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What you should consider when doing a Security Token Offering (STO)

The crypto fundraising trend is turning from utility to security tokens.

Launch a Security Token Offering – Why?

Currently, ‘utility’ tokens may be considered securities. This depends on the jurisdiction and its intrinsic characteristics and associated rights. A ‘true’ utility token represents future access rights to a company’s product and/or service, whereas a security token is backed by an asset that confers rights to income, assets and/or dividends of a company, among others.

Blockchain technology could change the way these assets are maintained and transferred and could potentially provide efficiency such as faster settlement, automated compliance, fractional ownership, among others, in addition to a removal of intermediaries, which may bring certain advantages and disadvantages as we will see below. Note that nothing on this article constitutes legal advice. If you wish to receive a legal opinion or tax advice on the matter(s) in this article please contact our offices and we will refer you to an appropriate legal practitioner.

Institutional Capital and Investor Interest

The proliferation of security tokens may be the key factor for the entry of institutional capital into the ‘crypto-market’ as utility tokens may be unsuitable under investment mandates that institutions must comply with, among many other reasons.

In an ICO or utility tokens issuance, the issuing company carried out an unregulated fundraising event in most countries, applying few or no restrictions and with arguably limited accountability to the participants. As an owner of a product, there are few (if any) enforceable rights against a utility ICO.

Legal, Marketing and Proposition Certainty

A security token offering is a fully regulated event. There are a series of limitations and restrictions, disclosures and other filings which vary between jurisdictions and that are relevant not only from the country of issuance but also the country where the investors are located.

In a STO, investors have a clear contractual relationship with the issuer and are granted a set of rights and obligations. Investors are protected by existing legislation and case law (both criminal and civil) which may make entrepreneurs more accountable.

For these reasons, the costs and regulatory burdens associated with the registration and issuance of security tokens (STO) may be higher than a utility tokens (ICO) launch.

Next, we’ll take a quick look at some fundamental aspects that an entrepreneur wanting to issue a security token offering should consider. In the following letters we will review where to issue and raise capital, including limitations and restrictions, both for tokenized funds and equity token offerings, and profit-share or revenue-share tokens which are the most common types of security tokens.

Type of Security Tokens

As we have said, a security token is a digital representation of some kind of security. The following is not legal advice of any kind and is just for general information purposes.

Generally these assets, are either equity, debt, or some derivative. There might also be another physical asset represented by a token (such as gold, land, etc.) and this might be considered a derivative, or commodity, it depends on the situation, etc.

The most common securities (and also security token) are those that represent equity in a company. Equity tokens may represent a voting right class of shares or non-voting.

Investments in equity tokens are anticipation of future returns in the form of dividends, the equitable participation in the income of the company and as the company grows these tokens may appreciate accordingly.

The token can also represent fund interests or shares, providing the right to receive fund returns to its holders, this is what is commonly called a tokenized fund. More on that in the next letter.

There are also security tokens that provide profits or revenue rights without conferring any kind of ownership.

A security token can also potentially represent debt. The company issues certificates of debt or promissory notes, with which the investors expect to receive a return in the form of interest and the amount of capital loaned on its due date, or may sell the loan to other investors.

A security token could also be backed by any investment contract or financial product such as bearer bonds, royalties, convertible notes, options, swaps, future contracts and other derivatives.

Then there are tokens backed by physical assets which may have to comply with securities laws. For instance, in some jurisdictions if the token’s underlying asset is a residential property project under development or to be developed it may be considered a security – as it would function similar to other regulated products such as a REIT (real estate investment trust)

Securities Regulations

Depending on the type of asset that backs the token and the jurisdictions involved, your company will be subject to different regulatory requirements and regulatory agencies that govern them with a series of obligations, limitations and restrictions, legal agreements, disclosures and reporting, KYC/AML, marketing, taxation, among other requirements. The following is not legal advice of any kind and it is just for general information purposes.

You have to take into account the securities laws and subordinated regulations of the country where your investors are located along with the country where your company or registered fund is, as well as where your employees are (as this may inadvertently create a nexus or domicile).  For instance there have been cases where ECI (effectively connected income) has created a nexus in the United States.

