Dr. Ozden’s STO Compliance Bible

October 25, 2018


LEX has been working on an increasing number of Security Token Offering (STO) cases from Asia and North America, and our clients typically start with the same question: How can I do it?   As discussed in our previous LEX View, LEX anticipates the next wave of disruptive blockchain innovation in two areas: Stablecoins and Security Tokens. This two-part LEX View will discuss the development of Security Tokens and the current path towards Security Token Offerings (STO).

Security Token vs. Utility Token

Blockchain innovation has caused disruption in the finance sector through the creation of an alternative financing model through the sales of Utility Tokens. Utility Token financings emerged first in 2014, and progressively became much larger in size, with some of the earliest issuances by projects such as Ethereum in 2014 ultimately reaching market caps in the tens of billions of dollars. This year, during the first half of 2018 alone, projects conducting sales of Utility Tokens have managed to secure US$13.7 billion in funding, more than all pre-2018 sales of Utility Tokens combined .

True “Utility Tokens” are crypto tokens issued on a blockchain which provide holders with future access to the product or service being developed by the project that issued such Tokens. When properly structured, Utility Tokens are not designed as ‘investments’ and should therefore not be subject to securities regulation.

Regulators in different jurisdictions have varying views on this. In the United States, Jay Clayton, the Chairman of the Securities and Exchange Commission (SEC) has stated that every initial token offering he has seen to date is a “Security” and are “investment contracts”. Meanwhile, as LEX reported last month from Consensus Singapore, the Head of the Technology Infrastructure Office at the Monetary Authority of Singapore (MAS) has said no tokens it has seen are “securities”. Meanwhile, the Singaporean authorities, like the Swiss and Japanese authorities, have guidelines on issuing “Utility Tokens” that are not ‘securities’. So why the confusion?

Most regulators around the world who have officially provided guidance on the industry view true “Utility Tokens” as ‘utility’ and not as a ‘security’. The notable exception is the United States, where the SEC is pushing the entire regime of Utility Token  generation and issuance under securities rules and regulations. This is an anomaly, and in LEX’s view and many others, not a proper application by the SEC of the laws of the United States, and the SEC’s actions are already being challenged in domestic courts. However today, this represents the reality in one of the world’s major markets for cryptocurrencies: all tokens at the time they are offered for sale, except for Bitcoin, are classified ‘securities’ in the United States.

With this background, you can understand the emergence of the “Security Token” in the United States. In the U.S., all tokens are being treated currently as ‘securities’, whether they are “Utility Tokens” or true “Security Tokens”. For the purpose of this LEX View, we will just focus on true “Security Tokens” that are an investment contract in an asset, as opposed to those that are actually for Utility.

During the first half of 2018, LEX and other top experts in blockchain in the United States and other markets co-operated as the “Token Alliance” to prepare the [Guide to Issuance of Utility Tokens, which report was submitted to U.S. Congress and the SEC and CFTC and other governments around the world. LEX was the only group from Asia to work on this major 110-page report, which is used by top cryptocurrency projects and practitioners as the ‘Bible of how to generate Utility Tokens’. For the second half of 2018, LEX and various top blockchain experts globally are working as a part of the Token Alliance on similar guidelines for Security Tokens and STOs, which will also lay out for government regulators and top projects and practitioners around the world the methods for generation and distribution of Security Tokens through STOs.

Security Tokens can include tokenized:

1. Traditional financial assets such as stocks, bonds, notes and other traditional debt and equity assets, such as companies like Anexio have done;

2. Non-traditional financial assets which include assets that have been historically difficult to trade, like income streams or revenue rights such as the tokens issued by Blockchain Capital or SPiCe VC;

3. Non-traditional assets which are illiquid and/or prohibitively expensive to own entire units and transfer ownership rights, such as real estate or art;

4. Rights and schema which can include voting rights and derivatives; and

5. Hybrid tokens where the token has both an investment and utility aspect in its function.

While most of the current STOs have been focusing on traditional and non-traditional financial assets, technology related to tokenization allows for assets to be separated into multiple layers of value, which may provide for even more opportunities for innovation.

