We have recently published a research paper on tokenized equity, together with law firm Watson Law. The following is an adapted excerpt from our report; please download the full report here.

Blockchain-based tokens have a variety of use cases and can be grouped into different categories. Increasingly, companies are looking into the possibilities of issuing and managing securities via blockchain technology. These developments have caused a rapid increase of interest in security tokens (synonym: digital securities). In our daily work with these concepts and as writers of the weekly newsletter on tokenized assets, we continuously notice the lack of understanding of when a token classifies as a security. Creating clarity on how a token is qualified is important, since it defines what regulations are triggered and what your business has to comply with. Let’s discuss this topic in light of European and Dutch legislation. 

 

What are Securities?

Securities are tradable financial instruments such as equity, bonds and derivatives. The exact classification and definition may vary among countries. Under Dutch law, the definition of a security is derived from EU regulations, more specifically the Prospectus Directive and MiFID II. Therefore, the following definition is basically the same for all EU countries.

Under Dutch law, a security is defined as:

  • (a) a transferable share or other equivalent transferable security or right other than an apartment right;
  • (b) a transferable bond or other transferable securitised debt; or
  • (c) any other transferable security issued by a legal entity, partnership or institution that entitles the holder to acquire a security referred to under a. or b. above by exercising the rights attached to it or through conversion, or that gives rise to cash settlement.

 

When do Tokens Classify as Securities?

Securities can be ‘tokenized’. This means that securities are digitally represented in the form of a cryptographic token. These tokens are issued, registered and transferred via blockchain technology.

For a token to qualify as a security from a legal point of view, it must be:

  1. a digital representation of a share or a share-like instrument, a bond or a derivative instrument regarding the two aforementioned instruments; and
  2. negotiable.

Let’s dive into both points. For now, we will only discuss equity and thus will not dive into bonds. Tokenized bonds is a topic for a later post.

 

Digital Representation of a Share or Share-like Instrument

Shares are units of capital, expressing the ownership relationship between a company and shareholder. Shares can have a variety of characteristics; commonly they confer the right to receive dividends (a part of a company’s profit) or voting power regarding certain decisions which are to be made by a company. Share-like instruments are instruments — in this case tokens — that do not represent shares themselves but have the same characteristics as shares, such as the characteristics mentioned before.

In most European jurisdictions, such as the Netherlands, shares in a company that are not listed on a regulated market (for example a stock exchange) can only be transferred by means of a notarial deed. This means that it is not possible to transfer these shares via the transfer of tokens on a blockchain.

In case of the Netherlands, this transfer restriction does not apply to depositary receipts (share certificates) created by a trust office foundation. In such a structure, a company issues all or a part of its shares to a trust office foundation. The trust office foundation factually becomes a shareholder of the company and can issue depositary receipts for the number of shares it holds. These depositary receipts embody profit rights or voting rights or both, depending on the trust conditions under which the trust office foundation issues the receipts.

Depositary receipts, regardless whether they embody profit rights and/or voting rights, can be digitally represented by tokens and qualify as securities in the context of the previous paragraph. Depositary receipts are usually negotiable, but the exact details depend on the conditions of the trust.

 

Negotiability

An important characteristic of blockchain technology is that it simplifies the transferability of digital (tokenized) assets, such as bitcoin. Many tokens are developed for the purpose of being transferred and are therefore in most cases negotiable by nature. It is not required that a token is listed on an exchange to be considered negotiable, since tokens can always be transferred peer-to-peer.

However, the transferability of tokens can be limited on a smart contract and protocol-level, but limiting transferability is insufficient; only if a token is made non-transferrable, it will not classify as a security.

 

Security Tokens under EU Regulation

This article gives you a summary of when a token classifies as a security, specifically under Dutch and EU regulation. As stated, the token should be a digital representation of a share (or share-like instrument, bond or derivative) and it should be negotiable. If these two conditions are met, the token will indeed be considered a security. 

If you are planning to issue a token, there are a few things to consider. Before looking at whether the token will be qualified as a security, we advise our clients to first look at their potential benefits and limitations. Why do you want to issue a token, and what is the token supposed to do? There are a wide variety of questions that you should answer about your token to ensure you issue a well-thought out, tokenomically correct token — that actually provides value to your company or ecosystem. Once this phase is complete, the next step is to check whether the token you plan will indeed be seen as a security. This article can serve as a starting point. However, if you want to be more certain about the legal aspect of your token, please contact us. We have helped issue a wide variety of tokens, and can provide you with the right advice.

 

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