Blockchain technology is at the forefront of the fourth industrial revolution holding the potential of reshaping and developing industries and sectors at a pace which would have been unimaginable a few decades ago and the Indian securities market is no exception to this. Out of the insurmountable use cases of blockchain technology in the securities market, the raising of capital using security token offerings (STO) for companies is also a use case that can help in rediscovering the method of financing for listed companies in the Securities and Exchange Board of India (SEBI) regulated markets. Considering that SEBI already has a Distributed Ledger Technology (DLT) framework in place, this article aims to analyse the interplay between STOs with the Indian securities law as well as identify challenges and tackle such challenges for the creation of a robust legal framework for STOs in India.
Understanding Security Token Offerings and their Interplay with Securities Law in India
A security token offering as its name suggests, is an offering of security tokens by issuer companies through a Distributed Ledger Technology (DLT) (commonly referred to as blockchain). The offering is made through the issuance of digital tokens known as security tokens. The distinctive factor of STOs from the traditional initial public offer process is that the entire process of issuance including pricing, subscription, allocation and the like can be undertaken on the blockchain itself. Unlike initial coin offerings which have posed significant threats across jurisdictions including India, STOs are better suited to the current framework of securities legislation and can be regulated efficiently. Security tokens can be classified into two types. Securities- based tokens have equity and debt securities as their underlying. Assets- based tokens have assets such as real estate, infrastructure, oil, minerals, gold, silver, precious metals or agricultural produce as its underlying asset.
Some of the benefits of security tokens are that it can grant liquidity to illiquid assets, assign blockchain powered immutability, assign divisibility to a high value asset or security, ensure immediate settlement of security tokens and funds, increase automated executions and automated compliances powered by smart contracts. There are several steps to the process of STOs which includes; firstly, preparation of investor- decks containing information of the offer and requisite regulatory disclosures; secondly, adequately designing of the security token offer as per regulatory requirements; thirdly, select the blockchain platform where the security token offer will be made along with appointment of other financial intermediaries; fourthly, issue the security token permitting investors to subscribe to such security tokens and undertake corollary allocation of security tokens to the investors; and fifthly, undertake listing of such security tokens in the respective exchanges.
Security tokens satisfy the Howey Test which was laid down by the Supreme Court of the United States of America in S.E.C. v. Howey, (1946) 328 U.S. 293 and the Howey Test has also been accepted under Indian law by the Allahabad High Court in Paramount Bio- Tech Industries Ltd. v. Union of India, (2004) All L.J. 2552 for the purposes of determining whether a particular transaction could be treated as an investment contract and resultantly, a security. The Howey Test asserts that a transaction must; firstly be, an investment of money or asset; secondly, there must be a profit expectation from such investment; thirdly, the investment must be a pooled investment as a common enterprise of the investors; and fourthly, the profit must be generated from the efforts of a promoter or a third party beyond the investor’s control. However, it is also noteworthy that the mere recognition on the basis of the Howey Test would not be sufficient and the definition of security under the Securities Contracts (Regulation) Act, 1956 must also include such security tokens. Section 2(h) of the Securities Contracts (Regulation) Act, 1956 includes shares, stocks, bonds, scrips, debentures, similar marketable securities, derivatives, collective investment scheme units, security receipts, mutual fund units, Government securities, rights or interests in securities as well as instruments notified as securities by the Central Government. The definition of ‘security’ under the Securities Contracts (Regulation) Act, 1956 is an inclusive definition and a security token possesses the characteristics of a derivative since its price is determined by the underlying real- world securities/assets. Further, it possesses the characteristics of an instrument which creates rights as well as interests in real- world securities/assets. It also possesses characteristics of a collective investment units when the underlying assets are sold in the form of security tokens after division of such assets into security tokens. But beyond the mere substantive recognition under the definition of securities, the absence of a procedural mechanism and operational provisions regulating security tokens would result in the substantive recognition to be otiose.
There are multi- faceted legal challenges in respect to security tokens under the Indian securities law. The first challenge pertains to determining the nature of the security token. Although a security token can possess characteristics of several securities, the inherent characteristics of the security token make it more likely to be attributable to derivatives. However, Section 18A of the Securities Contracts (Regulation) Act, 1956 specifically requires derivative contracts to be traded in a recognised stock exchange as well as be settled on the clearing houses of such recognised stock exchanges as per its rules and bye- laws. This leads to the second challenge pertaining to the non- tradability of security tokens on recognised stock exchanges since security tokens have to be traded on exchanges that are powered by blockchain, in the absence of which it risks the loss of its essential characteristics. Furthermore, the third challenge which emanates from a security token being treated as a derivative is that its settlement takes place instantaneously on the blockchain as per the automated self- executing parameters of the smart contract as opposed to the requirement of settlement by the clearing house of recognised stock exchanges as per its rules and bye- laws. Needless to say, the rules and bye- laws of all recognised stock exchanges in India do not have the requisite rules for governing the settlement of security tokens.
