Top Questions a Securities Lawyer will Ask an STO Issuer (in USA or Canada)

Security Token Offering is a serious business. The days of the ICO are over. These are clear messages not only from the SEC and other regulatory bodies but also from thoughtful and experienced professionals. The SEC, in particular, is delivering this message mainly through regulatory actions and the position of SEC Chairman Jay Clayton. Most recently, a federal judge ruled that the U.S. securities laws may cover ICOs, giving the Feds a much-needed victory in their battle against fraud and money laundering.

Regardless of the nuances and the debate, what should be clear to issuers who have legitimate businesses or startup plans is that investors, as well as issuers, require protection. If anything, legitimate issuers should welcome such scrutiny and regulation which ensures the market is kept free of bad actors and questionable affiliations.

However, companies considering a security token offering need to be prepared to respond to questions that their securities lawyers will ask. To this end, we reached out to top lawyers to learn which information is crucial to them when a client reaches out for advice on their Security Token.

The professionals that contributed to this list are Sara Hanks (CrowdCheck Law, LLP – USA); Ross McKee (Blake, Cassels & Graydon, LLP – Canada), Lewis Cohen (DLX Law, LLP – USA); Rajeev Dewan and Kosta Kostic (McMillan, LLP – Canada); Alessandro Lerra (Lerro & Partners – Italy), and Alan Goodman (Goodmans, LLP – Canada).

Below is the list of items on which lawyers and other advisors will be focusing. There is no particular order, but you should be ready when contacting your securities lawyer or advisors to make sure you are prepared. This list is subject to change as the market develops.

