Security Tokens in Europe for Issuers and Trading Venues
Legal Disclaimer: Please note, none of the information above should be relied upon as legal advice. Please contact Diacle to assist you in finding a suitable lawyer for your requirements.
Who should read this note
This note is intended for companies seeking to raise capital through the issuance of Security Tokens or for companies that intend to provide a trading venue for Security Tokens in the EU.
The EU is interesting as a market for Security Tokens as there are 500 million people in the EU and the laws for capital formation and trading of financial instruments are harmonised, this means an Issuer or Trading Venue needs to comply with EU law to be able to access all of the single market. In addition, the EU has introduced more flexible regulations for capital formation allowing for companies to raise up to EUR8m without the need for an approved prospectus. This makes the EU one of the most important and cost effective markets for the issuance and trading of Security Tokens.
This note asserts that Security Tokens are technical innovations of regulated securities and that they would be formally defined under EU law as Transferable Securities. The note states that centralised (where the control of the Security Tokens is with the Trading Venue rather than the participants) Security Token exchanges would be regulated, but it is unclear if decentralised markets will be. Lastly the note states that some ‘unconventional’ Security Tokens (defined as instruments that are not strictly defined under MIFID or Prospectus Directive) may be captured under Alternative Investment Fund Manager (AIFM) or local interpretation of EU definitions.
Definition. Security Tokens are in effect a technical innovation of a security (a security that exists solely in a digital form) so the legal definitions under EU law are well established in most areas.
Security Tokens are Transferable Securities. Under EU law, Security Tokens will most likely be considered Transferable Securities and/or Financial Instruments and therefore companies interested in capital formation for themselves in the EU will need to consider the Prospectus Directive. Regarding the issuing of Financial Instruments it is unclear whether non-investment firms involved in capital formation would need themselves to be licensed under MIFID, legal advice should be sought at a local level. In any event, for brokers and advisors involved in the Issuance, Distribution of Financial Instruments it is important to consider that their activity is likely to be licensable under MIFID.
Centralised Security Token exchanges will need to be licensed. Centralised Trading Venues of Security Tokens will need to be licensed as an MTF/OTF under MIFID but also need to obtain a Central Securities Depository (CSD) licence or cooperate with a CSD licensed operator.
Decentralised Security Token markets may currently fall outside of the scope of MIFID. It is arguable that Decentralised Security Tokens trading venues may not constitute Trading Venues for the purpose of MIFID and therefore may fall outside the scope of the requirements of CSD Regulations as well. That said this is a tentative approach for Decentralised Security Token trading venues looking to operate in the EU market.
Treatment of Unconventional Security Tokens. Unconventional Security Tokens (securities not strictly defined as Transferable Securities or Financial Instruments) could be captured directly by EU law under AIFM or via local re-interpretation of underlying instruments supporting EU law definitions or simply these instruments may be regulated at a local level (‘gold-plating’). It is critical for Unconventional Security Token issuers to locate a suitable local EU jurisdiction depending on how they wish for the instrument to be categorised.
Other local requirements. It is important to consider particular local requirements in the EU surrounding the transfer of Transferable Securities (Share tokens and Bond tokens in particular) before choosing a particular EU jurisdiction to issue your Security Token from.
Further details/analysis based on this Note:
Below we provide a framework of relevant questions that are the basis for the summary findings above:
How are Security Tokens classified in the EU?
They are either:
Financial Instruments (as defined by MIFID) being derivatives, options or similar
Transferable Securities (as defined by Prospectus Directive, hence MIFID) being Shares or Bonds or warrants for the same
For unconventional Security Tokens (described below) these could be regulated at a national level or under EU laws for Alternative Investments.
But Security Tokens are not all shares or bonds, some of them have a unique design, are they still Transferable Securities or Financial Instruments?
Some stakeholders have referred to what appears to be ‘unconventional’ Security Tokens and consider there may be a ‘carve out’ for these instruments. This is based on the contrast between a United States definition of a ‘security’ being ‘substance-based’, whereas the EU’s definition is form-based and exhaustive. The inference might be for Issuers and Trading Venues that these instruments sit outside of the purview of EU law. A ‘non-conventional’ Security Token may be characterised as instruments that offer, for instance, a form of contract-based return to investors delivered through a smart contract to the token holders. It is arguable that these ‘unconventional’ Security Tokens will still be regulated as a result of a 1) a broader local (in the sense of Member State level) interpretation of the underlying instrument of a Transferable Security or Financial Instrument (for instance, a local court may re-define locally what a ‘bond’ is in a non-formal manner through primary legislation as there is no harmonisation of these definitions in the EU) 2) local regulation of investment instruments (this refers to the ‘gold-plating’ of regulation in EU where Member States may decide to regulate other forms of financial services not covered by EU law) or 3) they could be captured at an EU level through Alternative Investment Fund regulations
Local interpretation of EU definitions & local regulations. The EU is intended to provide cross-border minimum standards for financial services. These appear to be defined at a local level according to local law. If unconventional Security Tokens are interpreted as ‘Transferable Securities’ or ‘Financial Instruments’ at a local level then EU regulations would presumably apply by extension; this is due to the fact that Member States appear to be provided with some discretion surrounding the definition of the underlying instruments referenced in MIFID or in the Prospectus Directive. Furthermore, it is equally possible for a Member State to regulate at a domestic level non-EU regulated investments. For instance, in the United Kingdom Collective Investment Schemes are regulated in the UK under UK law whether or not they constitute AIF or UCITS.
