Initial Coin Offering – Quo Vadis?

Virtual Currencies are currently extremely fashionable. Starting with the "mother" of all virtual currencies, the Bitcoin, which is currently – accompanied by the media – reaching astronomic prices (the "price" for a Bitcoin is currently* just under EUR 10,000 and rose briefly to up to EUR 13,000 at the end of 2017), many other virtual currencies have emerged over the last few years. Trading in virtual currencies (also known as digital currencies or crypto currencies) is booming. A more recent development in the crypto industry is the so-called Initial Coin Offering ("ICO"). Based on a company's initial public offering ("IPO") an ICO represents a new form of corporate financing for digital companies.

The success story around the ICO of the internet browser "brave" in May 2017 illustrates why an ICO can be attractive for start-ups / founders: within 30 seconds the record-breaking sum of USD 35 million was collected by means of the ICO of brave’s tokens. The by far largest ICO of the popular messenger service Telegram, which has already attracted USD 850 million in pre-token sales from institutional investors, is currently attracting attention. ICOs are also becoming more and more popular in Germany. The first German ICO was initiated by the shopping app Wysker. In the future, customers will be able to pay for their purchases with tokens. Another example are Bitwala, which offers a platform for financial transactions and a token which, according to its description, is designed as an equity investment (in a "digital company"), and Savedroid, which offers a virtual wallet for buying and selling crypto currencies.

The alleged advantage of an ICO for digital start-ups / founders is that many members of the crypto industry believe that ICOs and tokens are not subject to regulatory and capital market regulations and are therefore not regulated. Compared to a conventional IPO this could save substantial costs for capital market law support, in particular the preparation of a prospectus and avoid any subsequent obligations. However, this assessment may often not be correct from a regulatory point of view. In individual cases, this would result in far-reaching (liability) risks.

Initial Coin Offering as the initial offer of a newly created virtual currency

The term Initial Coin Offering is based on the term initial public offering (IPO). While the IPO is the first public offer of existing shares from shareholders or newly created shares from a capital increase, the ICO refers to the first offer of newly created tokens (also called coins) by the issuer of the tokens ("Token Issuer"). Tokens are units of a virtual currency which are often based on a blockchain. Interested parties acquire the tokens ("Token Holders") and thus fund the project planned by the developers. The ICO is often a blockchain-based form of crowdfunding since many people fund a project which is "digitally recorded" by a blockchain. The tokens can be designed in different ways and serve for the funding of a wide variety of projects. For example, tokens can include voting rights regarding the project to be funded, a right to receive a profit share / dividend payment, the use of a product or service or even no right at all.

The newly created tokens are purchased by investors either with traditional currencies such as EUR or USD. However, much more frequently they are paid with an already existing virtual currency such as Bitcoin or Ether. The long-term goal of an ICO is usually to fund a project – that can be either described in detail or more general. In general, the project does not exist when the new tokens are issued since a certain amount is required before the project can be realised. In order to convince potential investors, the developers of the tokens usually prepare a so-called "white paper" which describes the planned project and states the details of the ICO such as issue volume, price and period. Furthermore, so-called terms and conditions are published which regulate the rights and obligations between ICO issuers and Token Holders. In addition, often a secondary market for tokens is established. Here, the Token Holders can realise a profit when selling the tokens. In a nutshell, the intention of an ICO is to create a new virtual currency to fund projects.

Virtual currencies are "internet currencies" created in a computer network. All transactions and balances of virtual currencies are managed in a decentralised computer network. This distinguishes them from national currencies since they are not issued by a central state authority and are therefore non-governmental. Virtual currencies are limited to a specific maximum amount from the outset. The best-known examples of digital currencies are currently Bitcoin and Ether. These digital currencies are created by cryptographic calculation using blockchain.

What is a blockchain?

The blockchain is a database that contains a continuously expandable list of transaction data records in form of blocks and is organised on a decentralised basis. The transactions take place peer-to-peer without the intermediation of a bank. The blockchain is a kind of virtual "cash book" for all transactions regarding the respective virtual currency. The blocks of the blockchain are connected to each other. Each block contains a code of the previous block ("Hash"), a time stamp and transaction data as well as the entire transaction history of the blockchain. This information is encrypted in the respective block. This means that several transactions are combined in one block, which is chronologically based on the previous block. This creates the chain of blocks (blockchain). A new block must first be generated by the network participants, which is called "mining".

