Introduction: What is a Digital Security Offering (DSO)?

Conducting digital security offerings (DSOs), or security token offerings (STOs) is time-consuming and can be quite complicated. You will need to consider factors such as whether you need to register, what platform to use, how to create the coin or token, what it will offer, and so on. Simply put, a DSO is an offer and sale of securities—digital securities—that exist on blockchain technology. They have no utility value or consumptive purposes and are typically used for investment purposes and have their value derived from the value of an external trading asset. Understanding DSOs is critical to proper issuance and monitoring. This article, drafted by the blockchain and token offering attorneys at Oberheiden, P.C., explains DSOs, their advantages, and the top ten points of consideration before launching a DSO.

Advantages of DSOs

Digital Security Offerings (DSOs) offer many advantages to the issuers, the public, governmental agencies, and capital markets. Below are just a few:

• Immediate access to capital for businesses seeking to expand;
• Lower entry barriers, especially for fractionalizing certain assets such as real estate;
• Access to international markets and international investors via global offerings;
• Automatic execution on smart contracts;
• Elimination of the third-party intermediary in transactions;
• Increase in the liquidity of the underlying asset; and
• Immutability and transparency due to using blockchain technology.

The above are only examples of the advantages a DSO has to offer. In all cases, best practices dictate hiring an attorney experienced in DSOs, SEC filing requirements, and the definition of “security.”

“DSOs still have to be registered with the SEC and comply with its ongoing reporting and disclosure obligations. A DSO may also be exempted from registration in certain circumstances. Failure to properly register or file an exemption could lead to significant fines and penalties. Therefore, it is imperative to hire an attorney experienced in digital security offerings.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.

10 Things to Know for Your DSO

A DSO can quickly become a time-consuming and complicated process. If you are considering launching a DSO, keep the following ten points in mind:

1. DSOs are securities offerings and must either be registered with the SEC or follow an applicable exemption to registration.

DSO involving digital securities or digital securities offered to the public at DSOs must register with the SEC or be exempted just like traditional securities. In close cases, courts and the SEC use the Howey Test to determine whether the offering constitutes an “investment contract,” or a “security”—requiring registration. The Howey Test has four prongs: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profits, and (4) derived solely from the efforts of others. All four factors must be satisfied in order for the token or coin to be classified as a security token. If one or more prongs fail the Howey Test, the token or coin is instead considered a utility token and does not need to register.

2. Consider the possibility that your DSO project may contain other registration obligations above and beyond registering your token.

If the digital token is classified as a “security” for registration purposes, it is important to also determine whether your company has any additional registration obligations. For instance, if you are offering and selling digital securities, then your platform may have to register as an exchange and the individuals dealing with the digital securities may have to register as broker-dealers or, sometimes, investment advisers.

3. Many DSOs can claim one or more of the SEC´s exemptions from registration.

The registration process takes an incredible amount of time and may involve significant expenses. Fortunately, many companies can rely on an exemption to registration, most notably Regulation D and Regulation S. Regulation D allows an issuer to avoid registration if certain conditions are met regarding accredited versus unaccredited investors and solicitation. Rules 506(b), 506(c), and 504 are the three key rules when dealing with Regulation D that issuers need to keep in mind when completing Form D. If the issuer is planning to offer the digital securities to non-U.S. investors, then can use Regulation S. Regulation S applies when the offering takes place in a foreign country. In such cases, the offering is exempt under U.S. law but must follow the foreign country´s laws.

4. There are a few types of digital security tokens that issuers need to be aware of when choosing the best option for their business plan.

Digital security tokens can come in the form of equity or debt tokens as well as digital asset-backed tokens. Equity tokens offer ownership interests similar to traditional stock. Debt tokens operate much like a short-term loan on the interest rate of the value loaned to the company. Asset-backed tokens have their value derived from an underlying tangible or intangible asset of value. These digital tokens are distinct from utility tokens—which are not securities. Utility tokens have consumptive purposes and offer some utility to users. This “utility” is unrelated to the value of the company.

5. Unlike typical Initial Coin Offerings (ICOs), digital security tokens cannot be sold anonymously.

While decentralized ledger technology often promotes anonymity—or more appropriately, pseudonymity—such features are not allowed with DSOs. An issuer must know the individuals to which it is selling its tokens and oftentimes must comply with various AML requirements. Further, issuers may even have to determine whether their investors are actually “accredited” investors in order to qualify for certain exemptions from registration. Thus, knowing the identity of your investors is critical.

6. DSO issuers will need to develop a detailed and comprehensive whitepaper to be disseminated to potential investors.

A whitepaper is often the most important step during the DSO process. A whitepaper contains various important provisions such as details on the coin or token, information on the technology behind it, an industry overview, business model, financial projections, future plans for expansion, members of the issuer´s team, and legal disclaimers. Failure to draft a whitepaper that accurately describes the product can be devastating to your project.

7. Ensure that you select an appropriate blockchain platform and service provider, if applicable.

When the time comes to create your token, you will also need to determine which blockchain platform would be good for your token and for your investors. Make sure you are doing business only with reputable service providers and make sure you have a wallet that is safe and secure. These are important due diligence procedures that need to be undertaken at the preliminary stages even before launching your DSO.

8. Make sure you properly define and introduce your digital security token to the public before your DSO.

Having a pre-DSO is very common and typically entails introducing your new token to the public and to the market. This is an important promotional step and gives people the opportunity to learn more about the token, your business, the platform, and overall business plans. Many investors will not contribute funds to a project that did not provide them with critical information generally given at pre-token sale events—whether this information includes the token´s structure or the members of the company.

9. The costs and time involved in the federal securities registration (or exemption) process can be substantial and represent a significant disadvantage for DSOs.

While many consider it an advantage that digital securities have to be registered with the SEC, it is actually quite a disadvantage to issuers. Increased regulation, ongoing disclosure obligations, and continuous reporting requirements make keeping up with the SEC very challenging. In addition to the compliance obligations for the security token, other factors such as the exchange platform and promoters may have to be registered. The issuer may also have to implement stringent AML/KYC policies and procedures under the Bank Secrecy Act (“BSA”).

10. Be sure to monitor and exceed your investor´s expectations.

Investors who are willing to participate and give capital contributions to your project have basically put their trust in your business. Make sure you are continuously showing them that you are achieving your business goals on schedule, complying with all applicable laws and regulations, executing appropriate contracts, and maintaining significant business relationships. It is also important to consider how to outperform your business goals to increase revenue and enhance liquidity for your investors.

Conclusion

Are you planning to issue a DSO? Are you worried about compliance obligations regarding your security token? If so, then pay close attention to the ten tips in this article. You should ensure you are familiar with your digital assets, the DSO process, what is required of you, and how to achieve and maintain your ongoing business and federal compliance obligations, as some important examples. Lastly, and most importantly, invest the time and resources in researching and retaining an attorney experienced in handling DSOs. This includes making sure that your attorney is knowledgeable about the federal securities registration process—including the Howey Test—and the applicable exemptions.