EU Law capture. EU Law that does not capture an ‘unconventional’ Security Token may, however, be captured under the AIFM; any form of revenue share arrangement may be considered an Alternative Investment Fund (AIF) if funds are collected from investors for investment to generate a profit to share with investors. Fund managers of such structures would need to be licensed to operate.
What the implications of Security Tokens being regulated under EU law?
The first implication relates to their issuance, distribution throughout the EU region. The second is in relation to their trading in secondary markets.
The Issuance of Security Tokens classified as Transferable Securities would require compliance with the Prospectus Directive. The Prospectus Directive restricts the offer to the Public of Securities unless the Prospectus has been approved. However, if less than EUR8m is being raised over 12 months then there may be an exemption.
In relation to issuing Financial Instruments, issuers will need to consider whether they need to be licensed under MIFID for the same. MIFID states that all ‘Investment Firms’ need to be licensed to Issue and Distribute Financial Instruments even if for themselves. The FCA takes a more nuanced interpretation here stating that a ‘commercial company’ who is not professionally providing a financial service should not need to be licensed to issue itself Financial Instruments. Legal advice should be sought locally where the Issuing is taking place to understand the treatment here.
Trading Venues and the application of MIFID and MiFIR to centralised Security Tokens Trading Venues and decentralised trading venues (non-capitalised as not an EU defined term).
MIFID regulates all Trading Venues in the EU. These are typically Multilateral Trading Facilities or Organised Trading Facilities. Centralised Security Tokens Trading Venues will certainly be caught by the requirement to be authorised to ‘Operate an MTF or OTF’. However, it is unclear whether decentralised Security Tokens trading venues will be subject to the same; looking at MiFIR there appears to be a recognition that ‘bulletin boards advertising selling or buying interests’ would not be captured which may be the case in relation to a fully decentralised trading venue. However, this interpretation of MIFID would be a matter to be considered by local interpretation of EU law.
What is the impact of Central Securities Depositories on the secondary trading of Security Tokens on centralised Trading Venues?
This Regulation was introduced by the European Union to improve the settlement of securities being traded on Trading Venues. The purpose of these Regulations is to progress the transfer of securities on trading venues and to institute minimum standards for settlement of securities throughout the EU. Furthermore, these Regulations are meant to liberalise the licensing of CSD, offering the licensable activity to a greater pool of stakeholders. For Issuers of Security Tokens the CSD Regulations requires the Issuer to arrange that the Securities should be presented in ‘book-entry form as immobilisation or subsequent to a direct issuance in a dematerialised form’. For Security Tokens they are natively issued in a ‘dematerialised form’, however, they would still need to be presented to the CSD to hold in ‘book-entry’ form. As Security Tokens on a blockchain are, in principle, in a ‘book-entry’ form when combined with a software application to monitor the change of ownership, we may conceive that CSDs may elect to accept the ‘book-entry’ system presented by the Issuer subject to the CSD being satisfied that that system meets its own requirements under CSD Regulations. Technically, this could be effected via a switch of the administrator controls of the smart contract controlling the administration of the Security Token. However, the ‘adoption’ of an external ‘book-entry’ system by the Trading Venue would only be of marginal interest to a Trading Venue and is likely to increase the risk for the Trading Venue due to the current diversity of blockchain-based Security Token systems. In any event, it follows that for centralised Trading Venues in Security Tokens, CSD Regulations are highly relevant and they would themselves need to seek authorisation directly for that activity or cooperate with an already authorised CSD.
Decentralised Security Token trading venues and the application of MIFID/CSD.
To remove the applicability of CSD Regulations, it could be conceivable for a decentralised trading venue of Security Tokens to argue that it is neither a MTF/OTF under MIFID and rather a ‘bulletin board’, in which case a CSD would not be required in any event. This is a highly tentative argument and is unlikely to be a sustainable position due to 1) the lack of a fully decentralised solution for P2P trading which does not entail some form of delegation of ‘rights’ to the exchange 2) the lack of recourse in the event of a trade failure due to the smart contract or underlying blockchain.
What is the impact of local regulations on the transfer of Transferable Securities?
Local law regulates the formalities of transfer if transfers of a Transferable Security occurs outside of a Trading Venue and therefore outside of the jurisdiction of CSD Regulations. Transfers of equity interests in for example Roman Law jurisdictions may entail Notaries; separately, Stamp Duty may be applicable on transfers of equity interests in certain jurisdictions. These may present additional steps for Security Token issuers to consider.
Are ‘Unlisted’ equity-based Security Tokens outside of scope?
Lastly, there may be some discussion surrounding whether ‘unlisted’ shares in a company might be excluded from the definition of a Transferable Security and therefore outside of the scope of the Prospectus Directive. To this ESMA has provided clear guidance notes whereby they state that they consider company shares subject to shares restrictions stipulated in a shareholders’ agreement as being Transferable Securities. Further, at a Member State level, the UK FCA’s interpretation of Transferable Securities constitutes “shares in companies (whether listed or unlisted)”
References for this article can be found here.