Toward a more perfect Security Token

A discussion of current state and federal regulations in the United States and how they should contribute to the technical requirements of Security Tokens.

Eric Gravengaard (LinkedIn): @EGravengaard (Twitter) @Gravengaard (Telegram)

©2018 Athena Blockchain, BBLLC.

Introduction

The token is the stock certificate.

Security Tokens, combined with their underlying blockchain, will replace stock certificates and all other forms of recording ownership of private securities. Tokenization of securities allows for better auditability, reduced transfer costs, and faster updating of records.

Smart contracts can embed the legal terms , rights, and restrictions that govern the payment of dividends or interest, transfer of ownership, voting, and publication of notices. These functions are typically performed by corporate attorneys or in-house by small and midsized companies. Automating these processes in a smart contract using distributed ledger technology (DLT) will enable new business models, including enabling the lawful trading of private securities in a secondary market.

There is precedent for radical changes to the way ownership is recorded and proven for securities in the US. In 2012, Superstorm Sandy flooded lower Manhattan destroying one third of the paper certificates held by the Depository Trust & Clearing Corp. Estimates of the value of the loss range from $10 to $15 trillion. The reason this loss did not wipe out the wealth of the world, is because the paper certificates are not important. What is important for a functioning market is a trusted ledger of who owns which security, not the paper certificates that convey value to those ledger entries. The ownership of these paper certificates was recorded in the databases of the DTCC, the importance of the paper was symbolic and after it was destroyed, the markets eliminated this symbolic importance. In this way the US stock market was dematerialized. Soon it will be decentralized. (source)

The recent explosion in capital raising using the ICO and the ERC-20 standard for Ethereum tokens is proof that this model works for many investors and companies/projects looking to raise money. Athena Blockchain believes that this will continue, but that investors will begin to demand the rights and covenants of traditional equity and fixed income securities. To enable this, token standards must evolve beyond the most basic function transfer(address to, uint tokens) public returns (bool success); that is codified in the ERC-20 spec towards a standard token design that can accommodate the needs of corporations that want to issue their securities using tokens.

This paper is an introduction to the legal and regulatory landscape for both securities and blockchains; a primer on basic corporate actions involving equity; a survey of the existing securities token landscape; and finally an introduction to the Athena Blockchain Token Library. We will discuss both the variety of securities that can be issued in the US as well as the state laws that specify the formation and governance of companies. The federal rules regarding the offering, registration, and secondary trading of securities will also be discussed. This paper is not intended to provide legal advice, and no legal or business decision should be based on its content.

US Corporate Securities

Equity

A corporation is owned by its shareholders, who elect the board of directors who hire the management of the company. Corporations generally issue two distinct types of equity: common stock and preferred shares, although there can be many variations and classes of each.

Corporations, Limited Liability Companies, and Limited Partnerships are all legal forms that companies can take to limit the liabilities of the owners to their original investment. So if a company were to default on their debts, there is usually no recourse for lenders to receive money from shareholders. On the other side, if a company does well and is profitable then equity holders are compensated for holding the stock with dividends or appreciation of the stock price.

Common Stock

Most publicly traded stocks are “common shares” of a company. They do not pay fixed dividends, but they do have voting rights. Typical corporate votes include approving a slate of directors to be added to the board of directors, and authorizing changes to the company’s articles of incorporation or by-laws. Dividends are decided by the board of directors and are paid to holders of common stock.

In recent years it has become common for multiple classes of common stock to be issued. For example Facebook (FB) has three classes of common stock: the Class A has 1-vote per share and is publicly traded; the Class B has 10-votes per share is held only by company insiders like Mark Zuckerberg; and the Class C has no votes. All three classes of shares have equal rights to be paid dividends, which the company has never paid, but may in the future.

Preferred Shares

Many early stage companies, especially those with venture capital (VC) funds as investors, issue preferred stock. Investors in preferred stocks receive dividend payments ahead of common shareholders, and have certain “preferred” payments in the event of a liquidation of the company through a change of control (e.g. sale of the company, or a merger) or an IPO. Many of the features of preferred stock are designed to mitigate the downside risk to a VC if the company does not thrive. These preferences usually allow the preferred stock holders to receive money, up to some multiple of their initial investment, before any money is to be distributed to common shareholders. This is often referred to as the waterfall of the capitalization table.

