Security Token Offering 101 — Legal Considerations

by | Mar 26, 2020 | Medium

In previous articles, we considered the basics of a security token offering (STO) and the benefits for the token issuer and the token buyer. In this third article, we will touch upon some important legal questions surrounding a STO.

 

Given the novel nature of STO technology, sometimes it is difficult to know whether certain STO legal questions can fall within the scope of the existing regulatory perimeter, as, in this case, the world is trying to adapt existing laws to new technology.

 

However, while STO maturity is still dependent on regulatory clarification at a global level, launching a STO (and tokenization in general) is already possible, and therefore we can already look into the following three points based on the existing legal framework: ownership, legal qualification and licenses.

 

Ownership

First, the question of ownership. Countries around the world have followed different approaches on whether a token holder can be considered as owner of the underlying asset.

 

A number of regulators agree that security tokens represent ownership of a physical or digital asset that has been verified within the blockchain. If the token issuer is not able to verify the ownership of the underlying asset, token holders would have a claim against the token issuer as he/she would have been issuing invalid tokens.

As a consequence, although token holders would in principle own the security tokens (in accordance with the laws of their respective jurisdiction), it is a commonly accepted premise among many regulators that, in principle, ownership of the underlying asset remains with the token issuer.

 

This premise can become quite complex, for example, when the security tokens are meant to represent shares or stock in a company (the so called “equity tokens”). Given that most jurisdictions still do not foresee the possibility of issuing shares or stocks in the form of tokens, such jurisdictions would not consider equity token holders as direct owners of the underlying company.

 

However, this does not mean that token holders cannot be granted additional rights (added to the token and linked to the underlying asset). These rights are strengthened thanks to smart contracts, which are self-executing digital computer programs on a blockchain ledger. Smart contracts can be programmed to, for example, attach certain profit participation rights to the token, linked to the underlying asset, or provide for restitution of funds in the event a token is found to have been issued invalidly.

 

Legal Qualification

Secondly, and one of the most important legal points, would be the legal qualification of the token — do the tokens that are being issued constitute security tokens?

Legislators and regulators all around the world are still discussing the relevant criteria to determine whether the tokens that are being issued constitute “securities” under applicable laws and regulations.

 

Generally, in order to make such determination, one would have to first look at the rights that are attached to the tokens — what do the tokens represent? For example, if the tokens represent equity or debt instruments, and such instruments would normally qualify as securities, one could argue that the same reasoning would apply to the tokens.

 

An additional criteria that is often taken into account to consider whether certain tokens qualify as securities, is whether these are tradable in the secondary market and require drawing up a prospectus. Given that these would normally create grounds for traditional financial instruments to be considered as securities, in principle the same should apply to tokens.

 

Therefore, if the rights attached to the tokens represent similar rights to those attached to traditional securities, or fulfill the same criteria, there are high chances that such tokens would qualify as security tokens.

Licensing

Thirdly, we should consider whether the STO activity requires the obtention of a license. When launching a STO, the token issuer should consider, among other things, whether she/he needs a license to issue tokens.

 

Whether a license is needed largely depends on the jurisdiction where the STO would be conducted, many regulators worldwide have taken the approach that the issuance of tokens would not constitute an activity that would be subject to a license per se. However, depending on the accessory activities of the token issuer, these might fall within the scope of other licenses such as, for example, a banking license, a broker license or an intermediary license.

 

On the other hand, regarding the management of an STO platform, which is an IT platform or website on which STO’s are conducted, certain jurisdictions have taken the approach that at least a general commercial/business license would be required, due to the underlying commercial activity. The conditions to obtain such a license also vary from country to country, but in some countries a business license is obtained directly when incorporating a company.

 

Finally, additional legal considerations to keep in mind would be data protection, consumer protection, enforceability of rights created by tokens, regulatory and reporting obligations and anti-money laundering rules. These points could be considered separately in future publications.

 

Disclaimer: this article does not constitute legal advice in any respect. As you can tell from the above, although it is already possible to launch a STO, the process is complex and you should always seek professional advice to make sure that your STO project will be successful and compliant with applicable laws.

 

Our team at 2140 Consulting will gladly help you navigate through the STO process to ensure that you are in the forefront of this new exciting technology. Feel free to reach out to us!

 

Originally posted on Medium.

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