Security Token Offerings (STOs) for NFTs? – 5 things you need to know before you start | CP Oberheiden

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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. IPOs and STOs offer equity and usually also involve voting rights or the right of investors to receive dividends. Also, the value of the “security” will generally rise and fall with 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 acquired a somewhat negative connotation with the SEC. For example, the ICO boom of 2017-2018 led to significant monetary losses and instances 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 goal as ICOs – issuing tokens or coins on blockchain technology – but in a manner 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, which means they cannot be exchanged for each other. Each NFT is one of a kind. This scarcity creates value. The ownership of each coin is located on the blockchain, which represents a permanent and authentic record of ownership. No one can forget the NFT collage titled “Everydays: The First 5000 Days”, which was created by digital artist Beeple and ultimately sold for $69 million. This article, written by STO attorneys in Oberheiden, PC, provides key tips and explanations you should 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 small but important. 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 fall under an applicable exemption. The value of a security token is often correlated to the value of the company. Buyers buy security tokens with the intention of holding the token and making a profit. Although security tokens are registered with the SEC and compliant with federal securities law, compliance costs are often significant, not to mention the extremely detailed and onerous disclosure requirements of registration.

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

2. Before initiating a token offering, have an attorney assess whether the token meets the SEC’s definition of a “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. The Howey test comes from a 1946 Supreme Court opinion: SEC vs. WJ Howey Company, 328 U.S. 293 (1946). There are four parts to the test, each of which must be satisfied for the new coin or token to be considered and therefore regulated as a “security”. These four components are further explained in the SEC’s “Framework for ‘Investment Contract’ Analysis of Digital Assets”, published in 2019. In brief, the four components are:

  1. An investment of money;
  2. In a joint venture;
  3. With the expectation of profits;
  4. Derived solely from the efforts of third parties.

If one or more items are not satisfied, 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 to further compliance obligations

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

Additionally, many NFT projects that are “securities” will need to implement AML/KYC policies and procedures, including a comprehensive AML compliance program. The platforms offering the securities may qualify as financial institutions under the AML Act of 2020 or possibly the Bank Secrecy Act (“BSA”) regarding activities involving virtual currency transmission services.

Finally, in addition to registering your NFTs under the Securities Act of 1933, you will also need to comply with various reporting and disclosure obligations under the Exchange Act of 1934. In some cases, if you use a type exchange for your NFT project, this exchange may also need to be registered with the SEC. Additionally, some people who trade these NFTs as “securities” will need to be registered as brokers.

4. There may be one or more registration exemptions for your NFT project

Before you dive into the prospect of the SEC filing process, there may be several exemptions available for your NFT project. On this point, those interested in issuing NFTs through an STO should understand that there is also an exemption for projects that are attractive to non-UC investors. This can be very important as CSOs often involve multiple countries and individuals from multiple countries. For example, if a person or company wants to offer their NFTs to both US and non-US investors, they can use both the 506(c) exemption for US investors and Regulation S for non-US investors.

5. Failure to properly register your NFTs with the SEC when it comes to “value” can result in multiple violations and consequences

If your NFT project fails to register or is properly exempted, the people or company behind its issuance may find themselves in the middle of an SEC investigation for selling unregistered securities and violating anti-fraud provisions of federal securities laws. It can wreak havoc on his career and reputation.

“STOs are increasing both in number and in value. Failure to comply with the SEC’s registration or exemption provisions for your NFT project where it meets the definition of a “security” could result in fines, penalties, restitution orders, injunctions and irreparable damage to reputation. It is therefore important to first retain a lawyer experienced in STO and NFT projects. – Dr. Nick Oberheiden, founding lawyer of Oberheiden PC

Conclusion

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 consistent with the registration provisions of the federal securities laws. Individuals and companies that issue non-fungible tokens (NFTs) may need to register their NFTs as securities. Before taking any significant steps to launch a Security Token Offering (STO) involving NFTs, you should consider the five points discussed in this article as well as retain the services of an experienced STO and NFT attorney.

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