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Securities laws and regulations for the digital token: complete overview
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Securities laws and regulations for the digital token: complete overview

How are security tokens regulated, and what legal work do you have to go through to launch one? Find out below.

Tokenization and security token offering offer extensive benefits for private businesses like liquidity, the possibility of secondary trading, and simplified asset management. However, the lack of common knowledge undoubtedly stands in the way of rapid and global adoption: one of such blocking nuances is a security token regulation, and a place tokenization takes in law. This article will help understand the security token legal background better, shed some light on specific paperwork you will have to draft, and give some legal-related tips on how can you make an offering even more beneficial for your business.

What is tokenization from a legal point of view, and how is security token regulated?

Tokenization is the process of transferring an asset to the blockchain. It’s possible to tokenize anything, but the most popular tokenization use case refers to securities: not only do they obtain a more secure form and convenience in interaction but also become suitable for conducting a security token offering (STO). Security token offering is a blockchain-based analog of IPO and can be conducted by a private company; this time, the company’s securities are traded on specialized digital securities exchanges (similar to cryptocurrency exchanges), not on the stock exchanges. The security is merely being transferred to the blockchain during the tokenization process. Thus, the security token is a representation of a physical security, which is why it’s regulated exactly like the security in question.

What is the Howey Test?

It is worth mentioning that not all digital assets are defined as security tokens. In order to determine one, the Howey test is applied.

The Supreme Court devises the “Howey Test” to determine whether certain transactions qualify as “investment contracts.” If so, those transactions are deemed securities under the Securities Act of 1933 and the Securities Exchange Act of 1934 and must comply with specific disclosure and registration requirements.

To define securities, the Supreme Court has created 4 rules of the Howey Test. It suggests that 1. the money is invested 2. in a common enterprise 3. with an expectation to profit 4. relying on the third-party’s effort.

The legal body responsible for determining whether a specific token is a security or not is the Securities and Exchange Commission. Practically, this means the SEC will decide whether a token may be issued to US investors and if the business must submit a registration statement with the SEC.

However, the Howey test has a broad phrasing; this is why most utility tokens (tokens used inside the tokenized ecosystem) may be classified as securities, even if they were never meant to be so. Because of the numerous prohibitions on selling and trading securities, most ICOs are unavailable to American investors. In 2018, then-SEC Chairman Jay Clayton stated that every initial coin offering (ICO) he had dealt with might be classified as a security. In light of the supplied statement, there is an added risk. If a corporation issues utility tokens without first registering the offering, and the regulator later identifies the tokens as securities, the company might face significant penalties or even criminal charges.

Related: History of the SEC enforcement against crypto

security token regulation

Key legal aspects to consider when launching an STO

Before launching a security token offering, you have to make two crucial things clear: it’s about the jurisdiction your subsidiary company will be incorporated in and the jurisdiction (or a number of such) you expect the investors to come from.

The message between the lines is that the answers to these questions may differ. It is conceivable, for example, to establish a corporation in the United States while drawing only European investors, or vice versa.

Related: Multijurisdictional offering strategy: how to avoid legal risks 

Apart from late-stage complications like the listing threshold or the allowed investors type to target, the STO launch process is pretty standard in every country and requires a similar paperwork package.

What documents must be prepared for the security token offering?

If you have decided to conduct an STO for your company, you have to do two crucial tasks on the legal front: set up a legal structure and prepare documentation.

Not sure where to start and how much will it cost?

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Establishment of a legal structure

Setting up or modifying a corporate structure entails forming new SPV if necessary, establishing relationships between them (for example, by merging), transferring a specific asset to the new company in question, and opening bank and exchange accounts for all existing entities.

Documentation preparation

This responsibility includes three necessary groups of papers:

Documents of disclosure. This scope of docs should contain everything a potential investor has to know about your business. To begin, it’s an offering memorandum in which the business itself and how it operates should be described; potential hazards, offering conditions, and other nuances should be included too. If your company has been established for an extended period, it may have additional paperwork, such as previous financial statements.

The investors’ agreement over the course of an offering. The token purchase agreement, which describes the terms of purchasing a token and the rights provided to the investor, is usually the most important. You may need to draft some additional agreements based on the form of the business. Suppose you’re tokenizing an investment fund. In that case, you’ll need to prepare a fund management agreement in which the investors agree to transfer the money management rights and accept the commission distribution.

The company policies. Anti-Money Laundering (AML) and Know Your Client (KYC) policies are required, as you must examine your investors’ profiles when conducting the offering to ensure that your firm is not sponsoring money laundering or other unlawful activities. At the same time, the legal department will have to work on a privacy policy: you’ll certainly be gathering personal data from investors, so it’s critical to keep track of how that data is stored.

Summary

While tokenization is a young and yet-emerging industry, and its regulation is still being carved from marble, it already offers democratizing financial solutions for businesses. With a proper legal framework, it’s possible to raise money for your company in a considerable timeline, not having to sacrifice its interests or excessive budget. If you still have questions about tokenization law and regulations, book a complimentary 30-minute consultation with the Stobox specialists.

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