For example, a project can conduct an STO where it issues tokens that are based on the equity of the company, or allows for a share of the revenues or profits of a business, or gives the right to participate in dividend distributions, or some other aspects of the business operations or asset that would provide the Security Token holders with an ‘expectation of profit’. With a Security Token, you can also conduct some of the activities some of the regulators, such as the SEC, have said fall within the securities realm, such as voting corporate decisions, burning tokens and air drops, so long as you comply with applicable securities laws.

Another development that we anticipate more in the future is the issuance of “Dual Tokens” where a project will issue a Security Token that also comes with a Utility Token or some form of utility that is native to the project. For example, Tesla could issue a Security Token, where in addition to an investment to make profit, holders of the Security Token have the right to buy a new car at a discount, or get to the front of the queue of waiting for new models. The Tokens can be programmed such that the longer you hold the Token, the more your rights will increase. This can be through the digital Security Token or also through an attached Utility Token, which is added on to the offering as a ‘sweetener’.

Why Conduct a Security Token Offering?

Security Tokens can bring a number of improvements to traditional security offerings:

1. Reduced Cost: Many of the costs and fees associated with securities offerings (investment banking fees, legal fees, escrow fees) as well as the complexity and paperwork required to manage securities (collecting signatures, wiring funds, mailing distribution checks) will be reduced or negated through the programming of the token smart contract. For example, dividend rights, liquidation preferences and voting rights can all be encoded in the security token itself. However, issuers looking to reduce the role of investment banks, lawyers and other advisors in an STO will shoulder the burden of arranging for third party audits, prepare marketing materials, solicit investor interest, and conducting their own security and regulatory compliance. Traditional investors may be reluctant to participate in STOs due to the belief that a potential issuers are incapable of successfully executing these functions without traditional financial institutions.

2. Free market exposure: Most investment transactions today lack exposure to a global investor base. For example, it is hard for investors in Asia to invest in private US companies or real estate. With Security Tokens, asset owners may, subject to regulatory requirements, market their securities offerings to anyone with an Internet connection. Furthermore, companies which are in the angel and venture capital stage can achieve liquidity through issuing a Security Token that is trading. This will give earlier-stage companies access to a wider source of financing, and provide non-institutional investors access to high growth companies that were previously monopolized by institutional funds. This free market exposure should lead to a significant change in asset valuations since any asset that is not exposed to a free market may be mispriced. This feature is a major attraction to many of the projects LEX currently works with.

3. 24/7 Markets: Major stock exchanges are open for trading only during business hours during regular business days. Stocks may not be traded outside that time frame. However, blockchain exchanges are open 24/7 and around-the-clock trading hours across all time zones is possible.

4. Rapid settlement: Settlement of securities trades under traditional exchanges take days. For example, the SEC has only recently adopted a shortened settlement cycle for most broker-dealer transactions of T+2 (i.e. the transfer of ownership in the security does not occur until two business days following trade execution). Settling transfers of LP and LLC interests can take even longer. Token and cryptocurrency trades are settled in just minutes. The blockchain has the potential to increase settlement speed for securities. The degree to which these processes can be automated through interoperable smart contracts will determine the gains in settlement speed.

5.Fractional ownership: Security tokens allow companies to divide underlying assets into smaller units, enabling fractional ownership. This makes it more affordable for some investors to contribute to the STO and can also make the token easier to transfer on the secondary market.

6.Liquidity: Thanks to the global-by-nature default of blockchains, security tokens can, subject to the regulations of individual jurisdictions, be far more liquid and tradeable than traditional securities. We discuss the challenges of Security Token liquidity in further detail below.

What Type of Projects are Suitable for an STO?

Generally, any type of project with an asset for investment can conduct an STO. However, given we are in the early days of STO generation, LEX looks for some or all of the following qualifications for its projects:

I. Strong management team dedicated to long term vision and growth

II. High growth project

III. Already have some business history and revenues, or have angel or venture capital funding and desire to raise additional capital

IV. Project wants to provide liquidity to Security Token holders

V. Project wants to access global capital markets

VI. Project may want to combine their STO with a native Utility Token for their customer base

The most important aspect of this is the first requirement, which is a strong management team dedicated to long term vision and growth, particularly since this is the early days of STOs. If you look at earliest days of Utility Token sales, the most successful projects such as Ethereum which grew in a few years to large market caps all had strong management teams. Also, since STOs have a higher standard for regulatory compliance over Utility Token offerings, there will be larger and more institutional investors participating in the STO – who will themselves also seek a strong professional management team.

