Security Token Offering (STO) in the Cayman Islands

Security Token Offerings (“STOs”) are becoming an increasingly popular means of fundraising for new projects and utilise blockchain technology to do so. 

The typical example of an STO is where a project (usually operated through an entity) seeks investment in the form of fiat or cryptocurrency and, in exchange, offers a token connected with the project. If the project fails to reach its fundraising target, it does not launch and the commitments are returned to investors. For instance, an author could use an STO to fund the publishing of their book and each token entitles the holder to a copy of the book when published. These tokens can then also be traded.

Whilst no specific legislation has been passed by the Cayman Islands Government in connection with STOs and cryptocurrencies, it would be incorrect to say that STOs are “unregulated”. The fact is that some of the existing legislation in the Cayman Islands can, and in certain circumstances will, be applicable. We have listed the most relevant legal considerations when structuring an STO in the Cayman Islands below. We suspect that more-specific legislation will eventually be created although, for the time being, the regulators and lawmakers in the Cayman Islands are keen to avoid rushing through any legislation before the potential benefits and pitfalls of blockchain technology, cryptocurrencies and STOs are properly understood.

The Securities Investment Business Act (2015 Revision) (“SIBA”)

SIBA is the Cayman Islands’ primary legislation relating to the regulation of investments in ‘securities’ and associated businesses. Essentially, no person shall carry on (or purport to carry on) securities investments business unless that person is the holder of an appropriate licence or is excluded from the requirement to hold a licence.

The term ‘securities’ is defined in SIBA by reference to a list of particular types of security (including shares, stocks, partnership interests, instruments acknowledging indebtedness, options, futures etc.). This definition is narrower than that used in the US Securities Act of 1933 as there is no corresponding concept of an ‘investment contract’. There is instead just a specific list of types of security which does not specifically refer to a cryptocurrency or token.

As the definitions of ‘securities’ and ‘securities investment business’ are linked (i.e. securities investment business includes dealing in, managing and advising on securities), it is generally accepted that an STO should fall outside of SIBA. As always, this depends on the particular circumstances of the STO and so specialist advice should be taken on this point at the outset.

Mutual Funds Act (as Revised) (“MFA”)

In circumstances where the STO is related to an investment fund (tokenized or otherwise) or some other form of investment vehicle, the possible application of the MFA should be considered.

In general terms, the MFA regulates “mutual funds” which is a company, unit trust or partnership that issues equity interests, the purpose or effect of which is the pooling of investor funds with the aim of spreading investment risks and enabling investors in the mutual fund to receive profits or gains from the acquisition, holding, management or disposal of investments.

The MFA should not therefore be a concern where the STO is not intended to be an investment fund or engage in investment fund activity.

However, where the STO is related to an investment fund or investment fund activity, the current definition of “equity interests” in the MFA becomes critical. Currently, the MFA defines “equity interests” as a share, trust init or partnership interest that (i) carries an entitlement to participate in the profits or gains of the company, unit trust or partnership; and (ii) is redeemable or repurchasable at the option of the investor.

Accordingly, our view is that tokens issued by investment funds would not fall within the definition of “equity interests” in the MFA by virtue of them not being shares, trust units or partnership interests. However, those STOs which are structured as tokenized funds should take specific legal advice in connection with their structure and, crucially, the rights attaching to the tokens as we expect regulatory changes to be announced by the Cayman Islands Monetary Authority (“CIMA”) imminently. We do not currently know what these changes will be but we would expect the definition of “equity interests” in  the MFA to be extended to cover cryptographic tokens. Should that occur, tokenized funds which offer token holders the right to redeem would likely require registration with CIMA under the MFA and would need to also comply with the various requirements associated with such registration (including the requirement that each investor have a minimum subscription amount of US$100,000). We have several recommended solutions to address this until we have some specific legislation or guidance from CIMA.

Anti-Money Laundering (“AML”) Laws and Regulations

The Cayman Islands has established a comprehensive and robust AML regime which is comprised of the following specific laws and regulations:

• The Proceeds of Crime Act (2017 Revision) (the “PCA”);
• The Anti-Money Laundering Regulations, 2017 (the “AML Regulations”); and
• The Guidance Notes on the Prevention and Detection of Money Laundering and Terrorist Financing in the Cayman Islands.

