At present, there is little international convergence of regulation in relation to token offerings, though over the first half of 2018, certain jurisdictions have taken steps towards a more focused and coordinated approach to regulation. It is still too early in the development of this market to predict what the settled or common regulatory approach will be. However, in the current environment of heightened regulatory concern and scrutiny, issuers and advisers of token offerings need to consider the regulatory requirements, and risks of non-compliance, across multiple jurisdictions.
1. Where should the offering/generating entity be established and do any other laws apply?
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 and the carrying out of such activities is often subject to conditions (such as licensing or authorisation requirements). Depending on the structure of the token, other restrictions or requirements may also need to be considered.
2. Are tokens regulated investments?
Each token and token offering is different: there is currently no generally accepted, standardised model and tokens may fulfil differing commercial functions. Thus, the regulatory analysis must be conducted on a case-by-case basis.
Furthermore, what it means to be a “regulated” investment or instrument differs from one jurisdiction to another. In addition, the terms “security token” and “utility token”, although frequently used in the context of token offerings, are not recognised legal or regulatory concepts or categories in many jurisdictions. It is also important to recognise that whether tokens are “securities” is not the only relevant question: there may be other regulatory consequences, even if the tokens themselves are not “securities”.
Carrying out a regulated activity in France is generally prohibited, unless the relevant person is licensed or exempt. Many activities which involve “financial instruments” are regulated activities.
In addition, the marketing of “financial instruments” or “other regulated assets” in the French market is also restricted and the issue of any advertisement, invitation or document which contains an invitation to the French market to buy or subscribe for “financial instruments” or “other regulated assets” will need to be duly authorised by the relevant regulator, unless an exemption applies.
Whether (and if so, how) a token would be deemed a “financial instrument” or an “other regulated asset”, and therefore fall within the scope of French financial regulations, needs to be considered on a case-by-case basis.
Indeed, in the context of a public consultation on ICOs, the French markets regulator (AMF) has recognised that, although the tokens issued in the framework of ICOs do not usually fall within one of the categories of “financial instruments”, in certain circumstances these tokens may still be characterised as “financial instruments” or “other regulated assets”, depending on their specific features and how they are structured. The AMF has therefore considered that, in those situations the offering of these tokens may lead to the application of French financial regulations depending on the legal nature of the tokens (e.g. securities prospectus regime, other regulated assets regime, derivatives regime, etc.)
In addition, in its legal analysis dated 22 February 2018, the AMF considered that “cryptocurrencies” may constitute eligible underlying assets of certain derivatives if specific requirements are met. The AMF has therefore considered that where “cryptocurrencies” are the underlying asset(s) of a derivative product, that derivative product may be characterised as “financial/derivative contract” and, accordingly, that its offering to the French public is subject to the French rules applicable to the offering of financial instruments.
3. 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. Belgium, France, Germany, Hong Kong, Indonesia, Japan, Singapore, the UAE in respect of the ADGM and the DIFC, and the UK):
- 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
- 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 Thailand, the SECT is working internally to issue a regulation to govern the pre-sale arrangements of digital tokens and expects to publish a draft regulation for public consultation soon. However, based on an unofficial statement of the SECT competent officer, any type of pre-sale arrangement of digital tokens would at present be considered a public offering of digital tokens (where the delivery date thereof is scheduled for a future date) which is subject to the approval requirement, and requires the registration statement and draft prospectus to be filed with the Office of the SECT. Therefore, it remains to be seen how the new SECT regulation will facilitate the pre-sale arrangements of digital tokens.
For the US, pre-sale arrangements will generally 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” (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”.
As the authors of the SAFT acknowledge, their argument hinges on the assumption that the tokens (once issued) are not securities. However, this may not be possible to determine at the outset, as it remains possible that the value of the token continues to depend significantly on the efforts of the token sponsor or third parties. This assumption appears even less likely to be true in light of SEC chair Jay Clayton’s assertion that he considers all ICOs he has seen to be securities. If it transpires that the tokens are indeed securities, the fact that the tokens were purchased on a delayed basis through a SAFT does not particularly affect the analysis.
4. Is a prospectus (or other offering document) required?
Certain jurisdictions mandate that an offering document be made available before certain investments or instruments may be offered to certain classes of investors (such as retail investors). In the context of token offerings, this may apply, depending upon the structure, to either or both of the main token and any pre-sale arrangements that amount to such an investment or instrument.
It is important to note that even if an offering document is not strictly required from a legal perspective (for example, because an exemption applies), in most cases it will be advisable, with a view to limiting potential future disputes, amongst other things, to prepare documentation that clearly describes, for example, the tokens, any right(s) attaching to the tokens, the relevant platform, the principal legal relationships, the terms of the token offering (including selling restrictions) and relevant disclaimers (including risk factors).
