A mortgage backed Security Token – vision or reality?

Autor: Stefan Paulmayer

Crypto currencies and tokens are still among the trending topics. While the hype from 2016 to 2018 has focused mainly on so-called Utility Tokens, so-called Security Tokens are now “the next big thing”. Security Tokens offer investors the opportunity to invest in actual values. This distinguishes Security Tokens from Utility Tokens that – like vouchers – have mainly been used to provide services via platform solutions.

The current predominant examples of Security Tokens are tokenized profit participation rights. A Security Token, however, gets certainly even more interesting if one wants to use “real” values (i.e. real properties) as the underlying. The Austrian land register is, however, not known for its flexibility, but rather for its strict formal requirements.

Reason enough to consider whether there are possibilities under Austrian law to effectively collateralize Security Tokens through real estate:

Executive summary

The short answer is: Yes. Austrian law already offers regulations that could be used today to issue Security Tokens backed by mortgages.

How does this work? We have summarized the key features of a concept as follows:

• The Security Token must be in the form of a partial debenture (and commercially in the form of a loan). This implies that the Security Token would need to be repayable and bear interest.
• In the mortgage agreement, which is to be attached to the conditions of the subscription of the Security Token, the appointment of a “Joint Representative” within the meaning of § 15a Austrian Act on Trustees (“Trustees Act”) would have to be included.
• Following this concept, the token holders would directly hold the benefit of the mortgage – without each individual token holder being registered in the land register himself. Rather the Joint Representative would be registered in the land register. Even if the Security Token is resold, no entry or correction in the land register should be required.

Such Security Token could hence in particular be used as an alternative to a corporate bond financing for real estate projects.

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In the following, interested readers will find a detailed concept for the structuring of a mortgage backed Security Token:

Starting point – How do mortgages work?

In Austria, collateral over real properties is established by mortgages registered in the land register. As is usual with pledges, registration of the mortgage with the land register requires that the pledgee has his own claim – which is to be secured by the mortgage.

Except in a few special cases, each transfer of the secured claims requires a change of the mortgage and that the land register status be corrected and the new pledgee be registered.

These are certainly not the best conditions to create collateral for Security Token by way of mortgages. The formal requirements of the Austrian land register contradict the intended easy and fast transferability of Security Tokens. Not to mention the fact that Security Tokens are usually intended for distribution to several investors – which only further complicates the logistics of an effective creation of a mortgage.

Solutions from the “traditional” Banking & Finance world

Admittedly, the formal problems described above are not limited to the “new world” of digital value units – similar problems arise also in connection with syndicated loans where a majority of lenders seeks credit protection through pledges.

In these cases, a recognized solution for creating a pledge is to appoint a security trustee to hold and manage the collateral on behalf of all lenders. Due to the requirements of Austrian civil law, however, this security trustee needs a valid own claim against the borrower in order to effectively create a pledge.

If one of the lenders assumes this role, such pledge can be created in the amount of that lender’s share in the syndicated loan. However, is it possible to create a pledge held by one lender securing the aggregate amount of the syndicated loan?

Essentially, two approaches have been adopted for this purpose:

• In the loan agreement, a joint creditorship in favour of the security trustee is agreed. The security trustee is, thus, together with all lenders joint creditor of the debt of the borrower.
• A so-called “parallel debt” arrangement is established. A parallel debt agreement establishes an abstract liability of the borrower in favour of the collateral trustee in the total amount owed to all lenders. Since abstract liabilities are – with a few exceptions – not allowed under Austrian legal, the parallel debt is often subject to English or German law.

If you do not fully understand these concepts, then this all but confirms that the existing concepts are complicated. There surely must be an easier way?

The Emperor will fix it for you – the Joint Representative according to the Trustees Act

A law from 1874 that was relatively unknown until the insolvency of A-Tech Industries in 2010 may offer a practicable solution.

