Security Token Offerings (STOs) for NFTs?

I. Introduction

Thinking of selling NFTs? If so, you should be aware that the issuance of NFTs may, in some circumstances, constitute the sale of securities, which would require either registering the securities with the Securities Exchange Commission (SEC), qualifying for an exemption from registration, or risking exposure to future litigation.

In fact, platform developer “Dapper Labs,” creator of the NBA’s Top Shot platform, was recently sued for allegedly selling its non-fungible tokens (NFTs) as unregistered securities. Putting the merits of the claim aside, it is a striking example of the potential liability that current issuers of NFTs are facing; that is, existing issuers of NFTs may risk exposure to future lawsuits for selling unregistered securities by people who bought their NFTs in the past.

Accordingly, those thinking of selling NFTs should consider doing so through what is known as a security token offering (STO) – a process that legally enables entities to quickly fundraise under one of the SEC’s exemptions from registration, thereby remaining compliant with U.S. securities laws and regulations.

After qualifying for an SEC exemption, the tokens can be issued on a tokenization platform and then traded on a secondary market through an alternative trading system (ATS). While ATSs are not exchanges, they operate in a similar manner and essentially act as compliance platforms for issuing and managing digital securities.

For companies raising private capital in the U.S., the most commonly used exemption from publicly registering securities is what is known as  Regulation D (506(c)). Provided that all statutory requirements are met, 506(c) is advantageous for several reasons, including giving U.S. issuers the ability to raise an unlimited amount of money; advertise in the U.S.; and sell to U.S. investors–all without having to register with the SEC.

Moreover, structuring a security token offering under the 506(c) SEC exemption is a relatively quick process, which generally may take less than a month. An entity simply files what is known as a “Form D” with the SEC, which is a brief notice that includes the names and addresses of the company’s promoters, executive officers and directors, and some details about the offering, but contains little other information about the company.

Companies targeting non-U.S. investors can split their offerings, utilizing a similar SEC exemption, known as Regulation S (Reg S), in addition to 506(c), which allows for securities offerings to foreign investors contingent on two conditions: (1) the offer or sale must be made in an offshore transaction and (2) no “directed selling efforts” may be made by the issuer, a distributor, any of their respective affiliates, or any person acting on their behalf.

Furthermore, because almost all digitized units offered at the fundraising stage in the U.S. are considered securities, they have been commonly referred to as “security tokens.” And offerings to investors of the tokens have been referred to as STOs. Equity tokens are traditional shares issued and maintained in a digital form on a blockchain, with all transfers and settlement of such shares being recorded on the blockchain.

The U.S. regulatory environment already allows STOs, and it is expected to develop further. Although the tokenization process can be a challenging task due to the complexities associated with corporate, securities, and tax laws, as well as limitations that pre-existed the concept of digital securities on a blockchain, the process also offers both short- and long-term benefits that entities seeking to raise capital should consider leveraging.

And, given that certain NFTs may qualify as securities under what is known in Securities law parlance as the “Howey Test,” it is fair to assume that the rules and regulations that apply to STOs will also apply to NFTs which are deemed securities. NFTs, therefore, will have to comply with the applicable rules and regulations relating to exemptions from registration, as well as AML/KYC requirements of STOs.

II. Security Registration

A. What is a security?

Securities include investment contracts: An investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. In other words, in general, a passive investment.  The SEC has taken a “substance over form” position, meaning that regardless of how the transaction is characterized, courts will look at the economic reality underlying the transaction.

B. Potential Registration Requirements/Exemptions:

Although exemptions under the SEC regulations eliminate the need to register STOs with the SEC, qualifying for an exemption still requires careful compliance with US securities laws. In light of the fact that the sale of NFTs may in some circumstances constitute the offering of securities, NFT platforms, marketplaces, and service providers may be subject to liability if they fail to comply with the proper securities rules and requirements.

C. Consequences of NFT Constituting Securities

NFTs offered and sold as securities are subject to certain securities laws and regulations. As stated above, securities offerings can avoid the burdensome regulations imposed on registered securities by qualifying for an exemption. Moreover, individuals and entities dealing with NFTs as securities would also be required to register as Broker-Dealers.

Additionally, non-compliant NFT projects may be found in violation of the anti-fraud provisions of securities laws and face civil and criminal penalties. All this is to say that NFT issuers must be particularly cautious about offering NFTs which could potentially be considered securities so as not to fall within the definition of a broker-dealer under the SEC Act. And all of this can be avoided by qualifying for an exemption from registration.

As an additional matter, apart from the issue of the unregistered sale of securities, NFT issuers should be aware that NFT Platforms may constitute “Financial Institutions” under AML Act of 2020, which expanded the definition to include “dealers in art” and companies that engage in transmitting virtual currencies.

