France’s finance minister unveiled a decree to allow the trading of some non-listed securities using the blockchain technology. In the review below we look at real world cases in the regulation of blockchain assets – who is ready to follow France’s ambition?
Dr Bruno Le Maire, French Finance Minister
Security tokens – a new type of financial instruments created using blockchain technology – become popular in 2018. They attracted attention of all participants of the blockchain assets ecosystem. During the last year the cryptoassets market faced the following questions: Can such security tokens (which are considered some sort of digital securities in fact) become a new standard in a recognized and reliable system? Is it possible to raise considerable amount of funds using this instrument? What are the advantages of STO (security token offerings) against other forms of raising funds?
The blockchain assets ecosystem represents a combination of elements which jointly ensure the realization of the entire lifecycle of an asset: from token creation to digital securities trade. Token issuance, compliance with regulatory requirements, record keeping, custody, affecting further transactions and realization of rights relating to such tokens can be automated in many aspects.
Issuance of tokenized securities (security tokens) is not an enhanced version of ICO (initial coin offerings). It is rather a traditional way of raising funds but in electronic format.
Based on the results of the survey conducted to understand why companies have decided to choose such way of raising funds as STO it is possible to draw a number of conclusions about the advantages of this instrument:
it is the least demanding way to raise funds in terms of time and money. To put it simply, STO is easier and cheaper to realize than the traditional way of raising capital – IPO;
STO is a globally oriented solution which is intended to the wide range of investors;
the use of automated KYC system allows restricting of token trades among predefined range of investors;
due to the nature of the token itself (programming product) it is possible to determine the functions of this asset individually;
distributed ledger technology allows reducing of resources used to fulfill the obligations and trading tokens 24/7; and
blockchain also resolves the issues of reliability and trust.
In most cases tokens are classified depending on:
way of creation; or
As of today, from the legal point of view, it is correct to divide the blockchain assets into two main categories: security tokens and all other tokens. Such grouping is due to key differences in legal regimes for these two main categories of tokens . Within these two groups it is possible to classify tokens by referring them to various types.
There is no widely accepted legal definition of “security token”, so it is necessary to focus on market participants’ understanding of this term.
Main ideas are as follows:
it is a new type of token;
it provides the way of turning non-liquid assets into liquid assets; and
it is a new method for raising funds in a legally compliant way.
The last point gives rise to the hottest discussions. The market is interested in getting an answer to the question: how the projects that use tokenization in their business models should raise funds if the regulators throughout the world explicitly hint that it should be carried out in accordance with securities laws?
When we mention security tokens we mean securities issued using blockchain technology.
Still, does a tokenized security represent a new type of asset which requires adopting new regulations? Historically, the concept of securities as a new type of asset has emerged as a new method of recording title on particular medium to simplify the transfer of such rights between the participants of the transactions. Initially, securities were represented in paper form. Later on along with the development of computer technologies securities became electronic. Today all publicly-traded securities are in electronic form and recorded by registrars, depositories (custodians). The blockchain technology is a new way to record title to security in electronic form. Theoretically, it is more effective method than centralized record-keeping. Thus, tokenized security is not a new type of asset that is different from an ordinary security but it is a new way of recording title to such security.
From the legal point of view, the issuance and circulation of such instruments fall under the same legal regime as the issuance of classic securities. Additionally blockchain provides one more interesting possibility due to the use of smart contracts. In theory, the issuance of securities as tokens allows automated fulfilling of issuer’s responsibilities arising out of securities (e.g., automated voting, payment of dividends) which, for sure, offers very interesting and attractive opportunities.
To understand the principle of the issuance and circulation of security tokens it is necessary to look at how the global securities offering and securities trading is conducted and regulated.
The approaches to the term “security” differ in various jurisdictions. In particular, in most jurisdictions around the globe the term “security” is defined quite formally and is usually limited to the list of instruments recognized as “securities”. As a general rule, this list includes securities, bonds, other debt instruments, certificates of interest ownership in a fund, etc. The U.S. securities markets regulator, SEC, interprets the term “security” broadly and considers, at first, not to the lists of instruments indicated in the U.S. securities laws but what the rights such securities give to their holders. For example, in recent publication SEC has provided detailed analysis of the fact that tokens can be recognized as investment contract, i.e. an instrument that allows investing in particular companies for the purpose of gaining profit without participation in the company management.
There are two main types of securities offering: public and private. Public offering is traditionally a domain of big companies. The reason for this is the high price of public offering which requires involvement of a large number of participants such as market makers, banks, lawyers, auditors, preparation of expensive prospectus, performance of comprehensive due diligence procedure, preparation of financial reports and auditors’ letters, presentation of 10b-5 letter, listing on stock exchange, compliance with the requirement of post-listing information disclosure and maintaining the highest corporate governance standards. Startups and new businesses have no access to public offering primarily due to the absence of the financial history.
