Guide to Legalities of Security Token Offerings (STOs); The Road Less Travelled
ICOs are now evolving towards STOs, and here’s a comprehensive guide explaining the legal process for issuing security tokens.
STO (Security Token Offering) is more than a catchy phrase. It reflects the movement of the ICO (Initial Coin Offering) world from being legally freestyle and carefree towards having to adhere to well-established and enforced laws and regulations. The reason is the increased awareness of regulators towards ICOs as a loophole in the fundraising legal sphere and their desire to seal it, in order to protect the investors and consumers they have been appointed to watch over.
More and more regulators, including the US Securities and Exchange Commission (SEC), the Swiss Financial Market Supervisory Authority (FINMA) and other European and Asian regulators are of the opinion that if a token issuer is selling tokens for a platform which is not yet operational, then these tokens are probably being purchased by the crowd as an investment and therefore, should be regulated.
You should keep in mind that a token can trigger all kinds of licensing requirements besides compliance with securities laws. For example, a token which isn’t a security may still be considered as e-money, a payment service or as an alternative investment. The rule of thumb is: conduct a legal analysis on your token and then, if the conclusion is that a securities procedure or another licensing process is needed, choose the country where you wish to start according to your intended target markets. Then right jurisdiction for licensing and securities laws is always determined by the origin of your clients.
The European Union has regulated the issuance of securities on a pan-EU basis through the prospectus directive and the prospectus regulation. This EU directive is implemented internally by the state regulators, which make their own, country-specific rules, based on the directive, but the concept is similar and the idea is to have a standardized legal framework for all EU members. Let’s go over the main points of these EU regulations, which you should be aware of.
The regulatory process a securities issuer needs to go through isn’t obtaining a license, rather drafting a prospectus and getting it approved by the securities regulator in the country of the issuer’s choice. The prospectus requirement is the rule, where the exemptions are the exceptions. Using an exemption means you are selling a security, but in a pre-defined limited way, rather to the public (“retail”).
Before blindly choosing to go for the securities framework, there are some basics to go through, after you’ve chosen your jurisdiction:
1. What makes your token a security? Securities definitions are similar in spirit but vary from country to country and god is in the details. Securities in the EU are mainly shares in companies (“equity securities”) or bonds issued by companies (“debt securities”), which are negotiable on the capital market; or other securities which give a right to acquire such said securities or give rise to a cash settlement (besides payment instruments). In the US, the definition is wider and puts more weight on the purpose of the investment and what the entrepreneurs are doing with the invested funds, rather than on the actual instruments the investors are receiving in return for their money.
2. Is your token a payment instrument? To be considered a payment instrument, your token would need to mainly function as a form of payment, but not an obscure one - the token would need to enable the token buyers to buy an actual product or service using it, from day one. If your token is a mere payment instrument, then it wouldn’t fall under securities laws, but it may be considered e-money or a payment service.
The main characteristic differing an unregulated payment token from e-money or a payment service is the legal relationship between the coin holder and the issuer. When the issuer has liability towards the coin holders, for example, to buy back the coin, then it would usually mean that licensing is required.
3. Can you climb in through the window? If your token is actually a security, then the next thing for you to do would be to check whether you can use one of the exemptions. An exemption is a way for you to issue a security without having to go through the process of drafting a prospectus and complying with the prospectus directive or other local securities laws requirements. Bottom line - it’s an almost hassle-free way for you to issue and sell a security.
3.1. The qualified investors exemption, a.k.a. private placement - the term private placement has been getting a lot of love from ICO entrepreneurs lately. What it means is that you can sell your security tokens freely to qualified investors, meaning mainly institutional ones, high net worth individuals and their likes. The famous US equivalent is the Reg D. Don’t forget to draft a proper private placement memorandum and strong subscription agreement for the investors. You will most likely be dealing with experienced, “lawyered-up” investors and companies so you need to properly protect your interests.
3.2. The limited amount exemption - if you are looking to raise less than 5 million euros in your STO, then you don’t need to draft a prospectus and you can enjoy what’s called the “limited offer” exemption.
3.3. The limited network exemption - in the EU, if you sell your security token to up to 150 people (no matter if they are qualified or not) per member state, then you don’t have to draft a prospectus.
3.4. The nominal value exemption - if each token you sell is equal to at least 100,000 euro.
3.5. The large investments exemption - if each investor purchases at least 100,000 euro worth of your tokens.
4. Have you revised your business plan? You need to keep in mind that in the case of most exemptions, the meaning is you will not be able to list your token on exchanges at all. It’s obvious that if you undertake to only sell your token to qualified investors, or to a limited network, then the exchange listing option is immediately being crossed off your list. Even if you’ve chosen to draft a prospectus and to actually sell your security tokens to the public, the crypto exchanges which are listing security tokens as of now are limited. So, you need to make sure your business plan is prepared to walk the road less traveled, for example by dedicating proper legal budgets and by pre-scanning the exchanges which would be regulatory able to list your tokens.
Don’t feel like you’re up to it? It might be that you feel like you’re just not ready for the implications or for the process of issuing a security, or that you don’t have enough time. In this case, I would advise you to sit down with your lawyer, adopt a flexible approach and see whether you can adjust your token characteristics and choose the right jurisdictions in order to be able to sell the token as a utility or a payment token.
Disclaimer: This article is published as a general overview and should not be considered legal advice. Before launching an ICO or STO, seek personal professional advice.