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STOs: The What, Why, Who and How

18May2020

Part 1: What are security tokens?
Part 2: Tokenising real estate
Part 3: How are security tokens created as a matter of law?
Part 4: What regulations apply to security token offerings?
Part 5: Who are the key project team members for an STO?

Part 1: What are security tokens?

What is a token?

A token is a digital asset that represents rights in respect of an application built on a blockchain protocol. The owner of the token has the ability to access, use, receive the benefit of or transfer those rights on an anonymous basis. For example, Basic Attention Token is a decentralized application built on the Ethereum protocol, and the BAT is the token related to usage on that dApp.

What would it look like if I saw one?

Digital code.

Is a virtual asset the same as a digital asset?

Digital assets apply across all technologies. Virtual assets have acquired a usage that is specific to the blockchain and crypto space. So, virtual asset means a digital asset in the crypto space.

The Hong Kong Securities and Futures Commission (SFC) described virtual assets as a digital representation of value, which is also known as “cryptocurrency”, “crypto-asset” or “digital token”. The SFC further clarified that virtual assets would include “digital tokens (such as digital currencies, utility tokens or security or asset-backed tokens) and any other virtual commodities, crypto assets and other assets of essentially the same nature”. Then, the SFC described the features of virtual assets as including a means of payment, a right to present or future earnings, a right to access a product or service, or a hybrid of any of these. So, virtual asset means a digital asset in the crypto space.

You mentioned a blockchain protocol. What is that?

A protocol is a technology layer which exists independently without reference to or reliance on other protocols. A blockchain protocol uses blockchain technology, and is built on the internet protocol. Each blockchain protocol is independently created, and does not use other existing blockchain protocols. This is important because a security token is a token issued by an application built on a blockchain protocol. So, one of the first decisions to make is which protocol to use. For example, the Bitcoin protocol has issued coins called bitcoin, which allow users of Bitcoin to transfer bitcoin. Other examples of protocols include Ethereum, EOS, and Stellar.

And that’s the same as a coin, right?

Well, not really. A coin is the reward mined in a protocol, and which is then traded. A token is issued by an application built on a protocol, and only operates within that application (usually). But, once they come into existence, a coin and a token are quite similar.

Are there different types of tokens?

Here are the broad categories:

Utility tokens: A token with the primary purpose of providing access to, and buying or using a service provided on a blockchain platform. For example, STORJ is the token needed to make use of Storj, a decentralized cloud storage solution.
Payment (or currency) token: A token with the primary purpose of exchanging value or payment by users of a blockchain platform, for goods and services offered outside the platform. BTC is the classic example of a payment coin.
Security token: A token with the primary purpose of being a digital representation of a security instrument, or providing the rights and benefits of a security instrument. The SFC also described security tokens as “digital representations of ownership of assets (eg, gold or real estate) or economic rights (eg, a share of profits or revenue) utilising blockchain technology”. For examples, TZRO is the security token issued by tZero in its security token offering.
Asset token: A token with the primary purpose of being a digital representation of an ownership right in an underlying asset, or to revenue or profit generated by that asset. Asset tokens are a subset of security tokens. An early example of an asset coin is the Aspen coin issued in the tokenised asset offering in respect of the St. Regis resort in Aspen.
Hybrid token: A token that combines elements of these (and in future, other) categories of tokens.

These are evolving, and within these categories, there are tokens of many different stripes and colours.

What is the big fuss about security tokens?

One of the main problems is regulation. Many “utility” tokens can be classified as security tokens (or another form of regulated token). Also, even if a token is considered a utility token in one location, it could be considered a security token in another. It’s complicated, grey, uncertain and risky. There is much greater regulatory certainty if the token is treated by the project promoters as a security.

Regulation is a pretty heavy burden. Why would I want to take that on?

As the security token environment matures, the cost of a public offering will reduce. There will be disintermediation – less need for lawyers, brokers, registrars and other middle men. The ongoing compliance process will become significantly automated. From an investor’s perspective, investing in a regulated product will offer more comfort than an unregulated product. Think: securities compliance as a service (SCaaS). Regulation could become … attractive.

It is just about regulation then?

