Organizing Measures for Regulatory System on Security Token Issuance and Distribution in Korea

1. Background

- As securities are issued and distributed only in a specific form and method for the following three reasons in the current system, the government has adopted and is promoting the regulatory system under the Financial Investment Services and Capital Markets Act (“Capital Markets Act”) for the issuance of security tokens as a part of the list of national tasks.
  - The holder of physical securities under the Commercial Act and the person registered in the electronic registration account under the Act on Electronic Registration of Stocks and Bonds (“Electronic Securities Act”) are presumed to be legitimate holders of rights. However, the issuance of securities in other ways is virtually impossible as it may cause a double transfer problem.
  - Under the Capital Markets Act, in effect, beneficiary certificates and investment contract securities are excluded from securities subject to distribution.
  - The utilization of private placement and small public offering is limited, and securities are circulated only in the listed stock market due to strict sales regulations.
- In response, the Financial Services Commission (“FSC”), Financial Supervisory Service (“FSS”), Korea Exchange, and Korea Securities Depository jointly issued the “Organizing Measures for Regulatory System on Security Token Issuance and Distribution” (hereinafter, “STO Organizing Measures”) and “Guidelines for Security Tokens” on February 6, 2023, as the first step in the implementation process.

2. Presenting Principles for Determining Which Digital Asset Shall Be Categorized as Security

- In the STO Organizing Measures, the financial authorities clarified that regardless of the form in which securities are issued, if they conform to the concept of “securities” under the Capital Markets Act, they must be regulated under the Capital Markets Act.
- In addition, in the case of investment contract securities, it is a concept that is applied supplementarily when it does not fall under the other 5 types of securities. Its scope of application can be widely recognized as shown in Table 1 and Table 2, including main requirements for investment contract securities and examples of digital assets that have been categorized as securities.
- Most of the requirements for investment contract securities presented in the STO Organizing Measures are similar to those from the previous discussions. However, unlike the previous ones, even if the investor’s rights are fulfilled through a smart contract, it can be interpreted as a contractual right to an issuer if the issuer promised the implementation of the smart contract itself as a contract.
- The financial authorities also stated that they will prevent attempts, in the process of determining whether a digital asset is a security, to circumvent regulations by actively interpreting and applying implied contracts, the conclusion and execution of contracts implemented in smart contracts, the contents of profit distribution, and the contents of advertisements and solicitations, not limited to the contents of explicit contracts, terms and conditions, and white papers.

Table 1. Five Main Requirements of Investment Contract Securities

1. Joint Business	– If there is a relationship between two or more investors (horizontal commonality) or between an investor and an issuer (vertical commonality), it is a joint business.
2. Investing Fund, etc.	– The fund invested is not limited to legal currency, and the possibility of exchange with legal currency and the presence or absence of property value are comprehensively considered.
3. Mainly Operated by Others	– The efforts of others (issuers) must be undeniably significant and be essential managerial efforts that could determine the success or failure of the business. – Even if the issuer does not directly conduct all of the business, it includes cases where there is a joint and collective effort by business entities other than investors – If the issuing entity and the business entity are only formally different, they can be regarded as joint issuers. – Even if an investor conducts part of a business, if there is information asymmetry in most of the business, it can be regarded as mainly performed by another person.
4. Contractual Right to Attribute Profit or Loss as a Result of the Joint Business*	– It may also include cases where a contract is signed to receive profit or loss from business results when a certain point in the future arrives or when certain objective conditions (e.g., sales target) are achieved. – Investor rights are implemented through smart contracts, but if an issuer promises to implement the smart contract, it can be interpreted as a contractual right to the issuer. – Applicable when the issuer, etc. conducts business with investors’ fund, etc., and promises to return the profits according to the performance of the business conducted. In particular, if the promised profit is in proportion to the revenue or profit generated from the business, or if a promise is made to convert and distribute the revenue or profit generated from the business, it falls under the profit or loss resulting from the joint business. – The right to claim profits under the contract between the investor and the issuer must be recognized, such as the issuer expressly or implicitly promising to distribute the business profits directly to the investor, or the issuer promising that the third party will distribute the business profit to the investor based on an agreement with a third party.
5. Profit Earning Purpose	– Investor invested fund, etc. for the purpose of earning investment profit

Table 2. Example of Digital Assets Categorized as Securities

Cases Highly Likely To Be Categorized as Securities

Cases Unlikely To Be Categorized as Securities

– Having equity rights in business operations or dividends based on business performance and right to claim for distribution of residual assets (e.g., equity securities)

– If the investment can be repaid after a certain period of time (e.g. debt securities)

– Having a beneficiary right in a trust (e.g. beneficiary certificates)