Bonds and Debentures

In addition to owning a piece of the company, investors can also fund growth and expansion by loaning money to the company through bonds and other financial contracts that appear like bonds. Bonds are financial contracts where the issuer promises to re-pay the principle of the loan as well as interest in a fixed amount of time. For these reasons they are called fixed income securities. While media outlets like CNBC and Bloomberg TV focus their attention on equity markets, over 80% of the notional amount of securities are bonds and debentures.

Secured and Unsecured Debt

Companies can issue two main types of debt, secured and unsecured. Secured debts are backed by some asset, whether that be a factory, a patent, or any other durable good. Investors presumably will be willing to loan the company money knowing that if things go poorly, there is some residual value in the assets that back the loan. Unsecured debts are backed only by the credit-worthiness of the issuer, and in the event of a liquidation of the company, are repaid to the holder after the secured debts but before all equity holders. Investors can analyze the entire structure of a company, all the ways it has financed itself and the obligations entailed in those financings, and determine the likelihood of an unsecured loan being repaid.

Most of these loans are made with a fixed term and a fixed interest rate. Some loans will have features that allow the interest rate to fluctuate or adjust to market conditions. Other loans may allow the issuer to prepay, or call back, the loan. The full scope of such features is beyond the scope of this paper, but offers a rich and fertile field of research into what would be required for a token and library of smart contracts to accommodate such financial instruments.

SAFE and KISS

The Simple Agreement for Future Equity (SAFE) and Keep It Simple Security (KISS) are both attempts to simplify early (seed) stage venture investing. Neither are debt instruments, and therefore not subject to compliance with California Lender Laws or similar laws in other states. They are designed to let entrepreneurs and investors quickly come to terms and have most of the details worked out in future rounds.

The details of these securities are best found by reading the original documents and the many explanations of these documents here and here. Because these securities do not over-specify terms or commit the company to a specific course of action, they are perhaps not great candidates for smart contracts, at least those that might operate autonomously without several layers of human control and arbitration.

Structured Notes and Structured Products

Mortgage Based Securities (MBS) and Collateralized Debt Obligations (CDO) are just two types of structured products that can be issued by Special Purpose Vehicles (SPV) or trusts that pool the risk of some class of underlying security. Most of these products are focused on pooling first mortgages on family homes, but can also include bank loans or other forms of debts such as REIT loans.

The details of these securities is far beyond the scope of this document, but several key features are important to consider as they relate to possible implementations of smart contracts. Many of these securities come in multiple tranches that are paid according to a schedule that governs how interest and principle payments are distributed. For example, the Series A Tranche might receive all payments made by homeowners until some total amount is paid, and then Series B Tranche might begin to receive payments. In this sense it is possible to create novel securities that have embedded derivative components and therefore different risk profiles from the same pool of mortgages.

Security Tokens offer a compelling way to reduce the costs of administering and issuing a structured investment contract. Instead of relying on the US wire transfer system and manually tracking the ownership of such an interest, a distributed ledger could maintain the accurate and definitive record of ownership and also distribute payments. This should reduce the costs of issuance to a level where far more financial products can come to market with a much broader investment audience.

Corporate Formation by way of State Law

In the United States, company formation occurs at the state level by way of registration with the Secretary of State. Laws can vary somewhat from state to state, mainly with the allowed forms that companies and partnerships can take. The most common forms of corporate formation in the United States are Corporations, Limited Liability Companies, and Limited Partnerships. All forms limit the liability of passive owners to their amount of invested capital and shield them from repaying the debts of the company. In recent years, several states have taken the lead on introducing new and quite groundbreaking laws to govern companies that use blockchain and DLT for governance, registering owners, and conducting stock issuances. This section details some of the relevant sections of those states’ laws.

