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Digital Securities

Digital Securities

These unique tokens provide companies and investors with a regulated way to enter the crypto space. When a company launches a security token it’s called a security token offering (STO). Understanding the pros and cons of security tokens makes you a better-informed investor.

Regulatory integration is a huge step forward for the cryptospace. It allows traditional business models to convert over to more efficient blockchain-based structures. While this approach is perfect for many types of business models, it doesn’t always make sense due to some of the drawbacks security tokens contain. Let’s take a moment to examine the pros and cons of security tokens to get a better understanding of these amazing tokens' true capabilities and limitations.

Pros of security tokens

Security tokens allow traditional business transactions to be tokenized while still meeting the regulatory requirements set in place for the industry in question. Tokenization is the process of transferring an item to the blockchain. For example, a security token can represent ownership rights in a property.

Transferring property ownership rights requires that all parties involved in the transaction meet certain related regulatory requirements. Security tokens have the ability to integrate these regulations directly into their core protocol.

Reducing investment thresholds

Security tokens are a powerful fundraising tool which allows companies to lower their minimum investment requirements to nearly non-existent. In the past, companies were forced to require that involved investors provide a certain level of funding to participate in their campaigns.

This situation led to the dismissal of interested parties that were unable to meet the minimum requirements. In other words, companies were unable to accept capital from millions of investors because the cost of processing the investor’s information was too expensive.

Blockchain technology eliminates this problem by automating the majority of the process. Security tokens take the concept further and remove the regulatory workload through the use of smart contracts.

Enhancing asset liquidity

Security tokens provide investors with more liquidity. In its current state, there are thousands of investors locked into long-term investments in which they must wait until the maturity date to access their funds. Since many of these are long-term investments, it can leave these individuals without access to their money for years.

Security tokens can eliminate these concerns. Once a fund is tokenized, an investor can buy and sell fund shares as they see fit. This produces a more effective flow of assets and enables the development of secondary trading platforms to handle new market opportunities.

Lybrion. Guide. Digital securities. Liquidity

Issuance costs

Hosting an STO is far cheaper than hosting an IPO. Companies can see upwards of 7% of their raised capital go towards issuance and transaction cost in a traditional IPO. The reasons for these high costs are simple. IPOs require the involvement of numerous third-party verification systems. Each adds a fee to the total cost of the transaction.

STOs reduce the cost of crowdfunding significantly when compared to IPOs. Blockchain technology allows companies to automate the most costly parts of their transactions. Additionally, smart contracts can automatically monitor, track, and distribute investment funds without the need of any third party intervention.

Reduced fees

Security tokens allow companies to host international fundraising campaigns. Sending any form of fiat currency internationally can be a huge headache. Depending on the amount of funds being invested, you could see over a week in delays. Additionally, there is a risk of losing funds during the monetary conversion.

Security token investors eliminate these international costs. These tokens can be sent across the globe for no additional fees. Also, you won’t have to wait days for your blockchain transaction to complete. In most instances, the transaction takes minutes. Best of all, there is no need to convert your funds.

Improved market efficiency

The transparent nature of blockchain technology improves the current market systems significantly. Security tokens provide instant monitoring capabilities. Users can easily track their tokens and investments via a blockchain monitoring application. Investors gain untethered access to their investment’s fundraising progress.

Cons of security tokens

No token is without its imperfections. And security tokens are no exception to this rule. These helpful tokens are bridging the gap between conventional investments and the blockchain space. That being said, they are not without their limitations.

Investor accreditation limitations

One of the biggest drawbacks to security tokens is the inability of non-accredited investors to own them. In the US this means that more STOs will require you to be an accredited investor as part of their SEC compliance. Unfortunately, you need to earn at least $200,000 per year, or have at least 1 million dollars in the bank, if you want to be an accredited investor.

More expensive than utility tokens

Unlike ICOs, STOs need to include a host of other organizations in their crowdfunding campaign. Underwriting companies are a perfect example of an added cost that STO participants must foot the bill for. Regulation isn’t cheap and it’s much more expensive to host an STO when compared to an ICO.