– Receiving a recovery amount that varies in a pre-determined way linked to price fluctuations of underlying assets according to the Capital Markets Act (e.g., derivative-linked securities)

– If the right to subscribe or acquire securities to be newly issued is granted

– Having contractual rights or equity relationships in other securities deposited (e.g., securities depository receipts)

– If the issuer conducts business with the investor’s fund, etc., and attributes the profits generated as a result. In particular, if the details of the issuer’s efforts, experience, and ability to make the business successful are actively presented when recruiting investors (e.g., investment contract securities)

– Even if the fund, etc. paid to investors is formally in the form of compensation for investor activities, if the main source of the consideration is the issuer’s revenue generated as a result of conducting business with investors’ fund, etc., and the consideration is proportional to the business performance rather than the investor’s activities, and thus corresponds to the actual distribution of business profits. In particular, if the nature of profit distribution according to business performance is actively presented when recruiting investors (e.g., investment contract securities)

– If there is no issuer or no person who has to fulfill the obligations commensurate with the rights of the investor

– If there is no right indicated in the digital asset, or there is no investor’s right to business profits

– If issued and used for the purpose of consumption or use of current or future goods or services

– If it is issued for the purpose of maintaining a stable value for use as a payment or exchange medium and does not promise repayment

– If there is no information asymmetry in the business because the investor participates in the management and operation of the business on a daily basis

– If an investor provides important goods or services that determine the success or failure of a business and receives only funds, etc. corresponding to the price

– If only the share right to the real asset is indicated, and there is no commitment to the role of the issuer for the increase in the price and value of the shared object, contribution, and attribution of profit

3. Regulatory System Improvement Plan on Security Token Issuance and Distribution

- The financial authorities propose the following three points for improvement on issuance regulatory system, to accept the innovativeness of distributed ledger technology, to support the issuance of various rights, and to protect the basic property rights of investors.
  1. Security Tokens are accepted in the form of securities issuance under the Electronic Securities Act
    Acceptance of security tokens in the form of securities issuance under the Electronic Securities Act is largely 1) to give security tokens the presumption of rights and the ability to resist third parties in order to effectively prevent the problem of double transfer of securities, 2) to introduce a distributed ledger of the blockchain as a method of listing and replacing account books in the Electronic Securities Act. means introducing a distributed ledger of blockchain as an alternative method.
    In the case of the latter, in particular, the authorities aim to introduce a system that manages the books only with the records of the distributed ledger, unlike the cases in which beneficiary certificates were publicly offered through existing sandboxes mirroring the books and distributed ledger of the Korea Securities Depository.
    However, as it is necessary to meet certain technical requirements, such as not requiring a separate virtual asset (including gas fee) for distributed ledger records and not violating laws such as the Personal Information Protection Act, there seem to be limits on which blockchain networks can be introduced. Particularly, to abide by the Personal Information Protection Act, it is necessary to be able to delete personal information. This would pose some difficulties to the distributed ledger technology as information cannot be deleted from the ledger, in general, by the nature of the technology.
  2. Introduction of an Issuer Account Management Institution That Directly Registers and Manages Security Tokens
    Electronic securities under the current legislation can only be electronically registered through securities companies. In contrast, introducing an issuer account management institution would mean that issuers who meet certain requirements are allowed to register their securities directly with the institution.
    According to the provisional plan, the institution must meet certain requirements for equity capital, physical facilities, major shareholders, and executives, and manpower requirements such as having two of each legal professionals, securities experts, and computer experts. However, if the requirements are not met, security tokens can be issued in a conventional way through a securities company.
  3. Establishment of Over-the-Counter Trading Brokerage Business for Investment Contract Securities and Beneficiary Certificates
    The current Capital Markets Act does not have a distribution system for investment contract securities and beneficiary certificates. Regarding whether a distribution market can be opened without a regulatory exemption if the distribution system is not applied, the FSC provided answers in the “Reference 2 Main Q&A” section of the “Decision on Exemption From Sanctions for Music Cow Co., Ltd., and Determination of Whether Fractional Investment on Korean Beef and Artwork Categorize as Securities” press release. It stated that since the sales disclosure obligation also applies to investment contract securities, each time a sell order is publicly posted, a disclosure obligation arises for the fractional investment company, rendering it impossible to form a distribution market without a regulatory exception for the duty to disclose sales.
    The STO Organizing Measures plans to 1) establish an authorization unit for over-the-counter (“OTC”) trading of investment contract securities and beneficiary certificates to allow multilateral counterparty trading brokerage for general small investors, 2) prepare a large-scale transaction infrastructure for investment contract securities and beneficiary certificates, by opening the KRX digital securities market, to establish a new securities distribution system through the formation of a small distribution market and utilization of proven infrastructure.
    However, according to the provisional proposal, over-the-counter brokerage business must meet the following requirements:

