As the popularity of Security Token Offerings (STOs) rises, many issuers fail to realize the lengthy compliance procedures that are mandatory for a legal solicitation of investment. This article outlines some of the considerations that are overlooked amid the excitement of raising money via STO.
Attentive consideration is required by executives or project managers looking to tokenize any of their assets. Yes, liquidity is high and STOs have and will continue attracting large amounts of capital. True, the STO is a fast alternative to traditional financing like venture capital, private equity, and public stock exchanges. Notwithstanding this excitement, at all stages of any securities offering — including many events that occur before a digital security can be legally created — numerous compliance items must be thoroughly addressed.
Especially for STOs soliciting investment from U.S. citizens, complications can quickly arise at the behest of regulators like the Securities Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Financial Industry Regulatory Authority (FINRA), and Department Of Justice (DoJ). Regulators are highly vigilant and may prevent the listing of, sanction, halt, or delist any illegally tokenized securities. Closely-connected individuals to illegal STOs may also be subject to civil or criminal judgements as individuals.
Not to lambaste legitimate issuers, but it is further worth noting that the statute of limitations for most Americans extends back over five years of history. This means that the U.S. government may newly initiate criminal proceedings against someone in 2024 for something that occurred this year. So although compliant STO issuers have nothing to worry about, hopefully the reader sees beyond the scaremonger to heed the warning: take any security offering very seriously.
You Get Credit, But Not Much Credit, For Calling It a Security Token Instead of a Utility Token
Many self-congratulatory issuers believe they are clear of many obligations by virtue of their selection of a STO for their fundraising vehicle, versus the more popular, yet often illegal, utility token Initial Coin Offering (ICO).
“I believe every ICO I’ve seen is a security,” SEC Chairman Jay Clayton summarily declared on February 6, 2018, at the height of the ICO frenzy. He underscored his point throughout a U.S. Senate hearing, “I’m very not happy that people are conducting ICOs, when they should know they should follow the private placement rules.” Likening to penny stocks, ICOs “have proven over time to be fertile ground for fraud on investors.”
By selecting a STO instead of a disingenuous utility token offering, many issuers take comfort in that they have already made substantial disclosure to the public. Unfortunately, this is not substantially the case.
An issuer gets a small amount of credit, but not much credit, from regulators for this first step of honesty. Managers launching a STO in a compliant fashion under one of the available exemptions from SEC registration — for example, filing a Form D seeking Regulation D exemption — mistakenly think that this step would automatically qualify the STO for SEC approval. In reality, this could not be further from the truth.
To avoid any ambiguity, neither the SEC nor any government agency approve of any investment whatsoever. The most the SEC would do is to allow the exemption of an investment from certain registrations.
Per the commission’s October 11, 2018 statement verbatim, “The SEC does not endorse investment products and investors should be highly skeptical of any claims suggesting otherwise.” The commission’s investor bulletin continues, “Look out for these warning signs of possible ICO-related fraud: claims that an ICO is ‘SEC-compliant’.”
Considerations for a Compliant STO
Bearing in mind the above, issuers should seek licensed counsel prior to issuing or investing in a STO. In addition, below are a few items that could be included in a typical checklist.
1. Business Plan and Disclosure Documents
If a STO is related to the operation of business in any way, that business should have a comprehesive business plan and disclosure documents for potential investors.
Although some of the SEC’s exemptions from registration, such as Regulation D, do not require the issuer to submit a business plan or offering memorandum to the SEC, the issuers are still obligated to provide to their investors all material information that would be reasonably required prior to making an investment decision. In almost all cases, this disclosure includes a business plan, risk disclosures, and an assortment of additional documents that qualified counsel could assist in preparing.
Moreover, regulated ATS platforms may require a business plan, as well other documents, plus ongoing disclosure commitments, before listing a digital security underpinned by any business-like operation.
2. Secondary Trading (a.k.a. “Exchange Listing”)
Sometimes simply called an “exchange listing,” the secondary trading of digital securities on private and decentralized exchanges is surprisingly popular. Largely due to the expiration of holding periods of 2018’s first batch of STOs, recently unlocked tokenholders have sought listings on the few STO secondary marketplaces that exist. In the U.S., a secondary market for STOs should almost always take the form of a licensed Alternative Trading Systems (ATS). Examples of compliant ATS operations include tZero, Templum, and OpenFinance Network. Reader beware that there are few other examples.
On the one hand, most traditional business people considering issuing a STOs are not familiar with the blockchain technicalities than enable the tokenization of their assets, nor the legal implications surrounding digital securitization. On the other hand, some specialized technicians of blockchain projects wrongly assume that the listing process for digital securities should be similar to the listing process for ICOs on unregulated “utility token exchange.” Both parties here are misled.
Security token stakeholders often fail to acknowledge that compliant secondary trading requires careful compliance at all stages of a STO project, even before the security is tokenized.
Many securities must be limited in transferability, depending on the status of the business or investor. This is a complex issue yet well-established from a legal framework, such as when stock certificates bear a Restricted legend limiting their transferability into brokerage accounts.
Issuers should consult licensed counsel regarding transferability regulations in their specific situation.
From a legal perspective, STOs are little more than traditional securities offerings- investors just happen to take delivery as tokens. So similar to every other security offering, digital securities offerings must comply with current legal requirements. These requirements span times prior to the issuance of tokens, during the existence of the tokens, and especially, prior to and during any secondary trading of the tokens.
All security issuers should be eligible to offer and sell the security, seek regulatory exemption for any regulations they feel do not apply to their offering, should disclose all material terms of the security to potential investors, and appropriately restrict the transferability of security ownership, including tokens.
To achieve secondary trading, listings should proceed in a legally compliant manner, usually pursuant to Regulation D, Regulation S, Regulation A+, or Regulation CF of the Securities Act of 1933.
Violators of securities laws will fear regulatory investigations and enforcement actions, which may lead to civil or DoJ criminal proceedings.
Issuers should seek a reputable ATS which requires a thorough review of the token’s compliance with securities laws, and retain their own counsel as part of the due diligence process, prior to listing any token on any exchange-like platform.