  1. What jurisdiction is your company incorporated in and in what jurisdictions is your company doing or will do business?
  2. In which countries are you planning to offer your security token?
  3. Is the company already a public reporting issuer anywhere or are any of its other classes of securities already listed on an exchange?
  4. Will you be conducting a Direct Offering or a Broker-Dealer Offering?
    1. If a Direct Offering, how will you manage all of the regulatory requirements (including “Know Your Client” requirements)
    2. If you aren’t using a Broker-Dealer and you are selling to retail investors, how will you comply with the requirements of states that require you to register yourself as an issuer-dealer?
  5. Will this be for accredited investors only or will it also be made available to non-accredited investors?
  6. How do you plan to confirm or verify accredited investor status?
  7. How do you plan to confirm or verify investors are not on prescribed lists?
  8. Do you have a method to establish the suitability of the investment for an investor?
  9. What securities law exemptions do you intend to rely on for each jurisdiction you want to sell your security token?
  10. What documentation or certification will investors be required to sign?
  11. What is your investor record-keeping system and how do you plan to handle regulatory reporting of the distribution of securities tokens?
  12. What are the tax implications of the sale of the token for both the issuer and the investor?
  13. If ongoing tax reporting (e.g., FATCA) is required, how will that be handled?
  14. Which blockchain is the token going to be created on?
  15. Does the client understand the differences between public blockchains and closed or permission blockchains?
  16. Does the platform already exist?
  17. Do you know which Security Token Protocol you would like to use?
  18. Does the Security Token Protocol manage the lifecycle, custodianship requirements, and corporate actions of the security token?
  19. Does the Security Token Protocol have the capabilities to be managed by a regulated Transfer Agent?
  20. Has the smart contract code for the token been audited by a code audit firm?
  21. What level of assurance does the code audit firm give in terms of their work?
  22. Is the Security Token Protocol implemented on robust, highly-secure, and enterprise-class technology platform?
  23. Does the blockchain for the STO prevent cryptocurrency fraud, unauthorized mining, and forking?
  24. Does the blockchain for the STO provide guaranteed legal finality for securities transactions?
  25. Does the blockchain for the STO provide for recourse with forking or technical intervention in case of errors, losses, or fraud?
  26. Is there a utility element in the token?
  27. Is the security token coupled with a cryptocurrency?
  28. Does the blockchain have a well-defined and published governance model, and are you confident that the governance processes and governing entities are credible?
  29. Does the blockchain have adoption and recognition from financial institutions?
  30. Will the tokens be immediately delivered to the purchasers?
  31. What is the stated purpose of the offering and what is the business of the issuer?
  32. Is the number of tokens fixed or unlimited? Is there a release schedule for future tokens?
  33. How many tokens, if any, are being retained by management?
  34. Will the tokens have a fixed value?
  35. How many security token holders do you expect?
  36. Are you aware of the requirements for a Transfer Agent?
  37. What are the rights of security token holders?
    1.  Voting?
    2. Dividends?
    3. Share of revenue/profits?
    4. Wind up the business?Will the purchasers be seeking a return on their investment or are they buying the token for other purposes?
  38. Will the purchasers be seeking a return on their investment or are they buying the token for other purposes?
  39. What is the exit strategy for the company?
  40. Does your company currently have a Shareholders Agreement?
  41. Does the company have a board of directors?
  42. Do you have financial auditors?
  43. Do you intend to list the tokens on any secondary markets and are those markets in compliance with regulatory requirements that apply to securities exchanges?
  44. Following issuance of the tokens, are any lock-up periods required or advisable with respect to the token?
  45. Are there any requirements that the tokens may only be traded with persons in (or outside) certain jurisdictions?
  46. Once any lock-up period has concluded, where will the tokens be able to trade?
  47. How will any applicable resale restrictions be implemented and complied with? How will subsequent sellers and purchasers of tokens be made aware of these resale restrictions?
  48. How are any requirements for the tokens to trade on a given market or alternative trading system being handled?
  49. Does the company intend to provide ongoing reporting to investors and if so, how will that be handled?
  50. Will the blockchain be used to facilitate any additional levels of transparency?
  51. What social media platforms are you using?
    1. Telegram
    2. Twitter
    3. Facebook
    4. Medium
    5. LinkedIn
  52. Do you know what limitations on communication or other requirements (such as legending or delivery of an offering document) apply to social media communications?
  53. Are you planning set up a “bounty” or similar program that offers free tokens?
  54. Will you be using airdrops?
    1. How are recipients selected and what do recipients need to do in order to receive airdrops?
    2. Have you made sure the airdrops comply with applicable securities law?
  55. Do you have a white paper?
    1. Has the whitepaper been released?
    2. Does the whitepaper include a clear business plan?
    3. What statements, representations, or comments have been made by management in the whitepaper, any other publication, or orally, about the future value or investment merits of tokens?
    4. Should the whitepaper be characterized as an offering memorandum and if so, does it have the prescribed disclosures and notices?

We hope this can assist you in preparing for your security token offering (STO). Obviously, for those who have already raised their money, tokenizing their securities will require some of the same questions.

Life of a Company

I know, the title is odd. But the goal is to show how a company is formed and what is required for it  to be maintained. What most of the public sees is only related to sales or marketing, never the insides of the corporate structure or management.

The first step each of us make is to incorporate our organization, and we are provided with the company’s papers, also known as theMinute Book”.

The Minute Book
For entrepreneurs, board directors, management, lawyers, auditors, shareholders, and broker dealers, the Minute Book is a lifeline. It is the historical log of all the key decisions and corporate actions made in the company.  Now, some of you will go to your lawyer and get a Minute Book binder, and some will go online and construct your binder.

One very important thing about your company’s Minute Book is that there is only ONE original and you must protect it. At the same time, you are required to provide access to your lawyers, auditors, board directors, shareholders, and anyone who is doing due diligence on your company.