Table 3. Provisional Plans to Approve OTC Transaction Brokerage Business

Equity Capital, Physical and Human Resources, and Requirements for Majority Shareholders and Executives	Undecided, to be determined later after collecting opinions and taking into account the standards of bond brokerage companies
Scope of Business	Brokerage of trading of investment contract securities/beneficiary certificates outside the stock market
Investment Limit	Restrictions on annual investment limits for general investors The investment limit of investment contract securities will be set at a lower level than that of beneficiary certificates.
Securities Subject to the Plan	Investment contract securities and beneficiary certificates publicly offered or owned by small investors (owning less than 5% of total issuance, excluding issuers, acquirers, brokers, and their specially related persons)
Business Standards	Methods for brokerage application, brokerage application cancellation and correction, principles and methods for transaction conclusion, methods for correcting sales by mistake, methods for notification of transaction conclusion, methods for execution of transaction agreement, methods for creation and maintenance of records, methods for disclosure of the status of the issuer, standards for sanctioning violating members, standards for detecting abnormal transactions, etc. shall be established.
Prohibited Acts	Prohibition of transaction brokerage of securities issued, acquired, or brokered, prohibition of provision or leakage of information to third parties, prohibition of association between brokerage and other businesses
Other	Deposits, soundness, solicitations, advertisements, etc. are subject to the same regulations as securities companies

4. Regulation Implementation Schedule

- Following this guideline, the financial authorities plan to go through a phased implementation stage to formally institutionalize security tokens through sandbox testing, and amendments to the Electronic Securities Act and the Capital Market Act are expected to be submitted in the first half of 2023.
- The specific implementation schedule announced in the STO Organizing Measures is as follows.

Table 4. Implementation Schedule

	Task	Necessary Measures	Planned Schedule
Issuance	Acceptance of Security Tokens	Amendment to the Electronic Securities Act	Bill submission in the first half of 2023
	Introduction of an Issuer Account Management Institution	Amendment to the Electronic Securities Act	Bill submission in the first half of 2023
	Private Placement by Professional Investors	Amendments to the Capital Markets Act	Bill submission in the first half of 2023
	Increasing Limit on Small Public Offering	Amendment to the Enforcement Decree of the Capital Markets Act	By the end of 2023
	Introduction of Small Public Offering II	Amendments to the Capital Markets Act	Bill submission in the first half of 2023
	Consideration of Security Token Public Offering	Revision of Regulations on Issuance and Disclosure of Securities	Following the amendment to the Electronic Securities Act
Distribution	Application of Investment Contract Securities Distribution System	Amendments to the Capital Markets Act	Bill submission in the first half of 2023
	Introduction of OTC Brokerage Authorization*	Amendment to the Enforcement Decree of the Capital Markets Act	Following the amendment to the Capital Markets Act
	Sales Disclosure Exemption for Small Investors*	Amendment to the Enforcement Decree of the Capital Markets Act	Following the amendment to the Capital Markets Act
	Establishment of Digital Stock Market*	Amendment to the Enforcement Decree of the Capital Markets Act	Following the amendment to the Capital Markets Act
* These will be tested through the sandbox, and the results will be reflected in the amendment of the enforcement decree

5. Conclusion

- Despite the growing public interest in beneficiary certificates and investment contract securities following the recent increase in demand for fractional investment, distributing investment contract securities without going through a sandbox was limited due to the lack of a distribution regulatory system under the Capital Markets Act. Furthermore, as the distributed ledger of the blockchain and that of the Korea Securities Depository exist separately, it had to be implemented in a one-to-one mirroring method, rendering the technical advantages of the distributed ledger unable to be utilized even when going through the sandbox.
- If the laws and regulations are amended according to the STO Organizing Measures, it is expected that the distribution of investment contract securities will be stimulated in line with investor demand and that the technological advantages of blockchain can be introduced into the Electronic Securities Act.
- Recently, as stipulated in the STO Organizing Measures, the financial authorities are actively utilizing the private placement and small public offering system so that securities with less risk of damage to investors can be attempted without the burden of disclosure through the following three methods.
  - Private placement is recognized if all applicants are professional investors;
  - Increasing the limit on small public offerings from 1 billion KRW to 3 billion KRW; and
  - Introducing Tier II for small public offerings with a limit of up to 10 billion KRW while strengthening some investor protection devices compared to those currently in place.
- However, since security tokens will be regarded as public offerings through the “Revision of Regulations on Issuance and Disclosure of Securities” to prevent them from being used as a means of avoiding public offering regulations due to their high liquidity, it will be not possible to actively utilize private placement as mentioned above.