The founder of Prometheum recounts: How did we become the first STO exchange to meet SEC regulations?

This article is a speech meeting hosted by CBE China Blockchain Experts and Bitrise Capital titled "Breaking the Deadlock Issue 6 ------ The Current Status and Future of the Compliant Securities Token Environment in the U.S. 2019," with speaker Aaron Kaplan, founder and CEO of Prometheum, published by Chain News on April 17, 2019.

My name is Aaron Kaplan, and I am the founder and co-CEO of Prometheum, which is building a market infrastructure registered with the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) to utilize blockchain for the entire lifecycle of security tokens. I was a practicing attorney at a Wall Street securities law firm, Gusrae Kaplan Nusbaum PLLC, focusing on the application of distributed ledger technology in the securities industry and related regulatory issues.

In today's presentation, I will first provide background on how the SEC determines whether tokens are considered securities, then further discuss recent regulatory trends and events, and finally introduce Prometheum and explain why the financial infrastructure being built by Prometheum is crucial for realizing the potential of tokens as a true asset class of the 21st century.

The Prometheum team is dedicated to the intersection of securities regulation, blockchain, and the brokerage industry, particularly the application of distributed ledger technology in the securities industry and related regulatory matters. Prometheum was incubated from the Wall Street securities law firm Gusrae Kaplan Nusbaum, which continues to provide specialized securities law consulting services. Prometheum's strategic founding partner, Wanxiang Blockchain, is globally recognized as a large and highly professional blockchain engineering organization. The cross-disciplinary experience of the Prometheum team has built a unique capability that hopes to successfully establish tokens as a new asset class in the next generation digital economy: assets that have utility and are subject to financial regulation.

### I. Three Legal Bases for the SEC's Determination of Tokens as Securities

The legal basis for the SEC's determination that tokens are securities derives from three regulations. The U.S. Securities Act of 1933 outlines the disclosure and registration requirements for issuing securities in the U.S. The 1946 Howey case established the Howey Test, which is used to determine which instruments are considered investment contracts and thus securities; the Howey Test is employed by the SEC to ascertain whether tokens are securities. Ultimately, the SEC's investigation report on the DAO incident released in July 2017 became a milestone, essentially establishing that almost all tokens in the U.S. are considered securities tokens.

Basis One: U.S. Securities Act of 1933

The U.S. Securities Act of 1933 is the first major legislation regulating the issuance and sale of securities. The 1933 Act requires investors to receive accurate and up-to-date financial information from companies issuing securities to the public. This act created a uniform standard to protect investors from fraud. Unless the issuance of securities meets the requirements for registration exemptions, the Securities Act requires companies to submit a registration statement containing information about the company and the securities to be issued. The Securities Act specifies various exemptions—if certain conditions are met—the issuance and sale of securities can occur without SEC registration. All tokens issued in the U.S. must be registered under the U.S. Securities Act of 1933 or meet the conditions for exemption from registration.

Basis Two: The Howey Case and the Howey Test

The Howey case, heard by the U.S. Supreme Court in 1946, is significant as it outlines the test used by the SEC to determine whether tokens constitute investment contracts and thus securities.

Investment contracts are one category of securities and typically serve as a catch-all provision for determining whether a transaction involves securities. If a security does not fall under the category of stocks, equity, or other typical securities, the SEC will use the Howey Test to determine whether tokens constitute investment contracts and thus securities. The SEC continues to focus on the conditions outlined in the Howey Test to determine whether digital assets are classified as securities.

Basis Three: The 2017 DAO Investigation Report

The DAO investigation report states that any company raising funds from the public through the sale of tokens online is issuing securities.

The DAO investigation report answers the question of whether tokens are securities (as opposed to utility tokens) and places all token activities under the jurisdiction of federal securities laws. Before the SEC released the DAO investigation report, tokens operated in a regulatory gray area, where newly formed teams could raise tens of millions of dollars with just a white paper and a dream. The DAO investigation report clearly states that companies operating in the gray area are indeed subject to federal securities laws, thereby bringing the protections offered by federal securities laws into the realm of token activities.

The application of the Howey Test analysis in the DAO investigation report clearly indicates that almost all tokens are securities: that is, companies financing projects by selling tokens to the public on the internet are providing investments. Investors participating in these token investments hope that as the financing project develops, the value of the underlying tokens will also increase. The increase in token value is also a result of the efforts of all employees within the company. This is clearly an investment contract and thus a security.

### II. Recent Regulatory Events in the Token Space

Now that we have focused on the regulatory background, let’s explore some recent regulatory events/trends in the token space. Recently, there have been three major events indicating key trends in the securities token space. First, the Turnkey Jet no-action letter, which is the first no-action letter granted related to digital assets. Second, the SEC's framework analysis of digital asset investment contracts. Finally, Blockstack announced their intention to conduct a token sale through Reg A+. Each of these events is significant as they indicate that the SEC's understanding of securities tokens is evolving and how the token industry is being forced to mature by complying with U.S. legal regulations; these regulations are essential for tokens to transition into mainstream asset classes.