That is only one reason. There are quite a few practical benefits to security tokens. These generally arise from the use of blockchain technology in a securities context. These include:

Increased liquidity: Security tokens reduce friction in security transfer. This increases the ease of selling the security, and reduces the illiquidity discount often attributed to private investments.
Increased market depth: Security tokens increase the number of people able to participate in token trading. This can be done by fractionalisation of the investment. So, an expensive investment may have an investment threshold too high for many to participate. If that can instead be divided into many fractional interests, the bar to investment can be reduced. Then, there are many more people who can participate. For instance, there may only be a handful of people in the world that could buy an original Andy Warhol. But there could be many more who could buy a security token that represents 1/1,000 of an Andy Warhol. That’s depth.
Disintermediation: There should be less need, or even no need, for intermediaries who are essential to the current process. The ownership register will be automatically maintained in an irrefutable record. Transaction processing, clearing and settlement will be automated and almost instant. Assessment of permitted persons to participate will be governed by smart contracts, not lawyers.

We will tokenise the world!

Not quite. The best use case for security tokens is illiquid assets that are sensitive to the cost of capital but agnostic to the identity of investors.

Use English I can understand.

Well, let’s take a couple of examples.

Take a social enterprise business. The identity of the key stakeholders in the business is a critical feature. The notion that it could be anybody would be shocking. Not a good candidate for tokenisation.

Real estate is illiquid. Cost of capital dictates the attractiveness of the investment. Lower the cost of capital, and market entry is attractive. The identity of the investors is not important. These characteristics make quality real estate asset a good use case for tokenisation.

Part 2: Tokenising real estate

Why would tokenisation of real estate be attractive?

Fractional ownership will allow part of an asset to be made available by tokenisation. This provides the asset owner with different choices on how to approach the market. For instance, an anchor investor could hold a 40% interest, 30% could be released to other key investors, and 30% could be tokenised.

Tokenisation allows access to a broader range of people who can participate in asset ownership with potentially lesser costs. An investor can participate who may not be able to commit HK$50,000,000, but would be able to commit HK$500,000. Tokenisation makes this more possible.

In time, investors will be able to access to a broader range of property assets. Presently, the international property investment market is difficult to access, and investors need to rely on intermediaries to present opportunities. Tokenisation should help democratise this.

Real estate investment will be made more liquid. Tokens will be traded in the secondary market. A real estate investment is usually locked up for a number of years. Tokenised real estate could be sold wholly or partially at the discretion of the token holder.

Public trading in real estate. It’s like a REIT then.

Only at the surface level. In practice, tokenised real estate investment should be quite different.

REITs are securities traded on stock exchanges. The underlying investment and asset management policy is subject to many conditions. The operator and other participants all are subject to a high degree of regulation. The cost of formation and operation mean REITs are geared to a property portfolio comprising many expensive property assets. The nature of the investment lends itself to a buy and hold investment policy.

Here are some of the differences that will apply to tokenised real estate investments:

There will be less involvement from intermediaries compared to REITs.
Cost of formation will be significantly less. Upon maturity of the technology and infrastructure, it should be viable for a single property asset to be tokenised.
Trading in the secondary market will be on automated exchanges, not stock exchanges. Those exchanges will be operating globally, 24/7, 365 days a year. Clearing and settlement will be conducted almost instantaneously, and the register of members will be recorded on the blockchain.
Investment mandates, strategies and policies will be substantially driven by commercial drivers of the asset owner, and hence more flexible and varied.
There should be less regulation involved, compared to a REIT.

That all sounds very fine indeed. Any obstacles?

There are a number of challenges that lie ahead.