Delaware

Effective August 1, 2017, the Delaware General Corporation Law (the “DGCL”) authorizes corporations formed in Delaware to use a blockchain to maintain their stock ledger. This was done by amending Title 8 of The Delaware Code DGCL to specifically authorize the use of blockchains, clarify the definition of stock ledger and lay out three functions that a stock ledger must facilitate for a corporation.

Definition of Stock Ledger

Delaware law specifies that 10-days prior to a meeting of the shareholders, the company produce a list of the shareholders including their address, but not necessarily their email address. Failure to produce such a list can result in any such a vote being voided by the Court of Chancery. So to be compliant a blockchain or DLT must be able to permit the corporation to produce such a list of shareholders including their names and addresses.

Delaware Title 8 Section 219:

(c) For purposes of this chapter, “stock ledger” means 1 or more records administered by or on behalf of the corporation in which the names of all of the corporation’s stockholders of record, the address and number of shares registered in the name of each such stockholder, and all issuances and transfers of stock of the corporation are recorded in accordance with § 224 of this title. The stock ledger shall be the only evidence as to who are the stockholders entitled by this section to examine the list required by this section or to vote in person or by proxy at any meeting of stockholders.

Functions of a Stock Ledger

Section 224, as amended, requires that the stock ledger serve three functions contemplated by the Delaware General Corporation Law: it must enable the corporation to prepare the list of stockholders specified in Sections 219 and 220; it must record the information specified in Sections 156, 159, 217(a) and 218; and, as required by Section 159, it must record transfers of stock as governed by Article 8 of subtitle I of Title 6.

So the primary purpose of a stock ledger is to enable the corporation to prepare a list of stockholders. And then it must record certain types of information, which we discuss below. And finally the stock ledger must record transfers of stock as defined and governed elsewhere in the Delaware code. Most of the requirements are incorporated by reference. Some of the highlights are listed below, however we recommend that dedicated readers consult with Delaware code to view the specifics of all the related requirements.

Section 159: “Whenever any transfer of shares shall be made for collateral security, and not absolutely, it shall be so expressed in the entry of transfer if, when the certificates are presented to the corporation for transfer or uncertificated shares are requested to be transferred, both the transferor and transferee request the corporation to do so.”

Section 217(a): “(a) Persons holding stock in a fiduciary capacity shall be entitled to vote the shares so held. Persons whose stock is pledged shall be entitled to vote, unless in the transfer by the pledgor on the books of the corporation such person has expressly empowered the pledgee to vote thereon, in which case only the pledgee, or such pledgee’s proxy, may represent such stock and vote thereon.”

Section 218 details voting by proxy, which is an important consideration for securities tokens. It is important that tokens allow shareholders to grant their right to vote to other parties who can vote on their behalf. Usually you might give such rights to the Board of Directors, but in a Proxy Contest, you might want to delegate your vote to an outsider who wants to challenge the board. Someone wishing to solicit such interest in joining their voting syndicate need to be allowed to access the list of shareholders so that they can mail out such solicitations.

The recording of transfers of stock in Article 8 of subtitle I of Title 6 is beyond the scope of this document, except to say that basic transfers of ownership provided by ERC-20 are sufficient for most of the needs of recording transfers, but may not encompass all of the needs for Endorsements (Title 6 Article 8 Part 3 Section 8–304).

Summary

Delaware law requires corporations to be able to produce a list of shareholders (names and addresses), how much they own, and who is permitted to vote on their behalf. Additionally, certain stock transfers need to be marked as collateral security transfers. If a system that includes DLT can be used as a stock ledger, then it must fulfill these requirements.

Wyoming

In March of 2018, Wyoming passed The Wyoming Blockchain Legislation (the “WBL”), which comprises five separate bills. Those bills collectively define Open Blockchain Tokens (utility tokens) that can be used “for a consumptive purpose, which shall only be exchangeable for, or provided for the receipt of goods, services or content, including rights of access to goods, services or content.” The purpose of this paper is to discuss investment contracts, and the use of tokens and blockchains to track the ownership

One of the five WBL bills, Wyoming HB0101 (2018) authorizes “corporations to use electronic networks or databases for the creation or maintenance of corporate records; [authorizes] the use of a data address to identify a corporation’s shareholder; [authorizes] corporations to accept shareholder votes if signed by a network signature that corresponds to a data address; [specifies]requirements for use of electronic networks or databases”.

