- STOs – there’s a clue in the title – are securities, and nobody will be arguing that they aren’t – That means that they are regulated, not just on the issuance, but also on the secondary trades.
- The cost associated with an STO, from a legal point of view, is higher than a Series B investment round. But if a company is marketing the Series B rounds of venture capital, why not, in parallel, market STOs?
- At the start of this year, the FCA published a cryptoasset guidance for consultation. The results are expected to be published in June or July of this year, and this will give us much clearer guidance on where security tokens are going to sit and what the landscape is going to look like.
- The FCA and HMRC are knowledgeable on the subject of cryptoassets and they’re taking the time to ensure that that guidance is appropriate and proportionate.
- Security token offerings require capital markets. Gibraltar, Malta, Estonia, and others, don’t have capital markets like that. Okay, Hong Kong and Singapore do, but the two biggest capital markets in the world are London and New York, so, London and New York will have a place.
Please introduce yourselves and Baker Botts to our readers.
Neil Foster: My name is Neil Foster and I’m a Corporate Technology Partner. I’ve been working in the technology area since the mid-’90s. The fastest growing area of our practice, following the new technologies that our clients work with, is on the cryptoasset side. Amongst other things, I chair the BBFA cryptoassets working group, we’ve done quite a lot of work in this area already and I hope that, as STOs and other cryptoassets escalate and become more mainstream, we’ll be heavily involved in the sector in all of our 14 offices across four continents.
Daniel Green: My name is Daniel Green and I’m a Corporate Finance Associate. I first became involved in cryptoassets when writing a thesis on the subject a few years ago, and I’ve been involved ever since.
What benefit of doing STOs do you see for your clients?
Neil Foster: If you look at the 2017 ICOs, they were not necessarily for companies that had minimum viable products, their white papers were fairly slim, etc. STOs will have to be completely different from that. STOs – there’s a clue in the title – are securities, and nobody will be arguing that they aren’t – That means that they are regulated, not just on the issuance, but also on the secondary trades.
So there will be a big benefit for a lot of our clients that are ready to issue securities. And not really the small-scale ICO that might be a prepayment for t-shirts, a gig ticket and all sorts of best endeavors to produce a product, but these will be companies with products, and they tend to be the companies that we’re working with. Now, we do work with complete startups, but very often the deals that we’ll do will be sort of Series B, Series C companies. And if they’re ready to issue shares to venture capitalists, corporate venture capital, etc., then they will be ready to issue STOs, because they’ll understand the landscape. The big advantage is that these companies aren’t ready to be public companies, and so, generally speaking, shares in private companies won’t have any liquidity, they won’t be tradable, but STOs will be.
Do you see STOs as being a crowdfunding VT, where I’m able to go off and own $25 in a small company or do you really see this as a bigger play?
Neil Foster: It is very, very similar to crowdfunding and crowdfunding required a change of the law on April 1st, 2014. But investments of 50 pounds here or there are not going to work for a security token. The reason for that is because the issuance is regulated, they are securities. Okay, they are with crowdfunding, but with crowdfunding, you have regulated platforms, etc. And until we get to a time where there is a regulated platform like Crowdcube or Seedrs and others, it will be quite difficult for people to write small checks – for example, 50 pounds, dollars, or fraction-of-a-bitcoin investments. It will probably need to be bigger than that. But I do see this as a next generation crowdfunding.
What would you say to a client considering an STO? Should they consider it or should they avoid it? What stage do you think we’re at?
Neil Foster: First we’d work out the stage the company is at, and then, because there is regulatory uncertainty at the moment, and because it’s the early days for high-quality STOs, that means that the costs associated with it are high. The cost associated with an STO, from a legal point of view, is higher than a Series B investment round, and a Series B round might be 20 to 30 million.
So, if the company has intellectual property, customers, even early revenues and they’ve got a MVP and they are marketing securities anyway, then it is only a marginal increase in work, because they are already having to be compliant and they are talking to people like us and they understand that if they want to attract capital, not just from the traditional ICO investor but with STOs, they are going to have to know who holds those tokens in what jurisdiction. And so, it is going to be different.
But certainly, if a company is marketing the series B rounds of venture capital, why not, in parallel, market STOs? Now, does it have to be done in parallel? No, if it’s big enough, and especially if the company has technology in these areas – some of the deals that we’ve done, the companies are “blockchain as a service” companies rather than “software as a service” companies, for example. Those platform type software companies, it’s ideal for them to launch STOs.
Regarding regulation, the general view seems to be that there aren’t really any regulatory changes required. What’s your take on that? And secondly, you work very closely with financial regulators in the UK – the Financial Conduct Authority, the tax office, HMRC and other government bodies. Do you think that the UK government is managing this opportunity with STOs and cryptoassets fast enough?
Neil Foster: The key point is that STOs are regulated. If it’s regulated and if they’re trying to attract institutional money, which has got to be the future, then we’ll be talking about on-the-shore, high-quality, regulated security token offerings. That means that you can tap into the venture capital markets in London, New York and Silicon Valley. If everyone accepts that it’s a security, we’ve got hundreds of years’ worth of securities laws and we apply those.
