In our financial services updates at the beginning of the year (see here), we outlined a few regulatory pointers for FinTech coming out of a speech by the Chair of the Financial Stability Board (FSB). The upshot of that speech was that there really isn’t anything new under the regulatory sun. The FSB's basic regulatory premise is that just because something is new doesn’t mean it should be regulated any differently, and just because something is outside the regulatory perimeter doesn’t mean it needs to be brought inside.
In its Strategic Risk Outlook for 2017 (see our summary here), the Financial Markets Authority (FMA) broadly follows this approach to FinTech. It is an ongoing balancing act to ensure that the regulatory settings encourage innovation but also guard against the risks that attach to new technologies. The FMA supports and encourages technological innovation in financial services – that is, of course, one of the additional purposes of the Financial Markets Conduct Act 2013 (FMCA).
Initial coin offerings
An initial coin offering (ICO) is a process by which an organisation raises funds, using block chain technology, through the offer and sale of cryptographically secured digital tokens. Purchasers may use fiat currency (such as NZ or US dollars) or virtual currencies (such as BitCoin or Ether) to buy these digital tokens. Once they are issued, the tokens can usually be traded in secondary markets using virtual currency exchanges.
One example of an ICO that took place in 2016 is the token issue by the DAO (Decentralised Autonomous Organisation). The DAO was created by Slock.it UG (a German corporation) with the objective of raising funds to create a pool of assets that would be used to fund various projects. The funds were raised through the sale of DAO tokens and holders of those tokens stood to share in the earnings of the DAO’s projects. Various platforms also facilitated a secondary market in the DAO tokens.
There have been numerous ICOs in 2017, including Bancor which raised US$150 million in Ether in a matter of hours and Status which also raised more than US$100 million at short order. ICOs will often be made on the basis of a fairly short white paper that discloses the technical aspects of the organisation's proposal and occasionally funds have been raised without any functioning product in existence. There has been a perception that token offers sit outside the regulatory regime. However, the volume and speed at which funds have been raised and the general lack of limits on who can and can't participate are fuelling concerns about the emergence of a bubble and risks for unwary investors.
What are the regulatory approaches to ICOs and what should we (and regulators) take from the global surge in interest in ICOs? Are they a smart innovation by clever block chain technology companies with the potential to disrupt the traditional venture capital model? Or are they a dangerous development akin to Ponzi schemes (as some commentators suggest)?
The US regulatory response
On 25 July, the US Securities and Exchange Commission (SEC) issued a report on its investigation into whether the DAO violated US securities laws through its token issue (see here). In its analysis of the DAO, the SEC applied a test known as the Howey Test to determine whether the DAO tokens were an investment contract. The Howey Test requires an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The end result of the SEC report is that the DAO tokens are securities under US law and that many digital tokens are likely to be securities under US law. You can read our US office’s summary of the seven key takeaways from the SEC’s report on our website (see here).
Singapore’s regulatory response
On 1 August, in a further regulatory shot across the bow of issuers, intermediaries and platforms facilitating the trade of digital tokens, the Monetary Authority of Singapore (MAS) clarified its regulatory position on ICOs (see here). MAS noted that the function of digital tokens has evolved beyond just being a virtual currency and that many tokens now represent ownership or a security interest over an issuer’s assets or property.
MAS has made it clear that, in Singapore, those tokens may be considered an offer of shares or units in a collective investment scheme and would need to comply with the regulatory and licensing requirements for those issues.
And New Zealand?
New Zealand has a growing block chain community and there will be entities here looking at undertaking or investing in ICOs. Current constraints on access to funds for growth companies could encourage block chain focussed start-ups to look at ICOs as a fund-raising option, particularly if the ICO can be structured to sit outside the regulatory perimeter in New Zealand and elsewhere.
In New Zealand, for an offer of digital tokens to be regulated, the tokens will need to be a 'financial product' under the FMCA and there will need to be an offer of that financial product in New Zealand. There will be an offer of a financial product in New Zealand if the offer is received by a person in New Zealand unless the offeror can demonstrate that all reasonable steps were taken to ensure that persons in NZ can’t take up the offer (other than wholesale investors and certain others).
