The Securities and Futures Commission of Hong Kong (the “SFC”) issued a Statement on Security Token Offerings on 28 March 2019 (the “Statement”) in relation to the legal and regulatory requirements applicable to parties engaging in security token offerings (“STOs”), which involve Security Tokens and are typically structured to have features of traditional securities offerings. This Statement was particularly interesting and timely as it confirmed SFC’s approach towards STOs which are currently attracting a great deal of interests in the market in Hong Kong and other jurisdictions in Asia.
“Security Tokens” are normally digital representations of ownership of assets or economic rights (eg a share of profits or revenue) utilising blockchain technology. The SFC considers that Security Tokens are likely to be “securities” under the Securities and Futures Ordinance (the “SFO”) and as such are subject to the securities laws of Hong Kong. Any person or intermediary who markets and distributes Security Tokens in Hong Kong (or targeting Hong Kong investors) is required to be licensed for Type 1 regulated activities (dealing in securities) under the SFO (the “Intermediary(ies)”) unless an applicable exemption applies.
Certain key compliance issues
Intermediaries in STOs are to comply with existing legal and regulatory requirements, in particular:
i) Professional Investors only
Type 1 Intermediaries should only target clients who are professional investors as defined under the SFO for the offering of Security Tokens.
ii) Suitability obligations
When Intermediary makes recommendation or solicitation of a Security Token, it shall ensure the suitability of its recommendation or solicitation for that client is reasonable having regard to information about the client collected through due diligence. This involves the Intermediary assessing a client’s risk tolerance level, including understanding the client’s financial background and investment experience, knowledge of investing in Security Tokens or related products prior to effecting the transaction on his behalf as part of the know-your-client procedure.
iii) Complex products
The SFC considers Security Token as a “complex product”, which is defined as “an investment product whose, terms, features and risks are not reasonably likely to be understood by a retail investor”. If the Security Token is a “complex product”, the Intermediary should adopt additional investor protection measures to ensure clients are well informed about the key risks and features of such Security Token.
iv) Product due diligence
Intermediaries distributing Security Tokens should conduct proper in-depth due diligence of the STOs and also ascertaining the risk return profile of such STOs. Ongoing due diligence should be conducted at appropriate intervals having regard to the nature, features and risks of the Security Tokens.
v) Information for clients
To help clients make informed investment decisions, Intermediaries should make clear and adequate disclosure of material information relating to the STOs in an easily comprehensible manner.
Notification to SFC
Intermediaries should discuss with the SFC prior to engaging in any activities relating to STOs pursuant to Circular to Intermediaries on compliance with Notification Requirements dated 1 June 2018. The trading of crypto-assets is considered as a significant change in the nature of business of the Intermediary and would be subject to the notification requirements under the Securities and Futures (Licensing and Registration) (Information) Rules.
The SFC has timely issued the Statement at the initial phase of development of the global STO market, which lays the important regulatory foundation for the development of STO industry in Hong Kong. It provides clear guidelines for intermediaries who wish to tap into the new and booming virtual asset market in the region by providing trading or advisory services for Security Tokens.