Where to market a Tokenized Fund Offering

Flag Theory Weekly Letter – Monday November 5th, 2018

In previous letters we talked about some of the most important factors when it comes to setting up a security token offering and we then discussed one type of STO – a tokenized fund. This is a fund that issues its fund interests via a digital token in the blockchain. We also reviewed some of the jurisdictions that you could consider to set up your tokenized fund.

As we commented, when it comes to funds offerings not only do the regulations and laws of the jurisdiction where your fund is located matter, they also can matter to the jurisdiction where your investors are domiciled.

Generally, an offshore fund soliciting to investors in a third country would need to seek regulatory approvals or apply for an exemption – and in certain cases, only licensed local distributions could perform certain marketing efforts.

You should seek appropriate legal counsel in each of the jurisdictions you want to take investments from – not doing so is not a good idea as breaking financial market regulations may be a criminal offence.

In addition, usually, a tokenized fund investing in crypto assets and crypto startups would be only sold to professional investors because of the risky nature and asset concentration of its portfolio might not make it eligible for a ‘retail’ fund in most jurisdictions.

Next we will cover some of the jurisdictions where you could sell your tokenized fund and some things you should take into account if you plan to do so.

This article is just an overview of some of the key requirements to sell a fund in the covered jurisdictions. It does not intend to be a comprehensive analysis and it does NOT constitute legal advice. One should seek out qualified legal advice and various service providers before setting up, selling or soliciting investors for a fund or tokenized fund.

Marketing a Tokenized Fund in Hong Kong

The Securities and Futures Commission (SFC) issued on November 1 2018 a regulatory framework and guidelines for fund managers trading with cryptocurrencies and distributors of funds investing in crypto. Hong Kong crypto fund managers will be subject to the oversight of the SFC as any other fund manager – regardless of whether their portfolio’s blockchain assets fall under the legal definition of securities or futures contracts or not.

Hong Kong crypto fund managers will be required to obtain a Type 9 regulated activity license (Asset manager) – in addition to complying with a set of terms and conditions and additional licensing requirements imposed by the SFC if the fund manager plans to manage 10% or more of the gross asset value of the portfolio in crypto.

For its part, offshore tokenized funds may solicit to Hong Kong residents through a private placement via a licensed financial intermediary and may only be offered to professional investors.

Professional investors are generally individuals with a portfolio of at least HKD 8 million or corporations with a portfolio of not less than HKD 8 million or total assets of not less than HKD 40 million.

Only licensed financial intermediaries are allowed to distribute fund offerings to potential investors within Hong Kong regardless of whether or not the fund requires regulatory approval.

Distributors of funds (whether onshore or offshore) that invest in crypto will require a licence or registration for Type 1 regulated activity (dealing in securities). The offshore fund manager would need to be licensed or appoint a licensed securities dealer to market the fund.

Distributors of offshore funds not approved by the SFC that invest more than 10% of their portfolio in crypto will need to comply with a set of additional requirements which include an assessment on whether the investors have sufficient knowledge of investing in virtual assets or related products; ensure that the aggregate amount to be invested by the investor in virtual asset funds is reasonable considering his net worth; provide comprehensive information in relation to the fund as well as the underlying investments and several warning statements, and perform a comprehensive due diligence on the fund manager, the fund and its investments, among other requirements.

Note that advertising an offer to subscribe for or underwrite securities to the public without the regulatory approval and through the proper licensed financial intermediary is a criminal offence. Advertising is broadly defined and could be, for instance, websites, oral communications or other publications, among others.

Tokenized Funds in South Korea

South Korea is one of the most buoyant crypto-markets, one of the more advanced countries worldwide in terms of cryptocurrency adoption and an attractive market to target by tokenized funds. However, selling an offshore fund to Korean residents would be challenging, as we’ll see below.

Funds are regulated under the Financial Investment Services and Capital Markets Act, and its sub-regulations (FSCMA). Both private placements and public offerings should be authorized by the Financial Services Commission (FSC).

If the fund is marketed and sold only to Qualified Professional Investors, a simplified private placement registration applies.

Until 2017, only government entities, financial institutions and certain pension funds were considered qualified professional investors.

