Security tokens and equity tokenisation in Brazil

Co-authored with Adriano Ferraz.

Introduction

There are ever-growing opportunities for using crypto-assets and non-fungible tokens (NFTs). From the implementation of blockchain-based contracts and the trading of digital assets to the creation of tokens on blockchains that represent tangible goods, crypto-assets are firmly established. This is a global tendency that is also experienced in Brazil.

Despite this evolution, the sector is characterised by a technical vocabulary. This is especially true of security tokens and equity tokens. Although they share syntactical similarities and, in some cases, overlapping applicability, they are distinct concepts. In short, any tokenisation of an equity stake can be categorised as a security token, although the opposite is not true. This article aims to clarify and distinguish these concepts, while exploring some of the possible applications for potential investors focused in the Brazilian jurisdiction.

Definition of security token

A security token is essentially a digital representation of a non-fungible financial asset. Because of this, it can be classified among the various categories of crypto-asset, each of which has different functions and objectives. The similarity between these categories lies in their constitution, which generally occurs through distributed ledger technologies, also known as distributed registry. However, the crucial distinction lies in the purpose that each crypto asset fulfils. As an example of this differentiation, while cryptocurrencies serve as a means of payment, security tokens play the role of digitally representing certain investment products.

It is therefore correct to say that security tokens are virtual assets, created based on distributed ledger technology, which represent investment tokens subject to specific regulations. In other words, they are NFTs that represent investment assets, such as securities, debt instruments among others.

Security tokens are varied and can be classified into different categories, depending on the type of investment product they represent. These include equity tokens, debt tokens and real estate tokens.

The equity token, like the first category, represents equity in an underlying asset (typically the stock of a company) and generally gives the investor the right to receive dividends. The debt token, on the other hand, represents a tokenised debt instrument (eg, real estate mortgages) and makes it possible to automate the payment of interest and principal to its holders based on the payments made by the debtor. Lastly, the real estate token represents ownership of real estate, including fractional ownership in real estate.

In addition, security tokens have a crucial feature, which is the ability to be programmable. This means that they can perform complex tasks using protocols such as smart contracts. For example, when they take the form of equity tokens, they can be programmed to automatically calculate and distribute dividends among the holders of these assets.

Because of their characteristics, security tokens are often traded on regulated markets, providing greater reliability in the trading process and security for investors.

The launch of these assets is carried out through a process called security token offering, which uses distributed registration technology and allows companies, both new and old, to raise capital in an unconventional way.

Understanding equity tokens

One of the essential requirements to incorporate a company is the obligation for the partners to make contributions to its capital, which can be in the form of money, goods or rights. In the company’s incorporation documents, the amount of each partner’s contribution to the entity’s share capital must be recorded.

Therefore, the shareholder participation is intrinsically related to the amount that each of the partners have contributed to the company’s capital. In accordance with legal requirements, this stake can be adjusted, either by increasing it when the company’s capital increases, or by decreasing it when occurs a capital reduction.

Equity tokenisation is the procedure by which a digital asset is created, registered on a blockchain, in order to represent an equity issued by a company. This process of creating a token offers several advantages, which include the following.

Greater liquidity and global access

Tokens can be traded globally and are not limited by the opening hours of stock exchanges, thus allowing greater liquidity and the possibility of access to various markets.

Reduction of intermediaries

Tokenisation eliminates intermediaries involved in the processes of selling these assets, reducing bureaucracy and lowering the costs associated with companies raising capital.

Transparency and traceability

The tokenised assets are registered on blockchains, which guarantees transparency and traceability of transactions, making it possible to fully verify the history of these assets.

Equity tokenisation represents a significant advance in the way financial assets are represented and traded, opening up new opportunities for companies and investors around the world.

How to use equity tokens

The impacts of the equity tokenisation and the trading of equity tokens are still in the early stages in Brazil but offer positive prospects. Although it is not yet widely recognised as a popular investment model, it is a process that aims to provide greater agility and transparency for companies and investors. This is due to trading through smart contracts operated on DLT/blockchain networks, which makes it possible to reduce costs, simplify existing procedures and access a wider audience of investors, increasing the liquidity of the assets traded.

However, it is important to note that, despite the enthusiasm for the technological solutions offered by crypto assets, the process of equity tokenisation must comply with the corporate legislation in force in Brazil. It is essential to note that, despite being an innovative approach, the use of equity tokens is subject to the regulation of financial and capital markets, especially rules relating to the securities regulation.

In Brazil, the Legal Framework for Virtual Assets (Law 14.478/22) came into force in 2023, with the aim of regulating the Brazilian crypto-assets market. However, the new law is clear in excluding from its application tokens that represent securities, as defined in Law 6.385/1976.

According to the Guidance Opinion No. 40/2022, the Brazilian Securities and Exchange Commission recognises that a security token, when it meets the legal requirements, can be considered a security and is therefore subject to the securities regulation. The Guidance Opinion established the use of the Howey Test to verify whether the equity token should be classified as a security.

Finally, it is worth noting that the application of these instruments can be challenging or even incompatible in family or “partnership” companies, in which the “affectio societatis” is an essential element for their existence. Therefore, the adoption of equity tokens must be carefully evaluated in light of the structure of the companies involved, to ensure that these innovations are implemented effectively and in compliance with the laws and regulations applicable in Brazil.

For further information on this topic, please contact Adriano Ferraz or Guilherme Guidi at Freitas Ferraz Advogados by telephone (+55 31 4141 0308) or email (adriano.ferraz@freitasferraz.com.br or guilherme.guidi@freitasferraz.com.br). The Freitas Ferraz Advogados website can be accessed at www.freitasferraz.br.

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Originally published on Lexology (Link).