Over US$7billion is reported to have been raised this year, with over US$5billion raised in 2017, by way of token offerings popularly known as initial coin offerings (ICOs).
A summary and seven key questions answered in this guide to the legal and regulatory tratment of ICOs in the United Kingdom:
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 the UK is generally prohibited unless the relevant person is authorised or exempt. An activity is a “regulated” activity if, amongst other things, it relates to a “specified investment”. Furthermore, communicating in the course of a business an invitation or inducement to engage in investment activity is also generally prohibited, unless the relevant person is authorised or the communication is approved by an authorised person. Again, an activity is an investment activity for this purpose if, amongst other things, it relates to “specified investments” (or a specified class of investment). Some tokens will be “specified investments”. Packaging something that would otherwise be a “specified investment” in the form of a token will not generally change the regulatory outcome. For example, tokens that grant a holder some or all of the rights that would typically be enjoyed by:
- a shareholder (for example, entitlements to dividends declared, profits or the proceeds of the assets of an insolvent company);
- a bondholder (for example, a right to the repayment of a sum of money); or
- a participant in a fund (for example, to profits or income from the acquisition, holding, management or disposal of the fund property), are likely to be considered “specified investments”.
Tokens that give rights to other tokens or to other “specified investments”, or that have characteristics of derivatives (e.g. futures, options or contract for differences) are also likely to fall within the regulatory perimeter. Consistent with its previous comments on this topic, the UK Financial Conduct Authority (FCA) has reiterated in a recent statement that the regulatory characterisation of tokens will ultimately depend on the facts. Depending on the precise structure and the function of the tokens, it may therefore be the case that certain tokens do not fall within the regulatory perimeter as “specified investments”. For example, the FCA statement referred to “utility tokens” (which are neither transferable securities nor regulated products and only allow access to a network or product with no other legal rights attached) as generally falling outside the FCA’s regulatory perimeter. That being so, it remains the case that agreements or instruments (including other tokens) that refer to or give rights to such unregulated tokens may themselves amount to “specified investments”. For instance, there has recently been increased regulatory focus on derivative instruments that reference either cryptocurrencies or tokens. The FCA has highlighted that dealing or arranging transactions in, advising on or conducting other regulated activities in relation to such instruments requires authorisation.
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 “transferable securities” offered to the public in the UK (or for which admission to trading on a regulated market will be requested), unless an exemption applies. This may also apply to pre-sale arrangements, for example, that give rights to tokens that are “transferable securities” or are themselves “transferable securities”. The definition of “transferable securities” refers to “those classes of securities which are negotiable on the capital market”. There is uncertainty as to whether (or when) the market for tokens could be said to amount to a “capital market”. If the market for tokens amounts, wholly or partly, to a “capital market”, a prospectus would generally be required (unless an exemption applies) for those tokens amounting to securities transferable on that capital market. The term “security” for these purposes is not defined, but (following pronouncements from the European Commission) may arguably capture those tokens capable of being traded on an exchange.
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.
Payment services. A person may not provide a “payment service” in the UK, or purport to do so, unless the person is authorised to do so. “Payment services”, broadly speaking, relate to money or “funds” (which includes banknotes or coins, scriptural currency or electronic money). Depending upon the precise structure, a token offering may involve the provision of payment services (particularly where fiat currency is accepted in exchange for the tokens). The European Commission had previously suggested that the scope of payment services regulation may be extended to certain cryptocurrency exchanges and wallet providers, although this has not resulted in an express change for the time being. Regulation of exchanges and other market infrastructures. Where tokens are financial instruments for the purposes of MiFID II (which includes most “specified” (i.e. regulated) investments), operating an exchange that allows for trading in such tokens will generally be a regulated activity if conducted in the UK. Equally, safeguarding or administering tokens that are “specified” (i.e. regulated) investments in the UK will generally also be a regulated activity. Further requirements may also apply, for example, in order for transfers to achieve settlement finality, or to the extent tokens that constitute “transferable securities” are required to be held in a central securities depository. Anti-money laundering and financial crime. As recently highlighted by the FCA, entities that are already subject to anti-money laundering and terrorist-financing legislation are required to comply with their existing obligations, notwithstanding that crypto-assets (including token offerings) may be a novel context. Furthermore, the Fifth Anti-Money Laundering Directive (AMLDV) 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 will 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. Privacy and data protection. Privacy and data protection laws would be relevant if a token offering involves the holding of and dealing in personal information. For example, in respect of the recently introduced General Data Protection Regulation (GDPR) in the EU, rights to permanently erase or delete personal information held on a database may sit uncomfortably under certain structures with the tamper resistance of distributed ledgers. Supply of digital content. Specific consumer protection legislation applies in relation to the supply of “digital content” (i.e. data which is produced and supplied in digital form). Tokens may arguably amount to, or involve, digital content, and therefore trigger protections where consumers are involved in the token offering. These protections involve certain terms being implied as to the digital content being of satisfactory quality, fit for purpose and as described. The terms of consumer contracts are also subject to a “fairness” test, which could apply to the relevant subscription documentation in the context of a token offering. Consumers may also be entitled to enforce rights to a rebate or refund in certain circumstances. Unfair commercial practices. Protections from unfair commercial practices may also apply where consumers are involved in a token offering. These prohibit unfair commercial practices, misleading actions or omissions, aggressive practices and blacklisted practices. A breach of the prohibition may entitle consumers to pursue certain civil remedies (including rights to a discount, damages or to unwind the relevant contract), and may attract criminal sanctions in certain circumstances.
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.