A. From ICOs to STOs
The term ICO has been at the epicentre of discussions in the FinTech industry, being the main method of fundraising used by startup companies to develop innovative ideas on the Blockchain technology or other applications using Distributed Ledger Technology (“DLT”).
Although bringing a revolutionary change in traditional means of financing, ICOs have been criticised for their legal uncertainty and struggled to become widely acceptable by governments due to the increased risk for fraud[1].
‘The term ICO does not distinguish what type of token is being offered’[2], while most ICOs argue that their token is not a security but rather serves a function — a utility — on the issuers’ platform[3].
As ICOs have faced multiple challenges, startups and companies wishing to make a transition to the digital world have been striving to find more satisfactory means of funding where there is more security to potential investors, less uncertainty and less fraud.
Security Tokens are regarded to be the game changers which will provide a more secure path to companies seeking to raise funds.
B. STOs — Security Token Offerings
Unlike ICOs, STOs are as their name suggests, securities and are treated as securities from day one[4]. They are digital assets that are subject to security regulations and need to be compliant with any registration and/or authorisation requirements before being issued.
STOs are game changers for financial and ownership models, allowing any company to offer revenue such as annual income form the operations of the issuing company or other periodical income, percentage on profits, equity, debt or dividends and sometimes voting rights.
It is argued that ‘Security Tokens are an improved model of traditional financial instruments because they are liquid, secure, virtually incorruptible and accessible to trade by anyone with an internet connection from all around the world’[5]. These give investors the opportunity to acquire Security Tokens with minimum investment and without middlemen.
Private and/or public offerings of security tokens enable access to a pool of investors without avoiding regulations. Therefore, STOs incorporate all the advantages of ICOs and traditional financial instruments but also provide the additional advantage of investor protection and compliance with regulations.
C. Security Tokens — Definition
Although there is not a widely approved definition or legislation interpreting what deems a token to be a “Security Token”, ‘transferable securities as per Art. 4(1)(44) of the Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (“MiFID II”), means those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
a) shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares;
b) bonds or other forms of securitised debt, including depositary receipts in respect of such securities;
c) any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures’[6].
It can be argued that Security Tokens conferring similar rights to shares could fall within the meaning of “other securities equivalent to shares in companies” under sub-paragraph (a) above, of Art. 4(1)(44) of the Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (“MiFID II”), interpreting Transferable Securities[7].
D. The Obligation
As per the EU Prospectus Regulation 2017/1129 (the “Regulation”)[8], any public offering of securities is prohibited without the prior publication of a prospectus[9], which has to be approved by the appropriate authority under a certain procedure, unless such public offering falls under the exemptions of the Regulation. However, such exempted offers of securities to the public should not benefit from the passporting regime[10]. This means that the issuer of the STO has to ensure that it complies with every Member State’s national requirements on the ‘offering of securities’ before the issuance of the STO. Below that threshold, Member States are able to require other disclosure requirements at national level.
E. Which are the exemptions to the obligation to draw up a prospectus provided under the Regulation?
The obligation to publish a prospectus under the Regulation shall not apply to any of the following types of offering of securities to the public:
1. A public offering of securities where the total consideration is less than EUR 1.000.000 in the European Union or EEA* (expressed as the total consideration of the offer in the European Union or EEA over a period of 12 months).
2. An offer of securities addressed solely to qualified investors as defined by the law.
3. An offer of securities addressed personally to fewer than 150 natural or legal persons per EU or EEA member state, which are not qualified investors.
4. An offer of securities whose denomination per unit amounts to at least EUR 100.000. Minimum sale price to be EUR 100.000 per unit.
5. An offer of securities in the EU or EEA addressed to investors who acquire securities for a total consideration of at least EUR 100.000 per investor, for each separate offer.
*It is worth noting that different thresholds apply in each Member State as the Regulation provides that Member States are free to set out in their national law a threshold between EUR 1.000.000 and EUR 8.000.000. In Cyprus the threshold is currently set at EUR 1.000.000 but there is procedure in place to increase it to EUR. 5.000.000.
Member States are electing to set up the threshold between 1 and 8 million EUR according to the size of their financial markets. Some examples: Germany, the United Kingdom and Italy have elected to set up the threshold at 8 million EUR — Malta, Ireland and Lithuania have set the threshold at 5 million EUR.
Note: Irrespective of the above exceptions, when Securities are offered to the public or admitted to trading on a regulated market, a prospectus should be drawn up, approved and published.
F. Listing of Security Tokens on Secondary markets
Certain countries have started collaborating with token exchanges in an effort to build the infrastructure allowing Security Tokens to be legally traded on a “centralised” regulated security token exchange[11].
In order for Security Tokens to be admitted for trading on the secondary markets, an infrastructure must be built in order to allow for trading of Security Tokens whilst complying with KYC and AML requirements.
Certain solutions are being explored such as the possibility of centralizing compliance on the token issuance level by embedding a code on tokens ensuring they can only be traded by parties who are compliant[12].
Listing of Security Tokens will have to be overseen by the regulator who will grant the license to the exchange and permit it to operate. In effect, this will further provide investors a more trusted way of buying and selling Security Tokens as these exchanges will have to comply with KYC and proper systems safeguarding from cyberattacks and fraud.