The main advantage of private placement is that it does not require registration of prospectus and provides opportunities to startups and developing companies to reach investor base. In particular, unqualified investors not always can invest in startup’s securities.
Private placement assumes direct offering to the limited range of investors, quite limited involvement of consultants, limited obligations in relation to information disclosure, and absence of subsequent obligations of periodic information disclosure.
The regulations applicable to private placement differ from one country to another. The U.S. law is the most developed one in this respect. In accordance with Article 5 of the Securities Act of 1933, as a general rule, a securities offering is subject to registration by SEC. At the same time it offers a number of detailed exceptions describing the cases when the registration is not required and specifying in detail the steps which a company needs to perform to avoid registration by SEC.
Approaches of other jurisdictions such as European Union (the EU), Asian countries (including Hong Kong and Singapore) and the Russian Federation differs substantially from the U.S. approach. In these jurisdictions there is no definition of “private placement”, so, in practice, the offering of securities should be carried out in such a way as not to meet the criteria of public offering.
Currently in the U.S. law the most popular exception is private placement made in accordance with Rule 506(с) of Regulation D. Its popularity is associated with the following. First, this rule allows selling securities directly by the issuers (involvement of special third parties is not necessary as, for example, it might be required under Rule 144А of Regulation A or Regulation CF). Second, it is available not only to the companies registered in the U.S. and Canada but to foreign issuers as well. Third, it is not necessary to submit annual reports to SEC except for single submission of Form D. Last but not least, when the placement is performed under this exception it is allowed to advertise offerings in the U.S. publicly (so called “general solicitation”). In accordance with JOBS Act that has introduced some important amendments to the securities laws in case of selling under Rule 506(с) of Regulation D it is allowed to offer securities to unlimited number of people provided that the issuer takes all efforts to ensure that only accredited investors will become purchasers (HNWI, corporations that possess property for a certain amount and a number of other persons).
In the EU, there are no special regulations relating to private placement. EU regulations afford the most protection to retail investors, so it is important to arrange the process in such a way that on the EU territory securities are sold as well as offered to qualified investors only. The general definition of qualified investor is provided at the EU level but each country set forth its own requirements to this status at the national level.
In Asian countries regulation on this matter is midway between the U.S. and the EU. In particular, in Hong Kong there is no definition of private placement as well as no list of exceptions for registration requirements. Thus, all main efforts on private placement structuring are aimed at structuring the offering in such a way so it does not qualify as public placement. Among other things such measures can include limiting number of persons to whom offering is made, establishing a maximum investment amount, restricting the total offering size.
In Singapore. there are twelve exceptions from public offering regime. These exceptions include offering to a limited number of persons (not exceeding 50 investors), offering to qualified investors or professional investors, offering with limitation of maximum investment amount, offering with limitation of the total size of the offering (5 million Singapore dollars).
In Russia, similar regulations exist that permit private selling of securities without prospectus registration by the regulating authority if securities are offered to qualified investors only.
Crowdfunding is also worth mentioning. It has emerged in the U.S. and is currently spreading throughout the world. Crowdfunding is a collective cooperation of people (donors) who voluntarily merge their funds or other resources typically via the Internet in order to support the efforts of other people and organizations (recipients). Raising of funds can serve various purposes — helping people affected by natural disasters, support of sports fans, support of political campaigns, funding of startups and small businesses, development of free software, gaining of benefit from joint investments, etc.
In the U.S., crowdfunding is conducted in accordance with Regulation CF and only available to the companies registered in the U.S. and Canada. Despite the advantage of fast offering completion there are certain important restrictions such as limitation of maximum offering amount (1 million 700 thousand US dollars), restrictions relating to information distribution, requirement to engage a third party agent.
Today the EU regulation on crowdfunding is under development. In the EU countries the consultations relating to the requirements applicable to crowdfunding are currently running on the level of the Capital Markets Union. The recommended threshold for application of exemption from the requirement to register prospectus is 8 million Euros. So far only Great Britain and Germany have legislatively approved this limit.
For the projects planning to issue security tokens only private placement option is available, i.e. sell their tokens to professional investors or use crowdfunding regime that bears quite important restrictions on the volume of investments and procedure of fundraising.
When reviewing the examples of the largest token offerings of 2017 – 2018 it is possible to apply matrix on the transactions with tokens. We will analyze EOS, Filecoin, Telegram and tZero as examples. The examples are selected based on the amount of transaction – volume of raised funds, diversity of the functional features of offered tokens and variety of chosen structures of offering.
