Security Token Offering: Features, Exemptions, Risks
Offering security tokens is allegedly one of the most attractive ways for blockchain startups to raise funds. However, after the U.S. SEC has made it fairly obvious it’s not really happy about it last year, projects think twice before issuing a token that might be considered a security. In this explainer feature, we answer the most frequently asked questions about security tokens: what they are, how they work, why the SEC doesn’t like them, and how to avoid possible problems.
What are securities?
In the U.S., the term “security” is defined by the Securities Act of 1933 and the Securities Exchange Act of 1934. Both Acts deliberately give quite a broad definition to cover every investment instrument or contract possible.
Simply put, a security is a financial asset or instrument like futures, stocks, or options, among other things.
Securities commonly represent such rights and interests, as:
- Ownership rights and interests in a legal entity, including general partnership.
- A share in the company’s profits and/or losses, or assets and/or liabilities.
- The company’s equity interest.
Therefore, as a cryptographic manifestation of a traditional security, a security token inherits all of its benefits and shortcomings in addition to its own technological and regulatory peculiarities.
What are security tokens in a nutshell?
Security token is a blockchain-based cryptographic token that has the characteristics of a security. Thus, security tokens represent the holders’ rights in the issuer company (e.g., distributions of stock and stock rights).
What are the features of security tokens?
Just like utility tokens, security tokens have a set of features that make them different from other kinds of tokens:
- A security token derives its value from an external, tradable asset being actually a security.
- While utility tokens provide access to some product or service, security tokens give their holders certain rights in the issuer company and are mostly centered on financial benefits.
- Security tokens are usually backed by certain value: company’s assets, profit, revenue, etc.
Currently, there are several widespread ways to distinguish security tokens from other types of cryptographic tokens, among which the Howey Test seems to be the most common.
What is Howey Test?
The Howey Test determines whether a financial instrument is a security. The test consists of four components, and a token has to meet all of those criteria to be considered a security. Namely, the token should be:
- an investment of money;
- in a common enterprise;
- with a reasonable expectation of profits;
- to be derived from the entrepreneurial or managerial efforts of others.
A purchase of tokens itself constitutes investment of money, and therefore the SEC may deem nearly any ICO a security offering.
If the reward for any kind of effort contributed to the system (e.g., mining) has influence on other participants’ rewards, the blockchain system may be treated as a common enterprise.
If an investment is made with a reasonable expectation of profits, meaning that investors purchase tokens expecting to sell them later for profit or hold them to get periodic payments, the ICO in question is likely to be considered a securities offering.
If the investors expect their profits to be derived from the entrepreneurial or managerial efforts of others, and said efforts are significant for the project to succeed or fail, the ICO meets the final criterion as well.
What is a security token offering?
Security token offering is a process of selling security tokens for cryptocurrencies like BTC or ETH or fiat money undertaken pursuant to the securities regulation.
Generally, if a project sells its utility tokens way before the product is released or developed, those utility tokens are likely to be treated as securities.
How to offer security tokens legally?
Generally speaking, there are only two ways one can sell security tokens and comply with the SEC’s guidelines at the same time. Namely, your company can either go public or invoke some exemptions described in the Securities Act of 1933 . While most companies opt to use such exemptions, going public is also an option.
In brief, going public means your company holds an IPO, that very same thing that the term ICO refers to. It means that in order to raise funds a company sells shares of stock to the general public. Once the IPO is over, the company has to comply with other requirements, most notably those on public reporting. In order to have an IPO, a company will have to file a registration statement with the SEC and wait until the regulator says that it is “effective.” Most companies that want to hold an ICO do so mostly because they aren’t willing to go through all that bureaucracy, however, it’s still a viable option to raise funds.
Nevertheless, the majority of startups usually choose to invoke exemptions. The Securities Act of 1933 has three kinds of exemptions from registration, namely A+, D, and S, that are of interest for those who issue security tokens.
Exemption under Regulation A+ will enable one to sell securities to “non-accredited investors” for up to $50 million through “general solicitation.” However, registering securities under this exemption takes a lot of time and more money, and includes financial audit. Plus, whatever you raise, the entire amount will be viewed as a revenue, and therefore taxed (unless the money in question is equity for the company).
Exemption under Regulation D is probably the most popular one for everyone selling security tokens. It effectively exempts a company from registering its securities with the SEC, however, there are certain limitations. First, all investors have to be duly accredited, and they have to be provided with provably honest information that lacks any “misleading statements.” Additionally, the company will have to file Form D in electronic form once the securities are sold. Finally, the investors will be forbidden from selling their shares for at least a year after they have bought them.
Finally, exemption under Regulation S is just selling your securities anywhere outside the U.S. In that case, the SEC won’t have any interest in you. Still, it requires due KYC policy in place as selling a security to a U.S. national even unknowingly will sparkle the interest of the regulator in an instant.
What if a project fails to meet the requirements?
While security tokens are typically the most attractive option to potential investors, undertaking a security token offering poses substantial legal risks. Regardless of their country of incorporation, projects that sell security tokens to U.S. citizens or residents have to comply with the existing securities legislation. If the issuer company fails to comply with all those requirements, the ICO proceedings may be legally seized, and the founders may face serious fines or even a prison term.
By now, there are a few cases of ICO companies embroiled in litigation by the SEC or their own token holders. For example, SEC took action against Munchee and AriseBank ICO, halting their ICOs and filing complaints to courts.
Sometimes, projects faced lawsuits from their own token holders. Their demands are usually based the fact that the project failed to register their ICO with the SEC. Tezos, Centra Tech and ATBCoin, all of which face numerous class action lawsuits, are just a few examples.
Thus, projects should be careful in making predictions and promises to token holders as anything they say can and will be used against them in a court of law.
Please note that this feature should not be construed as legal or investment advice.
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