The FMCA provides for the following four types of financial product:
a) Managed Investment Product: A managed investment product is an interest in a 'managed investment scheme' that gives the holder of the interest the right to participate in, or receive, financial benefits produced principally by the efforts of another person under the scheme.
A managed investment scheme is a scheme whose purpose is to enable persons taking part in the scheme to contribute money (including money’s worth) to the scheme as consideration to acquire managed investment products and where the holders of those products don’t have day-to-day control of the operation of the scheme.
It is not surprising, given the increasingly conformed nature of global securities regulation, that the Singaporean definition of a 'collective investment scheme' is virtually identical to New Zealand's definition of 'managed investment scheme' in the FMCA. The managed investment scheme definition also bears some loose similarities to the Howey Test applied by the SEC in its US analysis of the DAO offer.
If a digital token offer looks and feels like an offer of an interest in a managed investment scheme then you can expect it to eventually be regulated like one. Unless an exemption applies, this would involve the preparation of a product disclosure statement, the appointment of a licensed manager and supervisor and the registration of the scheme and the offer on the Disclose Register.
b) Debt Security: A debt security is a right to be repaid money or paid interest on money that is owing by another person. 'Money' is defined in the FMCA as including 'money’s worth' but not for the definition of debt security.
It is possible that a digital token could carry a right to be repaid, something that is owing by another person and could have the features of a debt security. However, it will be difficult to fit a digital token into the FMCA definition of 'debt security' because the thing owed under the token won’t necessarily be 'money' – it is more likely to be another virtual currency that is owed to the holder of the token.
c) Equity Security: An equity security is a share in a company registered under the Companies Act 1993.
A digital token issued in an ICO may have many features of an equity security (such as voting rights and rights to distributions) but it is unlikely to be a share in a company.
d) Derivative: The FMCA contains a broad definition of derivative that includes futures contracts, options, swaps, and contracts for difference and is wide enough to capture new products as they are developed. For there to be a derivative, there must be an agreement that meets all of the following conditions:
- A party to the agreement must, or may be required, provide at some future time consideration of a particular kind or kinds to another person.
- That future time is not less than 3 working days (for a foreign exchange agreement) or 1 working day (in any other case) after the agreement is entered into.
- The amount of the consideration, or the value of the agreement, is ultimately determined by reference to the value or amount of something else.
If a digital token represents an agreement that satisfies these conditions for a derivative (for example an agreement set out in the smart contract sitting behind the token) then it will be a financial product under the FMCA.
Even if a token offer doesn’t fall squarely within the definition of a financial product under FMCA, the FMA has wide powers to declare that a security, that wouldn’t otherwise be a financial product, is a financial product of a particular kind. Any declaration needs to have regard to the economic substance of the security and the FMA must be satisfied that the declaration is necessary or desirable to promote the FMCA's purposes. The FMA also needs to consult with those that will be substantially affected by the declaration. By way of example, earlier this year, the FMA issued the Financial Markets Conduct (Shares in Investment Companies) Designation Notice 2017 to designate certain equity securities in investment companies as managed investment products in a managed investment scheme.
Not all token offers will be financial products and we certainly wouldn’t expect tokens that are not financial products to be brought within the regulatory perimeter. Whether the FMCA applies or not will depend on the particular facts and circumstances of the token offer. However, as mentioned at the beginning of this update, just because something is new doesn’t mean it should be regulated any differently.
In our view, it is possible to carefully structure an ICO so that it will not be regulated under New Zealand's current regime. However, we can't expect the FMA to allow rampant risk-taking to go unregulated where an ICO is and should be regulated. If a digital token is offered for sale or issue under an ICO and it meets the regulatory tests in the FMCA for a financial product then there is no reason why the ICO shouldn’t be regulated accordingly. In many ways, applying a level of regulatory vigour and oversight where appropriate will assist with making ICOs more palatable to mainstream investors.
Issuers of digital tokens, those involved in facilitating or advising on offers of digital tokens and platforms that facilitate the secondary markets in tokens should seek legal advice to ensure that they comply with the FMCA and other applicable laws (including those aimed at preventing money laundering and terrorist financing).