STO Roundtable Discussion (Part II)

December 21, 2018

Omer [RockTree LEX]: We’re now going to ask some questions on the legal side. Jonathan?

Jonathan [RockTree LEX]: Let us move on to the regulatory aspects of STOs. John, Carlos, from your perspective, what is the current regulatory landscape for security token offerings in North America? Omer can comment on the Asian perspective. Also, what changes do you think we might see in the next 12 months, if any?

John [SharesPost]: I think it is quite clear in the last couple of weeks we have seen a lot more noise coming out of the SEC in terms of effectively enforcing and issuing injunctions against ICO raises from the past. I think that is actually very good for the market because every time they come out and affect some sort of change in the ICO market, whether an injunction or some other regulatory action, it gives everyone a little bit more clarity. Now we wish they would just come out and give full clarity, but that is just not how they work. And as long as we keep getting more and more information from each one of these moves, everyone ultimately should be able to paint a better picture and to comply better. The effect of all this has made a lot of the issuers, the players in the market, the platform companies, the marketplaces and the advisors that are helping the issuers all move very much to a place where they think they are way outside of any gray zone, and so they can be very compliant.

Now if we all start there, there is not much that the SEC can do because the SEC’s view is that the rules are very clear. But what we are trying to do, and what makes it a harder process, is there are currently two sets of rules. There are rules for private placements, and there are the public security rules. And the STO as I said before is somewhere in between. We're trying to set a bunch of square blocks into a round hole. That is not easy and that is why every time the SEC comes out with something it helps us push that awkward square peg into that round hole better. I think we are all moving to the point where we are creating just a gigantic hole, so that the square falls in, and that is what I mean by not even dancing around the grey area, and just being very compliant from the beginning. If you start from that point, we are going to have plenty of STOs to begin with. And then once we have even more clarity there will be even more STOs.

Omer [RockTree LEX]:  SharesPost founder Greg Brogger is originally a securities attorney from Wilson Sonsini, which is a Silicon Valley law firm and I also originally started at a Silicon Valley law firm his competitor Morrison Foerster as a securities attorney. We both can see that from a finance perspective and blockchain perspective, regulatory development, government involvement and so forth is critical and a trend for the future.

As companies move into this market, they really need to think about regulatory compliance and what is coming down the pike. It is going to be more and more important in all jurisdictions, and it certainly is in the United States. In the blockchain industry, a lot of metaphors for it are used, such as it being the “Matrix”. If you want to navigate yourself within the Matrix you need to be legally compliant, period. And there are a lot of things that you cannot be fully compliant with because it is a gray area, and you just have to do the best that you can. But in the U.S. as John pointed out, there is a very clear regulatory framework for securities. In terms of Asia,  when we spoke with the FinTech director of MAS in Singapore, which is the equivalent of the SEC, he said to us: “I've seen a thousand ICOs, and not one of them have been securities”, which is a direct response to what the chair of the SEC said where he said: “I've seen every single ICO I've seen is a security”. So, in Asia and a lot of the Asian markets such as Japan, Singapore, Thailand and so forth there really is a recognition of utility tokens that are not securities.

In terms of the development of security tokens, because there has not been the demand up until this point, it really is a U.S. construct that every single token is a security, which is not the construct for a lot of markets around the world, including Switzerland, Japan and Singapore and the other ones that I mentioned. The fact is that there are legitimate, real security tokens which are investment contracts in assets. And that is coming down the pike. It is not as developed in Asia as it is in the United States. Both Greg and I were in Singapore two weeks ago and the MAS came out, and said they are very supportive of security tokens, and I believe SharesPost is applying for a license there as well, and we are going to start to see that, but it is going to definitely lag behind the United States.

Carlos [Securitize]: I think that the SEC is not saying that there is no such thing as a utility token. I think what the SEC is saying is that all ICOs have been selling securities, which is a different statement. I tend to agree with that statement. I think that utility tokens have a legitimate usage when you have a truly decentralize protocol, and have some token-centric mechanism for people to be part of the network and for them to monetize that. There are many utility tokens that are legitimate like that and have real utility. What the SEC said is, the moment you actually sell tokens to investors that have little plans into using them, and are basically just there to speculate because they buy with the expectation of appreciation, then what you are selling is really a security. Irrespective of whether the underlying instrument has utility or not. It looks like to me as a very logical conclusion, but I do not think that all regulators worldwide would tend to agree.

Jonathan [RockTree LEX]: I can add a Canadian perspective. Canada’s securities regulation is heavily influenced by the U.S. approach. Prime Minister Justin Trudeau was recently at the Singapore FinTech Festival where he has been saying some very positive things about trying to promote technology, including FinTech and blockchain. There is definite support for development. I think from a securities perspective, the Canadian Securities Administrators, being the various provincial and territorial securities commissions, have put out some guidance and provided some examples in their staff notices on what is potential indicia of a token securities offering versus a non-securities offering, which is interesting. They are not moving as quickly as some people would like, but at the same time they have two mandates to consider, which is investor protection as well as promoting efficient capital markets and confidence in the capital markets. I think they may be pushing a little bit more on the investor protection side than encouraging efficient capital markets at this point, and a number of people and groups who are lobbying for that kind of guidance. I think we will start to see and hear a bit more from the securities commissions in Canada over the next little while.