According to the provisions of the Trustees Act (Kuratorengesetz – KurG), a pledge in favour of creditors of partial debentures can be registered in the land register. The specific benefit is that not every single creditor has to be entered personally into the land register as pledgee. Rather, a “Joint Representative” can be appointed in the mortgage deed. This Joint Representative is then registered in the land register as the debenture holders’ representative.

The Joint Rrepresentative does not hold the mortgage for the creditors as a pledgee – hence, he is not a security trustee or security agent. Rather, each debenture holder has its own mortgage claim. This is one of the few exceptions under Austrian law, where the holder of an in rem right over real properties does not need to be registered in the land register himself.

So how can a Security Token be secured by a mortgage?

Admitted – when the Trustees Act was enacted in 1874, the legislator did not and could not have digital value units such as Security Tokens in mind. So isn’t it questionable to apply such a law to digital assets such as tokens?

Not at all – when the Trustees Act was enacted, there also existed no book-entry securities. These are securities that may be de-materialised. This means that there are no longer any individual physical securities that the investor can hold in his hand. Rather, such securities are book-entries in online securities accounts. Even in rem rights can be established by mere book-entry without having to follow any traditional property law requirements. The vast majority of all bonds issued in modern times are book-entry securities.

There is no doubt that the Trustees Act applies to such securities. The features of such book-entry securities as described above – in particular their de-materialised nature – can also be found in Security Tokens.

What is more – the Trustees Act does not expressly require that “transferable securities” be issued.  Rather, the Trustees Act is applicable to “bearer partial debentures“.

The law itself also provides for examples to explain what is to be understood by the term partial debentures: “partial obligations” or “batches” are covered by this term.

Even though mostly classical corporate bearer bonds have been subsumed under the scope of application of the law, the application of the Trustees Act to Security Tokens appears feasible. If these are structured similar to a bearer bond, one could qualify such Security Tokens as “partial debenture” within the meaning of the Trustees Act.

To this end, it will be necessary that the total nominal amount of the issuance will be divided by a defined number of issued Security Tokens – each Security Token thus represents a partial obligation of the issuer in terms of the total issue volume.

As partial debentures within the meaning of the Trustee Act represent a loan, Security Tokens would need to be repayable. Also, legal writing on the Trustees Act suggest that interest must be payable. However, interest claims could be covered – similar to zero coupon bonds – through higher redemption amounts.

In the mortgage agreement, which is to be attached to the conditions of the subscription of the Security Token, the appointment of the Joint Representative under the Trustees Act has to be included.

Conclusion

The concept for a mortgage backed Security Token may be summarized as follows:

• Security Tokens should be subject to the Trustees Act.
• In order for Security Tokens to be subject to the Trustees Act, they must have the same quality as bearer partial debentures.
• Commercially, Security Token would need to be structured like a loan. Token holders would have a right to repayment and interest.
• Security Tokens that meet these requirements should be able to be secured by a mortgage.
• The individual holders of the Security Tokens have an independent in rem right resulting from the mortgage.
• The individual holders of the security tokens would not be registered in the land register. Instead, the Joint Representative would be registered in the land register as representative of the token holders.
• Security Tokens are freely transferable. Each new holder of these Security Tokens would directly hold the benefit of the mortgage. A registration in the land register should not be necessary.

Such Security Tokens would thus be suitable, for example, as an alternative to “traditional” secured corporate bonds in the real estate sector.

PwC Legal will be happy to assist you with the issue of such security tokens.

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This concept of a mortgage backed Security Token also be discussed with participants of the FIBREE TOKEN-WORKSHOP in the sidetrack to Blockchain Real on 21 May 2019 in Vienna.

A more scientific discourse of the topic will also be included in the textbook “ Kryptowährungen – Krypto-Assets, ICOs und Blockchain – Recht – Technik – Wirtschaft “. The textbook is set for publication in autumn 2019 and may be ordered under ISBN 978-3-7089-1781-8.

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Stefan Paulmayer was attorney-at-law and Head of Capital Markets at PwC Legal Austria. He assisted Conda AG in the successful ICO of its CRWD Token and focuses on questions of Blockchain, SmartContracts, crypto currencies and crypto assets.