At the time of publication, the definition of qualified professional investor also comprises listed companies, corporations with financial investments of KRW 5 billion or more, and are subject to external audit, and high net-worth individuals with financial investments of KRW 500 million or more that have an annual income of KRW 100 million or more; or with financial investments of KRW 500 million or more and total assets of KRW 1 billion or more.

However, even if the fund is only targeting qualified professional investors, to be eligible for registration with the FSC, the fund must provide evidence of its investment track record – this requirement could be hard to meet for a newly established tokenized fund.

There is no precedent of a tokenized fund being registered with the FSC, so there is uncertainty whether the regulator will approve it or not.

Offshore funds must engage with a local licensed distributor to market its fund interests to Korean residents. As there is no specific definition of marketing, any activity that ends up with the investment of a Korean in the fund such as emails, calls, in-person meetings, or even attending a conference might be deemed as marketing in Korea. Therefore, these efforts should be strictly carried out by a local licensed distributor.

Tokenized Fund Offerings in Singapore

Singapore is other hot-spot for the crypto industry. It’s estimated that approximately 8% of all ICO’s have taken place in Singapore

The Monetary Authority of Singapore, is one of the most well educated and receptive regulators worldwide. The Singapore regulator has notably recognized payment tokens, security tokens and utility tokens.

Tokenized funds would likely be caught under Collective investment schemes (CIS). CIS in Singapore are regulated under the Securities and Futures Act (SFA).

Offshore funds are required to file a prospectus with the Monetary Authority of Singapore (MAS) in order to sell fund interests to Singaporean residents.

A tokenized fund with an offshore licensed fund manager might be marketed as a Foreign Restricted Scheme under the Section 305 exemption in Singapore to avoid a prospectus filing requirement.

Offers made under the Section 305 must be done only with accredited investors, or to investment companies owned by accredited investors or to investors that acquire fund interests worth at least SGD200,000 for each transaction.

Although there is no requirement to register a prospectus, a notification of the offer must be made submitting an information memorandum and other required documentation to the Monetary Authority of Singapore (MAS) – the notification can be done online and it can be approved in a couple of days.

If the fund is targeting retail investors, it will need to be approved as a Recognised Scheme and register the offering prospectus with the MAS. To be eligible as a Recognised Scheme, MAS will consider whether:

• The place of registration and business of the fund and the fund manager gives protection to Singaporean investors
• The fund manager is licensed or regulated in his place of business and is a fit and proper person
• The fund has provided and disclosed required corporate information and documentation
• The fund, the manager and the custodian complies with the SFA and the Code on Collective Investment Schemes
• The manager is managing at least SGD 500 million of discretionary funds in Singapore

Offshore funds, regardless of whether they are restricted or recognized schemes, cannot advertise or make an offer to invitation and are not allowed to incur any promotional expenses other than those paid via commissions to holders of a capital markets services licence authorized to deal with securities.

Legal advice should be taken in order to avoid conducting any marketing activity in Singapore without obtaining the appropriate licence or exemption or appointing a local regulated distributor.

Marketing a Tokenized Fund in the European Union

Although the European Union is a single market with a free movement of goods, capital, services, and labour, non-EU funds, regardless of whether they are managed by an EU fund manager or not will need to comply with the National Private Placement Regime (NPPR) of each EU jurisdiction where the fund interests are sold.

As a background, there are mainly three fund regimes in the European Union:

• The undertakings for collective investment in transferable securities regime (UCITS), which regulates EU investment funds offered to retail investors. UCITS approved in one EU member state can be passportable across the whole EU without needing an additional authorization. These funds are strictly regulated and have several requirements to comply with such as those related to liquidity or portfolio concentration.
• The alternative investment fund managers Directive regime (AIFMD), which regulates alternative investment funds (AIF) and alternative investment fund manager (AIFM). These regime regulates funds that are not eligible to be approved as a UCITS and target professional investors. Under this regime, EU AIF managed by EU AIFM authorized in one EU member state may be marketed across the whole European Union without requiring additional authorizations. Although there this passporting option may be available to certain non-EU funds approved as AIF at some point, currently it is not possible yet – which brings us to the third EU fund regime.
• National private placement rules (NPPR), in which each EU member state establish its requirements for marketing non-EU funds or EU funds managed by non-EU managers. In these regimes non-EU funds still need to comply with several transparency provisions of the AIFMD, and other requirements, but authorization in one country under its NPPR may not be extendable to another EU country.

