The Tokenization of Real Estate
This article was written by Alexandra “Sasha” Levin, Esq. and was originally published in the FIBREE annual report. Ms. Levin is a Partner, Co-Head of Emerging Growth & Technology Practice and Israel Practice, and Head of Real Estate Practice. She can be reached at (212) 837-2600 x1003 or [email protected].
While tokenization of real estate may be a relatively new innovation, it will likely have legal ramifications and costs in all jurisdictions. Therefore, it’s important to address them, with a focus on U.S. federal and state (known at the state level as “blue sky” laws) securities law for the purposes of this article.
Currently, tokens which represent a particular interest in real estate, such as debt, equity, right to rental income, etc. are gene- rally not structured as a right to a property directly but rather as an interest in a corporate entity which holds title or other rights to a particular property or portfolio of properties. This often mi- mics the structure of a traditional Real Estate Investment Trust (REIT) which offers tax benefits, and the shares of which can be privately held or publicly listed. As such, in the United States, such tokens are very likely to be considered securities and are therefore subject to federal and state securities laws.
Obviously, the U.S. market is large and robust (notwithstanding the current COVID-19 related economic challenges) and many sophisticated parties are aware that all tokens that are sold in the United States or to “U.S. Persons” must be compliant with U.S. securities laws, as the U.S. Securities & Exchange Commission (SEC) considers most (but not all) tokens to be securities. Additi- onally, the U.S. Commodity Futures Trading Commission (CFTC) may consider some tokens to be commodities, the U.S. Treasury Dept’s Financial Crimes Enforcement Network (FinCEN) consi- ders some tokens to be currencies and the U.S. Internal Revenue Service (IRS) considers some tokens to be property and there- fore taxable. Other regulations such as anti-money laundering (AML) and countering the financing of terrorism (CFT) rules and the Foreign Investment in Real Property Tax Act (FIRPTA). The- re are also state-specific virtual currency license requirements which tokens may need to comply with, such as the “BitLicense” in New York and the Uniform Regulation of Virtual-Currency Businesses Act which has been enacted in Rhode Island and has been introduced in California, Oklahoma, and Hawaii.
However, it may come as a surprise (and often as a frustration) to many entrepreneurs and investors outside the United States that the reach of the U.S. regulators is very long and may affect them, notwithstanding their best efforts to avoid U.S. markets. Please refer to the discussion of the Regulation S safe harbor below.
U.S. Securities Laws
Registration with the SEC, i.e. an Initial Public Offering (“IPO”)
After the U.S. stock market crash of 1929, Congress enacted the Securities Act of 1933 (as amended, the “Securities Act”) and the Securities Exchange Act of 1934 (as amended, the “Exchange Act.”). The general rule of U.S. federal securities laws is that all securities offered or sold in the United States using the means and in- strumentalities of interstate commerce (including the internet) must be registered with the SEC or comply with an exemption from regist- ration. Registration exemptions were offered because Congress believed that some investors are “sophisticated” enough to con- duct their own due diligence regarding the purchase of securi- ties without government protection and the additional disclo- sure of a full registration (which was implemented to prevent a future stock market crash caused by a lack of disclosure to “un- sophisticated” investors). Issuing a security using an appropriate exemption is less burdensome than pursuing a full registration.
Following is a discussion of the basic mechanics of how this all works in practice.
Is your token a security at the time of the sale?
The definition of “security” is broad and includes stocks, bonds and many other standard investment instruments including an “investment contract.” According to U.S. securities law, under the “Howey Test” (in SEC vs. W. J. Howey Co. (1946)), a token is considered to be an investment contract if it meets the following criteria: (1) it is an investment of money, (2) in a common enter- prise, (3) where there is a reasonable expectation of profits; and (4) any profits will be derived from the entrepreneurial or mana- gerial efforts of others. However, not all tokens are securities, as the evidenced by the SEC’s No-Action Letter to TurnKey Jet, Inc. on April 3, 2019. Additionally, timing is crucial. On June 14, 2018, SEC Director William Hinman stated that bitcoin and Ethereum are currently not securities, because “if the network on which the token or coin is to function is sufficiently decent- ralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entre- preneurial efforts – the assets may not represent an investment contract [and therefore may not be a security].” On February 6, 2020, SEC Commissioner Hester Peirce proposed Rule 195, a safe harbor period for token sales for 3 years from their first token sale to become “sufficiently decentralized” and therefore not likely to be a security.
If the token is a security, below are the options to comply with law (and again, please consult with U.S. legal counsel in all cases). The SEC has also provided a helpful comparative table with the requirements of the most common exemptions for offerings in the United States.