The network participants first have to solve a difficult mathematical problem by using their IT (computing power). They compete with each other for the fastest solution to the problem and thus for the validation of the transaction. The fastest computer that ultimately performs the validation receives a reward in form of accounting units or tokens. For example, regarding Bitcoin, the accounting units are so-called Satoshis which is the smallest subunit of Bitcoin (1 Bitcoin = 100 million Satoshis). Whoever ultimately performed the validation forwards copies of the blocks to all network participants; so that all network participants have always stored the latest status of the blockchain. Due to the decentralised storage, the information about the transaction is less susceptible to manipulation. In case a dishonest participant tries to alter the transaction information, the network will know right away that something has happened because the coding of the block would be invalid.

In principle, anyone who has the appropriate software can participate in the mining process. However, the participating computers are regularly professionally built mining farms due to the enormously high performance requirements. Therefore, these mining farms are extremely energy-intensive.

The advantage of the blockchain is its high level of transparency since all transactions can be viewed publicly in the "cash book". On the other hand, the block chain also offers strong anonymity since the persons involved in a transaction cannot be identified by name. The latter is sometimes criticised as being fertile soil for criminal activities.

Different types of tokens

In practice, three different types of tokens have emerged. Due to the current very rapid changes in ICOs the following types of tokens are neither exhaustive nor can they serve as unchangeable definitions.

• Utility Tokens: The tokens grant a (one-time) future benefit following the realisation of the project – like a digital voucher. Such future benefit can be e.g. storage space in a cloud storage service, access to a digital trading platform and payment methods on such platform or discounts for advertising-related product views. There are also Utility Tokens that do not grant any right at all. In such case, a shortage by so-called "burning" (disabling tokens) of all "undrawn" tokens shall increase the value of the “drawn” tokens. The “burning” is done by the Token Issuer or third parties after completion of the ICO. If the Token Holder sells his tokens on a secondary market, he can benefit from "rising prices".
• Investment Tokens: These tokens represent assets and can be structured as both, debt or equity. For example, Investment Tokens may provide for a debt claim against the issuer for future profits or capital or an equity-based membership right. Examples are Bitwala or KuCoin. Bitwala is a blockchain-based crypto currency bank. Its Investment Token shall be linked to shares in Bitwala GmbH, although further details have not been published so far. KuCoin is a stock exchange-like market for crypto currencies. Its tokens (known as KuCoinShares) aim to involve the shareholders in the trading fees generated on KuCoin.
• Currency Tokens: In principle, Currency Tokens do not go beyond the function as crypto currencies and should serve as a decentrally stored surrogate for money. They serve as a payment method for buying goods or services. In order to act as a suitable payment method, they must be stable in value, exchangeable and representative (in relation to an equivalent value). The best known example is Bitcoin. Other well-known examples of Currency Tokens are Ether, Ripple or spin-offs (so-called forks) of Bitcoins (Bitcoin Cash) or Ethers (Ethereum Classic, which continues the original Ethereum platform).

Of course, besides these, hybrid forms consisting of various tokens described above may exist. For example, Utility and Investment Tokens can also fall into the category of Currency Tokens, which can affect the legal classification.

Typical procedure of an ICO

ICOs often proceed as follows:

• publication of a white paper describing the project and its funding, and publication of technical specifications (software, etc.)
• Smart Contract (based on Ethereum blockchain) is created and allows generation and distribution of tokens at a later stage
• during a certain time period payments (mostly Bitcoins or Ethers) are accepted via Smart Contract
• each payment receives a public key (account number) from Smart Contract and assigns tokens to Token Holders based on public key
• tokens can be stored in wallets (from third parties), and can be traded on crypto currency exchange platforms
• tokens can be exchanged or sold for services after a project is completed