Specifically, the law defines a shareholder as the “owner of a private key that is uniquely associated with a data address.” Corporations don’t need to know the name of the shareholder, only their blockchain wallet address. Notices of shareholder meetings and other communications must be directed at such data addresses. Wyoming law requires corporations allow shareholders to sign on a vote, consent, waiver, or proxy appointment.

Finally, 17–16–730 allows the creation of voting trusts, “conferring on a trustee the right to vote or otherwise act for” one or more shareholders. Such voting trusts would then be required to deliver a list of shareholders who have signed on to their voting trust agreement.

These rules regarding “anonymous shareholders” would conflict with the SEC’s rules regarding providing lists of shareholders under two circumstances. These rule will only apply to securities registered under Rule 12, and not to exempt securities. Those two events, where the SEC requires the company to produce a list of shareholders and a method of contacting and delivering instructions, are corporate votes or proxy solicitations; and tender offers.*

Vermont

Athena Blockchain BBLLC is Vermont’s first BBLLC

In July of 2018, Vermont enacted 2017-S0269 which created a new type of limited liability company, dubbed the blockchain-based limited liability company or BBLLC. Companies must specify in their articles of organization that they are electing to be a BBLLC and “adopt voting procedures, which may include smart contracts.”

The law requires that BBLLCs “adopt protocols to respond to system security breaches or other unauthorized actions that affect the integrity of the blockchain technology utilized by the BBLLC.” We understand that to mean that the BBLLC must survive two different types of security breaches. First, a breach or loss of integrity of the underlying blockchain, such as Ethereum forking, must be addressed in the operating agreement. Second, in the event that a member loses control of his or her private keys, that member’s interest need to be protected. This is common sense, often missed by crypto-purists, that economically if a member loses his or her stock certificate or private key, the member’s interest in an LLC has not changed.

Unlike Wyoming, Vermont has not gone so far as to remove the requirement of knowing the names and addresses of the members of a BBLLC. 11 V. S. A. S 4176 states:

Except as expressly provided otherwise, this subchapter does not exempt a BBLLC from any other judicial, statutory, or regulatory provision of Vermont law or federal law, including State and federal securities laws.

Summary

Vermont has introduced perhaps the least comprehensive blockchain legislation of the three states examined in this paper. The requirements are a common sense approach to creating a LLC that uses blockchain technology for some forms of corporate governance. The legislation does not create a new method for anonymous ownership, instead it extends Vermont’s existing laws regarding Limited Liability Companies to include a new category for those companies looking to perform some record keeping and governance on the blockchain.

Common Corporate Actions

In investment parlance, a Corporate Action is any activity that materially changes a company and impacts the shareholders or owners of its securities. These can include thing such as name changes, such as reorganizing Google into a unit of Alphabet. Or these changes can be more impactful such as a stock split where old shares are replaced with some multiple (often two) new shares that presumably have half the value. There are some commonalities for all of these events. They are usually declared by the board of directors on a certain date, there will be a date when the change becomes effective, and in T+3 settlement there will also be the date (ex-date) when the change or activity will be reflected in the price of the security. The classification below is our own internal thinking about the impact of a corporate action and the complexity of implementing such an event in a smart contract.

Simple Corporate Actions

  • Change of Name
  • Change of CUSIP
  • Change of Ticker Symbol

Moderately Complicated Actions

  • Dividends
  • Stock Splits

Highly Complicated Actions

  • Mergers
  • Acquisitions
  • Tender Offers
  • Rights Offerings
  • Sale or Spin-Off of a Subsidiary

Describing each of these corporate actions is beyond the scope of this discussion, however we will highlight three that we think are important. The first is the dividend, a common way for companies to return profits to shareholders. These can be regular, as in quarterly, or special. The distinction has more to do with options listed against the securities, but in any case the dividends are declared and dates for payment and the record date are specified by the company’s board of directors in a public announcement.