Accordingly, a platform or entity that facilitates the trading of NFTs and/or movement of virtual currency from one party to another may be subject to federal and state money transmitter licensing requirements as well as federal law enforcement jurisdiction. To avoid the arduous requirements and risks stemming from the updated definition of “Financial Institutions,” issuers of NFTs should consider taking advantage of licensed ATSs, which enable compliant issuance and trading of their tokenized securities.

D. US Securities regulations:

A company does not necessarily have to be incorporated in the U.S. for it to be a compliant STO. U.S. securities laws allow certain offerings to be conducted by foreign issuers. Foreign companies may register their securities with the SEC; but a full SEC registration requires a significant amount of time and resources, making it generally unfeasible for private issuers, including issuers of preferred share tokens.

However, some of the SEC’s exemptions from registration allow both U.S. and foreign issuers to offer their securities to the U.S. and foreign investors. For example, foreign companies, like domestic ones, may conduct exempt offerings to U.S. and foreign investors simultaneously under Regulation D and Regulation S.  At the bottom, different exemptions offer different advantages and impose different restrictions.

On a positive note, there may be a significant tax benefit for non-US entities and individuals that to invest and trade in STOs, as non-U.S residents may be able to do so without paying any U.S. federal capital gains tax generated on the sale of appreciated STOs.

This favorable tax treatment can be found by non-U.S. investors under Internal Revenue Code (Code) Section 864. In particular, Code section 864(b)(2), provides that a non-US resident who trades in stocks, securities, or commodities through a U.S. broker (or other independent agent) does not constitute a U.S. trade or business.

This means that a non-US resident that generates capital gains from the sale of STOs, even if through a U.S. broker or other independent agent, and regardless of the frequency of trading activity, should not be treated as engaged in a U.S. trade or business, and therefore, not subject to U.S. capital gains tax.  This is because, in general, capital gains are sourced to the residency of the seller, and the residency of a non-U.S. resident, is whatever jurisdiction in which the seller is deemed to be a tax resident.

Whatever such jurisdiction might be, it is not the U.S., and therefore, such person is not subject to U.S. capital gains tax. This exemption applies to non-U.S. residents who are dealers in stocks, securities, and commodities, as well as to non-dealers.  Under the same Code section, trading in stocks, securities, or commodities by a non-U.S. resident, who is not a dealer in stocks, securities, or commodities, also is treated as a non a U.S. trade or business.

This is true, even if it is done by an employee or agent with discretionary authority that is located in the United States.  Therefore, for non-U.S. investors, taking the necessary legal steps to get NFTs registered as STOs could have significant positive tax-saving implications.

III. Legal NFT Framework

A. Structuring a compliant STO:

Targeting U.S. and foreign investors are highly complicated endeavors for STOs, both from a technical perspective and a legal one. Some of the legal considerations confronting every STO include:

• Determining the optimal corporate structure and place of formation, which starts with the analysis of tax-efficient structure;
• Determining the impact of, and compliance with, U.S. securities laws and the Investment Company Act;
• Determining whether local law in the place of formation permits the issuance of preferred shares on a blockchain;
• Obtaining corporate authorization to tokenize preferred shares;
• Designing appropriate rights/attributes for the preferred shares that will be issued; and
• Preparing appropriate documentation for the DSO.

B. Issues arising in NFT context:

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, and tax rules applicable to different types of assets or entities, among many other issues.

Some of the major practical considerations that should be addressed by an issuer prior to launching an STO are that security tokens may be subject to limitations on (1) resale, (2) trading on alternative exchange platforms in the U.S. and foreign jurisdictions, (3) number of investors, (4) amount of capital raised; and (5) ensuring the raise is being undertaken via a tax-efficient structure.

Moreover, the underlying nature of some NFTs—modeled after artwork rather than currencies or shares—implies they are not subject to the same financial regulation as other types of crypto offerings. However, the scope of STO is very broad and may include:

• Tokenized traditional securities, like shares of stock in a corporation;
• Utility tokens serving certain function on the project’s platform/ecosystem;
• 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.

C. STOs May Be Conducted Under Reg D 506(c) and Reg S Exemptions from SEC Registration

Companies who wish to offer their security tokens to both U.S. and non-U.S. investors can split their offerings between 506(c)– which allows offerings to U.S. investors– and Reg S–which allows offerings to non-U.S. investors. Additionally, issuers should take into account: (1) advisory and marketing arrangements; (2) arrangements with STO platforms; (3) broker-dealer issues; (4) team compensation and restrictions; (5) the 2,000-shareholder rule; and (6) special rules for certain asset-backed tokens.