Regulatory Event One: Turnkey Jet No-Action Letter

The SEC's recent Turnkey Jet no-action letter is the result of significant efforts to identify utility tokens as non-securities. Prior to this, there was no example of a purely utility token being recognized as not a security in the U.S. SEC Chairman Clayton even stated that every token he had seen before the Turnkey Jet no-action letter was a security.

By setting many boundaries and limitations (such as fixed pricing), the SEC established a very limited exception in which a token is a purely utility token and not a security. However, if the token price (i.e., the increase or decrease in token value) reflects market activity, it will always be deemed a security.

The Turnkey Jet no-action letter also indicates that a new era is dawning, where companies will consider regulatory impacts and seek guidance from the SEC before attempting to issue non-security tokens. This is a good sign that the industry is gradually maturing and considering compliance, and it is an essential step before tokens can become mainstream asset classes.

Regulatory Event Two: SEC Digital Asset Investment Contract Analysis Framework

The most important part of the SEC's digital asset investment contract analysis framework is that it provides a list of characteristics; the more pronounced the characteristics, the less likely it is to pass the investment contract test.

The framework is intended as an analytical tool to help market participants assess whether federal securities laws apply to activities involving the sale or distribution, purchase or trade, holding or storing, and providing professional services related to specific digital assets.

The framework explores the applicability of the elements of the Howey Test to digital assets and lists a non-exhaustive list of characteristics to determine whether federal securities laws apply when selling tokens.

When deciding how to design, operate, issue, and sell digital assets and tokens, issuers should consider the SEC's framework.

Regulatory Event Three: Blockstack Intends to Sell Tokens via Reg A+

In April 2019, Blockstack announced its intention to sell tokens through Reg A+. By selling tokens via Reg A+, they can raise up to $50 million from the public, and these tokens can be freely traded once issued on the secondary market. Because Regulations A+ allows full participation from individual investors, and the costs for a Reg A+ token offering are just a small fraction of the listing costs, Regulations A+ is the perfect rule for token issuers to raise funds. Regulations A+ also allows issuers to raise funds legally while enabling the tokens to be freely traded, making them usable in the decentralized economy.

Now that we have an understanding of the regulatory background and recent events, let’s explore how Prometheum's compliant market infrastructure meets federal securities law requirements in line with the latest regulatory dynamics.

### III. How Prometheum Meets the Securities Law Compliance Framework

Prometheum's comprehensive solution allows tokens issued on the Prometheum issuance platform to be traded on Prometheum's Alternative Trading System (ATS) and held through Prometheum's clearing facilities, all in accordance with the federal securities law compliance framework. Therefore, investors worldwide will be able to purchase and sell tokens across jurisdictions through their brokerage accounts in a compliant manner. All tokens are issued on Prometheum's blockchain, and transactions executed on our ATS are also recorded on it. As for the settlement of tokens held in wallet accounts, it is conducted on the relevant clearing facilities.

The protections offered by Prometheum's model enable participants with financial attributes in the token space to benefit as follows:

• Investors will benefit from the information disclosure requirements imposed on issuers by federal securities laws, which will require issuers to cover all important information in the token issuance offering;
• Issuers will benefit from a clear regulatory framework that allows them to issue freely tradable tokens to all investors (both accredited and non-accredited);
• Traders will benefit from the market integrity introduced by federal securities laws, ensuring a fair and orderly market and preventing manipulation and price gouging.

In a Harvard/MIT conference in January 2015, the first legal token framework was formed. My contributions and those of our Chief Technology Officer were recognized.

It is clear that in 2017, tokens were viewed as securities in the U.S., and we established this company to create the necessary infrastructure for tokens to be compliant financial assets while also being usable in the decentralized economy.

The Prometheum team consists of members focused on integrating securities regulation with blockchain and the brokerage industry. Our team members have particular experience in applying distributed ledger technology to the securities industry and related regulatory matters. Gusrae Kaplan Nusbaum PLLC is a Wall Street law firm specializing in complex securities issues, and Prometheum was incubated by it and continues to receive support. Our strategic founder and technology co-developer, Wanxiang Blockchain, is regarded as one of the largest and most professional blockchain development companies in the world.

The cross-disciplinary expertise of the Prometheum team gives it a unique advantage to complete the Prometheum network, which allows tokens to be compliant financial assets while also being usable in the decentralized economy, thereby realizing the potential of tokens—a true asset class of the 21st century.