The second corporate action we believe is important for all securities tokens to allow is the stock split. In a stock split, the company is increasing the number of shares outstanding by issuing new shares to existing shareholders. For example, Apple has completed three two-for-one stock splits and a seven-for-one stock split. There is no change to the market capitalization as a result of these splits, but the price of the stock is adjusted by the new lower share of the company that each share represents. These are usually done to reduce the price price of one share to make it more attractive to smaller investors. Berkshire Hathaway Class A (BRK.A) shares have never split and currently trade for more than $300,000 per share.

Finally, we believe that Tender Offers are an important mechanism for a company or a large shareholder to buy a large amount of tokens from the public. In a tender offer, the buyer usually specifies a total amount he is willing to spend on the security and the total number of shares that will be accepted. Then shareholders can tender their shares. If the offer is undersubscribed, then no exchange is made. If the offer is oversubscribed then some allocation is made to each shareholder who tendered their shares. Qualcomm recently announced a tender offer to purchase (buy-back) up to $10 billion of its stock. The company’s offer is not a fixed price per share, but rather a Dutch auction. source

As always we invite interested readers to visit Investopedia to learn more about corporate actions.

Securities Offerings: Registrations and Exemptions

Securities offered for sale in the United States must be registered with the SEC unless they are issued under one or more exemptions from registration. Public registration, as defined in the 1933 Securities Act. The act of registering provides the public with an opportunity to see information about the company, the key managers and employees, and the financial statements. This is done by filing a Form S-1. For companies not wishing to publicly disclose their business or become an SEC reporting entity they make be exempt from registration if they fall into one or more of these categories:

  • Private offering to a limited number of people
  • Offerings of limited size
  • Offerings made to foreigners not residing in the United States

Regulation D Rule 506(c)

The most commonly used exemption in public token offerings is Regulation D. This is for what are known as private placements, or securities that are only offered and sold to a small number of investors, usually those with a certain net worth or income (accredited investors). Rule 506(c) allows issuers to publicly discuss their offering so long as they only accept offers to purchase from accredited investors. This differs slightly from Rule 506(b), which contemplates very private sales by the issuer without any general solicitation and with less required documentation of the buyer’s accredited status.

To prevent non-accredited investors from purchasing securities offered under a Reg D exemption, most issuers will pre-screen investors and white-list them to participate in the offering. To screen investors requires more than just taking their word, but collecting appropriate documentation from the potential investor and reviewing it carefully.

Regulation S

Regulation S offers a safe harbor to issuer and distributors of securities when they are making offers to non-US persons. Specifically, issuers do not need to register their securities with the SEC if they are being offered off-shore. This exemption from registration can be used in conjunction with a Regulation D offering; it is not exclusive. The preliminary notes to Regulation S make clear that it is intended only as a way for issuers to sell securities to foreign buyers and not as a way to make an off-shore sale to a domestic buyer.

Regulation S is available only for offers and sales of securities outside the United States. Securities acquired overseas, whether or not pursuant to Regulation S, may be resold in the United States only if they are registered under the Act or an exemption from registration is available.

For a domestic issuer, a company formed in the United States or with significant employees, managers, investors, or assets in the US, their equity securities are subject to a one-year Distribution Compliance Period. During this period the issuer must not register the sale or transfer of securities from a foreign buyer to a US person.

The safe harbor exemption is primarily designed to prohibit selling securities off-shore and then allowing them to immediately come back on-shore. To make sure this does not happen, Regulation S specifies that all stock certificates or the equivalent contain a legend restating these restrictions:

Rule 903(b)(3)(iii)(B)(3) The securities of a domestic issuer contain a legend to the effect that transfer is prohibited except in accordance with the provisions of this Regulation S (§§ 230.901 through 230.905, and Preliminary Notes), pursuant to registration under the Act, or pursuant to an available exemption from registration; and that hedging transactions involving those securities may not be conducted unless in compliance with the Act

A complete discussion of Rule 903 is beyond the scope of this document, however issuers, promoters, and purchasers should all have an understanding of the three categories of securities specified in the law as well as the significant differences between equity and fixed income securities.

