Legal Intricacies of RWA Tokenization – Interview with Borys Pikalov

Stobox is a turn-key provider of RWA tokenization services, active since 2018. The company had the privilege of working with over 60 issuers from a dozen different industries, with fundraising targets ranging from $30,000 to $300M, scattered across all five continents. Assets include real estate, metals deposits, private equity, crypto mining facilities, etc.

All such engagements involved legal issues, which granted the company a solid and diverse base of explicit and tacit knowledge. A powerful side of Stobox’s expertise is a pragmatic approach to legal issues within the broader context of the client’s needs.

Questions addressed in such engagements aren’t ”How to structure a token offering?” but “How to structure a token offering at a reasonable budget within realistic timelines?”.

The company’s issuers highly value adaptability to unique needs and requests. Here, on the cutting edge, the Stobox team faces a variety of innovative business models that don’t fit pre-determined molds and require thoughtful, creative approaches. “First-principles thinking” over “One size fits all”.

This article addresses some of the most commonly asked questions and aims to prepare prospective issuers for the intricacies of the legal aspects of RWA tokenization.

Which legislation applies to tokenized RWAs?

Asset tokenization involves multiple layers of legislation, which is the primary source of legal complexity.

The following ones should be considered:

1. Securities law
   Most asset-backed tokens fall under the definition of securities. Assets have financial value primarily when income-generating, and some form of profit on tokens is usually enough to be considered securities. This legislation, among other things, introduces the requirement to disclose information to investors and obtain registration before selling tokens.
2. Financial markets law
   Entities that engage with securities and provide related services often need to be authorized by competent authorities. Financial market legislation defines relevant licenses and the authorization regime.
3. Corporate law
   RWA tokens often function as shares or bonds. The rights of holders of such assets are described in corporate law. Its convenience is an important factor in choosing a jurisdiction for the token issuing company.
4. Virtual assets laws
   As RWA tokens are virtual assets, they may also need approval under virtual asset laws, and entities facilitating transactions may need to register as virtual asset service providers.
5. AML legislation
   Ensuring the safety and transparency of financial markets is a shared responsibility. All entities involved, including issuers and platforms, must implement KYC/AML programs to ensure no illegal funds are used to purchase RWAs and no income from RWAs is used for illegal purposes.
6. Tax codes
   Investors and issuers must pay taxes, and this has to be taken into account when designing the structure. Given that most issuances are cross-border, double taxation and withholding taxes become an especially important issue as they can eat a large portion of profits. For example, Switzerland applies a 35% withholding tax on dividends to foreign residents (subject to rebates), which can take returns from above-market 10% to below-market 6.5%. 
7. Consumer protection
   For utility tokens that facilitate consumption, consumer protection law might apply. However, the authors haven’t seen any lawsuits based on these laws, so this is currently a more theoretical consideration.
8. Data Protection
   RWA issuers and platforms collect user data and must ensure its proper protection.

Though this list can seem daunting, there are solutions and procedures to comply with all the applicable legislation. Many of these things are built into technical solutions, including the Stobox DS Dashboard.

• Engage a knowledgeable legal partner or an in-house attorney.
• Analyze applicable law and determine your compliance requirements.
• Set up the proper corporate structure. It should ensure the direct link between assets and tokens, as well as provide an optimal tax environment.
• Prepare legal documentation, including disclosure documents that explain details of the business and risks to investors.
• Register the offering with competent authorities or comply with an exemption from registration.
• Submit required filings with competent authorities.
• Set up an investor onboarding process with the account of KYC/AML and data privacy requirements.

A critical mistake that so many issuers make is believing that only legislation of their country of incorporation applies. In reality, you must comply with the securities law of every country in which you sell tokens or provide services to investors.

This includes the need to register your tokens or be exempted from registration in each such country. If you need a license, it should be granted by or recognized in each such country.

Some clients neglect these requirements because of low enforceability. Many countries don’t pursue violations by foreign entities, especially if these violations don’t harm investors. However, such an approach is unethical and can backfire badly.

Are RWA NFTs considered securities?

Whereby an entire asset is represented as a single NFT, said NFT is unlikely to qualify as a security. However, most implementations presume the breakdown of such NFTs into fractions; otherwise, the main benefits of tokenization, such as fractional ownership and liquidity, don’t apply. Fractionalization turns NFTs into securities because it dilutes the power the holders have, thus creating the need for protections that securities laws provide. Basically, fractions of asset-backed NFTs are security tokens.

