Your guide to Token Regulation in Germany
With over $2bn reported to have been raised this year by way of token offerings, here is your guide to the legal and regulatory treatment in Germany.
Where should the entity issuing or generating the tokens be established?
A number of token offerings to date have involved an entity incorporated or established in the Cayman Islands, Gibraltar, Singapore, Switzerland, the UK or the US. There are many factors that drive the choice of jurisdiction, which vary on a case-by-case basis. A question frequently asked, however, is whether any law other than that of the jurisdiction of incorporation of the entity generating or offering the tokens needs to be considered in relation to a token offering.
The short answer is yes. In addition to the laws of the jurisdiction in which the entity issuing or generating the tokens is incorporated or established, the laws of each jurisdiction within which the tokens could be considered to be offered or sold, or in which a regulated activity may be deemed to be carried out, will also be relevant. Most jurisdictions regulate the conditions under which certain investments may be offered (if at all) within that jurisdiction. There are also generally restrictions on the ability of certain persons to carry out certain (regulated) activities in relation to such investments, or submit the carrying out of such activities to conditions (such as licencing or authorisation requirements).
Are tokens regulated investments?
Carrying out a regulated activity in Germany is generally prohibited, unless the relevant person is licensed or exempt. Many activities
which involve “financial instruments”(1) are regulated activities.Depending on the circumstances, tokens may qualify as some form of “financial instrument”.
Whether an activity relating to “financial instruments” is regulated depends on the activity. The sale and purchase of tokens that are “financial instruments” will likely qualify as a regulated activity, although certain exemptions (2) apply. Furthermore, the mere mining of, or payment with tokens should not constitute regulated activities.
Where, however, the sale and purchase of tokens takes place through a platform, authorisation requirements could be triggered for the platform. This would be the case, for example, where the platform carried out some form of brokering activity or placing business. Depending on the precise circumstances, the platform could also be regarded as a multilateral trading facility.
Furthermore, the marketing of “financial instruments” to the German market is also restricted and the issue of any advertisement, invitation or document which contains an invitation to the German market to buy or subscribe for “financial instruments” will need to be duly authorised by the relevant regulator unless an exemption applies.
(1) Financial instruments are broadly defined and cover not only securities but also units of account (Rechnungseinheiten). The German regulator (BaFin) has repeatedly stated that virtual currencies (e.g. Bitcoin) are to be treated as units of accounts and hence, are “financial instruments”.
(2) For example, although the sale and purchase of tokens that are financial instruments will likely constitute proprietary trading, an entity that does not carry on any other regulated activity or belong to a group of institutions, a financial holding group, or a financial conglomerate that includes a credit institution pursuant to the Capital Requirements Regulation (European Union Regulation (EU) No. 575/2013), will not generally require authorisation by reason of that buying and selling alone.
Are pre-sale arrangements themselves regulated investments?
Pre-sale arrangements (if any) vary significantly from one token offering to another. In some cases, a separate instrument is intentionally created (which may or may not itself be a token), which gives rights to, or is convertible into, the main token, once created. In others, the pre-sale is intended to amount to no more than a sale of property that will come into existence at a future date (the tokens). As for tokens generally, the variety in structures therefore requires any pre-sale arrangements to be considered on a case-by-case basis.
Broadly speaking, for most jurisdictions (e.g. Germany, Hong Kong, Singapore and the UK):
(i) if the main token is itself a regulated investment, security or other regulated product, pre-sale arrangements that amount to an instrument, certificate or agreement giving rights to the main token will generally amount to a separate regulated investment; and
(ii) even if the main token is not itself a regulated investment, security or other regulated product, pre-sale arrangements that have characteristics of a derivative, structured product or other financial instrument may nevertheless amount to a separate regulated investment.
For the US, pre-sale arrangements generally will be deemed securities because their value will be primarily dependent upon the sponsor of the tokens developing and marketing the tokens and the platform on which the tokens will be used. This is a classic example of “efforts of others” which, if coupled with an expectation of profit, will fall squarely within the definition of investment contract laid out in the Howey Test.
One of the more prominent attempts to create a legal framework for compliance with US securities law is the “simple agreement for future tokens” (the SAFT). The idea is that the parties will assume that the SAFT is an investment contract (and therefore a security under the Howey Test) and as such the token sponsor will structure the token sale in order to ensure that it can rely on an exemption from registration under the US Securities Act, such as limiting availability of the token to investors to those who qualify as “accredited investors”12.
As the authors of the SAFT acknowledge, their argument hinges on ensuring that the tokens (once issued) are not securities. However, this may not be possible to determine at the outset, as it may be possible that the value of the token continues to depend significantly on the efforts of the token sponsor or third parties. If this turns out to be the case, the fact that the tokens were purchased on a delayed basis through a SAFT does not particularly affect the analysis.
Is a prospectus (or other offering document) required?
An approved prospectus will be required if the tokens are “transferable securities”(1) (übertragbare Wertpapiere) or certain kinds of capital investments (Vermögensanlagen) and the intention is to offer them to the public in Germany (or if they are admitted to trading on an organised market), unless an exemption applies. This also applies to pre-sale arrangements that give rights to tokens that are “transferable securities”.