Secondary Market Trading Restrictions

There are many restrictions that apply to shares of a private company. Some of these restrictions might be imposed by the company itself. For example, the company may not want a competitor to buy its private shares. A company may also not want to have too many investors as this can trigger registration and reporting requirements. In addition, the securities laws of the US restrict who may sell and and when shares originally purchased in a private offering can be resold. Below we examine several non-exclusive safe harbors that owners of securities may rely upon when selling their securities. There are many such exemptions and this is not an exhaustive list, but includes the two we believe apply to many potential Security Token transactions.

Rule 144

When restricted securities are purchased in a compliant Reg D offering they cannot be resold unless they are either publicly registered or sold subject to an exemption from registration. Rule 144 covers two types of sales: Sales of Restricted Shares by non-affiliates and Sales of Control Shares by Affiliates.

Most investors in a security token will probably be non-affiliates and the issuing company will not be SEC reporting. Therefore, the primary concern of such an investor is the one-year holding period from the time of purchase to the time of a public resale. The determination of a affiliate status is fact-based and the SEC considers being a director, employee, or owner of more than 10% of a particular class of stock or security to be material facts when making that determination.

If the token holder is an affiliate, the distinction is made that their shares are not restricted securities but are now control shares. The number of requirements placed on the seller increase significantly to stay within the safe harbor of Rule 144. For affiliates, there are volume limitations, notice of sale requirements, and the manner of sale is also important. Affiliates need to carefully examine their specific circumstances before assuming that a sale would be compliant under Rule 144. Issuers must set up reasonable internal controls to prevent affiliates, including directors, employees and officers from violating Rule 144.

The full text of Rule 144 is complicated. It is the responsibility of the seller to comply with the requirements of the rule to be covered by the safe harbor. Security Token owners should not rely on the issuer or the broker to ensure full compliance with all of the provisions of this rule. The text of the rule can be found here.

FAST Act Section 4(a)(7)

In 2015, the Fixing America’s Surface Transportation Act was passed to improve the US transportation infrastructure. It also included a small amendment to the Securities Act that allows for the private resale of restricted securities from one accredited investor 90-days after the shares have been issued provided the seller relay certain information to the buyer. Morgan, Lewis & Bockius (law firm) has a fantastic write-up of all the implications of this law and how it applies to the ABS market. Here are a few of the conditions they noted in their analysis:

  • The purchaser is an “accredited investor” within the meaning of Regulation D;
  • Neither the seller, nor any person acting on its behalf, uses any form of general solicitation or advertising;
  • The seller is not the issuer or a subsidiary of the issuer;
  • Neither the seller nor any person who has been or will be paid for its participation in the transaction is qualified as a “bad actor” under Regulation D;
  • The issuer is engaged in business, not in the organizational stage or in bankruptcy or receivership, and is not a blank check, blind pool, or shell company that has no specific business plan or purpose and has not indicated that its primary business plan is to engage in a merger with an unidentified person;
  • The transaction does not relate to an unsold allotment to, or a subscription or participation by, a broker or dealer as an underwriter of the securities;
  • The securities have been authorized and outstanding for at least 90 days; and
  • For securities of issuers not subject to periodic reporting under the Securities Exchange Act, a variety of specified information has been delivered to prospective purchasers, including the issuer’s most recent balance sheet and statement of profit and loss and similar financial statements for the two preceding fiscal years during which the issuer has been in operation, prepared in accordance with generally accepted accounting principles (“GAAP”) or, in the case of a foreign private issuer, International Financial Reporting Standards (“IFRS”).

We believe that the restriction on general solicitation is problematic for Security Token trading, since it would seem to preclude the ability for the seller to list his or her tokens for sale on a publicly accessible website. Further, the issuer would not be able to be in an “organizational stage”, which in the crypto-currency and start-up world could include many young projects.

Finally, the requirement to deliver GAAP accounting statements from seller to buyer could be difficult if the issuer is not reporting timely and accurate financial statements to investors. Issuers who are interested in having their investors take advantage of this safe harbor to registration should read 15 US Code § 77d (d) in full.