Secondary market trading restrictions

Another drawback encountered by security token investors is secondary trading market restrictions. Security tokens can only be transferred via licensed platforms. The platforms must possess a security trading’s license in the country they operate in. Additionally, security tokens feature a time-lock mechanism. You can only trade these tokens between qualified investors for a predetermined amount of time after the STO.

Lybrion. Guide. Digital securities. Time lock

Benefits of digital securities

Now that you have a better understanding of the pros and cons of security tokens, you can make an informed decision on which is the right investment for you. Remember, there isn’t a one-size-fits-all when discussing tokens and what may be the perfect fit for one business, could be a total disaster for the next.

Security tokens are the chain that links conventional markets to the cryptospace. You should expect to see explosive growth in this sector over the coming months as the advantages of blockchain technology continue to become better understood globally.

The benefits of security tokens (also known as “digital securities”, “smart securities” or “programmable securities”) for issuers and investors have been written about at length. However the benefits of common crowdfunding and other existing market formats are often confused with the benefits of security tokens. In this article we will attempt to provide clarity around the unique advantages of security tokens issued by private companies relative to the tradiational market formats for private securities.

Rebuttal of misconceptions

1: Security tokens give access to a global pool of capital.

Access to capital from around the world was available for a long time before security tokens. As remains the case with sales of security tokens, investment documents are prepared and circulated to investors who sign them electronically. Laws are what permit more or less access to global capital and determine from which jurisdictions around the world issuers can raise capital. U.S. companies have been able to raise capital globally under Regulation S for decades. Most non-U.S. jurisdictions have similar laws that permit (or do not prohibit) capital to be raised globally. The sale of security tokens has not extended the reach of companies to raise capital outside of the jurisdiction of their incorporation.

Security tokens are not what make it possible or even more efficient to raise capital globally.

2: Security tokens allow companies to sell securities to U.S. non-accredited investors.

Securities laws are the only thing stopping companies from raising capital from non-accredited investors. Selling security tokens does not change those laws. Just as before the emergence of security tokens, the only way U.S. companies can sell securities to U.S. non-accredited investors in a general solicitation is through a registered offering (e.g., an IPO) or an exempt offering (e.g., Regulation A+, Rule 506(c) or Regulation CF). Companies can also sell securities to non-U.S., non-accredited investors under Regulation S so long as the sale is permitted in the jurisdiction where the person resides.

Security tokens are not what makes it possible or even more efficient to raise capital from U.S. non-accredited investors.

3: Security tokens enable 24/7 trading of private securities.

Private securities could always be traded 24/7. Two people could meet for coffee at midnight, sign transaction documents and pay and receive payment for the private securities. There is no doubt that transacting in that manner is slow and inefficient, but it could be done 24/7. Conversely, when public companies begin to issue security tokens, subject to potentially problematic regulations of exchanges and exchange rules, we should begin to see 24/7 trading of public securities, which was not previously possible because intermediaries could not make the transactions happen at all hours of the day.

Security tokens are not what make it possible to trade private securities 24/7.

Lybrion. Guide. Digital securities. Misconceptions

4: Security tokens reduce the cost of issuing securities.

The issuance of securities, whether it be traditional off-chain securities in tokenized form or native on-chain securities, will not be cheaper. Legal documents, such as private placement memorandum and purchase agreements, along with advisor fees, such as for legal and tax advice and broker-dealer placement agents, will not change. In the short term, those fees have been and will continue to be higher than with traditional securities. In the long term, those fees will be the same as for offerings of securities in their traditional form unless regulators determine less disclosure is required, which is highly unlikely.

Security tokens are not currently resulting in reduced issuance costs.

5 Security tokens create liquidity for private securities.

Private securities can already trade in secondary markets but the necessary infrastructure for that trading has never been developed in the same way it is currently being developed for security tokens. For example, buy and sell orders of traditional securities could be matched on an alternative trading system, which is the same type of “exchange” used for security tokens. However, because of other market factors and investor interest, that infrastructure was never fully developed to create a robust market in private securities.