It should also be borne in mind that disclosure documentation other than a prospectus may be required. In the EU, for example, the PRIIPs Regulation may apply to a token offering. Depending on the circumstances, tokens may constitute “packaged retail investment products” (PRIIPs) under the PRIIPs Regulation where the product is such that “the amount repayable to the retail investor is subject to fluctuations because of exposure to reference values or to the performance of one or more assets which are not directly purchased by the retail investor”. Amongst other requirements, where such products are being offered to retail investors, issuers are required to produce a “key information document” (KID) which provides detailed information about such products in accordance with certain prescribed criteria.
An approved prospectus will be required if the tokens are “financial securities” (titres financiers) and the intention is to offer them to the public in France (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 “financial securities”.
Even if the tokens are not “financial securities”, where the tokens constitute “other regulated assets” and the offeror is characterised as an “intermediary in other regulated assets”, an approved offering document may still be required to offer tokens to the public in France under the French regime applicable to “other regulated assets”.
Note that, following the AMF’s publication on ICOs, the French Government has decided to adopt a specific legal framework for ICOs offered to the public in France. This new legal framework would introduce an optional prior approval regime applicable to ICOs offered to the French public. This new regime is expected to be adopted in the course of 2018 under the Pacte Law.
5. 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.
French banking and financial solicitation regime (démarchage bancaire et financier). Démarchage is defined as any unsolicited contact, by any means, with any given individual or legal entity, notably for the purpose of obtaining their consent to the provision of banking, payment or financial services or the carrying out of a transaction in “financial instruments”.
A person is also deemed to engage in démarchage, irrespective of the person who initiates contact, when they visit individuals at homes, workplaces or places which are not intended for the marketing of banking and financial products, instruments or services, for the same purpose as listed above.
Démarchage can only be carried out in France by entities or persons which are either (i) duly licensed or passported in France to provide regulated services, or (ii) agents of the persons referred to in (i). These authorised persons are subject to specific conduct of business rules.
Payment Services. In its Position No 2014-P-01 related to Bitcoins transactions in France, the French banking regulator (ACPR) considers that, in the framework of a Bitcoins purchase/sale transaction against a legal money/fiat currency, the activity of intermediation consisting in receiving funds from the Bitcoins purchaser to transfer them to the Bitcoins seller entails the provision of payment services and, accordingly, requires a specific licence under the French payment services providers regime.
Anti-money laundering and counter-terrorist financing. As a general rule, most of banking, payment and investment regulated entities are subject to the French anti-money laundering and counter-terrorist financing regime.
Since 3 December 2016, any person who deals on its own account or acts as an intermediary, on a regular basis, to purchase or sell virtual currencies is also an entity in scope of the French anti-money laundering and counter-terrorist financing regime.
This is in line with the new requirements of the Fifth Anti-Money Laundering Directive (AMLDV), which extends the scope of anti-money laundering regulations to providers of exchange services between virtual currencies and fiat currencies, and custodian wallet providers. The legislation is expected to be transposed into the national laws of Member States by the end of 2019. Following such transposition, virtual currency exchanges and wallet providers in the EU would have to comply with various AML requirements in relation to risk assessment, customer due diligence, reporting, policies, procedures and supervision in the same way as established financial institutions.
Consumer protection. Certain consumer protection legislation may apply in certain cases to protect subscribers to a token offering, such as protections against unfair trade practices and unfair terms or protections to ensure pre-contractual/contractual disclosure or cooling-off periods.
6. 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.
In January 2018, the National Internet Finance Association of China stated that most onshore token offerings have been “cleaned up”, but it was aware that tokens have continued to be marketed to PRC residents on a cross-border basis and warned investors of the risks involved.
It is difficult to gauge at this stage whether and how the Chinese regulators would, in practice, 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.
7. What are some of the most significant practical issues currently faced in relation to token offerings?
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 anti-money laundering (AML) obligations.
A key practical issue is that banks generally require the source of funds to be established, which necessarily involves identifying:
- the institution or investor from which the funds originate; and
- 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.
Accounting and taxation. The classification of a token as a “security” or a “utility” may also have implications on its accounting and tax treatment. Such treatment will depend on the applicable accounting standards and tax laws in each relevant jurisdiction and will also depend on the specific features of the tokens and the token offering in question. Some issues to consider include:
- the corporate and personal tax implications relating to an issue of tokens;
- relevant sales, stamp duty and other ad valorem taxes; and
- how the token is accounted for in the financial statements of the issuer.
Issuers and other participants in token offerings should consult a professional accountant and/or tax adviser on these issues.
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.
Transfers, 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, and if so 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, 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. 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, adviser 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.