Borderless Assets, Not Borderless Investors: Who Can Invest in Tokenised Equity?

As the equities markets are generally moving towards tokenisation, a common question is how the marketing of tokenised equity differs from traditional equity.

In this respect, it is a mistake to focus on the “tokenised” element of tokenised equity. In the UK, tokenisation does not, from a purely legal analysis, expand the target market to whom shares can be sold. Where a token represents rights to, or interests in, an underlying share, it is very likely going to be treated as a security under UK law. This means the same regulatory framework that applies to traditional securities also governs the categories of investors to whom tokenised equity may be offered or sold.

In this respect, the rules that govern marketing into the UK are deliberately broad in scope and can apply even where the issuer is based overseas, provided the relevant communications are capable of having an effect in the UK. As such, before marketing or selling tokenised equity to UK investors, firms should carefully consider both who they can sell to, in particular the restrictions set out in the UK Financial Promotion Regime, and the disclosure requirements which apply, of which the Prospectus Regime is worth particular consideration given the cost involved in providing a prospectus.

The Financial Promotion Regime: governs who you can market to

The first consideration is the UK’s financial promotion regime. Under section 21 of the Financial Services and Markets Act 2000 (“FSMA”), a person (regardless of where they are located) is prohibited from making an invitation or inducement to engage in a “controlled activity” in a “controlled investment” which is “capable of having effect in the United Kingdom” unless the communication is made by an FCA-authorised person, approved by a person with the appropriate FCA authorisation to provide such approval, or an exemption applies.

In this respect, under UK law marketing of tokenised equity will generally be treated subject to the same restrictions as apply to non-tokenised shares. As shares constitute a controlled investment under the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (“FPO”), and dealing in securities is a controlled activity for these purposes, communications inviting or inducing investors to acquire tokenised equity are likely to fall within the UK’s financial promotion regime where they are capable of having an effect in the UK.

As such, the options available for selling tokenised equity into the UK will largely depend on the issuer’s budget and the intended reach of the token. Many firms rely on the exemptions contained in the FPO, which are largely based on the nature of the recipient.

Common examples include communications made solely to investment professionals, high net worth individuals and self-certified sophisticated investors. Interestingly, the exemptions available for tokenised equity are broader than those available for so-called “unregulated” cryptoassets, meaning that marketing based on exclusions is easier for tokenised equity than for example bitcoin. Where an exemption is relied upon, there are systems, controls and documentation requirements that firms will need to comply with, as part of evidencing that the conditions of the exemption have been satisfied.

It is possible to reach a larger target market for tokenised equity by not relying on exemptions, and in this respect common options are to either list on a UK tokenised securities exchange that is able to make promotions on its own behalf (and thereby indirectly promote the tokenised equity), or to partner with an appropriate principal under the appointed representative regime, which will be able to sign off on marketing of security tokens to the UK market. The latter approach has the additional advantage of enabling firms to have boots on the ground in the UK to promote the business, whereas otherwise promoters of tokenised equity may be restricted to operating solely on a cross border basis. Indeed, we are seeing a growing number of principals in the traditional equities space now building the capability to work with tokenised equity, in anticipation of a general shift from equities to tokenised equity.

The Prospectus Regime: governs what documentation you need to market tokenised shares

A separate consideration to who you can sell to is what disclosure requirements apply when selling shares. Some of these requirements are ubiquitous regardless of how a fundraise is structured, and indeed firms should at all times ensure that they operate in a way that is fair, clear and not misleading. Other requirements depend on the nature of the fundraise, and in this respect one of the most significant questions is whether a prospectus is required, given the cost involved in providing this document. This is governed by an entirely separate regime to the Financial Promotion regime.

As tokenised equity is treated as a security under UK law, in broad terms an offer of tokenised equity will require a prospectus where it constitutes a public offer, unless an exemption applies. The exemptions are useful, particularly for start-ups which are generally able to avoid the prospectus requirement. In this respect, the most commonly used exemptions include: offers made solely to qualified investors (essentially professional investors) and offers made to fewer than 150 persons in the UK (other than qualified investors).

Using an exemption represents a significant cost saving, and as such firms should consider this carefully before committing to a prospectus. Indeed, given that most sales of tokenised equity in the United Kingdom are structured to fall within a prospectus exemption, the prospectus is rarely needed. However that is likely to change as these companies mature.

The next phase: Secondary Trading

Once tokenised equity has been sold, the next priority is determining how best to go about secondary trading of tokenised equity. In this respect, this is where some of the real value of tokenising shares is unlocked, as it facilitates faster, more efficient secondary market trading, gives the ability to remove reliance on trading hours of exchanges, and enables new investment products to be developed which, for example, allow investors to buy bundled tokenised shares.

In terms of the regulation of secondary trading of tokenised equity, the rules that govern the regulation of equity will still broadly apply. In this respect, firms will need to partner with trading venues with the right securities licences in order to enable secondary trading. In this respect, we are seeing a shift by cryptoasset exchanges towards gaining securities licences in the jurisdictions in which they operate, in order to enable their clients to invest in tokenised securities alongside more “traditional” cryptoasset investments such as bitcoin.

Timing is key

A key theme in marketing tokenised equity is that there is steadily improving infrastructure to enable firms to sell equity in tokenised form. As this develops, so will the ability to develop new investment products that make use of tokenised equity infrastructure, and over time this additional value may enable tokenised equity to trade at a premium to its non-tokenised counterpart. Whilst therefore there may be additional complexity in launching a tokenised equity offering in the short term, there is real value to be unlocked for those able to negotiate the rules correctly.

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James Burnie and Holly Joseph are part of gunnercooke’s digital assets team and advise firms on structuring and marketing tokenised equity. If you are weighing up a tokenised raise and want to talk through the financial promotion, prospectus or secondary trading questions raised here, you can contact James at james.burnie@gunnercooke.com.