What happens to your tokenized shares when the blockchain startup goes under?

by Kevin Koo

Introduction

It wasn’t that long ago in 2017 that ICOs were all the rage. So popular were they, that it seemed, the number one use case of a blockchain was to sell tokens…. and make money.

The truth was, 2017 was a pretty good year for ICOs.

Startups loved ICOs because the mere mention of “blockchain” would generate huge interest and potentially send techies into spasms while pontificating about their favourite crypto projects. That, and the fact that startups were no longer reliant upon venture capital to reasonably be able to raise funds and grow their businesses. “Buy our token,” startups would say, “and we will build this platform, the first one in the world to do you-know-what, and you can use the token in our platform.”

The response was fantastic. Project after project saw great success.

But the day came when ICOs fell out of favour.

As the price of cryptocurrencies experienced a steady slide all through 2018, enthusiasm for ICOs waned. “I’m working on blockchain,” someone would start. “Err… Let’s talk about something else,” came the response. Many had poured their life’s savings into projects that promised huge returns. And they paid the price.

It wasn’t all about the price, though. There were notable exit scams like Prodeum that left a blank website with only the word “Penis” for their website visitors to meditate upon. There were also white paper “milestones” that were never realized.

ICOs became a dirty word.

It was in that dreadful environment that the idea of regulation-compliant token offerings began to take off. 

“Let’s have a token sale that complies with what the regulators want,” said some clever lawyers. “Let’s admit that we are selling securities, and sell securities in a compliant manner.” Slowly, the idea took off. What began as a way to bypass the regulators was evolving into an exercise that sought to comply with what the regulators wanted.

You may have heard of it: It’s called the security token offering (STO).

Tokenized shares and STOs

Tokenized shares are a key idea of STOs (security token offerings). Let’s be clear, that the idea of security token offerings aren’t confined to tokenizing shares. In fact you could tokenize other rights, or assets. Here are some examples.

ART: In September 2018, blockchain art platform Maecenas tokenized a 31.5% stake in an Andy Warhol painting and sold the tokens to investors. A few months later, Maecenas repeated the feat by teaming up with John McAfee and Ethershift to tokenize a Picasso painting.

FUNDS: In September 2019, Harbor announced plans to tokenize $100 million worth of real estate funds, in collaboration with iCap Equity.

REAL ESTATE: In October 2019, a $600 million hotel in London was tokenized using the Liquefy platform.

There are many other projects that have been planned and executed around the tokenization of assets and rights. Shares is one of those things.

How tokenized shares work in STOs

STOs differ from project to project. There is no fixed template upon which everyone must follow. After all, it is a developing field, and the dominant design is still emerging. Many of them go the path of exempt offerings – to qualified investors, through private placements. 

Some, like equity crowdfunding platform StartEngine, choose the Reg D route in the US. Others sell tokens, which entitle token holders to benefit from share appreciation, and to convert tokens into non-voting shares. Like Mycelium wallet did, when they sold their tokens in 2016. 

Some others sell tokens that can be treated as digital rights warrants. Like the SEFToken, issued through Securitize — which can be converted into equity in Mercari, a licensed exchange in Australia. 

And yet others approach token sales as debt-based fundraising, which need to be repaid — or get converted to equity. (It’s called the convertible loan, a very conventional arrangement.) Like the Automated Convertible Note, which Consensys, in conjunction with Latham Watkins LLP, have proposed.

Most of them work on the premise of selling tokens, which represent shares. They are tokens which can be converted to shares. Or, tokens which give the right to subscribe to new shares. In any case, the purchaser is buying tokens which are somehow tied to shares.

Here’s where it gets interesting

I was recently introduced to some prospective clients, who were in a problematic situation. Around three years ago, they agreed to invest money into a new promising startup. They were promised preference shares, which meant a fixed dividend, and protection in case of a liquidation. They even signed a Deed of Debenture to assure them that their rights as creditors of the company were secure.

However, early this year, to their shock and surprise, they found out that the company had been wound up. They recalled that they held preference shares, and made their way to the liquidator’s office… There, they were told, that they were not shareholders, and the liquidator refused to recognise their rights! 

They were very sure that they had invested their money into the startup. And they were very sure that they had signed an agreement to subscribe to new shares. 

They were bewildered, and wondered what had happened… At the lawyer’s office, they later heard that the shares had never been issued, and the Deed of Debenture had never been stamped.

The reason? The company’s promoters had failed to pay the lawyers their charges, and the lawyers did not want to use their own money. And since the lawyers were not paid, the company secretary was also not paid. And the investors were in a very bad position: Their money had been invested, but they were not shareholders.

The liquidator felt that he was not wrong to deny their claims of being preference shareholders. “Your names are not here, so you don’t have rights,” said the liquidator.

The lawyers felt that they owed no duty to the investors, as they had no direct contractual relationship with the investors. “You are not our client, and we never had a contract with you,” said the lawyers. Ultimately, I advised them that they may want to pursue the matter further with the company’s promoters. 

But that was that case.

Let’s talk about tokenized securities and the liquidator.

The liquidator and tokenized securities

The previous segment raised the issue, “Do shareholders-in-waiting have rights during a liquidation?” The investors were not yet shareholders. But they had a right to become shareholders. They were shareholders-in-waiting (just like Anwar Ibrahim is a PM-in-waiting).

How should a liquidator deal with them? 

This situation is pertinent to token purchasers. STO Tokens often entitle the tokenholders to exercise certain rights, for example, to exchange their tokens for shares.

If the token purchasers have a debt-based security, like a convertible loan, against the company, they stand as creditors and can claim as such. In such a situation, it is likely that they will not emerge empty-handed. If the tokens are “digital warrants”, on the other hand, they will have to be exercised in order to give the token holders shareholder rights.

So it really depends on what kinds of rights are attached to the tokens. 

As you may have guessed, there is no straightforward answer, and you will have to consult with a lawyer. Among others, how the STO was structured is a significant factor. (But that’s a topic for another day.)

Thanks for reading.

Important Note: This article has been prepared for general information purposes and should not be treated as legal advice. Please refer to a qualified lawyer before making any decision. If you are interested, we do offer consultation services about STOs, tokenized securities, and liquidation.

This article was first published on the Lex Futurus blog.