An STO provides both the projects and the investors the opportunity to have a wider pool of capital and companies at earlier stages. Excellent high growth projects that were previously only available to top institutional funds, now can be available to small investors, so long as securities laws are complied with. Meanwhile, investors get something they actively seek, which is liquidity upon the trading of the Security Token.

STO Regulations

While security laws vary by jurisdiction, for purposes of this LEX [View] we will focus on STOs in the United States, although we will also touch upon developments in other locations such as in the EU and Caribbean. In the United States, security offerings must be registered as a public offering with the SEC, or fall within an exemption from registration. Currently, no STO has been conducted as a registered public offering under the Securities Act of 1933 (the “Securities Act”). Issuers have looked instead to three primary exemptions from the registration requirement to conduct their STOs:

1. Regulation D: Companies issuing exempt Security Tokens have primarily used Rule 506(c) of Regulation D under the Securities Act, which allows companies to sell securities to an unlimited number of accredited investors and also broadly solicit and advertise the offering. Some also use Rule 506(b) of Regulation D, which has different restrictions on advertising.  Securities offered by non-public companies under Rule 506 receive restricted securities that cannot be sold for 12 months without registering them.

2. Regulation A: Regulation A under the Securities Act (sometimes referred to as Regulation A+ due to changes made in 2015 to expand its scope) allows a company to offer securities to the public under two tiers: Tier 1, for securities offerings of up to $20 million in a 12-month period; and Tier 2, for securities offerings of up to $50 million in a 12-month period. An issuer of $20 million or less of securities can elect to proceed under either Tier 1 or Tier 2. Subject to other restrictions, Regulation A is only available to companies organized and with their principal place of business in the US or Canada and limits the securities issued to equity, debt or debt convertible into equity. Investors may freely trade the securities after the initial purchase.

3. Companies conducting Regulation A offerings are required to file an offering statement with the SEC which includes an offering circular and two years of financial statements (Tier 1 financial statements may be unaudited while Tier 2 financials must be audited). The offering statement must be “qualified” by the SEC before sales can be made – which is a lower threshold than the traditional registration of securities under the Securities Act.

4. Tier 1 issuers are not subject to ongoing reporting obligations other than filing certain information within 30 days after completing the offering. Tier 2 issuers also need to provide a similar post-closing filing but are also required to file annual reports, semi-annual reports and current event reports with the SEC on an ongoing basis.

5. The United States Securities Exchange Act of 1934 (the “Exchange Act”) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of equity securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the SEC. Regulation A, however, conditionally exempts securities issued in a Tier 2 offering from this mandatory registration so long as the issuer remains subject to, and is current in, its Regulation A periodic reporting obligations. Additionally, for the conditional exemption to apply, issuers in Tier 2 offerings are required to engage the services of a transfer agent registered with the SEC. The conditional exemption is only available to companies that meet certain size-based requirements. An issuer that exceeds the size-based requirements is granted a two-year transition period before it would be required to register its securities, provided it timely files all ongoing reports due during such period.

6. Regulation S: Regulation S under the Securities Act provides that securities may be sold by a U.S. or foreign issuer without being registered in an offshore transaction (i.e. outside of the United States) provided no directed selling efforts are made in the United States. The offering must still abide by the security regulations in each country where the securities are being offered. In addition, depending on the type of securities being sold, whether the issuer is a US or foreign entity and whether the issuer is a public company in the US, the offering may be subject to a compliance period of up to 12 months where the securities cannot be sold to a U.S. person unless the transaction is registered under the Securities Act or exempt from registration.

LEX spoke with the Head of Digital Assets and Innovation at the SEC, Valarie Szczepanik who leads cryptocurrency for the Commission. She has informed us that there have been a number of Regulation A+ filings for cryptocurrencies filed and a handful of full-blown registration statements under Form S-1 and Form F-1 (as required under a traditional IPO in the U.S.) filed, but none have been qualified nor approved, as of yet. And even though the Form 1-A, which is used to file with the SEC for a Regulation A+ offering, is designed for equity, the SEC is permitting us to use this for “Utility Token” cases, so long as we make certain modifications to the information we provide on the Form 1-A for projects – such as (i) a deep description on the token and its usage, (ii) description of decentralization, forking and other similar considerations for blockchain projects, and (iii) detailing past compliance with securities laws for generating Tokens.