A tokenized fund will likely be set up offshore or under a professional fund regime in the EU. Therefore, a tokenized fund will need to comply with the NPPR of each of the EU jurisdictions where their investors are domiciled.

Most EU countries allow non-EU private placements but the requirements differ among member states – some countries have a more flexible regime, other stricter and some have even abolished their private placement regimes.

For instance, in Austria, there is no a private placement exemption and although filing a prospectus is not required, an information memorandum should be made available to investors and disclosed to the Austrian Financial Market Authority (FMA) – in some instances, this authorization might be passportable to certain EU states.

Under certain conditions, the non-EU AIF may be distributed in Austria to qualified private investors, which are those who own free deposits and securities of more than EUR 500,000, invests at least EUR 100,000 and does not invest more than 20% of his assets into the AIF.

In Belgium, offerings made to less than 150 investors, offers made only to professional investors or offers of funds which need at least EUR 250,000 per investor, among others, might be exempted of registration or prospectus approval.

For its part, Germany does not generally provide regulation exemptions for private placements. Non-EU funds or EU funds managed by non-EU managers may face a high compliance burden to distribute fund interests to German investors and a cooperation agreement between the German regulator and the regulator of the country where the fund or fund manager is domiciled must be in place.

However, under certain conditions funds marketed to German investors in a strictly private basis that do not exceed EUR 100m (leverage included) or EUR 500m (without leverage) might, in certain cases, be exempted from the German Capital Investment regulations.

In Luxembourg, there might be exemptions from the requirement to publish a prospectus for distribution of non-EU funds when they are addressed to qualified investors, or offers of units whose denomination is at least EUR 100,000, among other requirements.

Netherlands may not require a license for Non-EU funds distributed to qualified investors, if there is an appropriate cooperation agreement between the Dutch Authority for Financial Markets (AFM) and the regulator of the country where the Non-EU fund and fund manager is domiciled.

Normally, a qualifying investor in the EU is either a legal entity, trust or individual which has net assets in excess of EUR 750,000 or which is part of a group which has net assets in excess of EUR 750,000.

In most EU countries, reverse solicitation, which means that the investor directly gets in touch with the fund and/or fund manager on its own initiative, without a prior solicitation from the fund, might not be deemed as marketing the fund in the jurisdiction – and therefore the fund might not need to comply with NPPR.

However, definition and guidelines for reverse solicitation vary in each jurisdiction and care should be taken to make sure that these communications are not considered active marketing.

For instance, if the fund does not explicitly state the countries that is targeting, or if it uses local language in their marketing materials, or it makes references to a country where it’s not registered or it has a contact point within the country, will likely be deemed as active marketing.

In short, a non-EU tokenized fund should not treat the European Union as a single market – and seek the proper local legal advice in each of the country where they are offering and selling their tokenized fund interests to be compliant with local regulations.

Tokenized Funds in United Kingdom

Although there is uncertainty on how the BREXIT will affect EU alternative investment funds marketing in the UK, which most likely would lose its ‘passport’ and would need to adhere to the national private placement rules – as of now, the BREXIT impact to non-EU funds may likely be limited.

However, if the passporting option becomes available for funds domiciled in certain non-EU jurisdictions, they won’t be authorized to market in the UK.

Currently, Non-UK and non-EU funds are subject to UK NPPR which covers both professional and retail investor solicitation. Retail investor solicitation is also subject to additional financial promotion regulations.

An offshore tokenized fund manager would need to notify the Financial Conduct Authority (FCA) about its intention to market its private placement fund and meet certain conditions and disclosure requirements. There should be cooperation arrangements or memorandums of understanding in place between the FCA and the regulation authority of the country where the fund and the fund manager are domiciled.

