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Initial coin offerings – a regulatory overview

Initial coin offerings – a regulatory overview


On the back of the rise of cryptocurrencies, initial coin offerings (ICOs) have become an attractive means of fundraising, especially over the last year. The emergent phenomenon of ICOs could prove a viable alternative to venture debt or equity financing. At present, however, the legal and regulatory treatment is untested, which has prompted certain regulators to scrutinise ICOs under existing securities laws and regulatory frameworks. Due to the rising ICO activity and with a view to increasing the awareness of the manifold risks associated with investments in ICOs, a number of supervisory authorities, including the European Securities Markets Authority (ESMA) , have issued consumer warnings on this topic recently. This briefing provides an overview of a number of legal issues relevant to an ICO or a related investment decision. As well as a general explanation, it gives guidance on regulatory and capital markets aspects to be considered.

What is an ICO?

An ICO is a digital way to raise funds from the public within a limited period of time by issuing a coin or token1 that is related to a specific project, business model or business idea. The tokens are typically created and disseminated using distributed ledger or blockchain technology and may be tradeable on specific platforms.

What is a token?

In principle, tokens are ‘contracts’ granting certain rights to investors. The features and purpose of the tokens vary across ICOs. Depending on their design, tokens may represent a voucher for a one-time or recurring service or a right to participate in a share of (periodic) returns resulting from the investment object. However, some tokens may have no discernible value or grant no right at all.

How are the tokens issued?

The issuer or offeror puts tokens for sale in exchange for a so-called fiat currency such as the Euro, or, more often, for a virtual currency (eg Bitcoin or Ether). Typically, tokens are bilateral arrangements which are not issued in the form of a security / certificate or similar type of transferable instrument, although some tokens, depending on their structure, can be sold on specific exchanges specialising in such transactions.

The act of generating and offering tokens is also referred to as ‘crowd-sale’, ‘token sale’ or ‘token generation event’, which is structured typically as an auction process through the internet.

How can investors participate?

Anyone who has access to the internet can participate in an ICO. As usually most tokens are sold in exchange for virtual currencies, a potential investor needs such virtual currency as consideration. To this end, investors have to open a wallet which is offered by various providers and make a purchase at a specific cryptocurrency exchange. After the initiation of the ICO, the token seller will post an address where the funds are collected during a certain timeframe. Typically, the investor sends the cryptocurrency to the token seller and the underlying smart contract technology sends the purchased tokens to the investor’s wallet address immediately. After the issuance, the tokens can be traded in, or exchanged for, fiat or virtual currencies on specific exchanges that allow the sale and purchase of tokens by the general public.

Comparison to other means of fundraising

ICOs do have parallels to other means of fundraising.

Why is this different from crowdfunding?

In contrast to ICOs, crowdfunding takes place usually through an intermediating platform. Investments are privately-held and generally there is no secondary market to trade them. Notably, crowdfunding activities rely on recognised instruments (eg, shares, profit participating instruments, silent participations, subordinated loans) and are conducted within a set legal framework. Often crowdfunding does not involve tokens or cryptocurrency at all.

Why is this different from an IPO?

The term ICO is derived from the term ‘initial public offering’(IPO). While there may be an economic similarity – in both cases, funds are raised for the first time from the public – equating ICOs with IPOs would not be fitting and may be misleading.

IPOs are implemented on the basis of a comprehensive legal framework and established market practice aimed at addressing relevant stakeholders’ interests, including investor information requirements. In contrast, ICOs are very diverse in set-up and structure and there is no specific regulatory framework that applies to ICOs. Further, it is fair to say that there is no established market practice for ICOs.

Why is this different from venture capital (VC)?

VC is a form of financing that is provided by firms or funds to small, early-stage, emerging entities with high growth potential. As a compensation, equity or an ownership stake in the company is offered resulting in the VC investor having various controlling rights. VCs provide such financing in the interest of generating a return through a later ‘exit’ event (eg a private sale, an IPO or a merger) by using and relying on established legal concepts. In contrast, in the context of a typical ICO, investors are not granted any ownership rights in the company.

Legal implications

Are ICOs regulated?

Each token or token offering is different, as different rights are attached to particular tokens. Accordingly, there is currently no generally accepted or standardised model and no harmonised regulatory framework governing ICOs. Depending on the nature of the token, different rules will apply and thus, a case-by-case analysis is unavoidable.

Are tokens financial instruments?

As mentioned, the characteristics of a token and therefore whether it is a financial instrument must be evaluated on a case-by-case basis.

The ESMA argues that tokens may qualify as financial instruments, which include transferable securities such as shares in companies.

According to the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungs-aufsicht, BaFin), tokens in an ICO qualify typically as financial instruments in the form of units of accounts (Rechnungseinheiten) within the meaning of Sec. 1 para. 11 no. 7 of the German Banking Act (Kreditwesengesetz, KWG). However, the BaFin has determined that the German Stock Corporation Act (Aktiengesetz, AktG) would not apply to ICOs.

The UK’s Financial Conduct Authority (FCA) has said that many ICOs will fall outside the regulated space, but each needs to be determined on a case-by-case basis. Some tokens may constitute transferable securities.

What are the consequences of such a qualification?

In line with the ESMA’s statement, the application of the Prospectus Directive, the amended Markets in Financial Industry Directive (MiFID 2) or the Alternative Investment Fund Managers Directive (AIFMD) could be triggered, particularly if tokens are structured and tradeable in a way, that resembles common financial instruments.

Furthermore, under German law, if tokens qualify as units of accounts, natural persons or legal entities acting as a broker of tokens, the purchase or sale of tokens commercially or the operator of a platform on the secondary market on which tokens can be traded, such as a token exchange, generally would require a license from BaFin.

