2017 has seen cryptocurrencies continue to grow in popularity throughout Australia and the world. The rapid increase in value of Bitcoin and Ether, coupled with their volatility (demonstrated by a 20% crash over two days last month) and potential use benefits, make cryptocurrencies a fascinating and challenging prospect for the future.
Given their origin on the blockchain, not only do cryptocurrencies and tokens raise practical considerations on issues such as cybersecurity, as demonstrated by the theft of around US$32 million worth of Ether tokens in July this year,1 but they also present difficulties for lawmakers, reflected by uncertainty about the treatment of digital currencies under existing regulatory regimes around the world.
This article looks briefly at the legislation in place in Australia for cryptocurrency, examines the recent phenomenon of the Initial Coin Offering (ICO) and discusses some associated legal and regulatory issues.
Until recently there has been very little regulation in Australia specific to digital currency. Instead, regulators and businesses have faced the difficult task of applying laws, written with traditional company and trust structures in mind, to entirely new situations only possible through the development of distributed ledger technology. ASIC’s 2014 submission to the Senate Economic References Committee inquiry into digital currencies, in which it examined the application of the financial services regime to digital currency and contended that generally digital currencies do not fit within the legal definitions of ‘financial product’ under the Corporations Act or the ASIC Act2, was one of the first published applications of Australian laws to cryptocurrency.
Recent announcements from the ATO and ASIC and draft legislation aimed at regulating domestic cryptocurrency exchanges indicate big changes are afoot.
The government has announced that, with (retrospective) effect from 1 July 2017, it will align the GST treatment of digital currency (such as Bitcoin) with money.3 An exposure draft and explanatory material propose to include a definition for digital currency within the legislation in order to remove the ‘double tax’ treatment to which digital currency such as Bitcoin is currently subject.4 Whilst the law is yet to come into effect, the ATO currently allows affected businesses to lodge business activity statements in accordance with either the current law or the proposed measures.
In August of this year, the government also released draft legislation proposing to amend the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 to include a definition of ‘digital currency’. In addition, it will require all digital currency exchanges in Australia to register on a new ‘Digital Currency Exchange Register’ maintained by AUSTRAC. The bill will introduce reporting obligations on digital currency exchanges and impose penalties of up to two years’ imprisonment and/or fines of up to $105,000 for non-compliance.5
ICOs are characteristically the sale or issue of tokens stored on a blockchain which may entitle buyers to a set of rights in relation to a particular project. A company may issue tokens to raise capital to pay for expenses related to product or project development,6 or for use within a future ecosystem on a blockchain.7 Perth company PowerLedger recently held Australia’s first ICO.
ICOs diverge significantly in form and substance. The rights conferred upon investors in tokens can vary between interests in a project, a token for to be exchanged for goods and services, or even a future right to be repaid a debt. Tokens offered during an ICO may represent almost any value, depending on the nature of the project.8
ICOs have often been likened to IPOs, crowdfunding campaigns, the issue of securities or financial products. Whether or not laws apply will depend on the facts and circumstances of each ICO.
Late last month ASIC released an information sheet (INFO 225) providing guidance about the potential application of the Corporations Act 2001 (Cth) (Corporations Act) to ICOs. Ultimately, as every ICO is unique, each new issue of coins or tokens will need to be assessed on a case-by-case basis. Virtual coins or tokens offered in Australia could be classified in various ways under the Corporations Act. However, as ASIC is at pains to point out in INFO 225, new crowd-sourced funding legislation which allows small businesses to raise funds from retail investors does not apply to ICOs.
Often organisations provide investors with a ‘white paper’ or some form of disclosure document prior to raising money through an ICO. The document may outline the purpose of the ICO, a market case for the products or project or the practical use of the token which could provide assistance to companies and investors in determining how to apply existing legislation.
Could tokens issued in an ICO be considered securities?
The definition of ‘securities’ in the Corporations Act includes shares and debentures issued by a body, or a legal or equitable right or interest in a share or debenture.9 ASIC’s guidance notes that where the bundle of rights attached to an ICO is similar to rights commonly attached to a share—such as if there appears to be ownership of the body, voting rights in decisions of the body or some right to participate in profits of the body shown in the white paper—then it is likely that the coins could fall within the definition of a ‘share’.