Reverse solicitation is generally not subject to the private placement regime. Usually,

it’s sufficient a confirmation made from the investor that the placement was made via its own initiative, but legal advice should be taken on whether relying in this confirmation would suffice to comply with regulatory requirements.

Tokenized Funds in Switzerland

Switzerland is not part of the EU and therefore the EU AIFMD does not apply. Funds marketed in Switzerland are subject to the Collective Investment Scheme Act (CISA) and the Collective Investment Scheme Ordinance (CISO), and are regulated by the Financial Market Supervisory Authority (FINMA).

Switzerland regulates funds that are deemed to be distributions. Funds that are not considered to be distribution, and therefore exempted, are those marketed to regulated financial intermediaries (i.e. securities dealers, asset managers or financial institutions, among others), or those that are considered done through reverse solicitation, such as fund interests acquired by regulated financial intermediaries on behalf of their clients, among others.

Any other offering of funds interests to Swiss persons may be subject to CISA and CISO, and therefore required to seek authorization from FINMA.

There are mainly two different distribution categories: offers made to qualified investors (QI) which includes certain public entities, pension schemes and private enterprises, wealthy private persons that opted in to be treated as a QI and certain asset managers; and offers made to non-qualified investors, i.e. retail offerings.

Wealthy private persons are defined as those individuals who own directly or indirectly, financial investments worth at least CHF 2 million.

A tokenized fund targeting QI will be required to appoint a Swiss representative and engage with a local licensed fund distributor or obtain an authorization from FINMA to distribute foreign collective investment schemes.

Marketing a Fund in Australia

Investment fund units might be offered in Australia via public offering or private placement.

A tokenized fund might sell fund interests to Australians via a private placement to a ‘wholesale’ investor. Usually a wholesale investor would be required to invest at least AUD 500,000 in the fund and have net assets of at least AUD 2.5 Mil or gross income of at least AUD 250,000 within the preceding 2 years, among other requirements.

Note that the fund may be required to engage with an AFS licensed company or obtain an AFS license to market the fund in Australia. Specific exemptions from the AFS licensing may apply for certain foreign financial service providers marketing to Australian wholesale clients if they are registered with the UK FSA, Singaporean MAS, US SEC, Hong Kong SFC and German BaFin.

The Bottom Line

When launching a tokenized fund – you have to not only consider laws and regulations of the country where your fund is domiciled – also those from the country where your investors are located.

You should have the proper distribution strategy based on your target markets, jurisdiction crypto-friendly stance, prospects, regulatory and compliance requirements, liquidity, among others factors – and select the jurisdictions where you are going to market the fund and obtain legal counsel in each one of them. At Flag Theory, we can help you with that.

Even if it’s not required by law, usually it is highly recommended to engage with local licensed distributors such as securities broker-dealers and asset management companies – they are more familiar with local regulations, requirements and restrictions and will definitely help you sell the fund interest tokens more effectively. We do have connections in several jurisdictions for that.

Reverse solicitations (investors approaching directly the fund)  may be excluded from regulations in several jurisdictions, however a conservative approach should be taken here and you should definitely seek qualified legal advice in the given jurisdiction for these type of sales.

The definition of ‘marketing’ or ‘distribution’ might be broad depending on the jurisdiction and even follow up communications or a publicly available website can be deemed as marketing – relying on a reverse solicitation approach without being properly advised contains unmitigated risk.

At Flag Theory, together with our partners, we are putting in place a ‘Tokenized fund in a box’ package, in which we will:

• Help you select the most suitable structure and jurisdiction to set up and sell your tokenized fund and design a distribution strategy – according to your requirements and priorities
• Assist you with any registration/licensing process
• Introduce you to top legal counsel in the jurisdictions where your fund is operating and your investors domiciled.
• Introduce you to fund administrators and custodians
• Provide you a KYC/AML compliance software, and a digital identity solution for cross-platform secondary trading
• Introduce you to Blockchain developers to build your smart contract

Contact us for further information. It would be a pleasure to work with you. If you are a lawyer who is working with startups in the space, we are also happy to collaborate.

Would you like to receive the Flag Theory Weekly Letter in your email?

Subscribe to the Weekly Letter