Part 1/5: The Issuance of coins and tokens are an innovative way to raise capital and fund projects using distributed ledger technology. This first part introduces the technology, its structure and basic legal classification.
Initial Coin Offerings (ICO) are a financing option based on the idea of crowdfunding. Through an ICO, coins or tokens[i] based on blockchain technology are issued.[ii] The technical structure is flexible, as are the rights related to it. It is reasonable to divide tokens into three categories: currency tokens, security tokens and utility tokens.
BaFin (Federal Financial Supervisory Authority) commented on a possible regulatory assessment of ICOs by means of advisory letters and its publication series. It acknowledges that the definition of the rights associated with tokens are flexible. The supervisory obligation can only be determined by means of a case-by-case[iii] review.[iv] They may be classified as securities within the meaning of the WpHG (German Securities Trading Act) and WpPG (German Securities Prospectus Act) investments within the meaning of the VermAnlG (German Capital Investment Act) or shares in investment funds within the meaning of the KAGB (German Capital Investment Code).[v] Trading in tokens may be subject to approval under the KWG (German Banking Act)[vi] if they represent financial instruments within the meaning of the latter.
BaFin had previously clarified in a consumer warning[vii] and a technical article for consumers[viii] that not all ICOs are subject to financial market regulation. In addition to a consumer warning[ix], ESMA (European Securities and Markets Authority) issued an issuer warning[x], emphasizing that there are ICOs outside the regulatory framework according to Capital Market Law.
German politics have taken up the issue of the legal framework for ICOs. The Grand Coalition's coalition agreement provides for "the development of a comprehensive blockchain strategy" and "the promotion of an appropriate legal framework for the trading of crypto currencies and tokens at European and international level".[xi]
With an ICO, tokens that are only offered online are registered in the blockchain.[xii] The token standard frequently used is ERC20. Tokens themselves are data (packages)[xiii] that are issued by means of a transfer agreement for negotiable instruments, which can also be a Smart Contract[xiv]. Tokens are allocated to specific participants. Two separate keys are created for this purpose[xv], a Private Key and a Public Key.
While the Public Key represents some kind of account number, the Private Key, which enables the token to be used, is only known to the potential holder[xvi]. As data packages, tokens do not constitute physical objects; there is a lack of material quality within the meaning of sec. 90 BGB (German Civil Code) and no material rights can arise in relation to them.[xvii] As distinguished from the law of negotiable instruments, the aforementioned transfer agreement for negotiable instruments does not include an agreement under property law.
The token represents an underlying relationship of rights and obligations under the law of obligations.[xviii] This means that the transfer agreement for negotiable instruments under the law of obligations must be considered for a legal classification of the individual token.[xix]
If the issuer promises a participation or profit sharing, interest or the like, this is referred to as a security token or investment token;[xx] the term equity token or investment token is often used synonymously. The authors advocate the following distinction: with equity tokens, the purchaser receives an original company share in the issuer; with debt tokens, there is interest or profit sharing without original shareholder rights.[xxi] The term security token is the generic term for both tokens.[xxii]
Legal classification of tokens
The issuer is free to decide which rights are to be assigned to the tokens. Original company shares are rare in practice[xxiii], because mandatory law is to be observed[xxiv], and particularly difficult in a GmbH (limited liability company) due to formal requirements. However, most of the tokens are not issued in Germany.[xxv]
civil-law classification: Tokens are some kind of digital certificate of indebtedness for the underlying right. When tokens are issued, a contract is concluded between the issuer and the purchaser and any rights arising under this contract shall be represented by the token. The token is to prove a company share in the case of equity tokens, the promise of an interest or other return on investment in the case of debt tokens as well as the respective ownership of the right.
Regulatory classification: Depending on the type, security tokens in Germany can constitute securities (within the meaning of the WpHG and the WpPG) or capital investments (within the meaning of the VermAnlG). In the discussion in the classic legal literature that has been emerging since 2018, some discussion participants regard tokens as covered by the concept of securities.[xxvi]
The securities concept of the WpHG and the WpPG is influenced by European law and originates (directly or indirectly) from the MiFID II (Markets in Financial Instruments Directive II). ESMA as well as BaFin already clarified that tokens can be securities within the meaning of the Prospectus Directive. This also applies to the Prospectus Directive and thus to the Prospectus Regulation which (gradually) replaces the WpPG until July 21, 2019. A security are those "classes of securities which are negotiable on the capital market"[xxvii], with the exception of "instruments of payment"[xxviii] and, for prospectus law, "money market instruments […] having a maturity of less than 12 months"[xxix].
* The authors thank Timo Förster for his support.
* This article was originally published in German language in Zeitschrift für das gesamte Kreditwesen 2018 (21-23), p. 1117-1121, p. 1222-1226.
