Tokenized Security Regulations
Security tokens are gaining popularity as a way for companies to raise funds and offer investors future gains, such as dividends and interest. They have a liquidity advantage over traditional securities and make transactions more efficient. As the popularity of digital assets and Security Token Offerings (STOs) rises, the governmental and regulatory agencies become more involved in monitoring the process.
Sometimes it is hard to apply appropriate laws to ground-breaking products and services that are based on ever so quickly evolving technologies like blockchain. At the moment of launch, there might not even be a proper way to classify them. However, as Stephanie Avakian, Co-Director of the US Security and Exchange Commission’s Enforcement Division puts it,
“The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets.”
Currently tokens have to go through the Howey Test in order to be classified as either security or utility, in accordance with the Securities Act of 1933 and the Securities Exchange Act of 1934. In short, it determines whether “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” If the answer is yes, we are looking at a security token. In the case of tokenized real estate, individuals and institutions invest their fiat or crypto (money) in tokens backed by real assets (common enterprise) that are provided by a company (third party) which will manage the properties and distribute the profits (e.g. from rent) to the investors.
The current consensus is that all security offerings can either be registered with SEC or exempt under the Securities Act of 1933. Both options have advantages and disadvantages, depending on the investor pull a company is trying to reach and the target capital it needs to raise.
Filing for registration with SEC will lead to a public offering. On the one hand, this will allow participation of both accredited and unaccredited investors, public advertising of the offering, immediate trading of tokens and unlimited capital to raise. On the other hand, this is a lengthy and expensive process that not many companies can afford. It requires periodic reporting at least every quarter, which can distract management from focusing on real performance and prospects rather than immediate results to showcase. It also requires separate registration in each state where securities will be offered (blue sky laws) and forbids any written offers to sell before registration with SEC comes into effect.
Alternatively, there several ways to file for exemption, such as Reg A+, Reg D, Reg S and Reg CF.
Exemption under Regulation A+ is the closest to actually registering with the US Security and Exchange Commission. It will also require a review by SEC (taking up to a year) and reporting every six months. No investment company can qualify for this regulation and secondary trading is subject to blue sky laws. The funds to raise are limited to $50 mln. Its biggest advantages are the opportunity to transfer securities immediately and lack of restrictions on the investor’s status.
Within Regulation D there are Rule 506 (b) and Rule 506 (c). The first one is more popular for traditional securities and the second one — for STOs.
Rule 506 (c) only allows accredited investors to participate with the issuer having to confirm the status. It also locks in the investments, only allowing token transfers after 12 months. On the bright side, there is no limit to the capital the issuer can raise. Moreover, securities under this rule can be advertised and traded on a publicly available website with no need for invite-only network restrictions.
Rule 506 (b) follows a similar logic but allows up to 35 unaccredited investors to participate, does not require the issuer to verify the status of accredited ones and forbids public advertising.
Regulation S puts an international spin on securities. This exemption is applied when a security is offered and sold outside of the US. It requires an offshore transaction (cannot be to a US person or someone physically located in the US) and forbids advertising on the US territory. This regulation is non-exclusive and allows issuers to rely on other exemptions as well. For instance, securities can be offered in a private placement in the US under Reg D and offshore — under Reg S, as long as there are no conflicting forces (e.g. as a result of advertising).
Regulation CF allows engaging early adopters and users of a product or service since it doesn’t require investors to be accredited. However, this exemption also limits the capital to $1.7 mln, requires annual reporting, forbids investment companies to apply for this exemption and locks up tokens for a year.
As you can see, there are many rules that will affect security token offerings, their benefits and limitations for the issuers as well as investors. They offer different options to ensure that the goals of STOs are met and investors are protected. As the SEC CEO Jay Clayton said,
“The SEC is studying the effects of the distributed ledger and other innovative technologies and encourages market participants to engage with us. We seek to foster innovative and beneficial ways to raise capital, while ensuring — first and foremost — that investors and our markets are protected.”
REINNO is compliant with Reg D and Reg S to make sure that its security token offering is fully legal in the US. However, we acknowledge that the 12-month lock-in period can compromise liquidity that security tokens offer. To address this issue we plan to offer Tokenized Instant Lending (TIL). With real estate backed tokens, borrowers will be able to take out a loan and preserve the ownership of their securities, making their investment liquid — instantly. For more information visit reinno.io