Generally, full registration of an offering is an expensive endeavor. Costs range from $40,000 to $150,000 or even more. These are further compounded if licenses are required, or multiple jurisdictions are involved. Moreover, the process can take from six to eighteen months!

However, regulators recognize that these figures are expensive for most small and medium enterprises, and their purpose is to protect financial markets from disruptions and fraud, not to shut down any activity. Thus, they offer simplified regimes for smaller offerings to operate.

Issuers can sell securities under a regime called a private placement or an exempted offering. Provided certain requirements, known as prospectus exemptions or private placement rules, no registration is required, thus offering a much more cost-effective and faster time to market.

How to navigate private placement restrictions?

Typically, private placement rules have three types of restrictions:

• The type of investors, i.e., tokens, can be offered only to professional investors.
• Number of investors;
• Amount raised.

On the level of a single country, they can be pretty restrictive. But for a cross-border offering, one can raise very significant amounts without extensive legal fees. Utilization of exemptions doesn’t mean the absence of rules. It’s still required to provide detailed disclosure to investors and set up an AML and data protection policy. Moreover, certain simplified filings may still be required.

How to handle cross-border campaigns?

In cross-border campaigns, it’s important to be selective about the countries you target. It’s preferable to have fewer countries included but comply fully with local legislation and have focused marketing.

Targeted countries should be selected based on the following criteria:

• Deep capital markets;
• Community/brand presence;
• Synergies in registration, e.g., mutual recognition of licenses;
• Private placement rules that fit targeted investor profile;
• Double tax avoidance treaties with the country of business operations/

A promising approach to expanding targeted markets is using a reverse solicitation regime, also known as passive marketing. Many countries word their registration requirements in such a way that it’s the solicitation of investments (i.e., marketing) that is prohibited, but accepting investments. Therefore, if you don’t advertise in a certain country, but some investors find out about the company anyway and request to invest, it’s often legal to accept their investments. However, it’s tricky to show that there was truly no advertisement, so this technique should be applied with extreme caution.

Though not all compliance requirements can be encoded, a significant burden can be lifted from the clients’ shoulders.

Overall, licenses are applied to companies that provide services from a designated list to issuers or investors. These lists usually include investment advice, reception and transmission of orders to buy or sell securities, placement agent and underwriting services, asset management, custody of funds and securities, etc.

Examples of popular models that are likely to trigger registration requirements include: 

• Redemption at the request of investors is likely to classify the issuer as an open-ended fund;
• Platform listing and selling third-party tokens is usually acting as a broker;
• A token that provides exposure to returns generated by a basket of assets would probably be treated as a unit in an investment fund.

How does MiCA impact tokenized RWAs?

It doesn’t, as MiFID II financial instruments (i.e., Securities) are exempted. However, some RWAs can be categorized as asset-referenced tokens, for which MiCA introduces an authorization regime. Utility tokens issued by RWA platforms are also subject to registration under MiCA.

What clever tokenization strategies have been demonstrated?

When it comes to legal structure, it’s better to be safe rather than clever. However, some clients are interested in legal experiments to test novel business models or kick off potentially regulated operations on a smaller scale.

Two examples are presented below...

Using a Segregated Portfolio Company (SPC) as the backbone to tokenize multiple assets within a single platform. To tokenize multiple assets, they should be owned by separate legal entities to protect risks pertaining to one asset from spilling over the entire portfolio. However, a company that operates a platform with such tokens would then act as a placement agent to companies that hold the assets. No such services are provided only in the case of the token issuer conducting the placement itself. Therefore, normally, you would need each company to have a separate platform, which is a costly solution that offers a significantly worse user experience.

This dilemma can be solved using a segregated portfolio company. SPC is a company type in some jurisdictions that allows a company to have sub-units with segregated balance sheets. Each such unit can hold a separate asset and issue a token. An SPC that operates an investment platform offers its own tokens and thus doesn’t provide placement agent services.

