Just like regular US securities, security tokens need to comply with security laws. This means abiding and operating in the rules set out by the Securities and Exchange Commission (SEC).

While not always loved by market participants, these legal and regulatory frameworks exist for a reason. Here is how the tokenized real estate industry navigates this today.

In this article:

1. An introduction to securities
2. The two ways to issue: registration or exemptions
3. Regulation D offering - Accredited Investors
4. ‍Regulation S Offering - Non-US Persons
5. Regulation CF offering - Crowdfunding portals
6. Regulation A+ Offering - The ‘mini-IPO’
7. The role of tokenization
8. What's on the SEC horizon?

An introduction to securities

The basics - what is a security anyway?

Following some fraud and misrepresentations in the late 1920s and 1930s, the Securities Act of 1933 established the rules over what is a security and how the market must manage them.

The key precedent for determining whether a transaction qualifies as an "investment contract", and therefore considered a security, is the ‘Howey Test’. 

Defining an investment contract

Under the Howey Test, there is an investment contract if there is:

1. An investment of money...
2. In a common enterprise...
3. With the expectation of profit...
4. To be derived from the efforts of others.

In most cases, whether a token qualifies as an investment contract is basically if there is an "expectation of profit to be derived from the efforts of others”. However, there are a number of other important characteristics to be aware of.

The definitions of securities can be vague. For example, stablecoins are not securities, but as Blockfi found out in 2022 - a yield product on stablecoins is.  

If it’s deemed a security, then it's subject to disclosure and registration requirements under the SEC. 

The private placement framework for tokenization 

For tokenized real estate tokens, they are treated the same as the shares in a traditional private placement offering. 

There are thousands of these every year in the US.

So now we’re clear that security tokens are a contract - what legal docs do we need to know about?

Similar to traditional investments, a private placement memorandum describes the investment opportunity, explains potential risks, introduces sponsors, and more. 

Think of it as the private market version of a “public disclosure” document you get when investing in a public IPO.

Investors also receive a subscription agreement that defines the terms of the proposed investment. If you’re buying real estate tokens online on a new issuance - make sure you’re receiving one of these, if not - you might unwittingly be involved in securities violation.

Don’t forget - the underlying product is real estate

It should go without saying that the most important piece of a real estate security token is the underlying product - real estate.

High quality real estate is table stakes in security tokens backed by real estate. If the real estate doesn’t perform, it doesn't matter how good your technology or compliance is.

Once you have a good product, it's time to decide on which regulatory path to take. 

The two ways to issue: registration or exemptions

When a company wishes to issue securities to investors, there are two paths:

1. Register them with the SEC, or
2. Operate under an exemption

The same framework applies to security tokens backed by real estate.

The most common exemptions are accredited investors (Regulation D), non-US persons (Regulation S), crowdfunding (Regulation CF) and Regulation A+.

Pros and cons of different SEC exemptions

HoneyBricks tokens are today offered and sold in compliance with regulations D and S, and we plan to allow non-accredited investors access to the platform in 2023 under Regulation A+.

Here is a high level overview of the different exemptions companies can use to issue security tokens to investors.

Each has different audiences, advantages and disadvantages. Let’s dive deeper into the options available.

Regulation D offering - Accredited Investors

Regulation D is for accredited investors for which the SEC guidelines state:

• Earn >$200k of annual personal income OR
• Earn >$300k of joint annual income with spouse OR
• Exceed $1 million net worth exclusive of your personal residence.

These rules are evolving. In August 2020, the SEC amended its qualifications to include holders of the Series 7, Series 65, or Series 82 licenses, and in May 2023 - the The Equal Opportunity for All Investors Act of 2023 was introduced by Representative Flood paving the way for more non-accredited investors to become eligible to invest in private real estate investments.

Size of the accredited Market

This is a relatively small pool, with less than 1 in 10 households in the US an accredited household - but these households control >75% of US wealth.

Historically this has been an older demographic, well educated and highly considered in their decision making, however many millennials and early Gen-Zs are now entering this audience. 

Secondary sales in Regulation D

When securities are acquired in unregistered, private sale from an issuer, they are called restricted securities. This includes things like private placement offerings, Regulation D offerings or employee stock benefit plans.

If you want to sell your restricted securities, holders need to meet the applicable conditions set forth in Rule 144. 

This rule is important and the conditions cover:

1. Holding periods
2. Current Public Information 
3. Trading Volume Formula
4. Ordinary Brokerage Transactions
5. Filing a Notice of Proposed Sale With the SEC

All are legally required and the key takeaway for tokenized issuers is that securities need to be held for 12 months, there can be no brokerage on trading without a license and both parties need to have the same information.

506(b) vs 506(c) offerings

The Regulation D 506b Playbook

Within Regulation D - there are two paths for private placements that companies focus on:

• Rule 506(b) permits the sale to an unlimited number of accredited investors and up to 35 non-accredited, but prohibits general solicitation
• Rule 506(c) requires that all investors are accredited investors, but permits general solicitation

These playbooks are different, with different advantages and disadvantages for issuers.

The 506b playbook can be hard to scale and brings a lack of visibility. 

The typical process is:

1. Advertise the company (not the offering)
2. Attract an interested investor and schedule call
3. Conduct 30 minute interview about experience and sophistication
4. Wait 30 days for cooling-off period
5. Sign legal docs and invest

The Regulation D 506c playbook

The 506c playbook is increasingly common online but has more stringent access requirements. 

The typical playbook is:

1. Advertise the investment offering directly
2. Attract an interested investor
3. Verify their accreditation status
4. Sign legal docs and invest

‍Regulation S Offering - Non-US Persons

Regulation S was created in 1990 as a way to avoid registering the offer with the SEC when selling securities to investors outside the US. 