### IV. Three Facilities of Prometheum that Meet the Regulatory Framework

1. An issuance platform operating under Reg A+ that allows token issuers to issue tokens compliant with federal securities laws, which can be freely traded and accessed by the public;
2. A secondary trading facility designed for crypto securities, registered with the SEC as an Alternative Trading System (ATS);
3. Clearing and settlement facilities to handle customer crypto securities transactions and maintain custody and control of customer crypto assets.

Facility One: Prometheum Token Issuance Platform

Prometheum's issuance platform issues tokens under the provisions of Reg A+. Under Reg A+, issuers can raise up to $50 million from the public within a 12-month period. Unlike the illiquid Reg D/SAFT (Simple Agreement for Future Tokens), issuers under Reg A+ must submit their offering documents to the SEC for review before providing tokens to the public, allowing tokens to be issued to the public rather than being limited to accredited investors.

Finally (and perhaps most importantly), securities issued through Reg A+ can be freely traded on the secondary market (just like liquid securities), which means they can also be used across different blockchains in the decentralized economy.

Facility Two: Prometheum Secondary Market Alternative Trading System (ATS)

Tokens issued on Prometheum's Reg A+ issuance platform will be listed on Prometheum's Alternative Trading System (ATS), which is based on U.S. equity structures, compliant with U.S. regulatory requirements, and ensures investor protection, issuer accountability, and market integrity.

Prometheum's FINRA/SEC-registered ATS is an electronic marketplace and platform that is blockchain-native and employs a maker/taker liquidity model that attracts end investors and active traders.

Facility Three: Prometheum Clearing and Settlement Facilities

The third component of our regulatory framework is the clearing, settlement, and custody of tokens traded on the Prometheum network.

All of our clients' crypto securities and cash are handled by our Digital Clearing Firm.

Rule 15c3-3 (Customer Protection Rule) requires that customer funds be segregated from paid securities. The custody funds held by the Digital Clearing Firm are achieved through the separation of its master wallet and customer crypto securities assets, ensuring it can protect user assets in accordance with federal securities law requirements.

By adhering to the customer protection regulations required by federal securities laws, customer crypto securities assets are safeguarded according to the highest asset protection standards (federal securities laws), allowing customers to have peace of mind.

### V. Prometheum's Technology and Tokens

Technology: Two Blockchains Based on BCOS Technology

Prometheum has two blockchains, both based on BCOS technology (a derivative of Ethereum).

First, a "core" chain is permissioned, where all regulated securities activities will take place. Second, a public "utility" chain allows users to receive tokens outside of Prometheum's regulated space and use them in the decentralized economy.

To ensure that tokens can be considered compliant securities within the framework of federal securities laws while also functioning in the decentralized economy, Prometheum's multi-chain strategy is essential.

The permissioned access to the core chain allows regulated entities to provide the necessary assurances to regulators, while the public utility chain enables decentralized application (Dapp) creators to deploy smart contracts and integrate with other blockchains as they choose.

Tokens: Ember Tokens Issued Under Reg A+

Prometheum's Ember token, issued under Regulation A+, is the first securities token issued on the Prometheum ecosystem and serves as the fuel for the operation of the Prometheum network.

Prometheum's Ember token possesses utility/access and proprietary payment currency attributes.

From a utility/access perspective, the Ember token will be used as a utility/access token, granting rights to participate in network protocols and business ecosystems.

The network protocol participation rights allow token holders to provide services at the blockchain protocol level. The business ecosystem participation rights allow token holders to provide services at the application layer of distributed business ecosystems.

The Ember token will be used as the proprietary payment currency on the Prometheum network.

### VI. Q&A After the Meeting

Can you share about the collaboration with Wanxiang and why they chose to partner with you?

Aaron Kaplan: We have a true partnership with Wanxiang, as they are one of the co-founders of the company. We jointly develop all the technology and continuously collaborate with their engineering team. We have over 50 blockchain engineers in Shanghai, and we hold face-to-face meetings in Shanghai once a month.

Wanxiang chose to partner with us because our visions align. We both believe that tokens are the true asset class of the 21st century and that a new financial infrastructure allowing tokens to function as financial assets while also enabling their use in a distributed economy is necessary for the distributed economy to thrive.

Moreover, our expertise in legal and regulatory matters, combined with Wanxiang's expertise in blockchain and engineering, creates an unparalleled team!

What development plans will you pursue in China next? What differences do you see in dealing with projects or investors from China compared to the U.S., and what aspects should be emphasized?

Aaron Kaplan: Prometheum also plans to collaborate with regulatory agencies worldwide to ensure that token trading can meet international standards. The U.S. remains a huge capital market, and there are many great projects in China seeking capital from U.S. capital institutions and market opportunities. I hope that regulatory agencies around the world will take note of the SEC's positive policies and favorable news regarding tokens, possibly using the SEC's example as a way to ensure that they can feel more confident about tokens in their domestic markets.