Security Token Offerings (STOs)

A Primer

Last updated on - March 20, 2019

It all began with an investor-directed venture fund called The DAO. In May 2016, it set the record for the largest crowdfunding campaign in history, with a participation of 18,000+ stakeholders that raised 11.5 million Ether (ETH) or US $150 million. It was enabled by the Blockchain technology where the Code is Law or at least it was until some bad actor(s) exploited a vulnerability concerning recursive calls in The DAO smart contract code, enabling them to divert one-third of the funds to a subsidiary account. The stolen funds were put in a 28-day holding period and the Ethereum community debated about possible solutions which resulted in a split of Ethereum network: Ethereum Classic (ETC) where the hacker still has the funds and; the one in which they do not - Ethereum (ETH).[1]

Later on July 25th, 2017 - the US SEC (SEC from here) issued an investigative report concluding The DAO Tokens as securities. So, a computer code behind a decentralized autonomous organisation, essentially became a security in the eyes of SEC and government agencies around the world started taking note; issuing statements which resonates with those of SEC, and at times more generic resulting in a unclear stance on cryptocurrencies and tokens for the public.[2]

We must understand that The DAO was a special token. It was stateless and not tied to any particular nation state or country and embodied specific claims in its structure and that the code itself was the prospectus. The questions of how to deal with the governments was really hard to answer and it still is. Professionals in favor of cryptocurrency regulations are welcoming the stance of SEC to consider most tokens as security while still exploring exemptions (e.g. SEC Form D) to raise funds for their businesses. Regulation S provides a safe harbor to issuers from US securities regulation if there are no direct selling efforts within US to US residents/companies.

A research paper entitled Crypto-Securities Regulation proposed two policies to mitigate legal uncertainty concerning token sales -

First, we suggest tailoring disclosure requirements to the code-driven nature of token sales. Such an ICO-specific safe harbor would offer a clear and less burdensome path to EU law compliance for token sellers who suspect that their tokens may qualify as securities. This only requires the Commission to amend its delegated 2004 Commission Prospectus Regulation. Second, we propose that, on an international level, governments form a compact to bestow certainty about the application of their respective securities regulation regimes to token sales. This is, first, to avoid regulatory overkill on the one and regulatory lacunae on the other hand in online-mediated, global token sales.

Second, overlapping, and partially contradicting, securities regulation regimes can even undermine each other. In the end, only a joint international regulatory regime can efficiently balance investor protection and investor access in the face of the novel generation of decentralized blockchain applications.[3]

The paper also calls for an International Convention for crypto securities to help provide the investors and issuers a clear understanding of regulatory landscape. Tatiana Koffman provided a nice summary of the STO Market in her article which tells us that geographically,

Due to the nature of complex regulatory environments, US is in the lead for total STOs in the market, with Switzerland taking the second spot. Additional activity is noticeable in European countries, while Asian markets, although leaders in ICOs, are yet to catch up to STO activity. We expect untapped markets to continue to be curious about STOs, following the regulatory lead of the US.

while the securities on offer lead by revenue-share, tokenized funds and asset-backed deals, with equities and bonds trailing behind.

So to summarize… STOs allow projects to raise funds in a regulated manner, provides investors with rights over assets, profits or revenue in a company and reduces legal risk.

Security Token Standard

The call to extend the popular ERC-20 and the non-fungible ERC-721 has been in work for months resulting in ERC-1400 describing it as having many of the characteristics of both fungible and non-fungible tokens . Security tokens are designed to represent complete or fractional ownership interests in assets and/or entities. While utility tokens have no limitations on who can send or receive the token, security tokens are subject to many restrictions based on identity, jurisdiction and asset category. [4] The token is believed to have incorporating differentiated ownership, error signalling, document references, gate keeper (operator) access control and issuance / redemption semantics.

Supported by participating organisations and individuals including but not limited to - Polymath, OpenFinance, Tokeny.pl, Vertalo, ChronoLogic, Scott Purcell, Goldmoney, Securitize.io, celebrus strategies. The efforts for a standard will bring uniformity in its structure for the issuers to tokenize and issue various kinds of tokenized assets (securities on blockchain) easily.

According to a report published in CoinDesk, the securities token platform Polymath and Loopring recently demonstrated that tokens can be compliant on a decentralized exchange. hooray!