Offerings are normally classified into two broad categories – private placements and public offerings.

Registering a public offering and raising capital from retail investors may involve a cumbersome and tedious legal and financial process which a start-up, in most cases, cannot cope with.

Normally, STOs are carried out via private placements and only sold to accredited investors, which makes them subject to softer requirements or eligible for a registration exemption.

The ‘traditional’ ICO approach differs greatly here as they are generally involving some kind of public sale. Oftentimes ICOs restrict some jurisdictions because non-favorable securities laws or regulatory ICO guidelines. But they have a global approach and could raise funds from almost any jurisdiction. An ICO is generally unregulated, however there are some countries that have recently passed legislation such as Malta and Bermuda, among others.

In a security token offering, you are selling a regulated financial product which must comply with existing regulations.

If you want to raise capital from investors in a given country, even private placements offered to professional investors may face several requirements, such as filing an offering prospectus to the regulator of the given jurisdiction in order to make an invitation to subscribe for or purchase securities.

Many countries have strict regulations on how securities can be marketed. This is often while you’ll see a disclosure around “forwards looking statements” and other legalese on marketing materials. Many jurisdictions also ban the sale directly to investors and mandate that they bid out through local distributors such as brokers, banks, insurance companies and other companies licensed as securities dealers.

In short, an STO must not only carefully select where to carry out the issuance but also select the countries where it wants to sell it and have the appropriate legal advice in each of these countries, and engage with local distributors for the sale of securities.

Ongoing KYC/AML

In an ICO issuing a utility token, KYC is usually performed during the Sale by identifying its participants – some with more robust or adjusted to the legislation KYC/AML checks than others.

In many jurisdictions, utility ICOs are not explicitly subject to compliance regulations but they have adhered voluntarily to KYC/AML procedures since transacting with a sanctioned person, accepting illicit funds or having an ICO used for money laundering can involve serious legal issues, as well as to restrict residents of certain jurisdictions.

With a security token offering, the KYC/AML requirements enters a much more complex dimension.

With a STO you must know who is the owner of the securities and where they come from at all times – as you would almost certainly be violating laws and regulations otherwise.

There are certain regulatory restrictions on who can legally buy, where to buy and sell, and in some cases lock-up periods.

For instance, only qualified investors from certain jurisdictions may be eligible to acquire the token, not only during the STO, but also after the issuance upon the liquidity event.

The pseudo-anonymous and freely transferable nature of crypto assets means that appropriate transfer restrictions and tracking functions must be programmed into a security token. Typically this is called “KYC-whitelisting” and unlike a utility token ICO, it must be implemented for the entire lifecycle of the tokens.

While some have proposed that KYC-whitelisting happen at the wallet level, we feel this is a foolish implementation as it can easily be circumvented.

The KYC whitelisting should happen at the ‘blockchain level’. In other words, these restrictions should be built-in into the smart contract, so that STO token buyers should be able to acquire it only if they fit the requirements of the original STO sale and in a way that allows the STO company to track the tokens and its owners as they change hands.

Security Token Exchanges

One of the biggest attractions of utility token ICOs is their near immediate liquidity. Holders can trade these tokens in secondary markets without any restriction and oftentimes even anonymously.

If not formally listed on an exchange, utility ICO’s are often almost immediately listed on ‘decentralized exchanges’ which are permissionless and allow for a market to be made in almost any crypto asset.

Currently, the secondary trading and the liquidity of security tokens are lower or almost non-existent since security tokens cannot be freely traded and are subject to restrictions, limitations, and barriers to entry that can vary between jurisdictions.

There are certain factors to take into account which can have a certain impact on liquidity of a new STO asset.

For starters, most crypto exchanges will not provide securities token trading, in fact, we’ve seen exchanges de-list tokens that have elements of a security token.

This is because special licenses would be required – as capital markets are regulated.

Exchanges that provide trading of tokens that are considered securities are subject to registering with the regulator and obtaining licenses and permission to operate as such, e.g. alternative trading systems (ATS) or securities dealers, among others, which also vary depending on the jurisdiction.