The third legal challenge faced in context with security tokens is that there are specific intermediaries involved in STOs beyond the regular securities market intermediaries that aid the effective execution on the blockchain. These include the blockchain platform hosting the security tokens offering, blockchain miners and smart contract developers.
The fourth legal challenge pertains to the ineffectiveness of blockchain dispute resolution mechanisms such as blockchain arbitrations to resolve disputes arising out of smart contracts as such mechanisms undermine the principles of natural justice and the rule of law by not affording a fair and reasonable opportunity of being heard since blockchain arbitrations are based upon the voting system of jurors in the blockchain.
The fifth legal challenge is the absence of compliance and regulatory requirements pertaining to issue of offer documents, disclosures pertaining to the issuer company, rights and obligations of the issuer company as well as the investors, KYC verification requirements and the like.
Potential Way Forward
As the substratum of STOs is the blockchain technology, it is necessary that a regulatory sandbox framework is introduced for testing the integration of the current Indian securities market framework with blockchain technology and for the purposes of testing the offer and listing process of security tokens. In the past, SEBI has introduced fintech regulatory sandboxes and several cohorts of successful testing of new technologies had taken place under the sandbox framework. Implementing a regulatory sandbox framework for STOs and blockchain technology will enable SEBI, issuer companies and securities market intermediaries to identify the operational advantages and difficulties, enabling a robust regulatory framework for STOs. Another necessary step is issuance of clarifications on the nature of security tokens as derivatives alongwith substantive, operational and procedural provisions for on- chain listing, clearing and settlement. For this to occur, simultaneous inclusion in the rules and bye- laws of clearing corporations as well as stock exchanges will have to be made to accommodate such parallel listing and clearing processes to occur under off- chain and on- chain. So far, SEBI has introduced the DLT framework for monitoring and recording of charge for non- convertible securities and it has showcased the immense potential generated through its adoption. In addition to the regular compliance and disclosure requirements pertaining to offer documents, rights and obligations, KYC verification and the like, it is necessary that blockchain intermediaries involved in the STO process must also be regulated which include the blockchain platform hosting the STO, smart contract developer and blockchain miners.
Another key aspect is the dispute resolution mechanism. The blockchain arbitration mechanism suffers from several infirmities making it unsuitable for dispute resolution in most jurisdictions because the opportunity to present grievances and evidence is minimal for the disputants. No opportunity exists for the disputants to address their counter- claims and the interaction between the disputants and the jurors is unreasonably limited. The process of juror selection is linked to the amount of deposit which can be made by such juror to the blockchain platform, risking the lack of independence and resultantly, biased decisions. Furthermore, the decision is made by juror voting which may not always comprise of subject- matter experts, often compromising the quality of decision- making. Seen from the Indian perspective, the blockchain arbitration mechanism is not only violative of principles of natural justice but also significantly undermines the rule of law. Therefore, the current structure of the grievance redressal mechanism of SEBI which is known as SEBI Complaints Redress System (SCORES) as well as stock exchange arbitrations for dispute resolution can be integrated to the blockchain with the help of ‘blockchain oracles’ that permit inbound and outbound flow of information from and to the blockchain. Needless to say, a tender may have to be issued by SEBI in order to create a panel of entities that can provide such blockchain oracle service to SEBI for streamlining and integrating its dispute resolution method with the blockchain.
From the issues discussed in the article, it is evident that even though security tokens may substantively have legal recognition, it is yet to be backed with a robust procedural and operational legal framework. The creation of such a robust legal framework can enable the untapped potential for issuers to raise funds using STOs as well as ensure a more efficient mechanism powered by blockchain for aspects such as clearing and automated smart contract enabled regulatory compliance, ultimately benefiting the various stakeholders of the Indian securities market ecosystem.
(This post has been authored by Manohar Samal, a Senior Associate at Ratan Samal & Associates and Prashant Trivedi, an Advocate at Bombay High Court.)
CITE AS: Manohar Samal and Prashant Trivedi, ‘Security Token Offerings Under the Indian Securities Law’ (The Contemporary Law Forum, 12 September 2023) <insert link> date of access