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 Arab Emirates:
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”.
UAE: Abu Dhabi - ADGM
Carrying out a regulated activity in the ADGM is generally prohibited unless the relevant person is authorised or exempt. The ADGM maintains a list of “regulated activities”, which includes dealing in “financial instruments” (whether as principal or agent), arranging deals in “specified investments” and advising on “specified investments”. Securities are both “financial instruments” and “specified investments”. The Abu Dhabi Global Markets Financial Services Regulation Authority (ADGM FSRA) will assess whether a token is a “security” on a case-by-case basis. Tokens are likely to be considered “securities” if they 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).
Tokens that give rights to other tokens or to other “securities”, or that have characteristics of derivatives (e.g. futures, options or contract for differences) are also likely to fall within the regulatory perimeter as “financial instruments” and “specified investments”. 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 exempt, or the communication is approved by an authorised person. An activity is an “investment activity” for this purpose if, amongst other things, it relates to “specified investments”. The ADGM FSRA has, however, indicated that where tokens do not have the features and characteristics of “securities” such as shares, debentures or units in a fund, the trading of such tokens is unlikely to constitute a regulated activity.
UAE: Dubai - DIFC
Carrying out a financial service in or from the DIFC is generally prohibited unless the relevant person is authorised. The DIFC maintains a list of “financial services”, which includes dealing in “investments” (whether as principal or agent), arranging deals in “investments“ and advising on “investments“. An “investment” includes securities and derivatives. Furthermore, communicating in the course of a business an invitation or inducement to (i) enter into an agreement in relation to the provision of “financial services” or (ii) acquire, dispose of or exercise any rights conferred by a “financial product” is also generally prohibited, unless the relevant person is authorised or exempt, or the communication is approved by an authorised person. A “financial product” includes “investments”. The Dubai Financial Services Authority (DFSA) has issued an investor warning stating that tokens should be treated as “high-risk investments” and indicated that it does not currently regulate these types of product offerings or license firms in the DIFC to undertake such activities.
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.
UAE: Abu Dhabi - ADGM
Prospectus requirements apply where there is an offer of securities to the public (or application for such securities to be admitted to trading on a recognised investment exchange) in or from the ADGM unless an exemption applies. Accordingly, where tokens constitute “securities”, an offer of the tokens in or from the ADGM will require a prospectus to be approved by the ADGM FSRA. Exemptions are available for, amongst other things, offers to “professional clients” (other than natural persons) and offers directed at fewer than 50 persons in the ADGM in any 12-month period, in each case subject to certain conditions such as resale restrictions. The ADGM FSRA has, however, indicated that not all ICOs constitute an “offer of securities” and, where tokens do not have the features and characteristics of “securities” such as shares, debentures or units in a fund, the offer of such tokens is unlikely to be an “offer of securities”.
UAE: Dubai - DIFC
Prospectus requirements apply where there is an offer of securities to the public (or application for such securities to be admitted to trading on a recognised investment exchange) in or from the DIFC unless an exemption applies. Accordingly, where tokens constitute “securities”, an offer of the tokens in or from the DIFC will require a prospectus to be approved by the DFSA. Exemptions are available for, amongst other things, offers to “professional clients” (other than natural persons) and for offers directed at fewer than 50 persons in the DIFC in any 12-month period, in each case subject to certain conditions such as resale restrictions. The DFSA has issued an investor warning stating that tokens should be treated as “high-risk investments” and indicated that it does not currently regulate these types of product offerings or license firms in the DIFC to undertake such activities.
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.
UAE: Abu Dhabi - ADGM
Money transmission. Money transmission is a regulated activity if conducted in the ADGM. Money transmission includes, amongst other things, “selling or issuing stored value”. There is no express definition of “stored value”. However, depending upon the precise structure, the wallet associated with a token offering may involve “issuing stored value” where fiat currency is accepted in exchange for the tokens. Regulation of exchanges. Where tokens are “financial instruments” for the purposes of the ADGM’s Financial Services and Markets Regulations 2015 (which includes most “specified investments”), any entity operating an exchange that allows for trading in such tokens will generally need to be registered with the ADGM FSRA as a recognised exchange. Regulation of custody services. Where tokens are “financial instruments” for the purposes of the ADGM’s Financial Services and Markets Regulations 2015 (which includes most “specified investments”), safeguarding or administering those tokens in the ADGM will generally be a regulated activity. Crypto-asset business licence. In June 2018, the ADGM FSRA published its new crypto-asset business regulatory framework. Any virtual currency intermediaries that buy, sell or facilitate the exchange of virtual currencies (e.g. Bitcoin), or otherwise provide a platform to allow persons to exchange virtual currencies or provide custody services in respect of virtual currencies, will require a “crypto-asset business” licence.
UAE: Dubai DIFC
Providing money services. Providing money services includes, amongst other things, selling or issuing stored value. There is no express definition of “stored value”. However, depending upon the precise structure, the wallet associated with a token offering may involve “issuing stored value” where fiat currency is accepted in exchange for the tokens. No authorised firm is permitted to provide money services in or from the DIFC unless it does so in connection with carrying on of another financial service and providing money services is a necessary part of that other financial service. Regulation of exchanges. Where tokens are “investments” for the purposes of the DFSA’s Rulebook (which includes “securities”), operating an exchange in or from the DIFC will generally be a regulated activity. Regulation of custody services. Where tokens are “investments” for the purposes of the DFSA’s Rulebook (which includes “securities”), safeguarding or administering those in or from the DIFC will generally be a regulated activity.
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.