If an ICO were to be considered an offer of securities, the issuer would need to prepare a prospectus in the same manner as if the offer was a traditional IPO.
Could a token issued in an ICO be an interest in a Managed Investment Scheme?
Under the Corporations Act, the body responsible for an ICO could be operating a managed investment scheme (MIS). ASIC’s guidance notes that if the value of the digital coins acquired is affected by the pooling of funds from contributors or use of those funds under the arrangement, then the ICO is likely to fall within the requirements relating to MISs.
If an ICO were to be considered an MIS, a range of disclosure, registration and licencing obligations would apply.
Could tokens be considered derivatives?
Another form of a financial product which enlivens disclosure, registration and licencing obligations is a ‘derivative’, being a product that derives its value by reference to something else (subject to certain additional conditions). Although electronic contracting is generally instantaneous, it is possible, as noted in ASIC’s guidance, that a token offered under an ICO could fit within the complex definition of a derivative, and be considered a financial product. For example, an ICO could involve an option contract where investors would have the right, but not the obligation, to buy tokens at a set price on or before a future date.
How else could the financial services regime apply?
In the event that an ICO (or a token offered through it) were to be a financial product, any platform which allows investors to buy and sell could involve the operation of a ‘financial market’. In Australia, unless an exemption applies, the operator of a financial market requires a market operator’s licence.
Another form of financial product is a non-cash payment (NCP) facility. Although coins offered under an ICO are unlikely to be considered NCP facility themselves, they could well be the consideration that is used to make a payment through an NCP facility.
Regulation of Cryptocurrencies and ICOs internationally
Like Australia, jurisdictions across the world have been uncertain about the treatment of tokens offered in an ICO with different approaches and views from Canada, the United States, Singapore and China.
The Monetary Authority of Singapore (MAS) recently stated its position that digital tokens may represent ownership or a security interest over an issuer’s assets or property. An ICO could be considered an offer of shares, units in a collective investment scheme, or may be a debenture and regulated as such under Singaporean securities law. The MAS made it clear that tokens could be classified as securities, which may impose obligations on issuers such as lodging a prospectus. Similarly, intermediaries involved in ICOs could be subject to licensing requirements.
US ruling on the SEC
In June, the United States Securities and Exchange Commission (SEC) investigated the ‘Decentralised Autonomous Organisation’ or DAO, a virtual organization that used the distributed ledger and blockchain technology to facilitate the sale of DAO tokens to raise capital for the organization. In a 28-day period from April to May 2016 the project raised US$34 million. The DAO was intended to be set up as an organisation to exist without a physical address, directors or people in management roles, rather a set of contracts on the ethereum blockchain.
Applying existing US federal securities laws, the SEC determined tokens offered during the DAO’s ICO were securities and subject to US federal securities laws regardless of whether its tokens were purchased with virtual currency or distributed with blockchain technology.11
The Canada Securities Administrator (CSA) recently indicated tokens or coins offered from within Canada during an ICO would constitute securities in many instances. The statement made clear the CSA would ‘consider substance over form’12 and that case law required ‘an assessment of the economic realities of a transaction and a purposive interpretation with the objective of the investor protection in mind’.12
China’s recent ban on ICOs led by the People’s Bank of China briefly shocked the world and put a hold on what seemed like an unstoppable increase in the price of bitcoin. The future of ICOs in China is currently uncertain, however, it would be highly unlikely for China not to resume its position as a global leader of blockchain technology. More likely is a resumption of ICOs with restrictions to limit the size of ICO’s, strengthen information disclosure, supervise the substance and form of tokens and publish investment risk alerts.14
Cryptocurrencies and ICOs present new opportunities for transacting, exchanging value and raising capital, however their rapid emergence provides new regulatory challenges. Where money is being raised outside the understood application of existing regulatory regimes, risks exist that investors may not receive the protection the law intends to provide them.
On the other hand, when choosing to raise capital through an ICO, organisations must pay careful consideration to their form and substance to determine how their tokens may be classified and the legal obligations that may arise as a result.