What do you get in your Minute Book:

        • Certificate of incorporation – this provides a unique number to your company
        • The official date of incorporation in your jurisdiction
        • Bylaws: the rules you must follow in operating your company, such as
          • Number of directors
          • How many shares you can issue and class of shares
          • How to conduct board meetings
          • How to conduct shareholders meetings
          • Quorum for board and shareholders meetings

     

  • The Minute Book also has many other tabs for you to insert the ongoing corporate actions in the company.
  • The Minute Book is a living document and it requires that you update it as you are conducting your corporate actions. Those actions need to be recorded in your Minute Book and properly documented, so in the future when you are going through due diligence—for financing, acquisitions, going public, or opening a bank account—this information will be ready so you can move forward.Here is a list of some of the corporate actions your Minute Book needs to have. Some of these corporate actions will be in different sections of your Minute Book depending on how many documents are created.
          • Appointing director
          • Appointing officers
          • Notice of Shareholders Meeting
          • Opening a commercial bank account
          • Appointing auditors
          • Granting options
          • Accepting new shareholders
          • Accepting a loan, debenture, SAFE
          • Name change
          • Merger
          • Acquisition


      For each of these corporate actions, you will need directors’ resolution and/or shareholders’ resolutions and, in some cases, agreements, government filings, and regulatory filings. All of these documents will need to be stored in different sections within the Minute Book.

      This is important to know because as your company grows, more and more of these documents start to add up and the historical tracking becomes even more challenging to maintain.

      If your records are not up to date or properly recorded you will spend thousands and thousands of dollars to get those completed so that you can proceed with a transaction such as raising capital, loan, merger, acquisition, going public, etc.

      Along with managing all the corporate documents, you are also required to manage, report, and track all your shareholders on a timely basis. Depending on which exemption you used, the company would be required to provide quarterly,semi-annual, or annual reporting to your shareholders.

      I know all this might seems overwhelming. Welcome to being an entrepreneur! There are no shortcuts, but there is a way to do it so you are not burdened by all this and end up spending thousands of your hard earn money to fix issues when they emerge.

      As a fellow entrepreneur, I felt this pain. Having all these documents and no central place that everyone (board directors, shareholders, lawyers, auditors, regulators, etc.) could access 24/7, created further strain on my time.

      For a long time, I found apps that did only one thing but were not able to do all that I needed to meet my fiduciary obligations as an officer and director of my company.  It was very frustrating, but finally, in 2015 we launched the world’s first all-in-one platform—yes, an all-in-one platform—that takes care of everything I described above and so much more.

      Once you have a secure and centralized platform to bring your stakeholders, you have the assurance to meet your obligations and focus on growing the business rather than managing paper.

      No more duplicating your efforts – only do it once and KoreConX takes care of the rest.

      As you grow, the platform provides even further enhancement, so if you are a one person company or a company with 500,000 shareholders or more, KoreConX is your all-in-one platform.

A Big Lesson from the Delaware Blockchain Amendments

Andrea Tinianow, the founding director of the Delaware Blockchain Initiative (and ‘Blockchain Czarina’), recently published a very insightful article on the significant gap in the mainstream protocols for security tokens. The gap is in the way the Delaware Blockchain Amendments are interpreted by the mainstream security token platforms.

The Delaware Blockchain Amendments were an outcome of the Delaware Blockchain Initiative. The Amendments were introduced in the Delaware Senate Bill 69 and signed by the Governor on July 21, 2017. This landmark legislation allows Delaware corporations to maintain their stock ledgers on a blockchain. In making this provision, what the Delaware Bill meant was that all of the stock ledger data should be maintained on the chain, rather than only a portion of the data.

The more accurate interpretation of the provision bumps up against one limitation that public blockchains face. As the number of nodes in the chain grows dramatically—as it should in a truly decentralized system—the performance of the chain suffers. Validation, consensus, and finality take longer and longer. The problem becomes significant when security tokens are involved, since the data payload of securities transactions is much larger than the normal token payment data within Bitcoin and other payment-oriented cryptocurrencies and tokens. More importantly, contract execution is much more complicated than technical (or cryptographic) validation of transactions. Even simple contracts can generate a multitude of mini-transactions that need to follow a labyrinth of complex processes in the securities world. All this activity generates more data, exacerbating a problem that currently has no clean solution in fully decentralized public blockchains.

