Defining the Scope of STOs
STO can be any offering and sale of digital tokens that are considered securities under US law. The broad Howey test, which has become commonplace for digital token issuers, still defines a “security” as any contract, transaction, or scheme whereby (a) a person invests money or anything else of value, (b) in a common enterprise, (c) and is led to expect profits, (d) predominantly from the efforts of others.
Security tokens sold during STO are any virtual tokens that exist on a blockchain and meet the definition of a security under US law, whether the tokens represent function on a platform (known as “utility tokens”), ownership of a real-world asset (asset-backed tokens), interest in a fund (fund tokens), equity (equity tokens) or debt (crypto bonds).
Accordingly, the scope of STO is very broad and may include, for example:
- Tokenized traditional securities, like shares of stock in a corporation;
- Tokenized fund interests, including venture capital and real estate funds;
- Real estate;
- Diamonds or precious metals;
- Works of fine art, luxury cars and boats;
- Interests in a limited partnership or other business entity;
- Profit-sharing right in a business entity, etc.
Understanding the Advantages of STOs
By going through STO process, companies and funds can raise capital from investors while benefiting from the advantages that blockchain affords, including:
- Increased liquidity;
- Simplified access to capital on a global scale;
- Fractionalization of ownership;
- Increased transparency and security;
- Simplified investors’ management, etc.
Addressing the Risks Associated with STOs
While STOs are becoming one of the most viable methods of raising capital and dividing ownership or profits, security token issuers must structure each STO very carefully to take into account various pitfalls presented by securities regulations, AML/KYC requirements, tax rules applicable to a different type of assets or entity type, etc.
Some of the major practical considerations that should be addressed by an issuer prior to launching STO are that security tokens may be subject to limitations on resale, trading on alternative exchange platforms in the U.S. and foreign jurisdictions, number of investors, and amount of capital raised.
Our lawyers are well-versed in the legal and practical issues that arise in the context of planning, developing, and offering security tokens in the US. We help our clients develop a comprehensive STO strategy that anticipates and responds effectively to the arising challenges.
STOs Can Be Conducted Under Exemptions from SEC Registration: Reg D, Reg S, Reg A+, Reg CF
Before any security, including a security token, may be offered or sold in the US, it must be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption. Registering security is a costly and time-consuming process. But if an exemption applies to an offering, then it does not need to be registered.
Most commonly, STOs are structured under one of the following exemptions from registration offered by the US Securities Act: Regulation D, Regulation S, Regulation A+ or Regulation CF.
Although exemptions under the SEC regulations eliminate the need to register STO with the SEC, qualifying for an exemption still requires careful compliance with US securities laws.
Secondary Trading of STOs
To launch a successful STO, issuers will need to meet compliance standards, create a stable governance structure, and have shares that are able to be traded on the secondary markets called Alternative Trading System platforms (“ATS”) in the US, Europe and Asia.
Finally, the minted STO tokens must be compatible with the chosen regulated ATSs to be listed and tradable. This challenge should be addressed beforehand as different tokenization platforms and ATSs have different standards and protocols – some are still being restructured or developed.
The STO issuers should establish contacts with the ATS of their choice before the primary issuance to ensure that the issuer’s and platform’s configurations of digital securities match and the pre-listing procedures required by the ATS are adhered to.
Some of the ATS platforms offer all-in-one tokenization, marketing and listing services, which may simplify your task but still require an in-depth due diligence on the possible issues outlined above.
If the offering is poorly structured or documented, the digital security’s features are unenforceable for secondary trading, or if the security tokens are incompatible with the selected ATS, blockchain projects may be tempted by a seemingly simple technical solution – recalling the flawed security tokens and replacing them with the new ones.
However, this may not be possible or may be costly and complicated from the legal standpoint, as one cannot always simply recall the issued securities, albeit in the form of digital tokens.
Defects in STOs itself may be incurable for legal compliance purposes and may disqualify the security from being listed on a regulated trading platform.
So, getting your STO tokens to secondary market is something to consider well in advance, or risk the loss of the digital security’s value, or even liability for violation of securities and other laws.
Notes on Choosing ATS and Broker Dealers for Your DAO
A team of professional advisers should be able to assist STO issuers with determining which ATS platforms and broker-dealer are best for them.
First, there are jurisdictional considerations to be aware of. For example, Singapore, Malaysia, Thailand, Gibraltar are actively developing markets for security tokens and regulated STOs.
In choosing an ATS, there are factors such as offering density and built-in blockchain interoperability protocols with other ATS platforms.
Depending on the asset and offering size, it may make sense to list on multiple ATS (e.g., listing an offering on ATS platforms in New York and Singapore).
STO issues can choose to work with a multi-national broker-dealers to attract international investors, opening another investment pool that is not available in traditional real estate.
A massive benefit of tokenization is the ability to raise capital through international investors, creating new markets and greater opportunities for STO issuers.
There are tight-knit consortiums of broker-dealers and ATS, which could be an opportunity for efficiency gains.
It is important to conduct thorough due diligence before choosing a broker-dealer and ATS because making the wrong choice could lead to the expensive process of burning and switching tokens.
Helping Clients Through Every Stage of STO
Our attorneys represent a wide range of clients in all kinds of STOs, providing comprehensive services throughout the STO process, including:
- Conducting a comprehensive token analysis to determine whether the token is a security under US law;
- Determining the appropriate token structure;
- Determining the appropriate corporate structure for STO (SPV/trust, fund, hybrid, etc.);
- Structuring STO to qualify for an exemption from registration as security using Regulation D and Regulation S;
- Drafting private placement memorandum, investment agreements, and related documents;
- Developing AML/KYC policies and helping clients implement them to verify investors’ identities and eligibility to participate in the STO;
- Providing post-STO legal support, including by advising our clients on secondary trading issues, subsequent usage of security tokens, and the applicability of money-transmitter and other laws.
Token issuers must consult professional tax advisers to develop a sound tax-planning strategy in the weeks and months before an STO. Any such strategy must account for (among other issues):
- The type of tokenized interest and the rights associated with the token;
- How income generated in the token sale will be treated for tax purposes;
- What reporting and withholding requirements may apply.
The IRS issued IRS Notice 2014-21, IRB 2014-16, as guidance for individuals and businesses on the tax treatment of transactions using virtual currencies.
The IRS also published Frequently Asked Questions on Virtual Currency Transactions for individuals who hold cryptocurrency as a capital asset and are not engaged in the trade or business of selling cryptocurrency.
Launching a security token offering is a highly complex process that requires thorough research and careful planning. PLease read our Guide for Launching Security Token Offerings (STOs) in the US.
Security Token Offerings (STOs)
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Security Token Offerings for real estate, limited partnership interests, diamonds, arts, luxury cars and boats