Jonathan [RockTree LEX]: Moving on, we've been talking about the regulatory environment over the next 12 months. What about in 1 to 3 years? What kind of regulatory changes do you anticipate from a North American and Asian perspectives?

Carlos [Securitize]: For security tokens, there is really no need to change anything for the time being. My point is that these are clear regulations about securities and security token are just another version of securities, which are legal, they just happen to be on a distributed ledger rather than a centralized ledger. So at least we have a framework for how we can do things. Of course, many of these laws were written in the 1930s, like for instance the definition of “accredited investor”. I am hoping that some of these things will change, but I do not think they're going to change in one year as regulators tend to be conservative. I think what we will see is a change in behavior of people, certainly in the U.S. today. No one is doing an ICO, because the regulator has made it very clear their views on ICOs and they have already issued penalties for doing ICOs. I think we will see more ICOs, especially the ones that were done after the DAO Report was released by the SEC, to actually start being penalized. If someone wants to conduct a token sale, they should do it as a security token offering. What I am hoping is that security token offerings will become more than just making ICO legal and basically become a way for people to execute capital raises in a much more efficient way by leveraging blockchain technology.

John [SharesPost]: I agree 100% that the SEC and the regulatory bodies in the U.S. are very much first and foremost concerned about investor protection, but recent statements from the SEC also leads me to believe that the SEC cares that regular investors, not necessarily just accredited and other qualified-type investors, have access to certain securities that they previously did not have. We all know in the U.S., public shares trading on the various exchanges are about half of what it used to be just 10 years ago. Partially because of the increased regulation in the public markets, but also because of the changes to the private markets. The private markets have grown tremendously, and most of that has been through funds and private placements. The traditional regular investor really does not have access to that.

The JOBS Act was obviously for issuers to raise money in new creative ways but also was to allow everyday investors to get access to some of these venture-type deals. And right now, there is from my understanding a movement towards trying to increase the Regulation CF limit and also trying to push through more Regulation A+ type offerings. When those happen, they will allow more unaccredited investors to participate and therefore I think that's going to open a gateway to allowing more regular investors to invest in STOs as well. So that is what I would hope will happen the next 1 to 2 years. There is already a movement for that, and I just hope it comes into effect in the next 1 or 2 years.

Omer [RockTree LEX]: Let us move on to the benefits of conducting a security token offering over traditional security offerings for issuers. What type of issuers should conduct STOs over the next year or two years? What does a strong initial case look like and then how do you think this will morph in the future?

Carlos [Securitize]: If you think of about security tokens the advantages that they bring is primarily three things: One is better capital formation. The second one is automation of the process of managing the security and with investors, such as reconstructing the capitalization table, issuing dividends, payouts, conducting proxy vote etc. And the third one is liquidity. That really tells you that if you are a very small company, early stage and you are doing a series A type round  for a few million dollars, then the first capital formation should not be an issue because there is plenty of capital available for you. Automation is not necessary because you can have a small cap table with few people and you are probably  not ready for liquidity because you are too small and do not have enough history for people to want to trade your securities. From that perspective, I think that security tokens are better suited for more mature companies that are doing a series B, series C or pre-IPO raise or replacing a small cap IPO, so instead of going that way which is expensive and has a huge regulatory burden, you may choose the security token offering route.

Other types of companies suitable for STOs are those which have assets that are illiquid by definition (real estate is a good example), where the liquidity premium could actually increase the value of the assets and where the capital formation could benefit because of fractional ownership, which give access to investors that would not be able to buy the entire asset or a significant portion of it. I think today there are two types of cases that are more suitable for security token offerings as previously mentioned, but over time as the market matures with more liquidity options, and the cost of doing these things from a legal perspective and everything has come down, we may see more options. For the time being we recommend our customers, and customers we would like to bring on, fit into either one of those two classes.

John [SharesPost]: I agree with what Carlos says in terms of the underlying characteristics that lend itself well to certain types of issuers. I'm going to add one more little wrinkle to that. In the U.S. what we have seen is a distortion in terms of who gets better valuation in a startup company. For instance, there is a decent amount of money in the seed and series A and possibly series B rounds, but there is even more money available for the D, E rounds and the F rounds from, for example the Vision Fund from SoftBank, Tiger Global’s (who is raising a US$3.7 billion fund), Bessemer with their $3 billion fund. and Sequoia (who is raising another $3 billion fund). These are giant venture funds and when they only have 10 to 15 names in each one of these funds, they have to go for big deals. We have seen exaggerated valuations for later stage, right before IPO type companies. What is being left behind is that B and C round type, mid-market financing necessary tool. I think the security token ecosystem and stack will be perfect for that left behind mid-market B, C type stage firm.

