Key project team members for a Security Token Offering

Security token offerings (“STO”) are a next-generation financing model that combine the benefits of blockchain technology with traditional fund raising.  As with any fundraising exercise, conducting an STO can be stressful.  The stress is increased as the novelty of STOs makes the process more opaque.  In this overview, Pádraig Walsh and Alan Wong from our Technology practice summarise what to expect and who to involve in an STO.

Issuance Platform

The issuance platform is the technical advisor for an STO.

The key functions of the issuance platform are:

• minting and issuing the security tokens.
   
• drafting the smart contract to the requirements of the STO company.
   
• ensuring the technical specification of the security tokens are compatible with the listing platform.
   
• developing a platform for the STO company for token management after closing.

Other functions of the issuance platform can include:

• know-your-client or anti-money laundering (“AML”) services by either implementing an AML system in the platform or by directly conducting the AML checks.
   
• website design to facilitate direct token management by token holders.

An issuance platform will typically be engaged on a long-term basis, and not just for the STO.  The issuance platform has the technical expertise needed to continue to monitor the security tokens after closing of the token sale.  This can assist with managing the ownership registry, and ascertaining the ultimate beneficiaries of the tokens and their proportion of tokenised investment.  This is a critical function when the STO company makes distributions.

These are the key advantages the issuance platform brings to an STO:

• The issuance platform has the expertise to advise on integration with the listing platform, and is likely to have a working relationship with listing platforms.
   
• Corporate service providers may refuse to assist with an STO if no issuance platform is involved.
   
• There is a significant conflict of interest if the STO company also acts as issuance platform and directly manages all aspects of the token issuance and trading.
   
• The issuance platform can assist with coordinating subsequent listings on multiple listing platforms.
   
• The issuance platform has the expertise needed to update and upgrade the token and related management functions in accordance with evolving market practice and new requirements of listing platforms.

Distributor / Broker-Dealer

A person who engages in distribution or broker-dealing activities in Hong Kong needs to hold a Type 1 (Dealing in Securities) licence from the Securities and Futures Commission (“SFC”).  Security tokens are, by definition, securities.  Distribution of security tokens in Hong Kong must be conducted by a licensed broker-dealer.

The role of a broker-dealer is to:

• conduct due diligence on the STO to ensure it is structured and resourced in a manner that will comply with securities laws and SFC regulatory standards in Hong Kong.
   
• conduct the marketing and distribution of the security tokens in Hong Kong.

We recommend the engagement of a broker-dealer at an early stage.  The due diligence process may result in changes to the STO structure or process.  Also, once due diligence is completed, the broker-dealer will conduct a transparent and focused marketing campaign in Hong Kong.

Not all licensed broker-dealers in Hong Kong are approved to distribute security tokens.  The broker-dealer must have completed the notification and approval process with the SFC for approval to distribute security tokens. 

Listing Platform

The selection of the listing platform for listing and trading of the security token is a critical decision.

The key factors to consider in selecting a listing platform are the:

• regulatory status and reputation of the listing platform.
   
• quality of the security tokens listed on the listing platform.
   
• integration requirements of the listing platform with the security token to be launched.
   
• listing conditions and requirements of the listing platform.
   
• ability of the listing platform to connect to other necessary service providers (for example, custodians, issuance platforms, or corporate service providers).
   
• jurisdiction in which the listing platform is located.
   
• service support for the main places of operation of the STO company.
   
• popularity of the listing platform among customers.

Presently, listing platforms are mostly located in the United States, the United Kingdom and the E.U.  In Hong Kong, the SFC accepts applications from virtual asset trading platforms for the licences that will allow the virtual asset trading platforms to trade security tokens.  The relevant licences in Hong Kong are the Type 1 (Dealing in Securities) and Type 7 (Providing Automated Trading Services) licences.  Given the objective is to achieve a global 24/7 trading platform capability, we expect to see a concentration of listing platforms in key hubs in key regional geographies.  Hong Kong is well-positioned to be a key hub for the Asia-Pacific region.

The listing platform may manage its own wallet to store client virtual assets.  If so, the listing platform will need to work closely with the custodian, the issuance platform and the corporate service provider to ensure AML checks are properly completed.

