How Security Tokens Can Benefit Creditors in Bankruptcy Restructurings

These blockchain-based assets are SEC-regulated and can give investors a share of a failed business like Celsius' future profits.

AccessTimeIconNov 3, 2022 at 7:57 p.m. UTC
Updated Nov 14, 2022 at 9:10 p.m. UTC
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The 2008 downfall of Bernie Madoff after his $65 billion Ponzi scheme shook Wall Street to its core. In fact, nearly 15 years after the first headline appeared about the crimes committed, investors in Madoff’s fund are still looking to recover losses. From pension funds to grandparents, those nest eggs may be lost forever.

While the creditors and the court-appointed trustee in the Madoff case still work to recover more of the losses, the process has been slow, complex and inefficient – with many investors only receiving a fraction of what was stolen from them.

Renata Szkoda is the chief financial officer of INX, which offers a trading platform for security tokens.

What if those same people had had access to security tokens enabling the recovery of their losses and even profit from recovery of the business with a promise of future cash flows? Whether it's Madoff or crypto lender Celsius Network, security tokens may be the go-to solution to democratize and simplify bankruptcy recovery efforts for creditors and investors alike.

The new ‘fail-safe’ tool in finance

To fully understand the usefulness of security tokens, you must first understand what they are and what they are not. Security tokens are regulated tokenized assets issued on the public blockchain that represent an investment in an enterprise providing a profit share or equity stake to the holder. They are publicly traded on a regulated market and interact with smart contracts, which lowers costs and increases efficiencies. That said, security tokens are not cryptocurrencies.

Security tokens mimic the market for traditional equities. But unlike stocks, for instance, securities are available to trade 24 hours a day, every day of the year and settle instantly and directly to an investor’s wallet.

Because of their versatile nature, design flexibility and the regulatory setting, security tokens may be the answer to bankruptcy recoveries that investors (and creditors) have been looking for and awaiting.

Bankruptcy doesn’t mean it's over for tokens

In a typical corporate bankruptcy proceeding, creditors of the cash-strapped firm are likely left with a shortfall on their initial investment. Courts and trustees are appointed to pay back these investors as assets are recovered over time.

Traditionally, once a bankrupt firm files for restructuring its remaining assets will be moved to a bankruptcy estate. Those assets are available for distribution to creditors, who typically will not have any rights to the new and restructured enterprise. This process shuts investors out of future profits.

Instead of the status quo, what if creditors leveraged the power and versatility of security tokens? These Security and Exchange Commission (SEC)-regulated assets would be a tool for token holders to participate in the possible future equity appreciation and profits of the restructured enterprise.

More likely than not, businesses that file bankruptcy today prove profitable over time. Why should creditors and investors be blocked from a company’s rewarding future?

Issuing security tokens to investors allows them to participate in future cash flows or revenue of the company, but doesn’t necessarily lead to voting rights. Additionally, the token can be designed to act like preferred equity, thereby giving certain token holders priority on profit distribution and aligning it closely with preferred shares of a traditional company.

The crypto industry today is seeing a number of bankruptcy dealings – including failed lenders Celsius and Hodlnaut. Every creditor should carefully consider security tokens as an option.

Tokenized profit sharing: how it works

While issuing the security token, the issuing company either registers the token with the SEC as a private offering or becomes an issuer of a publicly traded equity token. The issuer of the security becomes a public company under the oversight of the SEC, as applicable for all other public entities.

After the company completes the initial coin offering (ICO), tokens are deposited directly into each participant's wallet and trading begins on a public market offered by a SEC registered broker-dealer. Any token holder is free to offer his/her tokens for sale or accumulate more in the market.

This registration process is well established and follows the traditional SEC-approved protocols for issuing equity. As with traditional registrations, each company must present a prospectus that properly reflects the nature of the entity, risk factors and characteristics of the token offering.

Security token initial coin offerings (ICO) and distributions are registered on a public blockchain and recorded and monitored by an SEC-regulated transfer agent. Token holders must also complete know-your-customer (KYC) onboarding to a broker-dealer.

Once this documentation is completed, the issued security instrument (the security token) provides the same regulatory protections offered by the SEC to any holder of a public security. This level of transparency and the benefits of blockchain-enabled self-custody make the asset class attractive.

ICOs over IPOs

Security tokens are no longer new and have been proven as secure and effective digital financial solutions in a variety of use-cases. It has also been proven time and again that ICOs provide superior issuance processes and secondary markets than initial public offerings (IPO).

Peer-to-peer systems – where the issuer is connected directly with the security token holder on a fully-regulated, end-to-end trading platform for issuing, minting and instant settlement – simplify the process.

As the traditional market structures continue to evolve through automated blockchain technology offered within a regulated environment, new digitized systems are becoming more effective and essential.

Instead of the door closing in creditors’ faces from shortfalls in bankruptcy, security tokens give them access to a public and regulated market for their share of unpaid debt – providing an opportunity to recover losses through an equity stake in the restructured company.

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Renata  Szkoda

Renata Szkoda is CFO of INX.


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