The main attraction of tokenised real estate is liquidity. Liquidity is driven first and foremost by quality assets. There is a risk tokenised real estate could become associated with low grade assets that could not otherwise be sold. So the risk is that initially tokenisation of real estate is used to move lower grade real estate assets, and then in the long term, the market assumes that tokenised real estate is poor quality real estate.
An offering of tokenised real estate is regulated. The offering does include a security, after all. The promoter should be regulated, or operating through a regulated person. The exchange on which the token is available should be regulated. The offering itself will need to comply with regulation. Any failure to meet regulation will be a problem.
Tokenised real estate projects will have less regulation than a REIT. This may be a bug, not a feature. Let’s take Hong Kong. A REIT is regulated in Hong Kong because the Hong Kong government took the view that public trading in real estate investment had specific features that demanded specific features to protect the public. It is regulated for a reason. An offering of real estate tokens is a high octane form of public offering of investment in real estate. Will lawmakers change the laws and regulation to bring tokenised real estate under the REIT umbrella of regulation (or a similar set of rules)? There may be a public policy argument for doing so.
The infrastructure is not there – at least not in Hong Kong. Banks, custodians, trustees, exchanges, brokers, valuers and auditors all need to be involved, and approved and licensed to do so. Then, the technology that links them needs to be fit-for-purpose. We are not there yet, though many great minds are working on this.

What’s a worst case scenario?

The worst case scenario is poor quality assets mis-sold, causing retail investor loss across multiple countries, and leading to a crisis of confidence in the underlying technology and an enforcement crackdown.

Sounds like ICOs.

Funny that.

Part 3: How are security tokens created as a matter of law?

If I buy a token in an asset-based security token offering, will I own a piece of the property? Am I tokenising the asset?

No. Let’s take real estate as an example. Tokenising the underlying real estate would require tokenisation of the Land Registry. This is not what happens. You will most likely indirectly own an interest in a share in a company that is the owner of the property. This is an indirect interest in the share, and the share in turn represents an indirect interest in the property. The token is an asset-backed security.

That’s an indirect interest. Isn’t that a structured product or a derivative?

If the token could be considered an instrument or agreement under which the return is determined by reference to the change in the price, value or level of property (or a basket of property), then that is a structured product.

This interpretation will influence the regulatory regime that will apply to the offering.

If the token is an indirect interest in shares, are we tokenising shares then?

Usually, shares or the share register are not being directly tokenised. It may be possible to do so in some locations. It would need the laws of that legal system to accommodate digitisation of each step of the share issuance and share transfer process.

Some questions to consider include:

Can shares be issued and transferred on an uncertificated or dematerialised basis without the need to execute transfer deeds?
If share certificates are needed, then can they be digitally signed in a way that can be hashed?
What filings with government registers are needed, and can e-filing be automated?
Are digital register of members permitted?
Are automated updates to digital register of members permitted?
Can stamp duty processes on share transfers be automated, and handled digitally?

These and other related questions will be answered in different ways in different places. Sometimes solutions can be found; sometimes not. If a solution cannot be found, then the issuer can choose another location, wait for laws to be updated, conduct a traditional security issuance, or find an alternative tokenised approach.

What kind of alternative tokenised approach?

The alternative that is presently used more frequently is for the company to issue shares to a custodian. The role of the custodian is to hold the shares (and hence the share register) static. Sometimes a trustee is used instead of or in addition to a custodian. This depends on the structure and the token rights. Then, the company declares that a digital token represents a right that is derived from and linked to the shares. This is typically a right to an earnings stream such as dividends, but can also include voting rights and other rights associated with shares. This is a structure similar to depositary rights.

Sounds complicated.

It is an additional layer to the legal structure used for the investment arrangement. So, it is an added level of complexity.

This is an offering to the public. Is the asset-owning company a public company?

Public companies could be used. But it doesn’t have to be a public company, and usually will not be. It will normally be a private company.

A private company is a company that, by its Articles of Association, limits the number of its members to fifty, is prohibited from offering its shares to the public, and contains restrictions on the transfer of its shares. A share is the share in the capital of the company. The company only has regard to the person entered in the Register of Members as the owner of that share. This person is the legal owner of share.

Even though it is private company, an indirect interest in its shares is being offered more widely.

Isn’t that contradictory?

It is possible to separate legal ownership to shares from equitable interests in or rights to the shares. Only indirect rights linked to shares are being offered widely in the token offering. When that token is traded in the secondary market, then only the indirect interest is being traded, not the legal interest in the share itself. The legal interest in the share remains static, and that legal interest will have restrictions on transfer prescribed by the Articles of Association.