One way around this problem is to put securities data off-chain and store the keys on-chain. This can provide some relief on storage but probably not as much impact on performance. Even with the limited payload, the Bitcoin blockchain has grown from around 1 MB in 2010 to more than 170 GB eight years later! Transactions speeds are even less impressive. Hardcore fans of Bitcoin deem it unfair to compare its 7 transactions per second with that of Visa (which conducts around 20,000-30,000 or even more transactions per second), since Visa had over 60 years to improve its technology. Presumably, Bitcoin fans predict that Bitcoin’s transaction speed would match that of Visa if the Bitcoin network too had a couple of decades of improvements. But these arguments miss the point: by the time Bitcoin achieves Visa’s throughput, Visa itself could double or treble its own performance. Ethereum too is facing similar issues and currently experimenting with various approaches, including sharding and proof-of-stake.

In any case, putting securities data off-chain violates the provisions of the Amendments. “Thus, although the ERC-884 is designed to transfer shares of stock, the share ownership information is captured in an off-chain database,” says Andrea Tinianow, alluding to a derivative of the ERC-20 protocol. “This arrangement is in stark contrast to what was contemplated by the Delaware Blockchain Amendments….”

In contrast, the KoreChain maintains all information on the chain. Scalability and performance are not issues precisely because this is a permissioned chain with functional sharding (a topic for another blog) but no mining, proof-of-work, or proof-of-stake. The KoreToken protocol also addresses the full ecosystem of participants in securities transactions. The implementation of services is too important to leave it to interpretations and all the subsequent hassle of reconciling varied interpretations. For example, even the most basic partial sale of security tokens on a secondary market exchange requires a minimum of twenty-five separate sub-transactions involving upto five participants. In order to be robust, real-life implementations have many more steps. Currently, all these steps do take place, but the majority of them happen after the primary sale transaction occurs. These tasks fall into various groups of activities such as clearance, settlement, reporting, disclosure, and corporate record-keeping.

There is no debate that the whole process is inefficient, costly, and error-prone. This makes the process an excellent candidate for true smart contracts on the blockchain. But this does not imply that the blockchain makes these tasks unnecessary. From the context of a naive security token protocol, Andrea Tinianow points out in her article, “Tokenized shares do not eliminate many of the types of errors that are symptomatic of a system that relies on third-party intermediaries to manage and control shareholder databases.” KoreChain, engineered carefully to be fully compliant with all the complexities of securities regulation and corporate law, mitigates errors and creates efficient end-to-end securities transactions without ignoring the risks. The KoreChain implements all tasks that are mandated by securities regulation and corporate law.

Capital Raising “Capital markets point of view” dealer

For private issuers, raising capital is the next natural step once you have exhausted other traditional forms of financing. It becomes even more enticing when you read about other firms doing it, and thinking why shouldn’t that be us.

However, being prepared to take the issuer to the next level can be a source of frustration if you’re not ready for it. Nobody is willing to just hand out money; you have to make a convincing case based on fact and incomplete due diligence documentation can leave you out in the cold.

Issuers must prepare comprehensive information which covers who the guiding minds behind the issuer are, who the current shareholders are, business continuity planning, company financials, what is it that makes you unique and a comparison with competitors in the same industry.

Dealers are bombarded by people who claim to have the next best thing, but if you can’t boil it down to facts and figures, they won’t spend much time looking at you. Using up to date technology to gather all the corporate information is critical to your success. Using a platform to house your cap table management, minute book, financials, investor relations and corporate data in electronic format means you can walk into a meeting prepared for whatever they throw at you.

For dealers, having a platform whereby issuers can login and input all the relevant information that you need from them, allows you to control the process and weed out the unprepared ones before you devote a lot of time to analysing potential deals. A controlled mechanism whereby issuers know what information they need to provide and where to put it, saves everyone significant time and effort.