Registration with the SEC is expensive, complex, and time consu- ming. It involves filing many forms with the SEC and preparing, submitting, and revising a full prospectus. However, the primary benefit of an IPO is that the securities are not restricted and can be traded. To date, there has been no IPO of a token declared effective in the United States.
Regulation CF
In the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), a new Regulation Crowdfunding (CF) was adopted which permits a public offering to any investor using an approved “fun- ding portal” for primary solicitation and disclosure, up to a cap of $1.07 million. There are several such crowdfunding portals which have hosted token sales on their platforms.
Regulation A/A+ Offering
This is sometimes referred to as a “mini-IPO” in the sense that it requires SEC approval and is a public offering to any investor so that, as with an IPO, the securities are not restricted and can be traded. However, there is a cap on the amount that can be raised ($20 million or $50 million depending on tier) and this ex- emption excludes asset-backed securities. Securities may need to register under the Exchange Act unless a registered transfer agent is used in the offering. On July 10, 2019, the SEC qualified the first Regulation A+ tokenized offering by Blockstack for $28 million.
Regulation D
Regulation D under the Securities Act provides an exemption from registration for a private placement (i.e. no public marke- ting) where purchasers are limited to investors who meet the definition of “Accredited Investors.” There is no SEC approval required, although formal notice (Form D) must be provided. There is also no cap on the amount that can be raised. However, tokens are restricted for at least one year following the original token sale (or for six months if the issuer is an SEC-reporting company). Additionally, Exchange Act registration may be requi- red if there are over 2,000 holders of record of equity securi- ties or 400 non-accredited holders. Under the JOBS Act, a new Regulation D provision, Rule 506(c), was adopted which permits public marketing but requires the issuer of securities to verify (i.e. review documentary evidence) that the purchasers in fact meet the definition of “Accredited Investors.” Please note that recently the SEC has proposed to amend this definition to in- clude other investors based on their “knowledge and expertise.” Unlike an IPO or Regulation A offering, Regulation D lowers the paperwork burden by requiring no mandated disclosure. However, in 2017, SEC Chair Jay Clayton issued a list of “Sample Questions for Investors Considering a Cryptocurrency or ICO” which is recommended for token issuers as a guide to provide disclosure.
Given that Rule 506(c) under Regulation D is currently the most common structure for token sales in the United States, the follo- wing is a list of actions that token issuers should, at a minimum, take in collaboration with their attorneys:
» Conduct a Howey Test analysis (if you suspect that your token is not a security)
» Consider which jurisdictions apply to the token sale for tax and regulatory purposes
» Apply for state-specific virtual currency licenses (e.g. New York’s “BitLicense”) or exclude residents of those states from the sale
» Form a U.S. corporate entity, if necessary
» Draft a disclosure document (including risk factors, term and conditions and other disclosure such as SEC Chair Clay- ton’s list, referenced above) – this is to attempt to prevent violations of securities laws as well as defend against future investor civil legal actions
» Draft a token purchase agreement (personally, I would not recommend using a Simple Agreement for Future Tokens (“SAFE”) but that discussion is beyond the scope of this article)
» Insert disclaimers into your website, whitepaper and any other marketing presentations, solicitation materials and other related materials
» Obtain Accredited Investor verifications from token buyers
» Perform “Know Your Client” (“KYC”) checks on token buyers
for purposes of AML/CFT
» File a Form D with the SEC within 15 days of the first sale of a token
» File Blue Sky filings in each U.S. state where token purchasers are located
» After the restriction period is over, receive a Rule 144 Legal Opinion (see below)
Regulation S
Regulation S represents a “safe harbor” from SEC registration for security offerings and sales that are made offshore, with sa- les prohibited to all U.S. Persons, as the term is defined by the Securities Act. Among other requirements, the token issuer must verify that the token sale is made outside the United States
to non-U.S. Persons and ensure that there are no directed selling efforts made in the United States by the issuer, a distributer, any of their respective affiliates or any person acting on behalf of any of them. Additionally, tokens issued under Regulation S cannot be re-sold or transferred to investors or token purchases in the United States or to U.S. Persons for at least one year following the original token sale (or six months if the issuer is an SEC-re- porting company) and then only if the tokens are registered or comply with an applicable exemption from registration. The is- suer must make use of every available mechanism to block U.S. sales and resales, which can include blocking U.S. IP addresses from accessing the token issuer’s website. It is common for some issuers to do a concurrent Regulation D offering for U.S. Persons and a Regulation S offering for offshore sales; however, as each of these types of tokens have their own restrictions, it may be difficult logistically to keep those two tokens independent.