Rule 12(g)

The JOBS Act and the FAST Act raised the thresholds for registration and termination of registration for a class of equity securities under Exchange Act Section 12(g). As a result of the statutory changes, an issuer that is not a bank, bank holding company or savings and loan holding company is required to register a class of equity securities under the Exchange Act if:
  • it has more than $10 million of total assets; and
  • the securities are “held of record” by either 2,000 persons, or 500 persons who are not accredited investors.

This does not immediately create a requirement for an issuer of a security token. However, most security token issuers who do not want to register their securities and become SEC reporting will want their securities to be held by fewer than 2,000 persons and fewer than 500 non-accredited persons. This is major concern for many security token issuers who want their token widely held to increase the number of people who are advocates for their company or services.

Foreign issuers who would otherwise be required to register their securities under Rule 12(g) can find a safe harbor if they have fewer than 300 US based shareholders. The exact treatment of employees who hold shares through an incentive plan is complicated and beyond the scope of this document, but securities token issuers should consult with legal counsel to see if their “team” share is properly distributed.

Requirements for a Security Token

Do these laws, regulations, and common corporate financial and governance practices provide a clear and concise roadmap towards the generation of single set of requirements for a universal security token? No.

We do not believe that they do. We believe that they show that there are a large and rich set of requirements and that each tokenized security will have to be both upgradeable and able to work well with other smart contracts that may have to be written well after the initial tokens have been issued. However, we do believe that for Security Tokens issued by US-based corporations there are a set of basic functions that the token must have to be compliant with Delaware or Wyoming state laws. In this section, we describe those minimum requirements.

Minimum Requirements

The following list of requirements comprise a minimum floor of functionality that issuers should demand of their Security Token technology platforms in order that they comply with state and federal laws and regulations.

Corporate Record Keeping

Corporations in Delaware, Wyoming, and all other jurisdictions must be able to produce a list of their shareholders. In the case of Delaware, that includes the names and addresses of shareholders. In Wyoming, it must only be the network address of the owner, in which case the basic ERC-20 map of owners will suffice. A database of names and addresses is probably something best kept off-chain, however there would be significant benefits from having an open (if encrypted) database with fewer places for an investor to update his or her information. There are several start-ups offering various types of Investor Passports to store this information and make it available to issuers.

Announcements and Notices

All states require that shareholders be notified of certain events such as annual meetings, upcoming shareholder-votes, and proposals by other shareholders. Delaware requires that a mailing list be delivered to a shareholder who wishes to communicate with other shareholders, but the law also allows for electronic communication if the investor wishes.

Is it sufficient notice for a Token to merely point at an official Twitter account? Unsure.

This is probably a legal question that will be debated by attorneys and regulators as to how to interpret Regulation Fair Disclosure (“FD”) and state securities laws regarding notice. At a minimum, we believe Security Tokens should describe, in their code, where the issuer will post official notices to shareholders and possibly a mechanism within the smart contract to notify owners that such a notice has been posted.

Voting

The common shares of a company allow the owners of the company to vote on certain matters. Those votes can be to elect a slate of directors to the board, or on more complicated matters of corporate governance. At a minimum, a Security Token should enable a shareholder to vote their shares, assuming they own the shares as of the proper date and time required to make such a vote. The votes would then have to be properly vetted, tallied, and reported to shareholders and management. In the spirit of openness and transparency, we believe this should be done on-chain via a Decentralized Application (“dApp”) or similar mechanism.

Proxy

All states require that companies allow votes to be cast via proxy, where one shareholder is given the rights to vote on behalf of another. This right can be granted for a fixed duration or for the entire time the security is held, depending on the agreement between shareholders. The proxy mechanism must be able to accommodate both proxy solicitation by insiders at the company and outsiders who may want to oppose management. Therefore the mechanism to create a proxy and register it as a legitimate agreement prior to a vote must be open to anyone. The smart-contract rules governing a shareholder who has both signed a proxy voting agreement and voted their shares individually would need to be written carefully to comply with both state laws, regulations, and corporate by-laws. This is just one example of what we believe is a complicated and complex set of feature requirements for Security Tokens to be usable as complete replacements for investor communications and governance.

