Tokenized equity on smart contracts hold a great deal of promise, the biggest opportunity being liquidity for secondary offerings tied to the blockchain. However, regulation is likely to play a role in how the smart contracts are structured to ensure compliance. It is certain that tokenized equity can provide immediate liquidity in principal, but the practical application is much less simple. Here are a few reasons why:
- Fund law can restrict the number of investors placing capital into a fund, especially when a fund may wish to avoid reporting under the Investment Company Act of 1940. Typically the number is restricted to 100.
- Securities law will also inhibit a private fund from staying private unless the number of shareholders does not crest above a specific threshold which in most cases is 500. Once that level is reached, law requires the necessity of reporting to the SEC as a pubco.
- Rule 144 holding periods also restricts the length of time a security must be held by the primary purchaser before it can be sold on the secondary market. Rule 144 also helps slow token velocity in an ICO or token crowdsale.
- Buyer and seller will be required to submit to KYC, AML, accredited investor and/or other filtration mechanisms for compliance purposes.
Numbers three and four above are relatively straight forward on a smart contract. Maintaining shareholder restrictions takes a little more creativity and engineering when building a smart contract.
Restricting the number of investors on an ETH smart contract would require one or more of the following:
- Shares are bought and sold in restricted “blocks” and only sold in those restricted bundles. The blocks or baskets of shares become the restriction that manages the number of shareholders. That is, there are a limited number of blocks.
- A single shareholder can hold multiple blocks, but the blocks cannot be bifurcated or subdivided.
- Standard Rule 144 restrictions on the sale of the blocks, typically for one year.
- Blocks can only be bought and sold by accredited investors in a closed system that processes KYC, AML and accredited investor checks.
New tokenized funds have been cropping up all over the world. Those outside the United States hold all the benefits of liquidity one might expect from tokenized equity. However, such funds also exclude relevant adherence to U.S. securities laws–which increases the relevant risk. Such laws are mechanisms implemented to protect the investing public. Accredited investor status, hold/sale restrictions and shareholder number thresholds are some such mechanisms. Luckily many of these can be engineered into an Ethereum smart contract. This is something we are currently working on. What are some ways in which you have seen these items overcome? How are others doing it?