX can serve as your warrant agent as well. This allows you and your shareholders to perform all transactions, from the initial purchase to the exercising of the warrant, through the RegA+ end-to-end platform. Fully compliant, KoreConX helps you to ensure that all your capital market activities meet the necessary regulatory requirements.

 

For warrant holders looking to exercise their warrants, they can contact the warrant agent (if they bought shares directly from the company) or their broker-dealer to inform them that they would like to purchase additional securities. At the time of the purchase, the warrant holder would pay to exchange their warrants and be issued the appropriate amount of new securities. 

 

Warrants are also able to be traded or transferred. For example, warrant holders could transfer their securities to a child or relative if they were looking to pass them down. Alternatively, warrant holders can sell them to an interested buyer. If the company’s value has yet to exceed the warrant price, they are typically less valuable because shares may still be able to be purchased at a lower price. 

KorePartner Spotlight: Sara Hanks, CEO of CrowdCheck

With the recent launch of the KoreConX all-in-one RegA+ platform, KoreConX is happy to feature the partners that contribute to its ecosystem.

 

With over 30 years in the corporate and securities law field, Sara Hanks has a wealth of experience. Before CrowdCheck began, Sara and one of the firm’s co-founders (whose husband became the other cofounder) served on the Congressional Oversight Panel where they spent 18 months in DC investigating the Troubled Asset Relief Program. Shortly after this time, the bills that became the JOBS Act were passing through Congress and Sara’s interest in the private capital markets grew.

 

Sara and the CrowdCheck co-founders began to discuss due diligence and the implication crowdfunding would have. With their combined legal and entrepreneurial experience, they knew they could help investors make good investment decisions and walk entrepreneurs through the compliance process. These conversations led to CrowdCheck, which Sara says was “founded on the back of a cocktail napkin.”

 

CrowdCheck and its affiliated law firm, CrowdCheck Law, provides clients with a complete range of legal and compliance services for issuers and investors. As a “weapon against potential fraud,” CrowdCheck does due diligence for investors, letting them see the results themselves in a report that is easy to understand. The firm also helps entrepreneurs through the complex process of compliance, making sure that they have met all legal requirements. Sara and CrowdCheck have tremendous experience applying exciting securities laws to the online capital environment, a skillset valuable in the crowdfunding space.

 

One of the things that excites Sara most about this space is that there are “so many cases of first impressions.” Raising capital isn’t new, but with crowdfunding, new questions arise every day and there is the opportunity for innovative delivery of information.

 

A partnership with KoreConX is exciting for Sara and CrowdCheck because KoreConX values and understands how essential compliance is. “This environment won’t work without compliance,” Sara Hanks said, so it was valuable finding a partner that did not need convincing when it came to compliance.

Wake up call, do you have the right chain for securities?

Polymath is the latest of the Ethereum fan club that has woken up to the fact that Ethereum isn’t the right blockchain platform for financial securities. The reasons include the permissionless and unverified participants, gas fees, unpredictable settlement, poor performance, and lack of scalability.

Vitalik himself was the first to point this out way back on May 9, 2016 (3.5 years ago—a lifetime in crypto-space) in a blog post on Settlement Finality: “This concept of finality is particularly important in the financial industry, where institutions need to maximally quickly have certainty over whether or not the certain assets are, in a legal sense, “theirs”, and if their assets are deemed to be theirs, then it should not be possible for a random blockchain glitch to suddenly decide that the operation that made those assets theirs is now reverted and so their ownership claim over those assets is lost.”

Independently, we (KoreConX) too came to the same conclusion when we first started looking for a good platform for our digital securities and our all-in-one applications that serve the market. This does not detract from the engineering prowess of the Ethereum team, who have taken on a monumental task in trying to create an open blockchain platform that is everything to everyone.