G. Final Remarks — Comments
Yet, despite the extraordinary success of ICOs, there is already a new model taking prominence, this being the STO. The latter seems to be the future of the industry, possibly because it represents a sale of securities, rather than mere coins or utilities. Needless to say, this attracts the more serious investors who want the comfort and guarantees of investing in a security (whether it is a share, debt or other financial instrument) structured in the form of a token.
As mentioned above, in order to offer securities to the public, the issuer of the Security Token must follow the rigid requirements of the Prospectus Directive and of existing security laws whether in Europe or any other jurisdiction whereby similar laws apply.
However, the numerous exemptions available at law give the proposed issuer sufficient flexibility to be able to structure the intended STO without incurring an unnecessary burden, whilst still selling a product under the title of security.
The concept of STOs, although at its early adoption, has been used by several companies which are moving towards a digital model for their businesses, and seem to have the potential to be applied on any real-world asset — from an art painting, to music rights, real estate, as well as in the shipping and renewable energy industries.
As the concept of STOs is still at its infancy, technology companies and regulators have been occupied in building an infrastructure to integrate them to the current security system. Security Tokens to create a safe, legal and fully compliant infrastructure in order to unlock the full potential of Security Tokens and tokenization of assets on the blockchain.
Nevertheless, Security Tokens could improve traditional means of financing and financial products, by providing more safety to investors liquidity to the market, offer more
Security Token offerings will arguably become the new ‘ICOs’ as with the security component they combine well-established security laws with blockchain technology.
H. Disclaimer
This publication has been prepared as a general guide and for information purposes only. It is not a substitution for professional advice. One must not rely on it without receiving independent advice based on the particular facts of his/her own case. No responsibility can be accepted by the authors or the publishers for any loss occasioned by acting or refraining from acting on the basis of this publication.
I. References
· Anthony Pompliano, The Official Guide To Tokenized Securities https://medium.com/@apompliano/the-official-guide-to-tokenized-securities-44e8342bb24f
· Fabian, The difference between Initial Coin Offerings and Security Token Offerings https://medium.com/@bootstrappingme/the-difference-between-initial-coin-offerings-and-token-sales-484cc7567e0e
· Michael K. Spencer, Security Token Offerings — STOs are the new ICOs https://medium.com/futuresin/security-token-offerings-sto-are-the-new-icos-d697ece5b6f9
· Tatiana Koffman, ‘Your Official Guide to the Security Token Ecosystem’ https://medium.com/@tatianakoffman/your-official-guide-to-the-security-token-ecosystem-61a805673db7
· Stephen McKeon, ‘The Security Token Thesis’ https://hackernoon.com/the-security-token-thesis-4c5904761063
K. Citations
[1] ‘Security Tokens Set To Take Center Stage in 2019’, https://www.nasdaq.com/article/security-tokens-set-to-take-center-stage-in-2019-cm982207
[2] Carlos Domingo, ‘Enter the Security Token Offering (STO)’ (Medium, 01 May, 2018), https://medium.com/securitize/enter-the-security-token-offering-sto-161573b431b9
[3] ‘Financing Real Estate Development on the Blockchain: A Hypothetical Case Study’, https://securitize.sfo2.digitaloceanspaces.com/case-studies/Real-Estate-Case-Study-Securitize-091618_181005_013057.pdf
[4] Carlos Domingo, ‘Enter the Security Token Offering (STO)’ (Medium, 01 May, 2018)
[5] Carlos Domingo, ‘Enter the Security Token Offering (STO)’ (Medium, 01 May, 2018), https://medium.com/securitize/enter-the-security-token-offering-sto-161573b431b9
[6] Art. 4(1)(44) of the Directive 2014/65/EU of 15 May 2014 on markets in financial instruments (“MiFID II”).
[7] Hacker, Philipp and Thomale, Chris, Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law (November 22, 2017). European Company and Financial Law Review Forthcoming. Available at SSRN: https://ssrn.com/abstract=3075820 or here, pages 25–28.
[8] Regulation (EU) 2017/1129 of 14 June 2017 on the prospectus to be published when securities are offered to the public or admitted to trading on a regulated market (the “Regulation”).
[9] Art.3 Regulation.
[10] (13), Regulation.
[11] ‘Boston Stock Exchange Partners tZero to Launch Regulated Security Token Exchange’ https://www.ccn.com/breaking-boston-stock-exchange-partners-tzero-to-launch-regulated-security-token-exchange/
[12] Julianne Sloane, ‘Security tokens: Enabling trading on secondary markets’ https://medium.com/@juliannesloane/security-tokens-enabling-trading-on-secondary-markets-4b5d6da5fa8f
Authors
CHRISTOS P. KINANIS
Lawyer — Managing Partner
Kinanis LLC
Christos.Kinanis@kinanis.com
ELENA ANDREOU
Lawyer
Kinanis LLC
Elena.Andreou@kinanis.com
Dr. FRANCESCO SULTANA
Lawyer — Manager
Kinanis Fiduciaries Limited
Francesco.Sultana@kinanis.com
Our Firm
Kinanis Law Firm is a Law and Fiduciary Firm and advises for over 35 years international investors and private clients offering legal and consulting services since 1983.
Kinanis LLC
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P.O. Box 22303, 1520 Nicosia, Cyprus
Tel: + 357 22 55 88 88 — Fax: + 357 22 66 25 00
E-mail: KinanisLLC@kinanis.com — Web site: www.kinanis.com
Kinanis
Law Firm
Kinanis Fiduciaries Limited
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