Security tokens are not what creates liquidity for private securities.

6: Security tokens enable fractional ownership of real-world assets.

Real-world assets can already be fractionalized simply using a few pieces of paper that state what percentage of an asset each person owns. A perfect example is when people hold real estate as tenants in common, which is a form of ownership in which multiple people own a direct interest in the real estate. In addition, although it is atypical, fractional shares of stocks are permitted in most jurisdictions. Thus, fractional ownership of real-world assets is currently possible but inefficient.

Security tokens are not what enables fractional ownership of real-world assets.

Real benefits

1: Security tokens will enable greater liquidity than traditional securities.

Although security tokens do not create liquidity for private securities, they do enable increased liquidity. This is due to the frictionless transfer of security tokens and potential for removal of intermediaries that are either currently necessary or convenient in connection with a transfer of traditional securities. Before liquidity in security tokens increases, several pieces of infrastructure are required, some of which are far along in development and use, and others that do not appear to be focused on much by the community.

2: Security tokens will enable the more efficient and cost-effective transfers of fractional interests in real-world assets.

When anyone currently wants to sell a fractional interest in a real-world asset, it is a slow, time consuming and expensive process. When combined with the potential greater liquidity of security tokens, the transfer of fractional interests through security tokens will be much more cost-effective and efficient. It will make what used to be a nonviable option both viable and common, which will unlock greater value than currently exists in fractional interests of real-world assets.

3: Security tokens will ensure greater compliance with laws.

Securities and other laws around the world are highly complex when dealing in financial instruments like securities. Some of them allow secondary trading of private securities, others do not. Some of them require time to pass before secondary trading of private securities is permitted, others do not. Some of them put limits on who can sell private securities and how much of them can be sold in secondary markets, others do not. With smart contracts coded with the applicable securities and other compliance requirements globally governing the trading of security tokens, companies can ensure that their securities are always trading in compliance with applicable laws.

4: Security tokens will enable more efficient cross-border trading.

Cross-border trading of securities has always been expensive and time-consuming because each individual seller and buyer hires legal counsel and other parties to enable the trade to ensure compliance with laws and avoid fraud. With smart contracts governing the compliance functions of security tokens and ensuring receipt of payment for the securities, those tokens can flow cross-border seamlessly with the costs of compliance being spread across all market participants by the companies building the smart contracts used to govern trading.

Lybrion. Guide. Digital securities. Benefits

5: Security tokens will enable better cap table management.

Cap table management is recognized as one of the biggest issues facing early-stage companies. Although solutions like Carta have facilitated cap table management, reducing costs and increasing accuracy, managing a company’s cap table still takes more time than anyone would like to spend on it. Security tokens provide a definite picture of a company’s cap table with all changes to the cap table automatically occurring upon transfers of the security tokens. Although it is surprising, the same benefits exist with public securities because of the massive number of intermediaries handling book entries for the securities, which often are inaccurate or delayed in ways that are problematic for companies and investors.

6: Security tokens will facilitate better corporate governance.

Governance of companies with securities trading in secondary markets (which has commonly been public securities) but is becoming more common in private securities results in low stockholder engagement because stockholders generally hold their stock beneficially (i.e., indirectly). When companies hold votes on important matters, the beneficial holders of stock do not participate, except through the direct record holders of the stock, which is inefficient and results in lower participation by the real “owners” of the stock. In addition, record holders have been known to make mistakes when acting on behalf of beneficial holders of stock. Security tokens allow for an efficient way for investors to hold stock as record holders and be more actively engaged in stockholder decisions. In addition, in the future, security tokens will enable on-chain voting for corporate decisions, which will increase the accuracy of the historically problematic voting process.

7: Security tokens will enable more efficient and transparent payment of distributions.

