In the crypto sphere, 2017 was deemed to be the year of the ICO, hailing a new means to source funds for start-ups, in what seemed to be a reply to the capital markets that may not have done enough to help start-ups seek the funding they require. 2018 was the year of reckoning for ICOs as the media reported high-profile scams, projects that were unable to deliver to their investors and a crypto market that was falling.
2019 has now been hailed as the year of the STO. Security Token Offerings are considered to offer more legal certainty and security for investors although this concept too has been rife with misconceptions and misunderstandings as to the obligations it entails.
The Regulation of Security Tokens
With the implementation of the Virtual Financial Assets Act, the Malta was one of the primary advocates that DLT Assets qualifying as financial instruments (in terms of MiFID) should be regulated under traditional financial services legislation. European authorities such as ESMA have also echoed this reasoning.
This stance also provided clarity to those seeking to issue Security Tokens that qualify as financial instruments. Thus, any Security Token issuer doing an offer to the public needs to issue a prospectus in line with the Prospectus Regulation as of 21st July 2019.
Seeking Legal Clarity
In a bid to provide more legal certainty and clarity, the MFSA has issued a Consultation Document on what DLT Assets qualify as Security Tokens and how their issue and listing on trading platforms should be regulated.
The Authority has sought to distinguish between “Traditional STOs” that primarily refers to traditional transferable securities and “Other STOs” which refer to the technology representation, including a token, that shares some qualities with traditional transferable securities, such as a token that only gives the right to profits of certain investments of a business.
In order to adopt a cautious approach, the MFSA is proposing that initially applications for approval of prospectuses and/or admissibility to listing relating to Traditional STOs be submitted by issuers which are incorporated as limited liability companies in Malta with its register of members being able to be kept in dematerialised form. The MFSA is currently liaising with the Registrar of Companies to implement the necessary amendments to the Maltese Companies Act, thus enabling companies to keep a register of members and adhere to the requirement of keeping securities in a dematerialised form, using DLT.
When presented with an application for approval of a prospectus and/or an application for authorisation for admissibility to listing, the MFSA will assess the applicant’s Financial Soundness, Corporate Governance and compliance with Transparency requirements. Particularly when assessing Financial Soundness, the Authority will take into consideration the fact that STOs are primarily intended to be an alternative source of funding for start-ups. A Financial Due Diligence Report, much like what is typically submitted in the case of a bond issue, may thus need to be drawn up by the Issuer. This would present the applicant’s business model against a defined set of parameters. The applicant may also be required to have an appropriate Cyber-Security framework in place as well as to conduct a Systems Audit in cases where the Board of Directors is also responsible for the innovative technology arrangements underpinning the storage and transaction in the securities.
One of the most pertinent issues affecting Security Token Offerings at the moment is the lack of secondary market trading venues where these tokens can be admitted to trading. In its consultation, the Authority is thus exploring the divergences between the use of centralised and decentralised exchanges as well as between permissioned and permissionless systems. The Authority has highlighted the matter of Direct Electronic Access and Transaction Reporting as requiring particular attention to continue adhering to EU legislation.
Similar to what was advocated under the Virtual Financial Assets regime, the MFSA considers the regulation of Market Abuse to be a fundamental requirement for an integrated, efficient and transparent financial market. The Market Abuse Regulation (Regulation (EU) 596/2014) applies to security tokens as a type of financial instrument and the rule must thus be adhered to when admitting such a token to trading on a regulation market, MTF or OTF or when the price or value of the security token depends on or has an effect on the price or value of a financial instrument, including, but not limited to, credit default swaps and contracts for difference. In its consultation exercise, the MFSA made reference to insider dealings, the unlawful disclosure of inside information and market manipulation. In this respect, ESMA has noted that the use of DLT may give rise to new abusive behaviours which are not currently directly captured by the Market Abuse Regulation or current market monitoring arrangements.
The Authority has also explored post-trade settlement constraints including the need for a Central Securities Depository (CSD) (in terms of the Central Securities Depositories Regulation, Regulation (EU) No 909/2014) and a Securities Settlement System (SSS). Another important matter is that of which governing law should apply when considering that participants in a DLT may be dispersed in different jurisdictions. The MFSA considers the CSD as the central authority to be a natural candidate to act as an anchor to governing law. Alternatively, upon registration for active participation in the DLT, participants would be required to sign up to a particular governing law which allows the CSD to choose the law of the jurisdiction in which its operating platform is based.
The consultation period is open until the 30th of August 2019 and all interested parties are encouraged to submit their feedback to the authority.
This exercise by the MFSA is also being conducted concurrently with a review of the Maltese Companies Act to ensure that the Maltese corporate legal framework is suitable for the use of DLT and the matters that may arise through the use of this technology.
Article by Dr Ian Gauci and Dr Cherise Abela Grech
This article is not intended to impart legal advice and readers are asked to seek verification of statements made before acting on them.