Because Regulation S affects all non-U.S. token issuers who exclude U.S. Persons, they should consider discussing the follo- wing suggested non-exhaustive list of actions with their attor- neys:
» Conduct a Howey Test analysis (if you suspect that your token is not a security)
» Consider which jurisdictions apply to the token sale for tax and regulatory purposes
» Form a U.S. corporate entity, if necessary
» Draft a Regulation S Private Placement Memorandum
» Draft a Regulation S Subscription Agreement and Confidenti- al Purchaser Questionnaire
» Code into the token the prohibition of sale or resale to U.S. Persons, if possible
» Insert Regulation S disclaimers into your website, white paper, and any other marketing presentations, solicitation materials and other related materials (and notify your U.S. attorneys when they are updated to ensure that the issuer’s descriptions and disclosures on its website use plain language, are transpa- rent, and are not misleading)
» Block U.S. Persons, to the greatest extent possible, from the issuer’s website and token sale (or if doing a concurrent Regu- lation D offering to U.S. Persons, consider creating a second website for this offering)
» Implement restrictions of the resale of Regulation S tokens to U.S. Persons
» Perform KYC checks on token buyers for purposes of AML/ CFT
Rule 701
Disclaimer:
A private offering of tokens that qualify as securities to emplo- yees, consultants and advisors may be exempt from registration under Rule 701 of the Securities Act. This exemption applies if the tokens are offered under a written compensatory benefit plan or written compensation contract for the participation of an organization’s employees, directors, general partners, trustees, officers, or consultants and advisors, and their family members who acquire such securities from such persons through gifts or domestic relations orders. Tokens issued under Rule 701 are not integrated with any other offering, but they are restricted secu- rities that cannot be resold unless they are registered under the Securities Act or are exempt from its registration requirements.
Rule 144
Rule 144 under the Securities Act provides an exemption where a restricted security token (e.g., under Regulation D) is eligible for resale after the purchaser has held the security for a mini- mum of one year following the original token sale (or six months if the issuer is an SEC-reporting company) and satisfies other requirements. Traditionally, while not required, the custom and best practice of securities issuers is to receive a written opinion from U.S. legal counsel stating that the securities may be trans- ferred in the manner contemplated without an effective regist- ration statement under the Securities Act or applicable Blue Sky laws. This further shields the token issuer from liability but such legal opinions for tokens are difficult and expensive to receive.
Conclusion
The SEC works with a variety of international organizations to set global standards and try to protect investors, including The International Organization of Securities Commissions (IOS- CO), The Financial Stability Board (FSB), Council of Securities Regulators of the Americas (COSRA), International Financial Reporting Standard Foundation Monitoring Board (IFRS), Inter- national Federation of Accountants Monitoring Group (IFAC), Financial Action Task Force (FATF) and Organization for Econo- mic Cooperation and Development (OECD).
While the laws and regulations regarding token sales and virtual currencies have evolved significantly since the first SEC Investor Alert on Ponzi Schemes Using Virtual Currencies in 2013, token issuers are strongly advised to consult with legal counsel in the United States and abroad as early in the process as possible to ensure compliance with all the laws of all jurisdictions in which it intends to sell tokens.
Nothing in this article constitutes legal advice. This is a general conceptual and theoretical high-level overview of virtual cur- rency, blockchain, token sales, tokens, the U.S. securities laws, some of the registration exemptions which might be available, real estate and blockchain and related topics. Nothing herein is intended or related to any particular factual situation. Nothing herein forms an attorney-client relationship. You are advised to consult with your own lawyer, accountant and other professio- nals before making any decisions. The comments and opinions expressed today and in this article are of the individual author and may not reflect the opinions of her firm.
The content in this article is offered only as a public service and does not constitute solicitation or provision of legal advice. This article should not be used as a substitute for obtaining legal ad- vice from an attorney licensed or authorized to practice in your jurisdiction. You should always consult a suitably qualified attor- ney regarding any specific legal problem or matter.
The opinions and thoughts in this article are of a casual nature and may change after further reflection. While we intend to made every attempt to keep the information in this article cur- rent, the author makes no claims, promises or guarantees about the accuracy, completeness or adequacy of the information con- tained in or linked to or from this article. This article may cont- ain hyperlinks to other resources maintained by third parties on the Internet. These links are provided solely as a convenience to you to help you identify related information. Reference to other resources is not meant to imply an approval, endorsement, af- filiation, sponsorship or other relationship to the linked site or its operator, contents, or trade names, logos, symbols, service marks or other intellectual property rights associated with the hyperlinks, citations or URLs we provide. This article does not incorporate or endorse any materials appearing in such linked sites by reference. The author disclaims all liability in respect to any decisions or actions, or lack thereof based on any or all of the contents of any third-party site.