Recent STOs

Invenium Capital Partners auctioning US $66 million building on Ethereum Blockchain; a WeWork occupied property in downtown Miami, Florida. The company is said to tokenize some US $260 million in four private real estate and debt transactions[6]

Aspen Digital - A real estate investment trust (REIT); single-asset REIT intends to only own the St. Regis Aspen Resort raised funds_[7]_

Andra Capital - A late stage, pre-IPO technology growth fund; an effort to democratize investment [AndraCapital]

Maecenas - Fine Art - Andy Warhol’s 14SEC sold through dutch auction bidding on Maecenas platform

436 & 442 East 14th St, Manhattan - Real Estate; investors offered to receive either analog or digital interests in the property in partnership with propellr using AirSwap Ltd

Lottery.com - Gaming/Gambling (revenue share token structure) [Lottery.com]

tZero - STO Exchange (offered equity with revenue participation)

22x - Venture Capital Fund (allowing investors to own up to 10% equity) [22xFund]

SPiCE VC, Blockchain Capital, Neufund, Monetizr (MTZ), INDX Capital, BlockEstate, TrustToken, Corl, Gainfy, Leaseum Partners, Vertalo, Hypd are also worth looking at.

Securities Agencies’ crackdown on crypto crowdfunding

1. 1Broker, a bitcoin futures firm registered in Marshall Islands which got its domain seized by US authorities back in September 2018 recently announced -“We are pleased to let you know that we settled the two lawsuits without admitting or denying the factual allegations of their complaints on March 4th 2019.” Funds of the investors will be returned and founder Patrick Brunner would also be required to pay US $26,000 in disgorgement fees. [9]

2. SEC did not bring any charges against The DAO (or Slock.it) but made it clear that federal securities law applies to anyone who offers securities in the US or to US citizens.[8]
3. Harbour [not Harbor] cancelled ICO planned on August 1, 2017.
4. Protostarr refunded ether raised after SEC’s investigation several days after the ICO.
5. PlexCoin ICO that promised 13x profit was halted by SEC.
6. **Munchee’**s MUN Token was described as utility multiple times in their whitepaper, but SEC concluded it to be a security. Munchee stopped the ICO (which raised US $15 million) and returned the proceeds while cooperating with the investigation.

In Conclusion

Should STOs exist? Yes. Startups and Small & Medium Sized Enterprises (SMEs) are often facing cash crunch barriers for them to access capital markets doesn’t help. Young and innovative firms should not be restricted by existing system.

Security tokens can have a huge impact on the financial system and society at large, as they combine the elements of blockchain technology, especially transparency and security, with the legal certainty of traditional financial instruments. This allows firms of any size to securely enter this new evolving ecosystem. Security tokens promise to provide startups and SMEs with an alternative form of financing that gives rise to a new capital market with 24/7 trading that obviates the need for brokers and bank custody of securities.[5]

Are they better than ICO? Perhaps. STO projects are usually registered entity which add to the legitimacy of the project and have the issuers accountable for their actions.

Does regulations mean Security Tokens will see upward-only growth?

Not really, but sure they are a regulated form of crowdfunding and have tremendous potential to change the securities markets. A Netflix documentary on The China Hustle tells us that even the highly regulated traditional market is also driven by hype. Financial crisis of 2007–2008 is still feared among the investors. Dot-com bubble should be a lesson that even though the businesses are at times legit, the valuation should be accessed with utmost care. Just because the offering is now called ICO or IEO or STO - it still is risky, and being informed is important.

There is an old joke that the biggest lie on the Wall Street is that - This Time, It’s Different.

[Disclaimer] — This article is not a legal advice. The views are personal and the ones that refer to external sources belong to them.

Sources

1. The DAO (organisation), wiki - https://en.wikipedia.org/wiki/The_DAO_(organization)
2. Cryptocurrency Regulations - https://medium.com/@rahulmanuwas/cryptocurrency-regulations-a-complete-summary-912e6de0c7a4
3. 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 http://dx.doi.org/10.2139/ssrn.3075820
4. The Security Token Standard - https://thesecuritytokenstandard.org
5. Ante, Lennart & Fiedler, Ingo. (2019). Security Token Offerings on the Blockchain: Capital Market Access for SMEs?. 10.13140/RG.2.2.21378.94408.
6. Invenium Capital Partners - https://www.coindesk.com/66-million-building-to-be-tokenized-on-ethereum-blockchain-in-record-deal
7. Coindesk report on Templum hosting token sale — https://www.coindesk.com/regulated-trader-templum-hosts-security-token-sale-for-luxury-resort
8. Sean Au & Thomas Power (2018) Tokenomics - https://www.packtpub.com/big-data-and-business-intelligence/tokenomics
9. Coindesk report on 1Broker - https://www.coindesk.com/sec-cftc-charge-bitcoin-futures-firm-1broker-with-securities-law-violations