For STOs meanwhile, many have been conducted have been through Regulation D, as no onerous filings are required. However, enforcing the 12-month trading restriction after distributing the security tokens has been an issue. Some companies have enforced a lock-up period, so the investors do not actually receive the tokens for at least a year, while others have issued the tokens while relying on the investors to self-enforce the trading restriction. Similar concerns apply to STOs conducted through Regulation S on ensuring the tokens are not sold to a U.S. person during the compliance period. An increasing number of STOs are filing under Regulation A+, yet based on our experience with the SEC, we will likely not see a qualified filing until sometime in 2019.

As discussed further below, a number of blockchain projects have been working to address the regulatory restriction issues on initial security token issuance (e.g. confirming accredited investor status at the KYC stage) as well as on secondary trading of the Security Token by investors. The restrictions inherent in a Security Token will be written into the Token smart contract itself, so that the Token can only be issued to approved investors (such as investors whose accredited investor status have been confirmed by the company or a third party compliance service in the case of a Regulation D offering, or who are non-U.S. persons in the case of Regulation S offerings) and investors can only freely trade the security token after the appropriate restricted period has passed.

How to Generate a Security Token

Security tokens are generally being issued on the Ethereum blockchain using the ERC-20 standard (the standard previously used for utility token issuances), with appropriate modifications to the smart contract as necessary to address the security aspect of the token. While issuers can write their own smart contracts as part of the tokenization process, a number of issuance platforms are being developed to provide a turn-key solution to embed regulatory compliance into the Security Token itself, such as Securitize, tZero, and Polymath.

For example, our strategic partner Securitize has designed a Digital Securities (DS) Services platform managed by a DS Protocol. The platform is made up of DS Apps (smart contracts designed for specific events of a security token, such as issuance, voting and dividends), DS Services (which include trust, registry and compliance services) and DS Tokens (ERC-20 compliance tokens with additional programming to check with DS compliance services before allowing for tokens to be exchanged between wallets).

“We are at a very early stage in the digital securities industry, which means there is still a lot to learn about what we can and cannot do,” said Carlos Doming, CEO of Securitize. “But by successfully issuing tokens like SPiCE VC, 22x and upgrading Blockchain Capital’s token, we’re already proving what’s possible with blockchain technology, and we anticipate once exchanges and marketplaces begin trading digital securities we will begin to see if all the promise of the technology can deliver. We very strongly believe that it will exceed all expectations.”

While tZero’s primary focus is on building a Security Token exchange platform, they also offer to issuers interested in completing an STO and listing on their exchange off-the-shelf smart contracts that they have previously developed for ERC-20 compliant security tokens. These contracts can be further customized for an issuer to build any additional features they may wish, in addition to trading restrictions.

The rise of issuance platforms reduces the complexity of issuing compliant Securities Tokens by issuers. We anticipate ease of Security Token issuance coupled with the growing number of security token exchanges being developed (as discussed below) will help drive the growth in STOs.

Dr. Omer Ozden, Founder/CEO of RockTree LEX, is a New York licensed Lawyer, he has more than 20 years legal practice experience. Omer was formerly a Partner with Baker & McKenzie LLP in New York, legal counsel to Facebook. He was also with the Silicon Valley law firm of Morrison & Foerster LLP where he was a part of the team that invented the variable interest entity (VIE) structure for foreign investment and IPOs for Chinese technology companies, and successfully completed venture capital investments and IPOs for top technology companies such as Alibaba, NetEase and Baidu with investors such as SoftBank and Goldman Sachs.

Dr. Ozden and his team of lawyers have collectively worked on over 120 utility token and public security offerings and hundreds of security private placements in 18 jurisdictions. His in-depth understanding to blockchain and legal experience on international securities, have made him the leading expert in STO multi-jurisdiction structuring, generation and listing. Omer is also being approaching by various STO issuers as mentor and business partner.