Security Token Offering in EU
What is STO?
On November 16, 2018 the Securities and Exchange Commission (SEC) pressed charges against two companies that sold digital tokens in initial coin offerings (ICOs). Official statement here. Even if regulation in USA differs from the one in EU, it is still very popular topic within blockchain community. Our representatives have recently visited several blockchain events across the Europe, such as Moontec in our beloved Estonia and Blockchain Summit in Malta where not only in several presentations, but also during coffee breaks and dinner parties ICO vs STO (Security Token Offering) issue was discussed more than once. Our area of expertise is EU law and therefore the goal of this article is to present future challenges with regards to ICO / STO regulation in EU.
The main difference between ICO’s and STOs can be found within the type of tokens which company would like to issue in order to raise funds to develop their project. According to SEC statement, most of the ICO’s are issuing security tokens, because their tokens passes the Howey test and they (ICOs) should convert their utility tokens to security tokens ASAP in order to avoid similar penalties like Airfox or Paragon (each charged with USD 250K fine). This is the case in the USA. Even though, regulations in EU hasn’t set out specific definitions with regards to utility / security tokens, it can be read from several existing Directives that utility token should be considered as a security only when the profit of the token holder would depend on the profit of the company which issued the token. Several months ago we created comprehensive article where we analyse utility / security tokens from perspective of Estonian legislation.
The main reason why it is considered that ICOs are history and the next big thing are STOs does not rely on any of the above stated facts. Most of the people who organized ICOs were well aware of these regulations and it was not a secret that SEC considers mostly all tokens as securities. Big reason why it is much harder to organize successful ICO even in EU is the large number of scams in the past. People don’t trust ICOs. Plain and simple. There are several studies which show that in 2017 more than 80 % of launched ICOs were scams. Our position in this is that if you truly believe your product and believe that it will be possible to launch it by offering pure utility tokens, then go ahead. However, it is clear that investors who will participate in the upcoming offerings will expect something in return.
It leads us to the following questions:
1. What is STO?
2. Are STOs the next big thing and are they here to stay?
3. How to register STO?
4. How to convert utility tokens to security tokens?
1. Security token offering means that tokens which company is offering to the public must be “backed” by tangible assets, profits or company revenue. For example, real estate which belongs to the company can serve as a security by being tokenized. The same goes for company’s shares. This system provides investors with guarantee that in case if ICO won’t develop the product, their investment (token) will be backed up by tangible asset and will still have some value on secondary markets (read: exchanges) even after the failure of the project. In theory, if the same principles of ICO would be applied, it would provide global reach for companies who wish to raise funds in order to develop their project, because compliance is already integrated into the token and it is not necessary to repeat it in every single jurisdiction. However (and this is a huge however) STOs does not work like ICOs. You are not allowed to trade with securities on unregulated exchanges and in situations when you shall do so, you will automatically apply for similar penalties like Paragon and Airfox in USA. If you wish to trade with securities, you must enter in to the regulated market place and play by the rules of local regulators.
2. So far, for obvious reasons (read: SEC), there are more STOs launched in USA than in EU. The first STO for general public in Europe was launched on 3rd September 2018 and it was Neon Exchange which was launched under regulations of Liechtenstein Financial Market Authority (FMA). In the beginning of November 2018, Desico launched their STO under the Lithuanian Crowdfunding Law which is considered to be one of the first STOs launched under EU regulation. In Desico case DESI token is classified as a Revenue Participation Note (RPN), with quarterly payouts to investors. This type of security token does not constitute ownership of Desico – instead, token owners will receive 12.5% of the total revenue created by Desico. More about Desico you can find here. Since there are not so many STOs in EU at this particular moment, it would be overstatement to say that this is definitely the next big thing and they are here to stay. At the same time, one shouldn’t ignore the huge potential which comes with relatively low costs and global reach which STOs brings.
3. And here comes the main question:
How to register STO?