So it is not contradictory, but it may seem counter-intuitive.

Can a Hong Kong private company limited by shares be used for this purpose?

Theoretically, yes, but unlikely in practice. Stamp duty is assessed on the transfer of a beneficial interest in shares under Hong Kong tax law. Even though security tokens are not shares, they may represent an interest in shares, and stamp duty may be assessable on transfers of security tokens. A better location might be a location that does not impose stamp duty on share transfers, or has an electronically enabled system for submission and payment of stamp duty.

Is this likely to change?

Perhaps with maturity of the ecosystem. So watch this space, but don’t hold your breath.

Part 4: What regulations apply to security token offerings?

Why does securities law apply to a security token offering?

Securities law applies because it is a security. The clue is in the title. Security token.

Take Hong Kong. The Securities and Futures Ordinance (SFO) outlines a long list of categories that are considered securities. One (and probably more) of those categories is likely to apply, and will be considered a security offering. The more likely categories are interests in shares issued by a company, interest in a collective investment scheme, or a structured product.

What is the consequence of the offering being classified a security?

In Hong Kong, the consequences relate to regulation of the offering documents, and regulation of persons conducting certain activities in or targeting Hong Kong in relation to the offering and subsequent trading.

What is the regulation that applies to the offering document?

Any offering document issued in connection with a security token offering issued to the public in Hong Kong must be authorised by the Securities and Futures Commission (SFC), unless an exemption or safe harbour applies.

Most offerings will seek to rely on an exemption or safe harbour. This is sometimes referred to as a private placement, which can in fact include quite a number of people. The specific exemptions or safe harbours will depend on the offering itself, and the legal nature of the token. For instance, shares and debentures in a company can rely on safe harbours that are different to securities that are not shares or debentures in a company.

An offering will not need SFC authorisation if it is limited to professional investors, or is not made to the public in Hong Kong (deemed to be 50 persons for share or debenture offerings). Professional investors are defined by the SFO and in general terms, comprise institutional investors, and corporate and individual investors that have high net worth. Other exemptions could apply, and some exemptions can be aggregated.

If the offering will be made on a retail business, open to all, then SFC authorisation will almost certainly be needed. However, the normal process for SFC authorisation of an offering document will need some adjustment to take account of the specific circumstances of a security token offering. SFC authorisations will be slow and uncertain at first.

It’s a technical area. Very technical.

Is a white paper an offering document?

It’s not about the label; it’s about the content. If it walks like a duck, swims like a duck, and quacks like a duck, then it’s probably a duck. Even if you call it a dog.

If the “white paper” is a document that contains an invitation to enter into an agreement to buy, sell, subscribe for or underwrite securities or structured products, or to acquire an interest in or participate in a collective investment scheme, then it’s an offering document. This is the same even if it is called a white paper.

Does that mean that white papers for security token offerings will need to be written like offering documents?

Yes, if they relate to an offering of securities. Actually, they should not be called white papers anymore. The white paper was a technical description of a technology application. A security token offering is simply an offering of securities, aided substantially in process and execution by technology. It is first and foremost a security offering.

That said, the standard Private Placement Memorandum for a security offering will need to be adapted for the significant and substantial impact of technology.

Does that mean the Token Sale Conditions will need to be written like a Subscription Agreement?

Yes, if they relate to a subscription for or purchase of a security. Typical language around the classification of the investor, and the nature of the offering, will be critical. The standard Subscription Agreement will need to be adapted for the impact of technology on the process.

What activities need to be regulated for a security token offering?

In Hong Kong, the most likely regulated activities involved will be:

Dealing in securities (Type 1)
Advising on securities (Type 4)
Advising on corporate finance (Type 6)

Other activities in the secondary market may also be regulated. These include:

Providing automated trading services (Type 7)
Asset management (Type 9)

This is not exhaustive. Different regulation might apply depending on the project.

So all I need to do is find a willing licensed company that has the right licences.

Not quite. You will need to find a licensed corporation that either has specific permission to undertake a security token offering, or is willing to notify the SFC to obtain that.