Legal Advisors

Regulation, legal structures, and legal process are at the heart of an STO.  The legal adviser is a key project team member that must be engaged at an early stage. 

The essential tasks performed by the legal adviser include:

• advising on the corporate structure.
   
• advising on the legal characteristics of the security token.
   
• drafting and preparing documents for the STO.
   
• advising on the applicable rules and regulations on marketing security tokens.
   
• advising the company on meeting the requirements of the listing platform.
   
• advising on regulatory and compliance issues generally for the STO (including AML regulations).

STOs are often conducted on a multi-jurisdictional basis, and the STO company will appoint a lead legal adviser to project manage the roles and responsibilities of lawyers from other locations.

The corporate structure is a key focus of any STO project.  Investors need to be assured that a security token – a virtual asset – represents the ownership rights of the underlying asset as a matter of law.  The category of the underlying asset has a significant impact on the legal issues involved in achieving this objective.  Frequently, the security token will represent an indirect ownership interest in the underlying asset.  So, trading the security token does not involve a change in the direct ownership of the asset.  For example, a security token could represent an indirect ownership interest in a building.  Trading the security token would not mean that there is a conveyance and transfer of title of the building.  Only the indirect ownership interest represented by the security token changes hands.  The legal advisor is the key person to review and assess the structure to achieve this outcome.

The key legal documents in an STO are:

• the offering memorandum.
   
• the subscription agreement or securities token purchase agreement.
   
• a trust deed or custodian agreement, if a custody arrangement is needed.
   
• transfer documents.

Other documents may include:

• distribution agreement.
   
• underwriting agreement.
   
• deed of guarantee.
   
• technical white paper.

Auditors and Valuation Company

The appointment of auditors and a valuation company will be required for listing security tokens on a listing platform.  Audited accounts should be prepared in respect of the business entity that holds the assets for tokenization, and the audited accounts should be prepared for a date close to the listing date.  The valuation report will be needed to finalise the audited accounts.  The relevant professionals need to be engaged at an early stage, so as to avoid complications or delay to the listing schedule.

Tax advisers are also critical, as the taxation of proceeds of an offering will be treated differently in various jurisdictions.  The tax adviser will also advise on tax consequences to initial purchasers of security tokens, and on subsequent trading of the security tokens. Tax advisers can also provide a tax efficient restructuring plan for assets in any pre-STO arrangements.

Trustee and Custodian

One of the key advantages of tokenisation of assets is that tokenisation should make liquid and active trading possible for assets that cannot be otherwise actively traded.  For instance, active trading of direct interests in property is not possible because of the tax, filing and other processes necessary to recording changes in the direct title to property.  The tokenisation process overcomes this challenge, and a trust or a custodian arrangement is one of the means of achieving this.

The trustee or custodian will be required to:

• monitor ownership of security tokens.
   
• verify ownership for the purpose of making distributions.
   
• hold documents of title to prove direct ownership of the underlying asset. 

The trustee and custodian must be able to demonstrate a skills, resources and capabilities in holding virtual assets.  Typically, the trustee and custodian will be regulated entities.

Financial Advisors

A financial advisor is another key adviser for an STO, and is likely to be the first person engaged by the STO company.  

The main functions of the financial advisor are to:

• assess the financial viability of the STO.
   
• provide guidance on the structure of the STO.
   
• provide tokenomic guidance and advice (including soft cap, hard cap, numbers of tokens to be minted, the issue price and proportion of allocation).
   
• facilitate introductions to other project team participants (such as issuance platforms, listing platforms, and other advisers).

The general expectation is that financial advisers in respect of security tokens will need to be licensed in Hong Kong for Type 6 (Advising on Corporate Finance).  However, the SFC has yet to confirm or provide guidance on this point.

An STO is a significant undertaking.  Those wishing to pursue an STO for their project need to be well-resourced, well-supported, and well-informed.  It is a regulated process.  Consult and engage the relevant professionals as early as possible.  This will help the STO to comply with some complex laws and regulation, and will support a smooth and successful completion to the STO.

Pádraig Walsh and Alan Wong

To enquire further about security token offerings, please reach out to Tanner De Witt Solicitors:

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.