Security Token Offerings
Law & Blockchain Consultancy provides strategic advise on your fundraising needs and can take care of the legal implementation of your STO, including the contracting of your STO, your legal structuring, compliance with (global) securities laws (incl. the drafting of a prospectus or the usage of exemptions thereto) and compliant KYC/AML practices.
The Dutch Digital Securities Offering
The Netherlands is increasingly emerging as an attractive jurisdictions for the issuance of security tokens. The flexibility of Dutch corporate law provides the opportunity to issue freely tradeable tokens which represent depository receipts over shares.
A Note on Security Token Offerings (STOs)
Security Token Offerings (STO) are increasingly being seen as a new avenue of fundraising. As compared to ICOs, an STO generally provides investors with actual economic rights to the underlying company or protocol. Sadly, the usage of the term ‘security token’ can be confusing and is starting to match the vagueness and lack of contemplation that the term ‘utility token’ is surrounded with. Therefore, let’s first categorize security tokens into four main categories.
- The utility/payment/security token-hybrid: The first one is the utility/payment/security token-hybrid that gives some sort of economic right to its holder, while also having a function in a protocol or application as a means of access, payment or governance mechanism. This category essentially encompasses utility tokens with some kind of economic rights (eg. rights to dividends or revenues). Good examples of hybrid security tokens are NEO and Binance Coin.
- Profit/revenue sharing tokens: A second category of security tokens exists of tokens that provide similar economic rights, while not providing any utility. Such profit/revenue sharing tokens can best be seen as negotiable and transferable contractual IOUs.
- Digital Securities: A third category exists out of traditional asset tokens, or digital securities. This category of tokens is designed to literally represent (bearer) equity, bonds, assets or derivatives. As the name suggests, digital securities can best be seen as a mere digitalization of traditional securities, with blockchain as underlying infrastructure.
- Investment Fund Tokens: Finally, there is the investment fund token, which is issued when a fund is tokenized. Investments from token holders are pooled and used to make investments. The return on these investments is subsequently distributed across all token holders. Examples are The DAO, BCap and SPiCE VC.
The STO and the law
For each of the categories of security tokens set out above, different legal requirements might be applicable to an STO. Of course, no specific law exists for STOs. Broadly speaking, the applicable legal requirements can be categorized in four different areas of law, listed below.
Securities laws is the field of law that is occupied with investor protection. It requires issuers of securities to register with authorities and provide their investors with information disclosure documents (i.e. a prospectus), in order to reduce information asymmetries between the issuer and the investor. Depending on the design of an token, the structure of the STO and the jurisdiction where the token is offered, different legal requirements might be applicable to an issuer. As STO issuers often want to issue globally, they have to deal with a multitude of securities laws regimes from different jurisdictions. Generally, depending on the amount raised, and whether the issuer wants to solicit investors from the public, one would seek to fall under specific exemptions to prospectus and/or securities registration document requirements for a multitude of jurisdictions. Additional legal complexities also arise in connection with the possibility of listing security tokens to public exchanges.
Depending on the type of token issued, the legal classification thereof and the jurisdiction(s) in which is offered, so-called ‘know-your-customer’ and ‘anti-money-laundering’ regulations might be applicable. In general, this requires the issuer to know and confirm the identity of his/her investors. Risk-analysis and risk-mitigation procedures might be applicable, as well as requirements relating to the monitoring of transactions and the checking of OFAC, sanction and PEP lists. When doing an STO, A proper KYC/AML implementation is vital to combat money laundering (and comply with applicable law).
Restrictions imposed by corporate law
In the issuer’s jurisdiction, it is moreover required to examine the system of national corporate law in place. Here, large differences exist across jurisdictions as tokenization might prove difficult because of a broad spectrum of possible legal challenges. Especially with regards to traditional asset tokens (or digital securities), rules might apply which might tokenization difficult or even impossible. Relevant laws could be concerned with restrictions in terms of the transferability of securities, requirements relating to legal structuring, the lack of recognition of digital (representation of) assets under property law or financial law, lack of recognition of electronic instruments, documentation, signatures or deeds etc.
Finally, the contracting around an STO (eg. relevant subscription agreements or the terms and conditions applicable to a token sale) is of vital importance. The usage of blockchain as an underlying infrastructure, by nature, brings about new risks that are not usually accounted for when selling traditional securities. Of course, such risks should be contracted for. The interests of both investors and the issuer have to be taken into account, while additional attention should be given to the compliance elements that are to be coded into the relevant smart contracts used for the STO.
The programmability of compliance
To achieve fully compliant security token offerings, many restrictions in terms of the transferability of tokens have to be in place, depending on the jurisdiction of the issuer and nature of the token. Interestingly, such restrictions can be programmed into the smart contract of the tokens themselves. For example, one could dictate in the smart contracts that, before a token is transferred, the transferor has to be whitelisted, based on a KYC/AML implementation. Similarly, vesting schemes or lock-up restrictions can also be programmatically enforced. The programmability of legal compliance has the potential to reduce frictions in capital markets and increase efficiencies across the board.