ICOs are not completely unregulated

In Germany, many members of the crypto industry and Token Issuers believe that ICOs are completely unregulated in Germany. This assumption may be caused by the lack of a specific national or European "ICO law". Germany’s Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht – "BaFin") has already taken a number of positions regarding the regulation of ICOs. First, BaFin has published a consumer notice pointing out the dangers of ICOs. The European Securities and Markets Authority ("ESMA") has also published a corresponding warning (which has also been translated by BaFin). According to BaFin, risks associated with ICOS can be, for example, the enormous price fluctuations of virtual currencies, the lack of a liquid secondary market and a possible total loss of the investment. In addition, white papers that are published in the context of ICOs are often hardly comprehensible or verifiable since they are not approved by BaFin. BaFin also refers to possible licensing or prospectus obligations under German law, which must, depending on the case, be observed.

Furthermore, in the end of February 2018, BaFin published an information letter which assesses the categorisation of tokens in the area of securities supervision in detail. According to this information letter, tokens may constitute securities within the meaning of section 2 para. 1 of the German Securities Trading Act (Wertpapierhandelsgesetz – “WpHG") or section 2 no. 1 of the German Securities Prospectus Act (Wertpapierprospektgesetz – "WpPG"). This would be irrespective of a possible securitisation or the designation e.g. as "Utility Token". Far more important are the corporate rights or debt claims as well as comparable claims embodied in the token. . Further, tokens could constitute interests in an investment fund within the meaning of the German Capital Investment Code (Kapitalanlagegesetzbuch – "KAGB") or - subsidiarily - an investment product within the meaning of the Investment Products Act (Vermögensanlagengesetz – "VermAnlG"). The consequence is the applicability of procedural obligations, transparency and market abuse requirements for intermediaries and prospectus obligations of Token Issuers.

In addition, there could be licensing obligations under the German Banking Act (Kreditwesengesetz – “KWG”) and the Payment Services Supervision Act (Zahlungsdiensteaufsichtsgesetz – “ZAG”). Licensing obligations pursuant to the ZAG must be taken into account if the intermediary provides payment services within the meaning of section 10 para. 1 ZAG. If the intermediary, at the request of the investor, transfers the real equivalent value of the token via its own account to the Token Issuer, the intermediary is conducting money remittance business within the meaning of section 1 para.1 sentence 2 no. 6 first alternative ZAG. However, virtual currencies (but not the real equivalent value of the token) are usually paid as the return for the "token purchase". Therefore, there is no transfer of the real equivalent value of the token and thus no money remittance business.

If the intermediary acts at the request of the Token Issuer, it may conduct acquiring business within the meaning of section 1 para.1 sentence 2 no. 5 second alternative ZAG. Both money remittance business and acquiring business require a licence by BaFin.

Other countries have also taken clear positions regarding the regulation of ICOs. In mid-2017, the U.S. Securities and Exchange Commission already announced its legal assessment that tokens may be "securities", depending on their structure. This would result in (subsequent) obligations under capital market law.. Likewise, the Dutch Minister of Finance took a position in this regard and, depending on the concrete form of the tokens, affirmed that they may constitute securities. The relevant Chinese and South Korean authorities even went one step further and completely banned ICOs. As a result, a large number of ICOs must be unwound.

The advance of these countries in the field of ICOs gives reason to take a closer look at the German regulatory and capital market requirements for Token Issuers and trading platforms. It must not be overlooked that the general provisions of German banking supervisory law and capital market law may apply to the (initial) issuing of tokens. In particular, non-compliance with possible licensing and prospectus obligations can lead to criminal liability, enormous fines and claims for damages. When examining possible obligations under German supervisory law, a distinction must be made between the Token Issuer and trading platforms or intermediaries offering services in connection with ICOs ("Intermediaries").

Token as securities – possible prospectus requirements for the Token-Issuer according to the WpPG

Whether tokens are subject to a prospectus requirement under the WpPG depends, in particular, on whether tokens are classified as securities.

Securities within the meaning of the WpPG are, in general, transferable securities that can be traded on a market. The criteria for the classification of a security are standardisation and transferability or tradability on financial or capital markets (fungibility).

