Compliance Considerations for a Security Token Offering (STO)

An increasing number of blockchain companies have launched tokenized securities with the assistance of attorneys. Many law firms simply have advised these companies on STO procedures which mirror traditional securities offering, such as the processes for secondary share offerings. However, as regulatory clarity has increased regarding new laws specific to cryptographic assets, issuers are discovering that a Security Token Offering (STO) is a highly nuanced event. Careful attention should be paid to the technical and legal processes of the token issuance, which is distinct from a traditional equity issuance.

Below are a few of the many considerations to which issuers must attend before launching their STO.

  1. Which Interests Have Been Tokenized?

Security tokens can represent a range of financial interest. The interests represented by the token depend on the structure of the token, ranging from ownership of physical assets, to debt claims, to equity interests, or even to incomes or intellectual property rights arising from the ownership of artwork. The tokenized interest directly correlates to how that STO appeals to investors, as well as the legal requirements of the token offering event itself. The characteristics of the interest also affect the ongoing disclosure requirements, such as quarterly or annual disclosure minimums.

  1. Formation of the Token

The formative structure of the STO can be significantly influenced by the physical or internet server jurisdiction(s) where the tokenized assets are located. Furthermore, the locations of the associated businesses, entities and managers are also important. It is necessary for the security token issuer to choose an appropriate authority, after taking into consideration various factors such as the following items.

  • The physical location of the tokenized asset or interest.
  • The domiciles and operating locations of the associated business entities.
  • The residency of the team members and project managers.
  • Whether residents of populous or highly regulated countries such as the USA, China or India were allowed to participate in the offering, bearing in mind that almost all countries have distinct regulations.
  • The tax treatment of the tokenized interest. As an example, there are distinct tax brackets and reporting forms for commodity gains, dividend income, real estate appreciation, and equity values.
  • The marketing strategy for the underlying operations: business announcements, press releases, advertising, etc.
  • The marketing strategy for the STO event itself: investment memoranda, investor relations, disclosure channels, social media channels, etc.
  1. Governance and Corporate Structure

A STO launch requires proper governance and legal structures. The company, trust, or other issuer should provide authoritative legal documents to execute the security token issuance. Especially if the offering is similar to a corporate security offering, substantial regulations apply to its public issuance. For example, the issuer might need to check if the law limits the number of holders of its tokens.

An issuer of digital securities can choose from a variety of structures, including a hybrid structure. The corporate structure of the issuer may include one or more of the following:

  • One party that has one or secondary classes of securities to be tokenized
  • Multiple parties with one or secondary classes of securities to be tokenized
  •    Securitization structures such as a Special Purpose Vehicle (SPV), shell company, reverse merger, or share swap
  • A trust or partnership
  1. KYC/AML Requirements

Most countries have imposed certain Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements on all kinds of financial business, including security tokens. These impositions are essential for ensuring the legality of the sources of the funds held in security tokens.

KYC and AML procedures are essential for complying with securities laws. Certain types of offerings in the USA may be sold to accredited investors only. The KYC process is essential here to determine which investors need to undergo accreditation certification. There are many third-party services providers for KYC and AML, such as Sphere Identity, Sum & Substance, IdentityMind, Simple Token, CoinFirm, Veadir, VeriFundr, Veratad, and others.

  1. Third-Party Tokenization Services

Today, token issuers have the option to choose from a wide range of tokenization platforms such as TokenSoft, Securitize, Polymath, Harbor, Token IQ, Swarm, Bankex, Blackmoon, BlockEx, TokenNY, and many more. When choosing a tokenization service provider, the issuer should be careful during its deliberation, because each platform approaches the tokenization process differently. Pricing models are unique for each platform, varying according to the complexity of the offering. Different platforms have different AML and KYC tools, licensing, and other legal and technical support offerings. There are also varied approaches to post-launch support and secondary trading assistance. Record-keeping, accounting, token transfers and distributions, custodial solutions, and many more characteristics vary by service provider.

  1. Banking Relationships

Despite the growing popularity of cryptocurrencies, there are vanishingly few banks in the world that are open to direct relationships with crypto businesses. Token issuers need to determine their banking needs and explore all of their limited options. Having accounts open with multiple banks is critical, as any individual account might become frozen temporarily, even at no fault of the issuer.

  1. Secondary Trading, or Token Exchanges

Early movers have undertaken the laborious process of launching compliant token exchanges or decentralized trading platforms. Exchanges which list STOs are limited in number, but several more are under development. Some of today’s operational platforms include OpenFinance, tZERO, and Templum. Other countries have also encouraged the establishment of STO-friendly token exchanges.

When choosing a secondary trading platform, the token issuers must ensure that their platform complies with pertinent regulations. They should also check the KYC/AML and listing requirements of the platform.

  1. Customer Record-Keeping and Token Custody

Countries have various restrictions regarding the maintenance of customer records, responsiveness to government information requests, segregation of customer information and account information, custody, delineation of assets, and thresholds for suspicious activity reporting. Platforms operators must maintain certain ledgers, tables, accounts, and other database items to comply with these laws.

Token custody also stands as a significant security issue in the industry. Traditionally, exchanges managed both the trading platform as well as the custody of the digital assets. However, many exchanges now enlist third-party custodians for some of their custodial responsibilities.

Whether the issuers enlist the help of third parties, or manage any custodial responsibilities internally, the above considerations apply to issuers as much as they apply to the other parties involved in these processes.

  1. Tax Requirements

Before the STO, token issuers should consult with tax advisors to draft a tax strategy. The documentation should reflect the types of tokenized interests, the treatment of income generated for tax purposes, and the reporting requirements to customers and regulators. An example of this might include the Internal Revenue Service’s Backup Witholding, which applies to senders of funds to certain USA residents. For all pertinent guidelines, the plan should be robust, drafted by accountants, and reviewed by qualified counsel. Since the execution of STO is a lengthy and expensive process, issuers should spare the time upfront to ensure that they are in compliance with all of their tax obligations, which include treatments for their investors.

Final Thoughts

The above list is far from exhaustive. Launching a STO is a costly process requiring in-depth research, careful planning, and the assistance of qualified counsel. The examples above demonstrate the complexities involved in issuing and offering securities, regardless of their form. There are many other factors that influence the success of a token offering, such as marketing, but the foundation of any STO must begin with tax and legal compliance.

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