[i] (hereinafter: "Token" Coins have their own blockchain, Token is used on an existing blockchain (e.g. ERC20) (cf. Schiemzik/Kübler, NWB 2018, 2038, 2042 [specialist journal of tax and business law]).
[ii] Cf. Jünemann/Kast, ZfgK 2017, 531 [journal of the entire credit system]; Eschenbruch/Gerstberger (footnote 2), 8.
[iii] FINMA (Swiss Financial Market Supervisory Authority) shares the view of BaFin regarding Switzerland, cf. FINMA, FINMA publishes ICO guidelines dated February 16, 2018.
[iv] BaFin provides information as a simple sovereign action without regulatory character (cf. Fußwinkel/Kreiterling (footnote 6) p. 56), the person concerned then lacks the possibility to have his/her/its opinion confirmed in court should BaFin deviate from it.
[v] In addition, it is also possible to structure tokens as an insurance business in accordance with the VAG Law on the supervision of insurance enterprises) (Insurance Token); this will, however, not be discussed here.
[vi] The concept of financial instruments under the KWG is broader than the one of the WpHG because it also includes foreign exchange and units of account.
[vii] BaFin, consumer warning: risks of Initial Coin Offerings (ICOs) dated November 9, 2017.
[viii] BaFin, Initial Coin Offerings: high risks for consumers dated November 15, 2017.
[ix] ESMA Statement of November 13, 2017, ESMA50-157-829; in addition to ESMA and BaFin, other supervisory authorities have issued consumer warnings, such as the Joint Committee of the three European Supervisory Authorities on February 12, 2018, and the International Organisation of Securities Commissions IOSCO on January 18, 2018, ICOSCO/MR/01/2018; further warnings and statements are available on the IOSCO website.
[x] ESMA statement of November 13, 2017, ESMA50-157-828.
[xi] "A new start for Europe, a new dynamic for Germany, new solidarity for our country, Coalition agreement between CDU, CSU and SPD", February 7, 2018, line 1935 et seqq., 3211 et seqq.
[xii] Hacker/Thomale: Crypto-Securities Regulation: ICOs, Token Sales and Cryptocurrencies under EU Financial Law, November 22, 2017, SSRN Electronic Journal, 10.2139/ssrn.3075820, available on SSRN: https://ssrn.com/abstract=3075820 or http://dx.doi.org/10.2139/ssrn.3075820; Zickgraf (footnote 6), 294.
[xiii] Cf. also: Keding, WM 2018, 64, 66
[xiv] With regard to Smart Contracts cf. also: Jünemann/Kast, ZfgK 2017, 531; Heckelmann, NJW 2018, 504 [New Legal Weekly Journal]
[xv] Cf. Lerch, JBB 2015, 190, 193; Schlund/Pongratz, DStR 2018, 598 [journal of the German tax law].
[xvii] Cf. Regional Court of Konstanz, judgment dated May 10, 1996, docket no.: 1 S 292/95, NJW 1996, 2662; Engelhardt/Klein, MMR 2014, 355, 357 [journal of multimedia and law ]; Lerch, JBB 2015, 190, 195; Wagner, in: Münchener Kommentar zum BGB (German Civil Code), 7th edition 2017, sec. 823 BGB, marg. no. 294; Fritzsche, in: BeckOK [Beck online commentary] BGB, Bamberger/Roth/Hau/Poseck, 44th edition, as of: November 1, 2017, sec. 903 BGB, marg. no. 10.
[xviii] Eschenbruch/Gerstberger (footnote 2) refer to it as t as the "digital equivalent of a bond or an investment certificate/share certificate".
[xix] Cf. IOSCO, January 18, 2018, IOSCO/MR/01/2018; Weitnauer (footnote 6), 232; Klöhn/Parhofer/Resas (footnote 6), 102.
[xx] FINMA, guideline (footnote 9).
[xxi] Cf. also Dietsch, MwStR 2018, 546, 547 [journal of the entire value added tax law]; or Krüger/Lampert, BB 2018, 1154, 1155 [journal for business consultants], who support the generic term "investment token" and a distinction between debt tokens and equity/trust tokens.
[xxii] A new phenomenon is the so-called Initial Loan Procurement (ILP), in which loans are issued as Future Loan Access Tokens (FLATs).
[xxiii] An example of a stock issue on the blockchain is the US online trader Overstock.
[xxiv] BaFin, Initial Coin Offerings (footnote 14).
[xxv] German supervisory law must still be observed if the token is offered in Germany.
[xxvi] Cf. for example conference report of the specialist conference "Blockchain: Chancen, Recht und Regulierung" [Blockchain: opportunities, law and regulation" by Jean Louis Schiltz, MMR-Aktuell 2018 [news service], 400563.
[xxvii] Art. 4 (1) no. 44 MiFID II.
[xxviii] Art. 4 (1) no. 44 MiFID II.
[xxix] Sec. 2 no. 1 WpPG, Art. 2 Lit. a) Prospectus Act.