Security Token Offerings (STOs) For NFTs? – 5 Things You Should Know Before You Take the Plunge | Oberheiden P.C.


Introduction: STO and NFT

STO stands for “Security Token Offerings”. They involve an offering of digitized securities such as stocks, bonds, or other token and coin projects. The difference between an IPO and an STO is that STOs are transferred and stored on blockchain technology. Both IPOs and STOs offer ownership interests and will usually also involve voting rights or the rights of investors to receive dividends. Also, the value of the “security” will generally rise and fall based on the value of the issuer.

The difference between an ICO and an STO is that an STO is registered or exempt with the Securities Exchange Commission (SEC) and complies with federal securities laws. ICOs are generally not registered with the SEC and have taken on a somewhat negative connotation with the SEC. For example, the ICO boom of 2017-2018 led to significant monetary losses and cases of fraud, circumstances that could have been largely avoided had issuers been forced to operate under the jurisdictional and regulatory authority of the SEC. As a result, STOs were developed to achieve the same purpose as ICOs (issuance of tokens or coins on blockchain technology), but in a way that complies with federal securities laws.

Non-fungible tokens (“NFTs”) are pieces of a digital asset that are stored on the blockchain. NFTs are unique and non-fungible, meaning they cannot be exchanged with each other. Each NFT is unique. This scarcity creates value. Ownership of each piece is held on the blockchain, representing a permanent and genuine record of ownership. No one can forget the NFT collage called “Every Day: The First 5000 Days” which was created by digital artist Beeple and eventually sold for $69 million. This article, written by STO attorneys in Oberheiden, PCprovides key tips and explanations to consider before launching an STO for your NFT project.

Thinking of an STO for your NFT?

Before launching a security token offering (STO) for your non-fungible token (NFT) project, consider the following five points:

1. Understand the difference between a utility token and a security token

The difference between a utility token and a security token is a fine but important line. Digital assets or investment contracts that meet the SEC’s definition of “security” are called “security tokens” and therefore must be registered with the SEC or be subject to an applicable exemption. The value of a security token often correlates with the value of the company. Buyers are buying security tokens with the intention of holding onto the token and making a profit. Although security tokens are registered with the SEC and comply with federal securities law, the costs of compliance are often significant, not to mention the extremely detailed and onerous disclosure obligations of registration.

Digital assets or investment contracts that do not meet the SEC’s definition of “security” are called “utility tokens” and therefore do not need to be registered or exempted at all. Utility tokens do not derive their value from the company, but rather fluctuate in value based on supply and demand. They provide users with the ability to use the token within a closed ecosystem to purchase goods or services or for other specific intended purposes. While inexpensive, utility tokens have a higher potential for fraud because they are unregulated.

2. Before launching a token offering, have an attorney assess whether the token meets the SEC’s definition of “security.”

To determine whether a new coin or token is an “investment contract” or a “security,” the SEC and the courts use a test called the Howey Test. Howey’s proof comes from a 1946 Supreme Court opinion: SEC v. W. J. Howey Company328 US 293 (1946). The test has four points, each of which must be met in order for the new coin or token to be considered and thus regulated as a “security”. These four points are explained in more detail in the SEC document “Framework for the analysis of “investment contracts” of digital assets”, issued in 2019. In summary, the four points are as follows:

  1. An investment of money;
  2. In a common company;
  3. With the expectation of profit;
  4. Derived solely from the efforts of third parties.

If one or more items are not met, the coin or token is not a security, it is a utility token, and does not need to be registered or exempted.

3. Launching an STO for your NFT project could open the door for other compliance obligations

Compliance with federal securities laws for your NFT project may not be the end of the story. His draft may involve several additional compliance obligations, one of which relates to the Investment Advisers Act of 1940 (“IAA”). For example, if someone in his business provides financial advice or financial projections for a fee, he may be considered an investment adviser and may be registered as such with the IAA.

In addition, many NFT projects that are “securities” will need to implement AML/KYC policies and procedures, including a comprehensive AML Compliance Program. The platforms that offer the securities can be considered financial institutions under the AML Act of 2020 or possibly the Bank Secrecy Act (“BSA”) in connection with activities involving virtual currency transmission services.

Finally, in addition to registering your NFTs under the Securities Act of 1933, you will also be required to comply with various ongoing reporting and disclosure obligations under the Exchange Act of 1934. In some cases, if you are using a platform of the type exchange for your NFT Project, that exchange may also need to register with the SEC. In addition, certain people who trade these NFTs as “securities” will need to register as broker-dealers.

4. There may be one or more exemptions to the registration of your NFT project

Before you get consumed with the prospect of the SEC registration process, there may be several exemptions available for your NFT project. At this point, those interested in issuing NFTs through an STO should understand that there is also an exemption for projects that attract non-UC investors. This can be very important because STOs often involve multiple countries and individuals from multiple countries. For example, if an individual or company wants to offer their NFTs to US and non-US investors, they can use both the 506(c) exemption for US investors and Regulation S for non-US investors.

5. Failing to properly register your NFTs with the SEC when it is a “security” can lead to multiple violations and consequences

If your NFT project is not registered or properly exempted, the individuals or company behind its issuance may find themselves in the midst of an SEC investigation for selling unregistered securities and for violating the anti-fraud provisions of the federal securities laws. This can wreak havoc on one’s career and reputation.

“STOs are growing in both number and value. Failure to properly comply with the SEC’s registration or exemption provisions for your NFT project where it meets the definition of “value” could result in fines, penalties, remand orders, injunctions, and irreparable reputational damage. . Therefore, it is important to hire a lawyer with experience in STO and NFT projects first.” – Dr. Nick Oberheiden, founding attorney at Oberheiden PC

Conclution

Security Token Offerings (STOs) are a recent phenomenon that facilitate the issuance of digital tokens on blockchain technology. These security tokens are offered to the public in a manner that complies with the registration provisions of the federal securities laws. Individuals and companies that issue non-fungible tokens (NFTs) may have to register their NFTs as securities. Before taking any major steps towards launching a Security Token Offering (STO) involving NFT, you should consider the five points discussed in this article, as well as retain an experienced STO and NFT attorney.