[Mihir is a student at National University of Study and Research in Law, Ranchi.]
Tokenization of real-world assets is becoming a common trend all over the globe as it increases the investment exposure especially for small ticket investors and provides with easy liquidity option for a number of potential assets. Blockchain technology augments tokenization of assets as it enables creation of digital tokens on a distributed ledger representing fractional interest in the underlying asset.
With the help of tokenization, any asset can be liquidated in a very similar manner as how any asset of a company can be liquidated by selling equity interests of the company. The only difference in both the cases is that in the former, it is the asset whose fractional interest is being sold, whereas in the latter, the fractional equity interest of the company which owns the asset is being sold.
However, it can become complex when direct fractional ownership of the asset is being sold to liquidate it but the control and management of the asset remains with the original owner. It can be argued that in case of securities, it is not the direct ownership but an equity interest that is transferred, and hence tokenization of assets by transferring direct ownership will remain out of the ambit of securities. In this post, author analyses the regulatory concerns arising in fractional ownership structures involving direct transfer of ownership of the fractional asset.
Tokenization of Assets-Species of the Fractional Ownership Genus
Recent time has witnessed crowdfunding for real world assets especially due to proliferation of blockchain technology. It has become much easier to fractionalize ownership and represent it digitally using virtual tokens, and this process is known as tokenization of assets. These tokens can not only represent the fractional ownership of the concerned fractionalized asset but also can program the contractual arrangements including the right to receive any financial produce. For example, a right to receive share in profits, as far as fractionally owned asset is concerned, can be automated by using smart contracts.
Crowdfunding for real world assets is not nascent; however, the use of decentralized ledgers has offered some trust and transparency to these arrangements, thus making it more lucrative in the contemporary scenario especially when the number of small ticket investors is on the rise.
Regulatory Regime for Fractional Ownership Schemes
Fractional ownership schemes are akin to collective investment schemes (CIS), and thus are likely to be governed under Securities and Exchange Board of India (Collective Investment Scheme) Regulations 1999 (CIS Regulations). However, currently, there is not even one single registered collective investment management company with Securities and Exchange Board of India (SEBI). As far as fractional ownership schemes in real estate are concerned, SEBI in 2014 formulated the Securities and Exchange Board of India (Real Estate Investment Trusts) Regulations 2014 in addition to CIS Regulations, as real-estate market is a major investment avenue and there are specific intricacies associated with the same. These regulations diversified the secondary market and investment opportunities by providing a framework for investors to invest in real estate without directly owning or managing properties themselves. Instead, they can purchase shares or units of a REIT, which represents their ownership interest in the underlying real estate portfolio.
However, REITs involved institutional investors (due to requirements such as minimum asset size of INR 500 crores and minimum offer size of INR 250 crores) with only 5 registered REITs in India hitherto. This resulted in proliferation of various platforms which facilitate small ticket investors to participate in investment in real estate fractional ownership schemes (FOPs). These FOPs were mainly unregulated until recently when SEBI in its board meeting approved the regulation proposed in SEBI’s consultation paper on micro, small and medium REITs (Consultation Paper).
As per the Consultation Paper, FOPs basically provide ‘an avenue and an opportunity to bring together diverse set of investors and create joint or fractional ownership of such real estate. The main advantage of FOPs is that a group of people can pool in money and jointly purchase real estate.’
It is pertinent to note that although SEBI has only taken into consideration FOPs for real estate but blockchain based tokenization has enabled fractionalization of almost all real-world assets, movable or immovable. Currently, industry leaders and leading economies such as Singapore, Hong Kong, the UK, etc. are exploring the option of asset tokenization in real world assets through pilot projects and have issued regulatory framework for the same. In India, it is still unclear whether a regulation like MSM REITs will be enacted to govern the FOPs involved in fractionalization of other real-world assets, and whether there will be a technologically neutral adoption of investor protection regulatory regime, extending its application to those who are engaging in tokenization of assets using blockchain technology and digital tokens.
