Introduction: STOs and NFTs
STOs stands for “security token offerings.” They involve an offering of digitalized 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 typically also involve voting rights or the rights of the investors to receive dividends. Further, 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 exempted with the Securities Exchange Commission (SEC) and is compliant with federal securities laws. ICOs are generally not registered with the SEC and have gathered somewhat of a negative connotation with the SEC. For instance, the ICO boom from 2017-2018 led to significant monetary losses and instances of fraud—circumstances that could have been largely avoided if the issuers had been forced to operate under the jurisdictional and regulatory authority of the SEC. As a result, STOs were developed to accomplish the same purpose of ICOs—issuance of tokens or coins on blockchain technology—but in a way that is compliant with the 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 for one another. Each NFT is one-of-a-kind. This scarcity creates value. The ownership of each piece is located on the blockchain, which represents a permanent and genuine record of ownership. No one can forget the NFT collage called “Everydays: The First 5000 Days,” which was created by digital artist Beeple and ultimately sold for $69 million. This article, drafted by the STO Attorneys at Oberheiden, P.C., provides key tips and explanations you should consider before launching an STO for your NFT project.
Thinking About 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 line but an important one. Digital assets or investment contracts that satisfy the SEC's definition of “security” are called “security tokens” and must therefore 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. Purchasers are buying security tokens intending to hold on to the token and make a profit. Although security tokens are registered with the SEC and compliant with the federal securities law, the costs of compliance are often significant, not to mention the extremely detailed and burdensome disclosure obligations of registration.
Digital assets or investment contracts that do not satisfy the SEC's definition of a “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 instead have value fluctuations based on supply and demand. They give users the ability to use the token within a closed ecosystem to buy goods or services or for other specific, intended purposes. While inexpensive, utility tokens have a greater potential for fraud because they are not regulated.
2. Before launching 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 “security,” the SEC and courts use a test called the Howey Test. The Howey Test comes from a Supreme Court opinion from 1946: SEC v. W. J. Howey Company, 328 U.S. 293 (1946). The test has four prongs, each of which must be satisfied for the new coin or token to be considered, and therefore, regulated as a “security.” These four prongs are explained in greater detail in the SEC´s “Framework for ´Investment Contract´ Analysis of Digital Assets,” issued in 2019. In short, the four prongs are as follows:
- An investment of money;
- In a common enterprise;
- With the expectation of profits;
- Derived solely from the efforts of third parties.
If one or more elements are not satisfied, the coin or token is not security—it is a utility token—and need not be registered or exempted.
3. Launching an STO for your NFT project could open the door to other compliance obligations
Compliance with the federal securities laws for your NFT project may not be the end of the story. Your project may entail several additional compliance obligations, one of which concerns the Investment Advisers Act of 1940 (“IAA”). For instance, if anyone in your business is giving out financial advice or providing financial projections for a fee, they may be considered investment advisers and may be registered as such under the IAA.
In addition, many NFT projects that are “securities” will have to implement AML/KYC policies and procedures, including a comprehensive AML Compliance Program. The platforms offering the securities may be considered financial institutions under the AML Act of 2020 or possibly the Bank Secrecy Act (“BSA”) concerning activities that involve virtual currency transmitting services.
Lastly, in addition to registering your NFTs under the Securities Act of 1933, you will also be required to follow various ongoing reporting and disclosure obligations under the Exchange Act of 1934. In some instances, if you are utilizing an exchange-type platform for your NFT project, that exchange may also have to be registered with the SEC. Further, certain individuals who are dealing with these NFTs as “securities” will have to be registered as broker-dealers.
4. There may be one or more exemptions to registration for your NFT project
Before getting consumed in the prospect of the SEC´s registration process, there may be several exemptions available for your NFT project. On this point, those interested in issuing NFTs via an STO should understand that there is also an exemption for projects appealing to non-U.C. investors. This can be very important because STOs often involve multiple countries and individuals from multiple countries. For instance, if an individual or company wishes to offer their NFTs to both U.S. and non-U.S. investors, they can use both exemption 506(c) for the U.S. investors and Regulation S for non-U.S. investors.
5. Failure to properly register your NFTs with the SEC when it is a “security” can lead to multiple violations and consequences
If your NFT project fails to either register or is properly exempted, the individuals or company behind its issuance can find themselves in the middle of an SEC investigation for selling unregistered securities and for violating the antifraud 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 in cases where it meets the definition of a “security” could lead to fines, penalties, disgorgement orders, injunctions, and irreparable reputational harm. It is therefore important to first retain an experienced attorney in STO and NFTs projects.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.
Security Token Offerings (STOs) are a recent phenomenon that facilitates the issuance of digital tokens on blockchain technology. These security tokens are offered to the public in a way that is compliant with the federal securities laws´ registration provisions. Individuals and businesses 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 NFTs, you should consider the five points discussed in this article as well as retaining an experienced STO and NFT attorney.