Payments of distributions can be made with cryptocurrencies, stablecoins being an especially good option. The current process of mailing checks to stockholders when they receive distributions from companies is inefficient. At times, the amount of the check is less than it costs to mail it. Beyond that issue, it is not logical to incur the cost and time involved with mailing checks when better solutions exist (and current better solutions are often not more cost effective than mailing checks). As confidence in stablecoins grows, the payment of distributions using stablecoins directly to the wallet in which investors hold their security tokens will make for much more efficient and cost-effective distributions. An even more obvious benefit is payments on debt, which can be increased in frequency and automated. In addition, with time, covenants could be required in loan documents for stablecoins on a transparent blockchain to be set aside in a wallet daily to ensure that the company behind the debt has the capital required to make payments on the debt, and creditors could tell immediately if the debtor is behind on its obligations.

UK Token Regulation

A number of token offerings to date have involved an entity incorporated or established in the Cayman Islands, Gibraltar, Singapore, Switzerland, the UK or the US. There are many factors that drive the choice of jurisdiction, which vary on a case-by-case basis. A question frequently asked, however, is whether any law other than that of the jurisdiction of incorporation of the entity generating or offering the tokens needs to be considered in relation to a token offering.

The short answer is yes. In addition to the laws of the jurisdiction in which the entity issuing or generating the tokens is incorporated or established, the laws of each jurisdiction within which the tokens could be considered to be offered or sold, or in which a regulated activity may be deemed to be carried out, will also be relevant. Most jurisdictions regulate the conditions under which certain investments may be offered (if at all) within that jurisdiction. There are also generally restrictions on the ability of certain persons to carry out certain (regulated) activities in relation to such investments, or submit the carrying out of such activities to conditions (such as licencing or authorisation requirements).

Are tokens regulated investments?

Carrying out a regulated activity in the UK is generally prohibited, unless the relevant person is authorised or exempt. An activity is a “regulated” activity if, amongst other things, it relates to a “specified investment”.

Furthermore, communicating in the course of a business an invitation or inducement to engage in investment activity is also generally prohibited, unless the relevant person is authorised or the communication is approved by an authorised person. Again, an activity is an “investment” activity for this purpose if (amongst other things) it relates to “specified investments” (or a specified class of investment).

Some tokens will be “specified investments”. Packaging something that would otherwise be a “specified investment” in the form of a token will not generally change the regulatory outcome.

For example, tokens that grant a holder some or all of the rights that would typically be enjoyed by:
(i) a shareholder (for example, entitlements to dividends declared, profits or the proceeds of the assets of an insolvent company);
(ii) a bondholder (for example, a right to the repayment of a sum of money); or 2.4.3 a participant in a fund (for example, to profits or income from the acquisition, holding, management or disposal of the fund property),
are likely to be considered “specified investments”.

Tokens that give rights to other tokens or to other “specified investments”, or that have characteristics of derivatives (e.g. futures, options or contract for differences) are also likely to fall within the regulatory perimeter.

The UK Financial Conduct Authority (FCA), has, however, indicated that “many ICOs will fall outside the regulated space”. Depending on the precise structure and the function of the tokens, it may therefore be the case that the tokens do not fall within the regulatory perimeter as “specified investments”. This could be the case, for example, if no legal rights attach to the tokens. Even if that is so, however, it remains the case that agreements or instruments (including other tokens) that refer to or give rights to such unregulated tokens may themselves amount to “specified investments”.

Lybrion. Guide. Digital securities. UK

Are pre-sale arrangements themselves regulated investments?

Pre-sale arrangements (if any) vary significantly from one token offering to another. In some cases, a separate instrument is intentionally created (which may or may not itself be a token), which gives rights to, or is convertible into, the main token, once created. In others, the pre-sale is intended to amount to no more than a sale of property that will come into existence at a future date (the tokens). As for tokens generally, the variety in structures therefore requires any pre-sale arrangements to be considered on a case-by-case basis.

Broadly speaking, for most jurisdictions (e.g. Germany, Hong Kong, Singapore and the UK):
(i) if the main token is itself a regulated investment, security or other regulated product, pre-sale arrangements that amount to an instrument, certificate or agreement giving rights to the main token will generally amount to a separate regulated investment; and
(ii) even if the main token is not itself a regulated investment, security or other regulated product, pre-sale arrangements that have characteristics of a derivative, structured product or other financial instrument may nevertheless amount to a separate regulated investment.