The real problem in the financial markets is that of investor safety. No amount of cryptography can guarantee the validity of participants and of transactions precisely because verification and validity is not in the technical domain. Rather, it’s in the social, economic, and regulatory domain. Blockchain will immutably commit all data regardless of its business validity, as long as it’s cryptographically valid. It is up to the blockchain applications and smart contracts to ensure business validity. This too is not a technical issue but a legal issue. Securities contracts should be authored by securities attorneys, not programmers. Indeed, smart contracts as conceived in Bitcoin and Ethereum are neither smart nor contracts. The word ‘contract’ is an obfuscation of ‘interface specification’ that is commonly referred to as a ‘contract’ between two applications in the software world. Unfortunately, 

To their credit, the thought-leaders of Ethereum were under no illusions about the supposed prowess of smart contracts, as defined within Ethereum. Vitalik Buterin, for example, tweeted back on October 13, 2018, “To be clear, at this point I quite regret adopting the term ‘smart contracts’. I should have called them something more boring and technical, perhaps something like ‘persistent scripts’.” Another Ethereum, Vlad Zamfir, preferred the term ‘stored procedures’.

The most important thing that the open blockchain community missed is that except for currency, financial securities are not bearer instruments. Creating fraudulent securities through shell companies is ridiculously easy with bearer instruments, which is why they are banned in responsible economies.

Besides the fact that securities are not bearer instruments, the public blockchain advocates seem to be coming to the realization that when securities are exchanged between two parties, independent and unverified miners have no business validating the transaction. Parties who have no fiduciary responsibilities, no regulatory mandate, or any skin in the game cannot perform business validation. Would you ask a stranger in New Zealand to approve the transfer of your shares in a private company to your friend when you, your friend, and the private company are all in the USA? As Polymath’s Dossa observers, “How ethereum settles transactions through mining also came into consideration for Polymath, Dossa said. Since miners, who process and sign-off on transactions for a fee, can operate anywhere in the world, institutions could face government scrutiny if fees are traced back to a sanctioned country.” More to the point, securities law does not recognize approvals from parties who are not associated with securities transactions.

Even as the public blockchain community tried to disintermediate regulators, when their assets were stolen from their wallets and exchanges, or the companies vanished outright, investors turned to those same regulators for recourse and recovery.

The other problematic aspect of Ethereum was the nature of finality, which in Ethereum, is statistical. This will not do in legal agreements. As we pointed out early last year in one of our KoreBriefings when evaluating Ethereum, “Finality [in Ethereum] if probabilistic and not guaranteed.” Would you sign an employment agreement where the fine print says there’s a one-in-ten chance that you would not be paid every two weeks. As Adam Dossa, Polymath’s head of blockchain, rightly observed, “At the center of contention is ethereum’s consensus mechanism, proof-of-work (PoW), which only offers a statistical guarantee of transaction finality.”

Incentives often have unintended consequences. We see this happen often with children and pets. Public blockchains are all about decentralization, but in fact miners’ incentives have all but centralized the blockchains. In contrast, consider that within KoreChain we have not left the question of decentralization to the vagaries of unknown miners. Instead, the KoreChain is engineered for decentralization. It is an implementation of the Infrastructure of Trust that currently runs in production in twenty-three countries; in barebones minimal cruising mode, it is capable of handling approximately 10 billion transactions per year (~318 tps) with consensus on business validity. KoreChain’s architecture also makes it massively scalable with very little effect on performance. However, as Vitalik rightly points out, finality can never be 100% even if the technology can achieve absolute finality, since the ultimate arbiter of finality is the legal system. For this reason, KoreChain includes KoreNodes independently are owned and operated independently by regulated entities and regulators worldwide..

If you hold fast to the idea that your powerful car is the only way to cross the ocean, you will be in for a continual hack of trying to make your car float on water. It is much better to recognize that a good ship is the right vehicle for the ocean. Many of the challenges of building a compliant securities application on Ethereum are actually unnecessary. Securities regulation in any one country is complicated enough. Multi-jurisdictional capital markets transactions compound that complexity by several orders of magnitude. Application designers should not be distracted by trying to create their own chains; instead, the real achievement lies in making securities transactions fully compliant in all jurisdictions, promoting innovation in financial markets, enabling flexibility, minimizing process costs, and providing an Infrastructure of Trust to which all regulated entities are welcome. 

The world’s capital markets are too dispersed, complex, and huge for any one participant to dominate. Revolutionizing the capital markets is only possible through collaboration. 

www.InfrastructureofTrust.com