FOPs: Collective Investment Scheme v/s Joint Ownership
In order to comment as to whether activity of FOPs engaged in tokenization qualifies as investment contract, it is imperative to understand how they structure and operate. FOPs can structure the arrangement between the investors, real world asset and itself in different manner but broadly there are two methods.
First, investors can invest in securities issued by a specific purpose vehicle (SPV) and SPV purchases the real-world asset. This allows investors to own a certain percentage / fractional share in the real-world asset through the securities issued by the SPVs. Second, investors can pool in money through FOPs and purchase real-world asset and become joint owner of the same. In order to enable FOPs to manage the real-world asset and generate revenue by the use of the same, all the joint owners collectively transfer the Power of Attorney for their fractional part of asset.
Juxtaposing the two different structures of FOPs, it can be said that one involves issuing of securities which evinces ownership interest and the other involves direct joint ownership in the asset. Joint investment arrangements for real-world asset which involve issuance of unit of securities are either regulated under specific regulation, if real-world asset is real estate, or are likely to categorized as CIS and will be governed under the CIS Regulations.
However, it gets complex when arrangement involves direct transfer of ownership rather than issuance of securities. Important factor which is looked into is management and actual ownership of the asset. If the joint owner is directly involved in managing the concerned fractional asset, it is not likely to be treated as a CIS. However, scheme promoters cannot evade the mandates of CIS Regulations merely by citing joint ownership arrangements. If arrangement creates a binding liability of the FOP with the owners for effecting any transfers and requires incoming transferee/s to also execute a POA in favor of the FOP and deprives owners of independently managing their fraction of asset, it is likely to be treated as a CIS.
As per Section 11AA of SEBI Act 1992, any scheme or arrangement will qualify as a CIS if:
i. the contributions, or payment made by the investors, are pooled and utilized for the purposes of the scheme or arrangement;
ii. the contributions or payments are made to such scheme or arrangement by the investors with a view to receiving profits, income, produce or property, whether movable or immovable, from such scheme or arrangement;
iii. the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors; and
iv. the investors do not have day-to-day control over the management and operation of the scheme or arrangement.
The definition of CIS is quite inclusive and depends majorly on the intent behind arrangements. It does not include explicitly those arrangements which involve joint ownership unlike its counterpart in the UK which explicitly provides that fractional ownership arrangements to receive profits, whether by becoming owners of the property or any part of it or otherwise, will come under the definition of CIS. Moreover, the UK Supreme Court in Asset Land v. SCA ([2016] UKSC 17), observed that for an arrangement to fall outside the scope of CIS, it must ensure that the owners actually control the management of their property (and that any management that is carried out on their behalf by the promoter is done on an individual basis and not on a collective basis). Further, the scheme must ensure that the owners are not subject to rights or duties, as against the promoter, or anyone else, that could lead to the conclusion that they were locked into any kind of collective management or development of the real estate asset.
Conclusion
Growing market of the FOPs requires clarity as to applicable regulatory regime, especially in light of the changing operational arrangements due to technological advancements. It is convincing that any arrangement promising returns and involves management of the asset by the promoter will be treated as a CIS whether it is done by issuing securities or transferring direct part ownership. Thus, as per existing regulatory framework, FOPs engaged in fractionalization of real-world assets except real estate are required to undertake operations through a registered collective investment management company, whereas for a real estate asset, MSM REITs regulation will be the parent framework.
SEBI has considered the issue of joint ownership structural arrangements of FOPs in real estate and opined that that the issues of due valuation, liquidity, and transparency subsist in joint ownership arrangements if the owners are circumscribed from independently dealing with their fraction of asset, thus raising concerns of investor protection. These concerns are likely to subsist in FOPs engaged in fractionalization of other assets besides real estate. Therefore, SEBI should consider either framing a specific framework or expressly clarifying the application of CIS Regulations for FOPs engaged in real-world assets besides real estate.