ICO: Regulation of Types of Token in Germany

By Dr Michael Jünemann, Johannes Wirtz

05-2018

ICOs (Initial Coin Offering), often referred to as ITS (Initial Token Sale) or TGE (Token Generation Event), are a current hot topic for debate. The product issued in an ICO is a blockchain-based coin or token (hereafter referred to only as tokens). Its technical design is as flexible as the associated rights such that the technical distinction between coins and token is of no legal relevance. However, a distinction can be made between three categories, Security Token, Utility Token and Currency Token, according to the rights a token conveys.

The German Federal Financial Supervisory Authority (BaFin) recently published an official note, at end of February 2018, in which it considers ICOs as potentially falling under the scope of existing regulation, depending on its respective design. There is no universal indication as to how an ICO is possible or how the exact legal classification of the tokens should be made. As such, each and every ICO has to be evaluated on a case-by-case basis to determine the possible regulation of the issued token.  However, in a consumer warning, an expert article and the official note, BaFin has made clear that some ICOs are not subject to regulation or capital market-specific investor protection requirements.

1. Security Token

By issuing security tokens, often also called equity tokens or investment tokens, the issuer promises some sort of return (either in the form of a commercial stake, interest or similar). Usually, they grant the right to profit sharing, but no original company share, which would be particularly difficult at least for a GmbH in Germany to do due to formalities. Examples of security tokens are EVN tokens (where investors from Germany were explicitly not permitted participating in the ICO) und tZERO. BaFin clarified that there are no legal limitations as to which rights a token must or can confer on the holder. Therefore, the provider has free reign in the design of its token. In particular, a security token does not have to grant any shareholder rights, information rights, control rights or voting rights.

Depending on the design, token can qualify as securities, according to the German Security Trading Act (WpHG) and German Security Prospectus Act (WpPG), or as capital investments, according to the German Capital Investment Act (VermAnlG).

The criteria for classifying as securities are comparatively clear and closely tailored to the capital market. In short, the token has to be standardized, tradeable on a (capital) market and transferable. If the rights represented by a token are comparable to shares, bonds and certificates, it is obvious that this is a transferable security. Whether tradability on a crypto exchange is already sufficient to qualify as to be tradable on the capital market is debatable. In any case, the classic capital market concept was based on the possibility of good faith acquisition. Unrestricted tradability on the market implies that the transactions can be handled safely and easily and that there can be no objections from third parties. This is regulated by law for some securities (for example bearer and order securities). For tokens, however, the applicability of good faith principles has not yet emerged, so that the token transfer by an unauthorized person need not be legally preserved and can be reversed. So far there is no other special legal regulation.

It is more likely that a token represents a capital investment, regulated under the German Capital Investment Act (VermAnlG). This includes, but is not limited to, shares that grant a share in the results of a business, subordinated loans, participatory loans, and “other investments” which provide or promise to provide interest and repayment, or any other form of cash settlement in exchange for temporary lending. Generally, in the event that a token promises a dividend or other kind of interest payment, it qualifies at least as an “other investment”.

Both securities and capital investments are regulated. Thus, in Germany (regardless of the issuer’s domicile), their offering requires the publication of a prospectus approved by BaFin (or an EU passport replacing such BaFin approval).

2. Utility Token

Utility Token are a kind of digital voucher which can be redeemed against a promised service of the issuer.  Examples include savedroid’s SVDs and filecoin. “True” Utility Token are not regulated as financial instruments in Germany. From BaFin’s point of view, simply naming a Utility Token as such is not sufficient criteria in order to legally determine the nature of the token. Moreover, the regulator does not outline any possibility, in any of its guidance publications, for the classification as a “pure” Utility Token that is distinguished from the Security Token in that it does not require a prospectus. Nevertheless, token purchases are still protected by consumer protection law even if no capital markets or financial instruments regulation applies.

3. Currency Token

More legal certainty exists with Currency Token, also called cryptocurrency. The most well-known example for a coin is Bitcoin. Other examples of Currency Token are Ethereum (or Ether) and Ripple. An essential feature is the money replacement character of the token, as they serve as decentralized currency.

The legal classification in Germany was made by BaFin at an early stage. Already by the end of 2013, BaFin determined that Bitcoin constitutes so-called units of account. Units of account are comparable to foreign exchange. As a consequence of this classification, they are considered financial instruments and their trading is therefore subject to special financial regulatory requirements; an uncomfortable reality experienced, for example, by one crypto company at the end of January 2018, when BaFin ordered cessation of its unauthorized Bitcoin broking services..

The company advertised to sell Bitcoin for customers on cryptocurrency exchanges. However, since Bitcoin is a financial instrument, permission from BaFin is required: in the specific example given, for the provision of brokerage services (Finanzkommissionsgeschäft).

4. FinTech companies are not in a legal vacuum

It is important to remember that the FinTech sector does not exist in a legal vacuum. Recently, the Higher Regional Court of Hamm confirmed a decision of the district court of Münster, which ordered the attachment on commissions of nearly €3 million, which a company had received for forwarding purchase price payments for OneCoin to the respective issuer, without having BaFin’s permission as a payment service provider (Higher Regional Court of Hamm, Decision dated 4. Januar 2018, Re: 4 Ws 196/17; 4 Ws 197/17).

These developments highlight the highly regulated and legally-complex nature of the financial services market in which today's FinTech businesses operate as well as the value of good legal advice when conducting business in the sector.