Formation of security tokens
In the last article, I had explained that the facilitation for retail investors benefiting directly from the returns generated by real estate assets is difficult to achieve through traditional investment tools viz. REITs or Sukuk. This is simply for the reason that the originator or the operator would like to attract institutional investors and high-net-worth individuals to limit the number of investors it would need to deal with.
However, there is an indirect channel via real estate funds where retail investors are able to invest smaller amounts and receive the income generated by the properties held by the fund, albeit such funds also have certain minimum investment bar. Also, the fund manager pays the dividend to investors pursuant to certain deductions. These are mainly the fund manager’s administrative charges besides its performance bonus and a few other outlays, thus considerably reducing the yield to investors.
The aforementioned limitation need to be addressed through the technologically disruptive approach that could bring in massive numbers of retail investors to enjoy the secure real estate returns directly. At the same time, it should be attractive enough for tech-savvy Gen Z and Gen Alpha, besides being away from the wild-swinging cryptos.
The search ended on the tokenization of real estate assets through fractionalization of their ownership by using modern technology. The combination of finance and technology coined the word ‘fintech’ during the first decade of this century and it covers digital banking, digital trading of stocks (also called robo-advisory), payment services and of course, not forgetting cryptocurrencies (Bitcoin, Ethereum, etc). Hence, the security tokens too could be termed as a fintech tool.
Although I am not aware of any Islamic security token in operation as of now, broadly speaking, the following should be the process for the creation of Shariah compliant security tokens:
• The originator of the security tokens makes the selection of real estate assets owned by it
• These should be revenue-generating sets of assets which must be free from any encumbrance
• The originator hires the services of a licensed digitally experienced professional entity (private equity term ‘general partner’) to prepare the digital private placement memorandum (DPPM) in compliance to the country’s virtual securities Act. The PPM shall have all customary details, similar to any traditional fund’s prospectus
• The general partner shall create a special purpose vehicle for receiving the subscription amount from investors and work as it’s manager
• The PPM will inform investors as to the token’s structure, the aggregate market value of the ring-fenced properties, the defined headroom for tokens (ie tokenization will be up to 80% of the value to provide a fluctuation cushion), the current revenue stream, the projected distributable income to the token holders besides the frequency of distribution
• As the next step, the licensed entity should complete the process of uploading the perfected transaction documentation and the Fatwa from the Shariah committee to the portal for review by the potential investors for their satisfaction that the investment opportunity is Shariah compliant
• Pursuant to reviewing the PPM and the documentation to their satisfaction, the investors (private equity term ‘limited partners’) should start subscribing by digitally signing the subscription agreement
• The subscription process should stop upon completion of the required amount to avoid oversubscription. In my opinion, there should be a gauge in the shape of a green bar to show how much investment is remaining for completion before closure. The bar color should turn red upon getting the required amount
• If the subscription amount is not completed until the pre-agreed closing date, the originator shall have the option either to be content over the amount so received and curtail the tokenization size which shall strengthen the security position for the investors, or to cancel the offering and return the amount to subscribers
• The general partner will arrange the transfer of the unencumbered title in the fund’s name against digitally releasing the subscribed amount to the originator
• The security token’s operation should commence from this stage whereby they become entitled to the rental income being generated by the properties from that point
• However, if the originator has collected any amount on account of the advance rentals or part rental beyond this stage, he will hand over such amount to the general partner for adding it into the distributable income to the token holders on the next distribution date
• The security token may be perpetual or time-bound. In the latter’s case, the general partner shall exercise the put option in terms of the digital purchase undertaking signed by the originator for the benefit of investors, calling for the originator to purchase the portfolio of tokenized assets and the security tokens shall be redeemed by the general partner out of the sale proceeds, and
• The token holders shall also have the option to exit through the digital platform where the tokens are traded at any time during the investment period at the prevalent market price of the token.
The purpose of this educative series and the article is not to hurt any religious or commercial sentiments either consciously or even unwittingly.
Sohail Zubairi is an Islamic finance specialist and AAOIFI-certified Shariah advisor and auditor. He can be contacted at sazubairi1979@gmail.com.
Next Week: Discussion on the security token to culminate next week.
