It’s one thing for an issuer to authorize a class of tokenized common stock, but as Commissioner Hester Peirce observed in a recent speech, things get more complicated once tokenized securities are distributed to the public – particularly if somebody other than the issuer of the securities is doing the tokenizing:

Market participants who distribute, purchase, and trade tokenized securities also should consider the nature of these securities and the resulting securities laws implications. For example, depending on the particular facts and circumstances, a token could be a “receipt for a security,” which is itself a security but is distinct from the underlying security held by the distributor of the token.

Alternatively, a token that does not provide the holder with legal and beneficial ownership of the underlying security could be a “security-based swap” that cannot be traded off exchange by retail persons. While blockchain-based tokenization is new, the process of issuing an instrument representing a security is not. The same legal requirements apply to on- and off-chain versions of these instruments.

This Skadden memo digs into some of the legal issues implicated by tokenization by third party distributors, including possible compliance challenges under the Investment Company Act, the potential need for distributors to register as broker-dealers, the possibility that the trading platform for tokenized securities might be a securities exchange, the need to comply with SEC & CFTC rules on swaps, as well as the potential applicability of anti-money laundering and know your customer regulations. So, while the SEC is willing to work with people on the issues associated with tokenization, there appears to be no shortage of issues to work through.

– John Jenkins