Licences are issued according to the business plan provided to the SFC, and the licensing conditions imposed by it. If there is a material change, then the licensed corporation must notify the SFC. Security token offerings are new, and would constitute a material change. Very few, if any, licensed corporations have this as part of their approved business lines.

Sounds hard to find.

Yes. But it’s still early days.

What about exemptions?

There are different exemptions for each of the regulated activities. But it is hard to conceive of an exempted structure that would allow a security token offering be launched in Hong Kong, without the persons in Hong Kong doing so being licensed.

Also, it’s technical. Very technical.

What if I only target professional investors?

It will help with the offering document regime, assuming you are able to confirm, before an offer is made, that the person to whom you intend to make an offer is a professional investor in accordance with regulatory guidance on the evidence needed.

It is unlikely to help too much in respect of the regulated activity regime. The professional investor exemption only applies to one regulated activity (dealing in securities), only in respect of institutional professional investors (not corporate and individual professional investors such as family offices and high net worth individuals), and the person must be acting as principal.

General principle. If you have people on the ground in Hong Kong working to launch a security token offering, then there is a very high probability (near certainty) it is a regulated activity and those people need a licence.

What if I only provide technology services?

Perhaps, needs analysis. Unlikely though.

Maybe if the structure is moved entirely out of Hong Kong?

Not just the structure; all the people too.

Maybe I should get the licences myself.

Yes, if you intend to be in the business of conducting security token offerings or trading in security tokens. Be prepared that it might take some time to get the licences.

Those are weighty regulatory obligations.

Yes. These are securities.

So it’s not like an ICO.

It is not like an ICO.

Doesn’t sound easy.

It’s not easy.

And it’s still a good thing?

Yes.

Part 5: Who are the key project team members for an STO?

Who do I need to work with to conduct an STO?

You will likely need to work with a Issuance Platform, a distributor (broker-dealer), a listing platform, a legal team and a financial advisor. You may also need to work with an auditor, a valuation company and a trustee.

That seems like a lot of parties. Who should I contact first?

The project won’t really get off the ground until you have got in touch with everyone. You can start first with the legal team, the financial advisor and the issuance platform.

So lawyers, financiers and issuers. What are their roles?

The issuance platform provides the technology platform and support for the token issuance. The issuance platform also works closely with the corporate service provider and the listing platform, especially if they already have a good working relationship. They can also assist with coordinating subsequent listings, and keeping the tokens up-to-date with the evolving market practice and new requirements of listing platform.

The legal team can advise you at an early stage on how to structure the underlying asset to the STO, and advise you whether there is any major legal or regulatory obstacle to your business model.

The financial advisor can give a preliminary advice on the expected costs and return of the STO. You will be able to assess whether this is acceptable to you before it’s too late.

Are the engagements only for the STO project?

No, an issuance platform will be engaged on a long-term basis, and not just for the STO. The issuance platform will continue to monitor the security tokens after closing 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 in the future after closing.

The legal team can also continue to provide ad hoc legal support to the STO company, even after the STO is completed. For instance, you may want to seek legal advice before issuing announcements to investors.

Are the financial advisors the glue to keep the project together?.

Yes. A financial advisor is the critical 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.

You mentioned broker-dealers above. As there is a listing platform for security tokens I’m guessing I need broker-dealers?

Yes. In Hong Kong, a person who engages in distribution or broker-dealing activities of an STO needs to hold a Type 1 (Dealing in Securities) licence from the Securities and Futures Commission (“SFC”). But their role is more than that. They can also:

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.
assist you in launching marketing campaigns, which you are not permitted to do so without a broker.

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.

And when should I start talking to a broker-dealer?

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.

How do I know where to conduct the STO?

You will need a listing platform for listing and trading of the security token is a crucial aspect of STO.

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.

What listing platforms are available in Hong Kong?

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 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.

Does a listing platform bring anything else to the offering?

Yes, a popular listing platform can bring volume to your STO. They can also assist with managing the token holders and help with dividends payment.

What is the role of the legal team?

Regulation, legal structures, and legal process are at the heart of an STO. A 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.

Is there more to “corporate structure”?

Yes, 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. Otherwise, they will not invest. 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 different outcomes for you.

What documents are involved?

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.