Taking it one step further, for registered dealers to have the ability to easily showcase their approved products online, along with pertinent information about the issuer – corporate biographies, financial information, information about the proposed raise –  helps dealers to bring their proposed offerings to potential investors. From a compliance perspective, it means having all of your due diligence in one place, for when the regulators come to visit.

Taking it two steps further, for investors to b able to view potential offerings, input their Know Your Client (KYC) information to determine their eligibility, answer questions to determine the suitability of the investment, have the platform conduct the necessary AML checks and then provide an efficient method for payment, once approved by the CCO, and you have an efficient and cost effective ecosystem which helps issuers, dealers and investors communicate.

KoreConX has an all-in-one platform to accomplish this and ensures that all parties are acting in compliance with securities regulations. Issuers can effectively connect with dealers who in turn can connect with investors all while ensuring that they have the necessary KYP/KYC processes and documentation in place, should they get audited.

StartUp Law 101

Late last year I had the opportunity to collaborate with Catherine Lovrics, B.A., LL.B at Bereskin & Parr LLP, on the inner workings of raising capital for entrepreneurs. Her book, Startup Law 101: A Practical Guide, published last week.

The basis of our conversations surrounded accessing funding at the right time and identifying the the business expenses that are needed most, from capital expenditures to operational costs.

As part of a panel discussion during last Wednesday’s launch event hosted at MaRS Discovery District, I was asked several great questions about funding that I wanted to discuss further.

Q: Securing funding for early-stage companies can be the biggest challenge for founders. What are some of the opportunities that have developed recently in the equity crowdfunding space for early-stage companies?

A: Without crowdfunding, the ability for early stage companies to access capital would not exist in such high numbers.

The emergence of online platforms helping private and public companies access capital from accredited and non accredited investors has literally transformed the investor landscape.Today’s private capital investor can invest as little as $50.00 into a company.  This was not possible five years ago.

Part of this transformation includes the addition of online payments. It has not only increased the speed in which an investor makes a decision to invest, but has changed the perception of how an investor views an investment. All an investor has to do is enter a credit card number using their VISA, MasterCard, American Express, etc.

With this new dynamic, companies need to have a very proactive approach to their new stakeholders.  Your investor relations strategy and tools will be the key to maintaining and growing your company.

Q: What are some of the major changes and challenges we’re seeing in equity crowdfunding?

A: The biggest challenge globally in equity crowdfunding is that companies are not ready.  We see 98 percent of companies stall in their funding process when they engage in online platforms to help startups raise capital.

What companies don’t understand is that nothing has changed from the days of applying to Venture Capital firms, Angel groups, etc.  Sites like like StartEngine, FrontFundr, BankRoll Ventures, MicroVentures, etc., expect you to have your company and critical business documents in order.

The largest barrier and one of the major delays is the lack of up-to-date corporate records. Make a checklist — update your corporate records, capitalization table, signed agreements, legals for the offering, business plan, executive summary, financials, projections, etc.

Q: There has been a lot of buzz this past year with the rise of cryptocurrencies and ICOs. What are we seeing now with the regulation (and potential demise) of ICOs and the rise of token offerings or ITOs?

A: In 2017, we saw the rise of crowdfunding v3.0 with the introduction of Initial Token Offerings (ITO).  For many in crowdfunding, ITOs have proven that people will invest from around the globe if they trust the underlying technology that is managing their investment, i.e. blockchain.  

Out of the gate, many companies took advantage of this type of capital raising and many investors lost billions of dollars. Like any new form of technology, it can be used for good and bad.  

We will see a rise of security token adoption in 2018 as companies begin issuing tokens like selling securities. But, these tokens will also have the capability to trade on secondary exchange.

This just scratches the surface of what we covered and Catherine was generous enough to provide a copy of Chapter 6, “Canadian Startup Funding Sources” for KoreConX followers.