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. 

D. Implementing Security Token’s Features:

All of the legally imposed requirements and limitations should be programmed into the security token and maintained throughout its lifecycle, including secondary trading. Two of the principal requirements in the securities world are maintaining the holding periods/resale restrictions and capital table. Before listing, you will have to demonstrate to an alternative trading system (ATS) that the applicable legal restrictions (or digital restrictive legends) are maintained.

Restrictions on a capital table vary depending on the applicable laws and regulations. A lot of issuers are aware of the thresholds established by the Exchange Act’s Regulation D offerings, under which a U.S. issuer with total assets above $10 million and more than 2,000 holders of record of a class of equity securities (or 500 holders of record who are not accredited investors) must register those equity securities with the SEC.

There are additional statutory restrictions that you may be required to implement into a security token, which issuers often overlook. For example, to avoid registration under the Investment Company Act of 1940, private funds and SPVs that do not qualify for other exemptions may have to limit their capital table to no more than 100 beneficial owners or strictly to qualified purchasers (as defined in the ICA).

E. ATS + ATS Compatibility:

Approved ATSs can operate very similarly to an exchange, which has led to a proliferation of crypto platforms applying for ATS status. One such example is “tZero,” which is a compliance platform for issuing and managing digital securities on the blockchain. tZero’s enables seamless, fully compliant trading across multiple markets simultaneously.

Issuing NFTs under the STO framework requires compatibility between a minted token and a chosen regulated ATS for the token to be listed and tradeable. This challenge should be addressed beforehand, as different tokenization platforms and ATSs have different standards and protocols – some are still being restructured or developed.

You or the employed tokenization platform will need to establish contacts with the ATS of your choice before the primary issuance to ensure that the issuer and platform’s configurations of digital securities match, and that the pre-listing procedures required by the ATS are adhered to. One recent development is the announcement that tZero will soon integrate platform developer Securitize’s “Digital Securities Protocol” into their network, allowing issuers of security tokens to list their tokens on a proven secondary market, along with helping increase market liquidity.

To illustrate, mechanisms must be established between the ATS and the tokenization platform so that token issuers can get constant access to its full capital table during the token’s secondary trading. This mechanism should provide for the issuer’s instant access to identities of investors newly onboarded by the ATS and integration of the new investors into the issuer’s overall cap table initially established by the tokenization platform.

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.

F. Hypothetical Example

Take a famous painter, for example. Suppose she owns a painting with a fair market value of $10 million USD, and she wants to issue NFTs representing ownership shares in the painting. Under the STO framework, the first step would be to speak with a cross-border tax attorney to determine the best structure in which to issue the NFTs.  Thereafter, the owner of the painting would transfer title of the painting to a suitable legal entity, such as a C-corp.

The next step would be to tokenize preferred shares in the C-corp, with each token representing an interest in the preferred shares of the corporation. From there, depending on the registration exemption the painter chooses to fundraise, secondary trading of the securities can be accomplished via ATS’s such as “tZero” or the recently approved “Figure.”

The end result, effectively, is a legally compliant issuance of NFTs. The painter accomplishes her goal of fragmenting ownership in the painting and fund raising while avoiding the potential liability associated with unregistered sales of securities.

IV. Conclusion

NFT issuers should be aware that the issuance and sale of NFTs may, in some circumstances, constitute the sale of securities.  As such, NFT issuers should consider structuring their token offerings through an STO framework or face potential exposure to liability for the unregistered sale of securities.

Resources:

• Understanding Digital Tokens – Lowell Milken Institute
• Rulemaking Regarding Non-Fungible Tokens
• Security Token Offering Research Papers
• Spotlight on Initial Coin Offerings (ICOs) – SEC.gov
• SEC Halts Alleged $1.7 Billion Unregistered Digital Token Offering
• Statement of Cryptocurrencies and Initial Coin Offerings
• Use Caution When Buying Digital Coins or Tokens – CFTC Guide
• Regulation of Cryptocurrency Around the World
• Colorado Digital Token Act
• Token Taxonomy Act of 2019
• Launching a Security Token Offering in Switzerland
• Security Token Offerings STOs are the new ICOs
• Crowdfunding Capital in the Age of Blockchain-Based Tokens
• From Securitization to Tokenization
• Coin-Operated Capitalism – Penn Law: Legal Scholarship
• Implementation of the “Do No Harm” Approach in Initial Coin Offerings
• Sample Offering Statement for Debt Until Security Token Offering
• Proposed Rules to Govern Trading of Equity Securities on Boston Security Token Exchange
• Tokenization of Assets: Why Liechtenstein is Revolutionizing Security Token Offerings?
• H&G Science | Security Token Offering Statement