Dividends

Mature companies, with positive net income, often begin to pay regular dividends to shareholders. Companies whose shareholders own their shares via a Security Token should be paid their dividend in the native currency of the DLT platform of the token. In the case of Ethereum, companies should pay dividends in ETH to shareholders who owned their tokens on the record date for a dividend. We believe that the declaration and payment of a dividend should all be carried out using smart contracts. We also believe that there should be an open and easy to understand API for exchanges to learn about announced dividends; properly record ownership; halt trading to allow for price adjustments; and distribute funds to the correct users.

Legends

When stock is issued to an investor, it often comes with legal text or legends that warn or inform the owners of their obligations under securities laws and regulations. This can include a notice that the shares were purchased under an exemption such as Regulation D or Regulation S. This legend text might indicate that these shares cannot trade until a certain time or other rules that the owner must obey. In the case of a Regulation D legend of a non-reporting issuer, the legend might inform the owner that the shares should not be sold to the public until one-year from purchase. After the year has elapsed, the shares could then have the legend removed, and the shareholder would be able to sell the shares to the public. These legends can be specific to the buyer and not apply equally to everyone who owns the same class of share.

For example in the case that shares were sold under a Regulation S exemption, the prominent law firm, Morrison Foerster, recommends “that the certificates for the securities of a domestic issuer contain a legend to the effect that transfer is prohibited except in accordance with the provisions of Regulation S.” They also include sample legend text that would satisfy, in their opinion, Rule 903:

These securities will be offered only outside of the United States to non‐U.S. persons, pursuant to the provisions of Regulation S of the U.S. Securities Act of 1933, as amended. These securities will not be registered under the Securities Act, and may not be offered or sold in the United States absent registration or an applicable exemption from the registration requirements.

Further, Morrison Foerster states that Regulation S requires the issuer to “refuse to register any transfer of the securities not made in accordance with the provisions of Regulations S.”

How then should this be implemented in a Security Token that does not have a physical certificate form? Many of the Security Tokens we have reviewed do not specifically include the legend text as part of the smart contract. Instead they implement an external transfer regulator that enables or disables the transfer based on the investor and presumably which legends his or her Smart Tokens have. This external regulator may consult with an off-chain database of legends and or consult with the on-chain record of ownership to see which legends still apply to which tokens. We believe that while this implements the issuers requirement that they not register an improper transfer, it does not create an open an easy way for the shareholder or a broker to know what legends may still be attached to a token even if a transfer is permitted.

Existing Solutions

Athena Blockchain has reviewed several different Security Token frameworks. Many of these have been conducted under confidentiality agreements. We believe that it would be improper to disclose in this document the details of those discussions and non-public information about each of these platforms. However, we will briefly list some of the Security Token offerings that exist and encourage potential issuers to engage with us regarding how best to use this technology to reach their goals.

Athena Token Roadmap

Athena Blockchain is committed to helping clients achieve their financial goals by using the right blockchain technology. That means helping clients to choose from a variety of token solutions from other vendors (see above) or using our own Athena Token Library to implement a complete Security Token.

The Athena Token Library consists of external smart contracts that can be used by corporations and other Security Token issuers to use with their standard ERC-20 token. As of August 2018, we have begun to finish some of these components of the Library, and will continue to release more components over the course of the next several quarters.

The major corporate tasks that are possible with the Athena Token Library will include:

  • Paying Corporate Dividends to Common Shareholders
  • Making Interest Payments on Fixed Coupon Bonds
  • Making Interest Payments on Multi-Tranche Structured Products with Variable Payments
  • Conducting Shareholder Meetings with Proxied Voting
  • Making a Tender Offer to Purchase Tokens

We encourage current and potential issuers of Security Tokens to contact us for more information on using our library to accomplish their goals.

Legal Notice

Athena Blockchain BBLLC is a blockchain based limited liability company that is affiliated with several FINRA registered broker dealers, each of which may or may not deal in securities. It is affiliated with Athena Bitcoin, Inc, which is a corporation that buys and sells bitcoin and other crypto-currencies.

Copyright Notice

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Disclaimer

This report is for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem. The opinions expressed in this document are the opinions of the individual author(s) and may not reflect the opinions of the firm.