There are too many people focused on the early stage and then too much money on the late stage. Just because you are a company that doesn't have a total available market (TAM) that's a US$1 trillion, you may still be a very good company because your TAM is only US$500 billion. So why should those companies not get the same opportunities? They have been forlorn, and this is a way in terms of the security token ecosystem to provide those companies distribution and access to money.

Omer [RockTree LEX]:  I think that what this can do for the market is bring a democratization for capital formation, both in terms of issuers and also in terms of investors. Eventually we may even be able to move out of the accredited investor realm and have retail for security tokens as well and trading When we talk to our security token projects, we say at this stage of the game, keep it simple. And like you said those series B, series C type companies are great candidates as issuers. But in the future, we are going to see more complex, financially engineered security tokens, different asset classes just as Carlos was mentioning as well.

Let's dive into the technological benefits. Can we get a little bit more granular into the application advantages as opposed to traditional equity today? For example, (T+2) versus the potential for (T+now).

Carlos [Securitize]: The (T+2) versus (T+now) is really something that benefits publicly traded companies, because those are the ones that have that problem. If you are Facebook for instance, you have two problems. One is you do not know who your shareholders are, because most of their shares will be registered in the street name of a broker. And therefore, when the company reports on the cap table, Facebook for example will report 3,500 shareholders. But that is obviously not true because it is a US$600 billion company. It is because they do not actually know who holds their shares, and that is a problem when they want to conduct proxy votes or issue dividends, which becomes a costly and problematic process. In the past, there have been issues with companies conducting important proxy votes that did not get the voting done right.

The second problem, and this is not a Facebook problem but a problem of the exchanges and the ecosystem, is that because of the issue of not settling the trade automatically, there are always middlemen and agents involved who charge commissions for holding the risk of their trade not happening and not being settled. With the blockchain, you could eliminate that, because on the blockchain, when you buy something you own it instantly. Today, if you buy a Facebook share, you do not actually own the Facebook share. You own a beneficiary right to the share while actual title to the share that is held by a central depository. That share is not actually traded, and the ownership is not changed right away. This is in respect of public securities. For private securities, it is a different story. For private securities, it is not (T+2), these are (T+several weeks), because it is very difficult to trade private securities as you do not have access to all information about the type of agreements or the different shareholders with different share classes, there may be rights of first refusal so you may have to offer your shares to someone else first, there's no public information about the company, etc.. I think the potential disruption is much bigger for private securities in terms of automating and providing liquidity. 

John [SharesPost]: I want to highlight the point that Carlos just mentioned. Obviously at SharesPost we know about private securities, and I can tell you it is sometimes more than a couple of weeks. It is (T+30), (T+60), (T+90) even, and to have an automated process through blockchain or through tokenizing a lot of the process, you are going to see that save so much money for both parties and for all the collateral that is going to get held up. There are so many ramifications of tokenizing and using blockchain that we may not even think of.

I have been in New York for the last couple of days, and have been asked to go speak to three major investment banks. One of these banks actually has used a private blockchain to do debt security token offering. They ran it internally. They parallel process a traditional private placement of those debt securities offered as well as doing it on their own private blockchain. I asked these guys why they would do this. And the answer is right now they have gotten so good at figuring out the costs to distribute (meaning sell) a debt offering. If it is a US1$billion debt offering, they know what it costs and how much it would cost to go to each individual potential buyer. So ideally for a US$1 billion offering, they want to go to people who can write US$100 million checks. That's because each time there is an outreach that cost a certain amount of dollars. Through their experiment of doing a private blockchain and offering this debt product, they have learned that for that same US1$ billion offering, because of the cost efficiencies that they are achieving through their private blockchain, they can now start going to guys who can write $US10-15 million checks as well. That is part of the democratization that Omer was talking about earlier. It is not democratization down to the retail level, that is a whole different ball of wax, but at least there is a certain level, of democratization that is going to be created just from the cost savings that we will see from the blockchain, digitization and tokenization.

Omer [RockTree LEX]: My hope is that 5, 10 even 20 years from now people have a chance to listen to this or read this article, and get a view of some of the pioneers in the STO and digital assets space, and what they were thinking. There are so many ongoing paradigm shifts and developments today that we currently cannot anticipate. The speed is fast, and the development is fast. If I compare it back to the 1990s and the early Internet days, we now know the Internet was over-delivered. To take it from a Chinese perspective, people started talking about B2C and they just did not imagine that that was even possible in China. Somebody tried it in the 1990s and ordered something, and in the box would come a brick. People thought it was just something impossible but today everything is B2C. People order on their cellphones and it has radically changed society through the adoption of the technology within 5, 10 years and even today, 18 years later. I hope that we will be looking at this podcast wistfully even 5 years from now and see that the world of finance has radically changed over the next 5 to 10 years.

I really want to thank you all. This was really amazing. John, Carlos, thank you.

John [SharesPost]: Thank you. I love the cross-border nature of this. It is fantastic. I think that is ultimately what we want the security token to be like. This is great.

Everyone: Thank you. Take care.