The FCA states that businesses involved in an ICO should consider carefully if their activities could mean that they are arranging, dealing or advising on regulated financial instruments. This would require the business to be authorised or fall within an exemption.

Does the issuance of tokens trigger a license requirement for the deposit-taking business?

As funds are accepted from the public, issuers must consider carefully whether the fundraising constitutes deposit-taking business which is a regulated activity unless exemptions apply. However, if the token sale is structured in a manner that the issuer is not obliged to pay back the funds received, issuers will not fall under the scope of such regulated business activity.

Could the issuance constitute a MiFID 2 financial service in form of investment advice?

Investment advice is the personal recommendation of a financial instrument, which must be presented as suitable for the investor based on a personal assessment of the investor's knowledge, experience and financial situation. In general, publishing a White Paper that includes information on a token, which qualifies as a financial instrument under MiFID 2, should not constitute investment advice, since an issuer does not assess an investor’s personal situation.

Could the issuance constitute a MiFID 2 financial service in form of acceptance and reception of orders?

The acceptance and reception of orders includes the arrangement between an intermediary, an investor and the provider or issuer of a financial instrument. Absent any such tri-party arrangement, no regulated activity would exist.

When is a prospectus mandatory?

Only if a token falls within the definition of a transferable security within the meaning of MiFID 2 would the publication of an approved prospectus be required in accordance with the rules of the Prospectus Directive. In such a case, a prospectus – for which detailed information requirements apply – must be prepared before the offer to the public or the admission to trading of such securities on a regulated market located or operating within an EEA Member State, unless a prospectus exemption is applicable.

Depending on the design and structure of the tokens, they could also qualify as an investment product for which different national prospectus regimes would apply (eg in Germany the Investment Product Act (Vermögensanlagegesetz)).

Are there other obligations to disclose information?

Besides potential regulatory obligations to inform investors of the instrument issued, token issuers must be aware that any wrong or misleading information or the omission to disclose adequate information with respect to the token may trigger claims for damages under the applicable civil law regime.

May an ICO scheme qualify as an Altenative Investment Fund (AIF)?

If an ICO is used to raise capital from a number of investors with a view to investing in accordance with a defined investment policy, it might qualify as an AIF. Firms involved in such ICOs may therefore need to comply with the AIFMD.

Do tokens represent a currency?

In most jurisdictions, tokens are not recognised as legal tender. However, if they represent a digital representation of value that is neither issued by a central bank nor a public authority nor necessarily attached to a fiat currency, but are used as a means of exchange and can be transferred, stored or traded electronically, they might be classified as a virtual currency.

Does the amended Payments Serivces Directive (PSD 2) apply?

Broadly speaking, payment services are provided if funds are accepted in order to transfer them to another person. Where tokens are offered against legal tender, an intermediate platform through which tokens are acquired or sold may carry out regulated payment services as set out in the PSD 2. In addition, depending on the design of the relevant cryptocurrency, issuers should consider whether the activity could be classified as the issuance of e-money.

Are there AML requirements?

The Fourth Anti-Money-Laundering-Directive (MLD 4) applies to a wide range of persons or entities including regulated financial institutions. It will therefore depend on the qualification of the token or token offering whether issuers fall within the scope of The MLD 4. If the token issuer falls within the scope of the MLD 4, it is required to carry out due diligence on customers and to have in place appropriate record-keeping and other internal procedures. Furthermore it would be obliged to report any suspicious activity and to co-operate with any investigations by relevant public authorities.

The regulators’ approach

At present, there is little international convergence of regulation in relation to token offerings. The regulators that have issued statements on this topic so far, including ESMA, BaFin, the FCA or FINMA, have stated that each individual ICO must be evaluated on the basis of the relevant facts and circumstances in order to decide whether it falls within the scope of existing regulations. Furthermore, they have expressed their concerns over the manifold risks resulting from ICOs, especially for investors, emphasising concerns such as:

  • tokens acquired in an ICO often experience significant price fluctuations;
  • projects financed using ICOs typically are in a very early stage so that their performance and development are unpredictable;
  • the information provided by the issuers in form of White Papers or terms and conditions is often insufficient, misleading and does not meet a level of transparency comparable to a regulated prospectus;
  • ICOs are susceptible to fraud, money laundering and terrorist financing;
  • ICOs have very limited investor protection; and
  • there is a good chance of losing the whole investment

With that in mind, regulators note that investors should be aware of the risks, research the project fully and invest only if the investor is experienced and prepared to lose the entire stake.

Practical aspects

What should be considered when preparing an ICO?

Prior to an ICO, issuers should analyse carefully whether the ICO could be subject to regulatory or capital market restrictions. Even if no prospectus is required to be prepared, issuers should provide potential investors with detailed information on the project or investment eg in form of a White Paper.

What should a White Paper include?

There is no guidance or best practice standard regarding the minimum content of a White Paper in connection with an ICO. However, it is recommended that potential investors are given a detailed overview of the ICO and the underlying business model as well as any risks associated therewith. This might include information on the underlying legal entity issuing tokens and its recent financial situation as well as the business plan of the ICO. Furthermore, the amount of cryptocurrency (or fiat-currency) sought and the use of proceeds should be mentioned. In addition it is advisable to provide a technical presentation of the project and a description of the token structure, the mechanics, the issuance and any post ICO features for the specific ICO. Moreover, a risk disclosure, warnings and disclaimers, as well as the application of legal rules and the designation of a competent court in the EEA should be included.

1 For reasons of simplicity, we hereinafter only refer to the term token.