How do these apply to an STO that is being structured using a Cayman Islands company? The PCA is of general application to all Cayman Islands entities and requires them to take certain steps in the prevention of money-laundering and terrorist financing, including the imposition of various penalties for non-compliance.

The AML Regulations are perhaps of potentially greater practical significance to an STO by virtue of their wide application and the requirements for compliance. The AML Regulations apply to those who conduct ‘relevant financial business’ which is defined by reference to a specific list of activities. The most obviously relevant activities to an STO would be (i) acceptance of funds and other repayable funds from the public, (ii) issuing and managing means of payment, (iii) money broking and (iv) money or value transfer services. If an STO issuer’s activities fall within this definition, it would need to establish written AML procedures, conduct identification verification checks and also appoint specific officers (Compliance Officer, Money Laundering Reporting Officer and Deputy Money Laundering Reporting Officer) among other things. It is therefore imperative that legal advice be sought as to whether the STO in question constitutes ‘relevant financial business’ and, if so, how compliance with the AML Regulations is achieved. In particular, advice may be required as to how best to conduct identification verification checks when the nature of the cryptocurrencies being paid in respect of the STO are, by their very nature, encrypted.

Money Services Act (2010 Revision) (the “MSA”)

The MSA regulates ‘money services business’ in the Cayman Islands. This would include businesses which provide currency exchange and money transmission services. In order for an entity to conduct money services business, it would need to be appropriately licensed by the Cayman Islands Monetary Authority. It is, in our view, generally unlikely that the MSA will apply to an STO although it will of course depend on the specifics of the offering. Again, specific legal advice should be sought on this point before an STO is commenced.

Automatic Exchange of Information (“AEOI”)

The Cayman Islands has entered into a Model 1B (i.e. non-reciprocal) intergovernmental agreement with the United States in connection with the implementation of the Foreign Account Tax Compliance Act (“FATCA”) and has also entered into a Multilateral Competent Authority Agreement to implement the Organization for Economic Cooperation and Development’s Global Standard for Automatic Exchange of Financial Account Information - Common Reporting Standard (the “CRS”). A detailed summary of the implications of FATCA and CRS is beyond the scope of this note but let it suffice to say that an entity which is considered a ‘financial institution’ under these regimes would be under an obligation to identify and report on its account holders. Prospective STO issuers should seek specific legal advice as to their status under FATCA and CRS to ensure that they are operating in compliance with such laws.

Register of Beneficial Ownership

All Cayman Islands companies are now required to establish registers of their beneficial owners (generally speaking those who directly or indirectly hold more than 25% of the interests in the entity or who otherwise control it). Typically, we would not expect token holders to be considered registrable persons for these purposes although, of course, it will depend on the nature of the tokens and the offering and will need to be considered at the outset.

Electronic Transactions Act (2003 Revision) (the “ET Act”)

The ET Act is the Cayman Islands’ primary legislation relating to the conclusion of transactions/contracts electronically. Given the nature of STOs, the ET Act is therefore of potentially critical significance when establishing the terms and conditions of the STO (whether in the form of purchase agreements or otherwise) and how contracts are concluded. All terms and conditions governing the STO, as well as the STO mechanics generally, should be considered in the context of the ET Act to ensure compliance.

How can we help?

We have seen a significant increase in activity in the cryptocurrency and STO sectors and are well placed to provide advice on a prospective STO.

In addition to the incorporation of a Cayman Islands exempted company or limited liability company (through which the STO would be operated), we can provide a full ‘health check’ service pursuant to which we would review the terms of the STO against the Cayman Islands legislation referenced above and provide you with certainty as to which laws and regulations apply and how to operate in compliance with them.

Read the PDF on Virtual Asset Service Providers Registration and Continuing Obligations. 

This publication is for general guidance and is not intended to be a substitute for specific legal advice. Advice should be sought about specific circumstances. 

If you would like further information please contact Chris Humphries at chris.humphries@stuartslaw.com.