What we haven’t had in the UK is a new law to do with cryptoassets. Now, we’ve had quite a lot of debate and we’re very active, but then we’ve had Malta and Gibraltar and elsewhere, that have brought in their own regulations and they’re ahead of the game. Obviously, they don’t have deep wells of capital in those jurisdictions, but they do have a regulatory advantage on us. But then again, if something is a security, it isn’t something people should be wary of, being high quality and on the shore.
Daniel Green: We all know that the government is very busy with the B-word at the moment. However, there are quite a few things going on in the background in relation to cryptoassets and the DLT more generally. We have the cryptoasset task force, which is a group comprised of the Treasury, the Financial Conduct Authority and the Bank of England, and they, in the tail-end of last year, published fairly comprehensive guidance on cryptoassets, setting out the basis of taxonomy. Following on from that, at the start of this year, the FCA published a cryptoasset guidance with a consultation. The results are expected to be published in June or July of this year, and I think this will give us much clearer guidance of where security tokens are going to sit and what the landscape is going to look like.
In addition to that, HMRC is working very hard in the background. They’ve published personal tax guidance in December last year and they’re currently working on corporate tax guidance. So, I think once we have all these pieces in place, the landscape will be much clearer. And there are two encouraging things from our perspective. The first is that there is some extensive consultation taking place, and I think that’s important to ensure that stakeholders are able to input their view, and separately, all the people that we’ve spoken to – the FCA and HMRC are knowledgeable on this subject and they’re taking the time to ensure that that guidance is appropriate and proportionate. One of the key things is that we get the taxonomy right, to ensure that the various classes of cryptoassets are regulated appropriately, and in that respect, I think it’s important that those more thought-out and delayed regulations are perhaps better.
Could taxation be challenging with regards to secondary markets and exchanges?
Neil Foster: I’m on the HMRC cryptoassets working group, and when it comes to security tokens, there should be no tax on the issuance. The way that our UK-based accounting works should mean that, on an accruals basis, the company issuing the security token isn’t taxed straight away. Now, it’s slightly different in America because they account on a cash basis, not on an accruals basis, and that matters a lot, because if you issue a token and have 25 million dollars coming in, and you’re taxed on a cash basis, then you’re taxed straight away, but you haven’t necessarily built the product yet. So that’s an advantage for our jurisdiction from an accruals accounting perspective.
Then we’ve got the secondary transfers, but we’ve got to make sure that it’s clear that VAT doesn’t apply to the transfer in and out of European jurisdictions, and it shouldn’t with security tokens. Also, if a security token is a bit like share capital, then what about the stamp duty? Stamp duty is referable to the transfer of shares of English companies and so, if stamp duty is referable to it, everyone is just going to simply incorporate a Gibraltar or Malta or Ireland or wherever outside of the UK company and issue its security tokens out of those. And that’s not in HMRC’s interest either, which is why I am busy liaising with HMRC on that very point.
You both mentioned Malta, Gibraltar within Europe, there’s also Singapore and Hong Kong in Asia, and then you have the big financial hubs: London, New York. Where do you see the market going? You’ve got these smaller, more nimble, dynamic jurisdictions and then you’ve got big, old, slow, heavily regulated London. Do you think London or New York are going to catch up, could they even be the leaders in the future?
Neil Foster: Security token offerings require capital markets. Gibraltar, Malta, Estonia, and others don’t have capital markets like that. Okay, Hong Kong and Singapore do, but the two biggest capital markets in the world are London and New York, so, London and New York will have a place.
The other two big areas will be stable coins and fractional ownership under a unit trust or collective investment scheme type. That could be fractional ownership of a media library, film library, music catalog, that type of thing. So intellectual property, but also real property. Now, all of those STOs, fractional ownership, stable coins – they all require large pools of capital. They could structure things using Gibraltar or Malta, but you’re not going to have similar pools of capital in those jurisdictions, you need London and New York. You might need Singapore and Hong Kong, but the capital markets will begin to dominate. For that to happen, and it’s slightly counter-cultural for the decentralized movement that cryptoassets are associated with, the institutions need to play – institutions being banks. Bank accounts need to be opened, and that’s a problem that will be dealt with, but it hasn’t yet.
Another issue is research. Rather than flimsy white papers, actual research houses writing research on tokens are needed. And they can’t do that with a small issuance, but can do it with larger ones. And then there are corporate brokers, investment banks and merchant banks advising on STOs or stable coins, etc. – there will be money to be made. It will be a new asset class and it will be an opportunity for somebody to make a brokerage, and sensible people in the City of London we’ll do that, that’s emerging already. And then the other institutions that need to play in this market are the exchanges, and exchanges are emerging as well. All of these institutions are not going to be interested in small ICOs for companies with no products, that are going to be interested in larger alternatives to IPOs, because a lot of smaller companies have no alternative but to go to the capital markets too early and become public companies. And this is an alternative and it’s an alternative private equity class, but with liquidity.