Despite the fact that the functional features of tokens of all four projects are different (as well as offering structure and settlement procedure) they are all similar in one aspect: all these transactions most likely should be qualified as securities offering. All these projects were raising funds to implement an idea, so purchase of their tokens was an investment for the buyers. The essential nuance here is the difference in approaches to the definition of securities in the U.S. and the rest of the world. In the U.S. the relationship test is used to determine whether a seller sells a security or not. The passiveness of investments is the key factor for such determination. If funds are given to someone in expectation that this person will perform something to increase the amount of money, then this relationship is called investment contract and, therefore, such investment contract is a security.
By the way, this concept has not emerged on its own. The U.S. Securities Exchange Act is formal enough but its provisions are subject to interpretation by courts who have developed this concept by defining the criteria of what investment contract is (case SEC v W.J.Howey Co., so called “Howey test”).
In Europe, Russia, Asia and the rest of the world the situation is different. The approach to the determination of what security means is more formal in these countries and is based on the respective definitions in relevant legal acts of corresponding country. Thus, everything that is not covered by this definition shall not be formally deemed a security from the legal point of view. It is the source of the key statement of crypto industry of 2017 – 2018 – structure a token in such a way so that it would not represent a security and sell it wherever you want, just exclude the U.S. and those countries where selling of tokens is prohibited. “In such a way so that it would not represent a security” means that it is required that a token will grant no rights usually associated with the rights granted by such securities as shares or bonds.
As a whole, the concept of funding through utility tokens has originated from startup crowdfunding industry due to advance payments for the unfinished products at the stage of their creation. It was known even before ICO occurrence. But it involved other funding volumes. In 2017 – 2018, ICO promoted funding of promised products or services to another level which should be disturbing by itself. But it is not the key point here. The purchase of a still non-existing product on Kickstarter does not assume formation of a secondary market for this product until it is finally produced. In 2017 and 2018, it was expected from the very launch of the majority of projects that the raising of funds for implementing their ideas would be successful depending on the promise of formation of the secondary market. Availability of a highly liquid secondary market for a functionally empty utility token makes disputable the correctness of the statement that if tokens do not match the definition of securities then such investment can be done in any way and the special regime shall not apply. The correctness of this statement still needs verification.
As for EOS, it was the first largest ICO. The placement was launched before SEC’s key announcements that it considered all ICO projects with no products to be securities offerings. So, it became the first really large placement the market has tested:
the tokens had been sold sold in accordance with token purchase agreements during the year;
next day token delivery, but such tokens were dummy-tokens (i.e. a receipt in the form of ERC-20 token which can be converted into a token of EOS network if and when it is launched);
the receipt-tokens had no functions at all except for the potential possibility of conversion into a token of EOS network;
the secondary markets existed (Block.one has not confirmed its participation in organizing it).
It was the most long-term fundraising process – the transaction lasted one year. It was possible to purchase a token with next day delivery and at the same time the secondary market existed. Block.one has not ever confirmed its participation in arranging it. From the point of view of common sense, the purchasing of tokens was a purely speculative investment and with regard to the current position of SEC it was a placement of securities.
Basically, the purchase of tokens was given a status of charity contribution by Block.one. It does not mean they promised nothing, on the contrary – they stated that it would likely not result in anything, and in case of success they would not accept any responsibility for it, as they were only responsible for coding and the network could be launched without their participation. It looks like a futures contract but it is not a futures as the underlying asset is not provided. The secondary market exists but it has been organized by the buyers themselves.
So, in case of EOS placement the decision was as follows: the U.S. is excluded from selling; selling to anyone else was permitted for ETH only without minimum investment limit, without KYC/AML.
ICO of EOS is considered to be one of the largest utility tokens selling transactions but this structure remains highly disputable.
Three other transactions were performed in another way. Filecoin, Telegram and ТZero did not arrange crowdsale. Despite the fact that the tokens of Filecoin and Telegram were not securities as the token had non-security functions, they were sold as securities because there was not minimum viable product (the MVP) at the moment of offering. The tokens of all three projects were sold under agreements providing payment immediately after signing and token delivery in the future. Out of three projects the tokens were delivered only by TZero. The tokens of Telegram and Filecoin will be delivered to the buyers only after the launch of their networks.
As none of these projects has registered securities prospectus with respective regulatory authorities, they sold tokens only through the closed subscription to the limited number of persons who had to meet the requirements of the accredited investors in the U.S..
Telegram transaction was a club transaction. While Filecoin and, on the second offering stage, TZero accepted funds from the accredited investors in any amount, Telegram had initially set very high minimum investment amount which were unaffordable for the standard range of the qualified investors. This gave an opportunity for all projects to sell their tokens worldwide, including in the U.S., in reliance on Regulation D. The investors from the countries under sanctions were excluded. Investing from China was also allowed, as it was not ICO prohibited there but typical placement of securities through the closed subscription.
There is no secondary market for these tokens. It is prohibited by the token purchase contracts and the U.S. securities laws. Temporary restrictions were imposed on reselling. The rights under the contracts can be assigned only by agreement with the issuer.