This is where we (lawyers) come in. The “New Prospectus Regulation” which entered into force on 20 July 2017 aims to facilitate access to capital at each stage of a company’s development, helping businesses to raise capital. In accordance with the New Prospectus Regulation from July 21, 2018 a prospectus is not required for offers to the public in the EU with total value of less than EUR 1M in total over a period of 12 months. Prior to the New Prospectus Regulation threshold was EUR 100,000.00. Additionally, individual Member States may exempt domestic offers where the total consideration of each offer in the EU is between EUR 1M and EUR 8M. Basically the New Prospectus Regulation sets out provisions that up to certain threshold public offerings can be regulated according to individual Member State. And even more – individual Member States have power to increase threshold for offerings without prospectus up to EUR 8M. Therefore, if company is planning to launch STO and their hard cap is up to 8M, we would recommend looking in to specific EU jurisdiction. For example, if company wishes to launch STO in Germany, it would be important to take a closer look at legislation in Germany towards public offerings up to certain threshold. While there are countries which look at virtual currencies and blockchain as a high-risk sector and imposes regulations to limit the use of it, there are countries which open “blockchain - related business” with open arms - Estonia, Lithuania, Malta, Denmark, Germany, Netherlands, Slovenia. Therefore, we recommend to our customers to launch their STO in one of these member states. Great example is Lithuania where it is possible to launch STO under Crowdfunding Law.
If the hard cap of STO is above EUR 8M then company must prepare prospectus. All listing prospectuses must be prepared in accordance with the Prospectus Regulation 809/2004 and EU Prospectus Directive 2003/71. Prospectus registration application must be submitted in to Member States regulating authority (for example, Estonian Supervision Authority if submitted in Estonia).
The most popular way on how to organize STO is to offer it only to “accredited investors”. Basically, these are financial institutions or experienced investors with minimum investment of EUR 100,000. In this way company wouldn’t have to create a prospectus and would not have to enter regulated secondary market in order to trade with the tokens. There is a shortage of publicly accessible information on STOs for accredited investors, however opinions on it are different. Compared with typical ICOs which are usually launched in the initial phase of the business development, privately held STOs are for companies who has already proved their worth in the market and are ready to disclose their financial information to potential private investors in order to convince them to invest at least 100K in their business development. The process is still much easier, faster and cheaper than IPO, but at the same time completely different from the idea of ICO.
4. There are several companies who have launched successful ICOs and are converting utility tokens to security tokens. As mentioned above, the legal way how to convert tokens vary between individual member states, therefore it is not possible to generalize it. For example, in Estonia, it would be possible to convert utility tokens to security tokens by granting initial investors with loan agreements where they would be entitled to receive certain interest from profits of the company in correlation with their initial investment. And in the case if token holder (initial investor) would like to sell his token, then he would also sell the loan agreement, in accordance with transfer of claims and obligations arising from Estonian Law of Obligations Act Chapter 9. However, such transaction could not take place on unregulated secondary market.
It is more complicated to issue security tokens compared with issue of the utility tokens due to the existing regulations. However, we believe that this is not a bad thing. We believe that there had to be come some regulations with regards to ICOs, because when there are 80% scams in the market, it does not shed a positive light on blockchain technologies in general.
As stated above, up to certain threshold STO can be launched within individual Member State without creating prospectus. This will help SME to access funding for their projects when they are still in development process. Access to capital is a great thing and we believe that in 2019 we will see many great ideas rising because they will receive funding through STOs. However, the number of EU Member States were you can launch STO which is available for general public and not only to accredited investors is limited and we are expecting changes in legislation of Member States in order to stimulate the development of public offerings based on digital assets.
GATE TO BALTICS OU offers consulting services on how to comply with legal requirements while launching STO and how to convert utility tokens to security tokens.
Information provided above does not constitute a legal advice and we recommend anyone who is interested to organize security token offering to consult with professional from legal field.