These regulated platforms are licensed to operate in a particular place and face several restrictions on which products can be negotiated and who can negotiate. This means that security tokens may not be globally transferable within the platform.

In addition, as we have said before, security tokens require a continuous KYC/AML process adjusted to their specific restrictions and limitations which may represent a technical and compliance challenge.

For instance, how does KYC/AML performed at multiple exchanges happen with respect to a single asset – is that asset centrally managed, and by whom? How does the exchange know the KYC requirements of that asset. How does the asset manager know that the exchange is performing adequate KYC. There are projects working towards this end, but it is a technically and operationally challenging endeavor.

Marketing for a Security Token Offering (STO)

In a utility token issuance, the issuer markets the ICO globally on the internet, builds community and hype towards a token distribution event.

In a security token offering, marketing generally to the public is oftentimes not possible and you may be breaking certain laws. STO projects will have restrictions on who you can solicit to.

Traditionally, securities issuances are distributed by brokers or other duly regulated financial institutions that are responsible for tasks such as solicitation, signing agreements and also the preparation of marketing materials and compliance. One of the advantages in a securities issuance via blockchain is the removal of intermediaries which can reduce costs.

However, in a STO, it is usually the company itself that solicits and markets the securities token offering. This entails some disadvantage, such as responsibility burden on the issuer.

As a general rule, a security token offering can only be marketed to residents of jurisdictions where the STO is effectively registered/exempted of registration. If it is done through a private placement, the investment solicitation usually must be made on a strictly private basis to qualified investors. To make matters more complicated, the risk disclosures and qualified investor status that would be mandatory often varies between jurisdiction to jurisdiction.

In addition, the definition of marketing and/or advertisement also varies between countries and what is acceptable in one jurisdiction (a podcast for instance) might face uncertainty elsewhere.

In some countries a definition of ‘marketing’ or ‘solicitation’ is well defined and proven, while in others it is relatively broad. In some jurisdictions simply announcing the event on the company’s website, which is accessible in the jurisdiction, could be understood as marketing to the public and be in violation of securities regulations.

Given the global and public nature of the internet, STOs usually do not carry out a marketing campaign for investors and they mainly attract prospective investors via networking and private introductions, also known as a private sale.

The Bottom Line

As opposed to ICOs, which are mostly unregulated, STO’s face a considerable regulatory burden.

ICO’s may fall into a ‘grey area’ – with STOs, you are fully subject to securities laws and other regulations. Your issuance will have certain restrictions and limitations, you will face mandatory disclosures and fillings and your investors will have certain rights.

When planning an STO, projects cannot have the ‘traditional’ ICO approach, aggressively marketing it and building a huge community promoting your project and hype – this would entails a considerable legal risk.

STO’s generally select targeted jurisdictions and register the security, or apply for an exemption.

A conservative approach, approved by practicing lawyers and professionals, especially when it comes to marketing, is generally a good idea. STOs are a totally new event which are subject to laws that were not enacted considering its specific characteristics, the internet and blockchain. There is oftentimes no legal precedent, and prudent caution should be the rule.

The Bright Side

However, the crypto market trend is moving to a security token market which will help to remove bad actors, protect investors and attract institutional capital in to the token market. Security tokens may bring crypto to the mainstream, and is generally seen as a positive development in a developing industry.

It is possible to issue a compliant STO. Securities laws have been in place for a long time and there have been countless of securities offerings.

With security tokens, there may be some technical and legal challenges but with the proper legal advice and technical systems in place, a successful STO is possible.

At Flag Theory, we can help you navigate across the different jurisdictions where you may want to set up and sell your security token offering – to design and implement the proper corporate structure for that purpose, while introducing you to the proper lawyers for drafting of documents and providing you legal advice.

In the next letters, we will review some jurisdictions where you could potentially set up and sell your tokenized fund, and some key aspects you should consider.

If you are planning to do an STO, Flag Theory and its partners can provide you a full STO issuance solution, including jurisdiction and regulatory comparison, introductions to legal advisors in the relevant jurisdictions, custodians and administrators, banking, KYC/AML systems providers and Security Token Smart Contracts specialists. Contact us today, it will be a pleasure to assist you.  

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