For the US, pre-sale arrangements generally will be deemed securities because their value will be primarily dependent upon the sponsor of the tokens developing and marketing the tokens and the platform on which the tokens will be used. This is a classic example of “efforts of others” which, if coupled with an expectation of profit, will fall squarely within the definition of investment contract laid out in the Howey Test.

One of the more prominent attempts to create a legal framework for compliance with US securities law is the “simple agreement for future tokens” (the SAFT). The idea is that the parties will assume that the SAFT is an investment contract (and therefore a security under the Howey Test) and as such the token sponsor will structure the token sale in order to ensure that it can rely on an exemption from registration under the US Securities Act, such as limiting availability of the token to investors to those who qualify as “accredited investors”.

As the authors of the SAFT acknowledge, their argument hinges on ensuring that the tokens (once issued) are not securities. However, this may not be possible to determine at the outset, as it may be possible that the value of the token continues to depend significantly on the efforts of the token sponsor or third parties. If this turns out to be the case, the fact that the tokens were purchased on a delayed basis through a SAFT does not particularly affect the analysis.

Is a prospectus (or other offering document) required?

An approved prospectus will be required if the tokens are “transferable securities” offered to the public in the UK (or for which admission to trading on a regulated market will be requested), unless an exemption applies. This may also apply to pre-sale arrangements, for example, that give rights to tokens that are “transferable securities” or are themselves “transferable securities”.

The definition of “transferable securities” refers to “those classes of securities which are negotiable on the capital market”. There is uncertainty as to whether (or when) the market for tokens could be said to amount to a “capital market”. If the market for tokens amounts, wholly or partly, to a “capital market”, a prospectus would generally be required (unless an exemption applies) for those tokens amounting to securities transferable on that capital market. The term “security” for these purposes is not defined, but (following pronouncements from the European Commission) would arguably capture those tokens capable of being traded on an exchange.

Lybrion. Guide. Digital securities. Prospectus

If the tokens are not regulated investments, do other potential regulatory issues arise?

Payment services. A person may not provide a “payment service” in the UK, or purport to do so, unless the person is authorised to do so. “Payment services”, broadly, relate to money or “funds” (which includes banknotes or coins, scriptural currency or electronic money). Depending upon the precise structure, a token offering may involve the provision of payment services (particularly where fiat currency is accepted in exchange for the tokens). Recent regulatory pronouncements from the European Commission have suggested that the scope of payment services regulation may be extended to certain cryptocurrency exchanges and wallet providers.

Regulation of exchanges and custody services. Where tokens are financial instruments for the purposes of MiFID (which includes most “specified”, i.e. regulated investments), operating an exchange that allows for trading in such tokens will generally be a regulated activity if conducted in the UK. Equally, safeguarding or administering tokens that are “specified” (i.e. regulated) investments in the UK will generally also be a regulated activity.

Supply of digital content. Specific consumer protection legislation applies in relation to the supply of “digital content” (i.e. data which is produced and supplied in digital form). Tokens may arguably amount to, or involve, digital content, and therefore trigger protections where consumers are involved in the token offering. These protections involve certain terms being implied as to the digital content being of satisfactory quality, fit for purpose and as described. The terms of consumer contracts are also subject to “fairness” test, which could apply to the relevant subscription documentation in the context of a token offering. Consumers may also be entitled to enforce rights to a rebate or refund in certain circumstances.
Unfair commercial practices. Protections from unfair commercial practices may also apply where consumers are involved in a token offering. These prohibit unfair commercial practices, misleading actions or omissions, aggressive practices and blacklisted practices. A breach of the prohibition may entitle consumers to pursue certain civil remedies (including rights to a discount, damages or to unwind the relevant contract), and may attract criminal sanctions in certain circumstances.

Can tokens be offered into the People’s Republic of China?