It should be noted that such a structure isn’t available in many countries or often can’t be used to fundraise. Also, not all countries and courts recognize the segregation in the SPC, leading to weaker asset protection compared to fully separate SPVs and a lower ability to utilize Prospectus exemptions. Lastly, such a platform can still be considered to provide other investment services, like the reception and transmission of orders. Therefore, it’s not a silver bullet and should be utilized with utmost care, if at all. 

Another example is using highly decentralized governance so that tokens aren’t treated as securities. A Howey Test, which is used in the US to determine whether something is a security, uses “reliance on efforts of others” as one of the criteria.

Basically, if you give your money to someone else to create a return for you, it’s an investment.

Therefore, if all investors act as employees, at least in some capacity, actively involved in operations, there might be a chance for tokens to avoid being classified as securities.

If that is the case, the upside can be very significant, including broader access to investors and reduced expenses. This is especially useful for investment funds, which typically need at least $20M in assets under management for the fees to cover legal expenses – that barrier can be reduced more than tenfold. 

This is a very uncertain approach, and no court or competent authority yet confirmed the conditions under which such a model would be legal. There are doubts about whether it can scale to hundreds or thousands of investors and what level of involvement is required. However, there are a few court precedents that indicate it’s possible. Therefore, innovators in the space should thread extremely carefully and get no action letters before enacting such models.

When choosing a jurisdiction, one should consider the following criteria:

• General ease of doing business, including taxes and the cost and complexity of incorporation;
• Traction in token offerings conducted by issuing incorporated in the country;
• Reputability, including the absence of the country in AML gray lists and strong investor protection;
• Legal possibility to store a register of securities on the blockchain;
• Absence of the requirement to report each transaction and stamp duties on them;
• A securities legislation that doesn’t restrict international fundraising;
• Good conditions for crypto businesses, including the possibility of opening bank accounts and accepting investor funds.

Some of these factors are negatively correlated, e.g., ease of doing business and reputability, so trade-offs should be made based on the project’s priorities.

By itself, a token is merely an accounting unit on the blockchain with no value. In the case of fully on-chain assets and businesses, it’s possible to create a direct link between the asset and the token. In most realistic cases, however, such a link has to be created using legal methods that entitle holders of tokens to certain rights.

The first aspect of providing legal power to tokens is properly structuring the ownership of assets. A company that issues tokens has to own the assets so that it can guarantee the execution of its obligations to tokenholders using its ownership of assets. Alternatively, the token-issuing entity should have a strong claim against the owner of assets that it can enforce with a high degree of certainty.

The second aspect is legal documentation that explicitly states the rights of tokenholders. This documentation includes an Offering Memorandum that describes the terms of the token offering, a token purchase agreement, and a decision of the Company’s Board to recognize tokens as its shares or other securities. 

A test to judge whether the link is strong enough is to determine whether investors have sufficient legal power to enforce their rights. If legal documentation allows enforcement against the company, and the company controls the assets or can enforce against the owner of assets, investors can receive the returns they are owed.

The complexity of enforcement and the probability of it being successful determine the strength of investor protection.

Regulation has been created with a view of operations being conducted in a single country. It turns out to be inadequate in many ways to innovative global models, stifling innovation but being unable to conduct proper enforcement.

Though it’s not purely a technology problem, tech solutions can be used to reduce its severity. Not many people yet recognize that blockchain is a RegTech technology that can be used to alleviate the issue.

There are four ways in which technology can be used to facilitate compliance.

1. Firstly, proper legal processes can be designed into the investment flows in the technology platforms. For example, the need to read disclosure documentation and sign an investment agreement before purchasing tokens.
2. Secondly, technical services can be used for some legal processes, such as verifying the validity of documents and checking the investor against blacklists during the KYC process.
3. Thirdly, blockchain can be used to increase transparency. Disclosure data can be published as immutable records on-chain, and governance can happen via on-chain voting, thus reducing information asymmetry. Blockchain’s transparency also facilitates transaction monitoring and reduces the probability of fraud.
4. Lastly, private placement rules can be encoded in the smart contract that processes transactions to reduce the probability of violation, intentional or not. This can be a game changer for global offerings, as there are very few compliance officers who are familiar with rules in dozens of countries and can be responsible for compliance. 

International collaboration and harmonization of rules are needed to solve the problem more robustly. Until this is done, technology can help reduce some of the inefficiency arising from legislative differences and help promote innovation.