Even if the tokens are not “transferable securities”, an approved prospectus may still be required to offer tokens to the public in Germany under the German Investment Act (Vermögensanlagegesetz)as it applies broadly to capture products(2) which fall outside the securities prospectus regime.
(1) The relevant criteria for determining whether an instrument qualifies as “transferable securities” are: (i) fungibility (ii) free transferability, (iii) transfer pursuant to the law applicable to moveables, and (iv) rights reflected in a negotiable instrument.
(2) Broadly, any instrument which gives rise to a right, or an option, to receive cash, interest or payments of any nature.
If the tokens are not regulated investments, do other potential regulatory issues arise?
While important, laws relating to the regulation of investment products and services are not the only potentially relevant regulatory issues. Some important examples are set out below.(1)
Payment Services. Where tokens are offered against legal tender, an intermediate platform through which tokens are acquired or sold may carry out regulated payment services and will thus require an authorisation under the German payment services regime.
Can tokens be offered into the People’s Republic of China (PRC)?
A circular was issued jointly by seven regulatory authorities in the PRC on 4 September 2017, which, amongst other things, demanded that all token offerings cease immediately and any completed offerings be unwound (i.e. any proceeds raised should be returned to investors). In addition, cryptocurrency exchanges could no longer provide any trading services (between fiat and cryptocurrencies, or between cryptocurrencies) or pricing/quote services.
The circular does not specifically address whether it is only targeted at domestic token offerings, although insofar as it relates to cryptocurrency exchanges, the penalties stated suggest that it is focusing only on exchanges operating in China.
It is difficult to gauge at this stage whether and how the Chinese regulators would seek to enforce against cross-border token offerings. It is expected that new regulations will be introduced to prohibit illegal fundraising activities (which may include token offerings) in the near future.
What are some of the most significant practical issues currently faced in relation to token offerings?
Security and token holdings. A significant issue in the context of token offerings has been whether and how tokens can be held in a secure way. In particular, it is generally unclear, both as a practical and legal matter, whether or how a claim to tokens that have been lost (for example, because the relevant wallet provider was hacked, or due to fraud) can be enforced.
Bankability. Token issuers have faced difficulties in banking fiat currencies converted from cryptocurrency proceeds received from token offerings. Banks typically view token offerings as presenting a high risk for money laundering, which means that banks would be obliged to undertake enhanced customer due diligence and enhanced monitoring of business relations to comply with their “know-your-client” (KYC) and money laundering obligations. A key practical issue is that banks generally require the source of funds to be established, which necessarily involves identifying:(i) the institution or investor from which the funds originate; and
(ii) the activity that generated the funds. It may be difficult to ascertain the source of funds in relation to token offerings, given the generally anonymous nature of cryptocurrency proceeds, particularly where conversion takes place on a cryptocurrency exchange. Globally, a number of banks are reported to have closed bank accounts of companies offering cryptocurrency services. At present, there does not appear to be a clearly identified practical solution to the “bankability” problem.
Clearing and settlement. The legal basis of transfers, clearing and settlement of transactions in tokens and other cryptocurrencies or assets is unclear. For example, in certain jurisdictions, it is unclear whether (or how) the holder of a token could successfully enforce a “proprietary” claim to the token against a third party (for example, in the case of theft or misappropriation). Mechanics applicable to other types of investments such as bonds or shares are not applicable or easily adaptable to tokens.
Ability to exchange for fiat currency. Many tokens are not directly exchangeable for fiat currency or, even if they are, they are not exchangeable easily. The ease with which a new token will be able to be transferred and exchanged will depend on whether they are accepted for trading by a cryptocurrency exchange platform. While more popular tokens and existing cryptocurrencies will be traded across multiple platforms, new tokens may not be accepted by exchange operators and therefore liquidity will be negatively impacted. Without easy access to a market price for any new token, it could be difficult to exchange the token for fiat currency.
Regulatory Status. As noted above, in many jurisdictions tokens and token offerings can be subject to multiple classifications, each with their own regulatory requirements. One recent example of this was highlighted by the U.S. Commodity Futures and Trading Commission (CFTC) in its recently published Primer on Virtual Currencies (1). In its primer, the CFTC stated that tokens issued in connection with token offering may be both a “commodity” for purposes of the U.S. Commodity Exchange Act and a security for purposes of the securities laws, while emphasising that it will look beyond the form to the actual substance and purpose of an activity when applying CFTC regulations. To the extent that a token is a CFTC commodity it could become subject to a host of regulatory requirements which are substantially different to those imposed on securities (e.g. trading and clearing requirements, transaction reporting and position limits). Therefore, as the regulators in each of the discussed jurisdictions develop their views on the status of tokens and token offerings, any issuer, advisor or purchaser should be aware that the terms of the transaction will determine the financial regulations to which they are subject and that the securities analysis, while critical, is not the end of the discussion.
(1) The Primer on Virtual Currencies can be found at: http://www.cftc.gov/idc/groups/public/documents/file/labcftc_primercurrencies100417.pdf.