A circular was issued jointly by seven regulatory authorities in China on 4 September 2017, which, amongst other things, demanded that all token offerings cease immediately and any completed offerings be unwound (i.e. any proceeds raised should be returned to investors). In addition, cryptocurrency exchanges could no longer provide any trading services (between fiat and cryptocurrencies, or between cryptocurrencies) or pricing/quote services.

The circular does not specifically address whether it is only targeted at domestic token offerings, although insofar as it relates to cryptocurrency exchanges, the penalties stated suggest that it is focusing only on exchanges operating in China.
It is difficult to gauge at this stage whether and how the Chinese regulators would seek to enforce against cross-border token offerings. It is expected that new regulations will be introduced to prohibit illegal fundraising activities (which may include token offerings) in the near future.

What are some of the most significant practical issues currently faced in relation to token offerings?

Security and token holdings. A significant issue in the context of token offerings has been whether and how tokens can be held in a secure way. In particular, it is generally unclear, both as a practical and legal matter, whether or how a claim to tokens that have been lost (for example, because the relevant wallet provider was hacked, or due to fraud) can be enforced.
Bankability. Token issuers have faced difficulties in banking fiat currencies converted from cryptocurrency proceeds received from token offerings. Banks typically view token offerings as presenting a high risk for money laundering, which means that banks would be obliged to undertake enhanced customer due diligence and enhanced monitoring of business relations to comply with their “know-your-client” (KYC) and money laundering obligations.

A key practical issue is that banks generally require the source of funds to be established, which necessarily involves identifying:
(i) the institution or investor from which the funds originate; and
(ii) the activity that generated the funds. It may be difficult to ascertain the source of funds in relation to token offerings, given the generally anonymous nature of cryptocurrency proceeds, particularly where conversion takes place on a cryptocurrency exchange. Globally, a number of banks are reported to have closed bank accounts of companies offering cryptocurrency services. At present, there does not appear to be a clearly identified practical solution to the “bankability” problem.

Clearing and settlement. The legal basis of transfers, clearing and settlement of transactions in tokens and other cryptocurrencies or assets is unclear. For example, in certain jurisdictions, it is unclear whether (or how) the holder of a token could successfully enforce a “proprietary” claim to the token against a third party (for example, in the case of theft or misappropriation). Mechanics applicable to other types of investments such as bonds or shares are not applicable or easily adaptable to tokens.

Ability to exchange for fiat currency. Many tokens are not directly exchangeable for fiat currency or, even if they are, they are not exchangeable easily. The ease with which a new token will be able to be transferred and exchanged will depend on whether they are accepted for trading by a cryptocurrency exchange platform. While more popular tokens and existing cryptocurrencies will be traded across multiple platforms, new tokens may not be accepted by exchange operators and therefore liquidity will be negatively impacted. Without easy access to a market price for any new token, it could be difficult to exchange the token for fiat currency.

Regulatory status. As noted above, in many jurisdictions tokens and token offerings can be subject to multiple classifications, each with their own regulatory requirements. One recent example of this was highlighted by the U.S. Commodity Futures and Trading Commission (CFTC) in its recently published Primer on Virtual Currencies. In its primer, the CFTC stated that tokens issued in connection with token offering may be both a “commodity” for purposes of the U.S. Commodity Exchange Act and a security for purposes of the securities laws, while emphasising that it will look beyond the form to the actual substance and purpose of an activity when applying CFTC regulations. To the extent that a token is a CFTC commodity it could become subject to a host of regulatory requirements which are substantially different to those imposed on securities (e.g. trading and clearing requirements, transaction reporting and position limits).

Therefore, as the regulators in each of the discussed jurisdictions develop their views on the status of tokens and token offerings, any issuer, advisor or purchaser should be aware that the terms of the transaction will determine the financial regulations to which they are subject and that the securities analysis, while critical, is not the end of the discussion.

The aggregate security token market capitalization is still relatively low, around $145 million worldwide in June 2020. However, the prospects for tokenizing business capital and debt markets are clear and will bring significant benefits to investors in the future.

// By Alexey Pogorely, Director of Lybrion, 26.07.2020

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