ТZero is interesting because it was one of the first projects involving securities issuance in blockchain where a token itself represented a security. Basically, TZero issued preference share taking advantage of the amendments to the corporate law in Delaware. In the end of January 2019, Tzero announced that the launch of secondary trading of its tokens via its own alternative trading system.
Use of blockchain technology for recording title to securities
Delaware is the state where the majority of publicly-traded U.S. companies is registered. This state has the most developed corporate laws. In 2017, it adopted the law that allows using blockchain to keep records of securities (keep records of rights using distributed ledger technology). This law is only applicable to the companies registered in Delaware. Its main purposes are as follows: first, make keeping of records of rights more transparent and, second, substantially reduce the time required to perform transactions related to securities transfer and settlements for them which will make securities more attractive for investments. In accordance with Delaware law the requirement to use depository is not applicable, if the shares are issued on blockchain.
Currently, keeping of records of rights to all publicly traded securities is performed by Deposit Trust Company with settlement in T+3 mode (i.e. within 3 days from entering into deal). SEC proposed to switch to the settlements in T+2 mode (within 2 days). Taking into account the adopted law the settlements under transactions can be made within one day in T0 mode.
In December 2018, a decree was adopted in France granting the right to use the distributed ledger technology for the registration of securities, recording the title to security and transfers thereof. Now French law provides that the recording of title in blockchain has same legal effect as the recording of title on the securities account.
Beyond the U.S. and France there are still no special laws which allow record keeping of title to security with the use of the distributed ledger technology. In a number of jurisdictions such as Luxemburg, Baltic State and Russia similar draft laws exist. The main problem here is that European countries have different legislative systems and use diverse approaches to recording title to securities. In many countries with the continental legal system (e.g., in Germany) strict requirements are set out with respect to recording title to securities of private companies (requirement to involve a notary, keeping of register in paper form, etc.). In other countries, for example in Cyprus, there are no such requirements applicable to record- keeping of title to securities. To make this initiative work, it is necessary not only to amend the laws of the countries with continental legal system but also the laws of the countries with common law system.
An answer to the question if it is possible to switch from classic system of recording title to securities to the blockchain system depends on whether or not such corporate procedure is provided for in the law. In Delaware some restrictions currently exist relating to recording title to earlier issued shares on blockchain, and the procedure allowing such transformation from depository to blockchain has not been specified in the law. Other countries (except for France) have no such laws at all, but, as mentioned above, there is an idea of providing the possibility of such recordkeeping and amending the law to this effect.
At the moment there are many projects building tokenization platforms. You can find special projects for particular assets and platforms focusing on securities tokenization.
The purposes of such projects:
automatization of securities issuance by means of blockchain (the platform should perform automatically everything that is currently done by lawyers and bankers);
simplification of compliance in relation to secondary trading of such securities among the limited range of investors;
automatization of interactions between the security holders and issuers (distribution of dividends, dissemination of information, participation in corporate governance, etc.).
Tokens issued on such platforms are definitely represent securities.
Some projects follow the securitization model where a company running the platform becomes the owner of tokenized property. Other projects choose the technological solutions that allow issuing of securities directly in blockchain; in other words, the use of technologies to keep records of title to securities and get additional options for secondary trading compliance.
The platforms that offer technological solutions are playing a risky game as their viability depends on whether or not the legislation will be amended to allow the use of their technologies for recording title to security and exercising rights attached to them.
There is a fairly large number of projects dealing with tokenized securities. These projects work towards creating of trading platforms. From the technological point of view they do not differ from ordinary exchanges much but they have a distinctive feature.
Organization of securities trading is a regulated business in all countries. Correspondingly, the launch of such projects requires obtaining of relevant licenses from the local regulating authorities in addition to the development of technological platform.
The license type depends on the platform location, performed operations and package of provided services. At least, it includes broker license. It can also include custodian, clearing house, market operator license or even a stock exchange license, if retail investors are supposed to participate in trading activity. In retail business the situation is different. If any company manages to obtain the stock exchange license then retail investor can get access to trading of only those instruments in relation to which the prospectus is registered. In the near future no such participant is anticipated to occur due to the reasons we described above.
It is known that out of all U.S. crypto exchanges only Coinbase has acquired a broker company as of December 2018. Thus, it will be allowed to register a trade platform. As a rule, other crypto exchanges obtain only money transmission licenses to operate in the U.S.
Today the decentralized token exchange platforms are also actively developing. SEC has recently punished EtherDelta exchange for illegal organization of securities trading despite the decentralized nature of the platform.
Obviously, the classic players possess all necessary infrastructure and if they enter this area with the liquidity, experience and funds they already have for the new players it will be hard to compete with them, especially in a regulated market conditions.
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