The Legal Framework for Security Tokens

Security tokens, a digital representation of ownership in an asset, are subject to securities laws. This is because they are considered securities, similar to stocks and bonds. The legal framework for security tokens is still developing, but there are some key principles that have been established.

Understanding Security Tokens

Security tokens or digital security tokens are digital representations of ownership in an asset, much like traditional securities like stocks or bonds, but issued and managed on a blockchain. This underlying technology brings transparency, efficiency, and potentially greater liquidity to the process.

Think of it this way: a company wants to raise capital. Traditionally, they might issue shares of stock. With security tokens, they issue digital tokens representing ownership in the company, stored on a blockchain. Each token signifies a fraction of ownership, similar to a share.

Security Tokens vs. Utility Tokens

The key difference is that security tokens are subject to securities regulations, just like traditional assets. This distinguishes them from utility tokens or Initial Coin Offerings (ICOs), which provide access to a product or service. Security tokens represent an investment contract, meaning the investor expects profit from the efforts of others.

Advantages of Security Tokens

Security tokens work on a blockchain, and they can offer advantages like fractional ownership (allowing smaller investments), automated compliance, and faster settlement times on the authentication server. They have the potential to democratize investment by making it more accessible and efficient.

Why are Security Tokens Subject to Securities Laws?

The main reason why security tokens are subject to securities laws is that they are considered investment contracts. This means that they are investments where the investor expects to make a profit from the efforts of others. This is the same test that is used to determine whether or not a traditional security is subject to securities laws.

Key Legal Principles That Apply to Security Tokens

Understanding the legal landscape surrounding security tokens is important for both issuers and investors. Because they represent ownership in an asset and are offered for investment, security tokens fall under existing securities laws. There are some key legal principles, including relevant acts and tests, that govern their issuance and trading, ensuring compliance and investor protection.

Here are some of the key legal principles that apply to security tokens:

• Securities Act of 1933: This act requires that all securities offered or sold to the public in the United Kingdom must be registered with the Securities and Exchange Commission (SEC), unless an exemption applies.
• Securities Exchange Act of 1934: This act created the SEC and gave it the power to regulate the securities industry.
• Howey Test: This test, established by the Supreme Court, is used to determine whether or not an investment contract is a security.
• State Securities Laws: In addition to federal laws, security tokens are also subject to state securities laws (also known as “Blue Sky Laws”) in some situations.

Security Token Exemptions from SEC Registration

While security tokens are generally subject to SEC regulations, several exemptions allow businesses that issue security tokens to offer and sell them without full registration. These exemptions are important for facilitating capital formation, particularly for smaller companies and innovative projects. However, it’s essential to understand that these exemptions come with specific requirements and limitations.

Regulation D (Reg D)

Reg D is a widely used exemption for private placements. It offers several distinct rules, such as Rule 506(b) and Rule 506(c).

Rule 506(b) allows for raising an unlimited amount of capital but prohibits general solicitation or advertising. It also limits the number of non-accredited investors.

Rule 506(c), on the other hand, allows for general solicitation but requires all investors to be accredited investors (meeting specific income or net worth thresholds).

Regulation A+ (Reg A+)

Reg A+ provides a scaled-down version of a public security token offering, often referred to as a “mini-IPO.” It allows companies to raise up to $75 million in a 12-month period. Reg A+ has two tiers:

• Tier 1 allows for raising up to $20 million and is subject to state-level review.
• Tier 2 allows for raising up to $75 million and preempts state review for qualified purchasers.

This exemption is suitable for larger raises than Reg D but involves more extensive disclosure requirements.

Regulation Crowdfunding (Reg CF)

Reg CF enables companies to raise up to $5 million from a large number of investors through online platforms. It is designed to facilitate smaller raises from the general public. Reg CF has specific requirements for disclosure, intermediary involvement, and investment limits per investor.

Exemptions Don’t Mean No Regulatory Oversight

It’s important to note that using an exemption doesn’t mean complete freedom from regulatory oversight. Issuers must still comply with anti-fraud provisions and other applicable securities laws.

Challenges and Opportunities of the Security Token Legal Framework

The legal framework for security tokens is still developing. There are a number of challenges that need to be addressed, such as:

• Lack of clarity: The SEC has not yet provided clear guidance on how security tokens will be regulated.
• International regulation: There is a lack of international harmonization of security token regulations.
• Enforcement: The SEC has been taking a cautious approach to gain access and enforcement in the security token space.

Despite the challenges, there are also many opportunities for security tokens. They have the potential to:

• Increase liquidity: Security tokens can make it easier to trade illiquid assets.
• Reduce costs: Security tokens can reduce the costs associated with issuing and trading securities.
• Increase access: Security tokens can make it easier for investors to access alternative investments.

One Legal Square LTD. Provides Guidance Through the Security Token Legal Framework

The legal framework for security tokens is still developing. However, it is clear that security tokens are subject to securities laws. This means that issuers of security tokens must comply with a number of regulations. Despite the challenges, security tokens have the potential to revolutionize the financial industry.

. offer in-depth insights regarding your investments and assets. Our blockchain lawyer team has helped many clients achieve their goals with security tokens. Call us today or use our online contact form to schedule a consultation to discuss your options with digital assets.