This basically means that if you’re an issuer of securities - you can sell them to people that are neither US-citizens nor US tax residents under Regulation S.

With the US only accounting for 330 million of the worlds 8 billion people - the non-US persons market is a massive market however comparatively with not as much purchasing power.

That said, with the US-dollar continually being cemented as the de facto world currency and the strong legal protections that the US legal system provides - it makes sense their continues to be strong demand for US assets that generate USD. 

Understanding tax, accreditation, and resales in Regulation S

Securities sold under Regulation S have some drawbacks and benefits compared to other SEC exemptions - specifically when looking at taxation, accreditation requirements, and resales.

Taxes

You might expect that if only non-US persons are investing in the security tokens, then some of them may avoid paying US taxes on their gains. 

Uncle Sam always gets his cut.

When security token issuers are distributing returns to offshore investors (either through dividends, operating income or capital proceeds), the issuer is required to withhold 30% of the proceeds and give it directly to the Internal Revenue Service (the IRS) under the Federal Withholding Tax. 

A reduced rate may apply if there is a tax treaty between the foreign national’s country of residence and can be reclaimed later, but the tax is generally withheld from the payment made to the foreign national.

Accreditation

Secondly, investors in Regulation S offerings outside the US can be of any wealth level. This makes it much easier for the investor to be eligible for the offering, and for the company raising capital to find a bigger audience than under a Regulation D offering.

It's important to note that foreign investors can still invest in Regulation D offerings as accredited investors, but must be accredited by US standards (i.e. of certain wealth levels).

Resales

Lastly, securities sold under Regulation S have significantly less restrictions on resale. They can generally be listed for trading purposes on Alternative Trading Systems with very little disclosure and reporting requirements, but cannot be sold to US persons for one year.

You might be thinking that an easy solution might be to do a Regulation D offering for US persons, and Regulation S for non-US persons? 

A so-called ‘double barrel’ offering is unfortunately quite cumbersome. Due to unique requirements and restrictions - this is very hard to do and are normally kept as separate offerings, and subsequently two sets of tokens.

With the main benefit of real estate tokenization being the liquidity benefits, separating offerings cuts the potential liquidity benefit in half. 

Regulation CF offering - Crowdfunding portals

Regulation Crowdfunding is the second most commonly used exemption for tokenizing real estate and allows a company to raise up to $5 million in a 12-month period.

Anyone can invest in a Regulation Crowdfunding offering, including unaccredited retail investors, and the offering is required to be listed on a crowdfunding portal.

Crowdfunding Portals

A crowdfunding portal is like an online marketplace for different investments where fundraisers can connect with investors to fund their projects independently. 

These portals are generally used to market securities of early-stage projects that have consumer appeal (i.e. robotics, cannabis farms or hospitality investments).

Unlike broker-dealers that require different licences, crowdfunding portals have a number of limitations to the kinds of activities and services they can perform. They must also register with the SEC as a broker or as a funding portal and become a member of a national securities association (FINRA).

While these portals charge high fees for listings, they do offer a wealth of administrative services including marketing the investment, ensuring KYC of investors, and general compliance of the offering.

There are a growing number of companies that can do this for you including SeedInvest, Republic, Startengine and MainVest.

Regulation A+ Offering - The ‘mini-IPO’

Regulation A is similar to a mini-IPO, and allows U.S. and Canadian companies to publicly advertise investment opportunities and raise up to $75 million in a 12-month period from an unlimited number of unaccredited investors.

A big benefit of securities issued under Regulation A+ is that they can have immediate liquidity to investors. This means tokenized securities under Reg. A+ can be traded on day 1 on regulated Alternative Trading Systems (ATS) both in the US and overseas.

Growing SEC approval of tokenized offerings

The SEC has been increasing SEC acceptance of tokenized offerings, with several getting regulatory approval in recent years including YouNow and Blockstack.

The role of tokenization

How tokenization improves compliance in securities offerings

Blockchain technology can significantly improve compliance through code, with a key opportunity in syndicated investments.

In a traditional syndicated investment, investors need lawyers, accountants, and advisors checking the legality of purchase and transfers of the transaction. This creates a lot of complexity, and leads to high friction, transaction costs and lack of liquidity.

Through the use of smart contracts running on the blockchain, these regulatory and compliance requirements can be coded into the security token contract including who can buy, trade, sell or hold the securities.

The smart contract can then verify the eligibility of any transactions before they are recorded and settled.

How HoneyBricks manages securities compliance

At HoneyBricks, we gives both asset owners and investors comfort that token offerings are set up in a compliant way, have an appropriate governance structure, and that the tokens can be traded on secondary markets.

We use a mix of more traditional and blockchain based systems to do this:

• We verify all investors on the platform, and subsequently for each tokenized real estate investment. 
• A security token contract mints the tokens, and an individual smart contract belonging to each security token contract is maintained on the blockchain. 
• When a buy or sell of the token is attempted, the security token contract checks the whitelist to ensure each side of the transaction is authorized and that the transfer is compliant with security regulations.

What's on the SEC horizon

There are a number of significant changes in the real estate tokenization market, however all rely on a supportive and clear regulatory framework to operate in.

Real estate is a massive market with US$327 trillion of global stock that suffers from low accessibility, slow transactions, and poor composability. 

The genie is out of the bottle on the technology to solve this, and the most significant change will be expanding the accredited investor restrictions. This is already in motion with the The Equal Opportunity for All Investors Act of 2023 making its way through the US congress and expected to become available in 2024.

The good news is that SEC rules are always evolving and adapting to the market. There are growing calls for accreditation rules to be made more inclusive and enable greater access for investors.

By applying the benefits of new technology, companies like HoneyBricks can structure security token offerings that increase access, efficiency, and transparency in private real estate, while ensuring protections put in place by the SEC are adhered to.