Standardisation means that the securities can be determined on the basis of common, standardised characteristics and are therefore tradable. This means that the type and number is sufficient for the securities to be tradable. Investment instruments that have been individually designed to meet special client requirements are not standardised. Tradability means fitness for circulation. This is in particular the case if the transfer of the securities is based on principles of property law but not by assignment. The transfer must therefore not depend on restrictions. For example, shares of a German “GmbH” are unfit since a transfer requires a notarized agreement. It is not necessary that a security is securitised.. However, a right must be embodied in the security. In addition to the definition of securities, the WpPG provides for an exemplary catalogue of securities, including:

• “shares and other securities which are comparable to shares or shares in corporations or other legal entities, as well as certificates representing shares

• any other securities which grant the right to acquire or dispose of such securities or which result in a cash payment determined by reference to transferable securities, currencies, interest rates or income, goods or other indices or measures”

The interesting question is whether the three abovementioned examples of tokens constitute securities. This plays a key role in the question of regulation by the WpHG or WpPG.

As a rule, a Utility Token grants a future benefit after the realisation of a project. Utility Tokens are generally standardised. In addition, the token must embody a right. Since Utility Tokens lack special rights such as voting rights or comparable rights, they highly likely do not constitute securities.

Currency Tokens are units of a crypto currency. As far as Currency Tokens have not been further developed, a Currency Token as a "substitute currency" is probably not a security either. This is due to the lack of corporate and property rights (or comparable rights).

Investment Tokens contain asset values. They can be structured as both, debt and equity. For example, they can be linked to profit-sharing or membership rights. In this case, a classification as a security must be examined in detail on a case-by-case basis. In principle, tradability is possible via crypto trading platforms. Here again, the tokens are standardised, provided that the company / project issues a certain amount of tokens of the same type. The Investment Tokens regularly contain shareholder rights (e.g. voting rights) and/or asset values. However, the Token Issuer can exclude the transferability of the tokens. For example, it must be carefully examined whether the transferability of the tokens has special requirements. This is due to the fact that the transferability is already legally strongly limited depending on the company structure of the Token Issuer. This applies particularly if tokens are linked to company shares – which is planned in the crypto scene at the moment. Further, the rights granted by the token must be assessed in detail.

Token as an investment product – possible prospectus requirement for the Token Issuer according to the VermAnlG

Provided that tokens are not subject to securities prospectus regulations, tokens may constitute investment products (Vermögensanlagen) within the meaning of section 1 para. 2 of the VermAnlG. This depends on the rights associated with the token. If a token constitutes an investment product within the aforementioned meaning, it is subject to a prospectus requirement under the VermAnlG.

According to section 1 para. 2 no. 1 VermAnlG, investment products are "shares granting a participation in the result of a company". This may comprise all tokens issued by companies that grant a right to profits of this company, provided that the right is based on fixed rules. In particular, an Investment Token could constitute such investment product if it grants a right to profit distribution or revenue share or a subscription right when additional tokens are issued. Utility Tokens and Currency Tokens generally do not grant any right to  profits. Therefore they highly likely do not classify as an investment product within the meaning of section 1 para. 2 no. 1 VermAnlG.

Tokens probably do not constitute (profit-participating) subordinated loans ((partiarische) Nachrangdarlehen) within the meaning of section 1 para. 2 no. 4 VermAnlG. Subordinated loans within the meaning of section 1 para. 2 no. 4 VermAnlG are loans granted by a lender to a borrower, and which provide for a qualified subordination. In addition to a fixed interest rate, subordinated loans can also provide for a participatory interest.

The equivalent to be paid for an Investment Token may constitute such subordinated loan. Irrespective of this, however, a loan classifies as a “loan” (Darlehen) under civil law if an amount of money is provided. This means that the tokens must not be paid with other tokens such as Ethereum or Bitcoin. Rather, they must be paid with "real" money (EUR, USD, etc.). According to German Law, only legal tender (“Fiat Money”) constitutes ”real” money. within the aforementioned sense.

Utility Tokens or Currency Tokens rather do not meet the criteria of a profit-participating subordinated loan. This is because the Token Issuer has no repayment claim against the subordinated lender (Token Holder) for the equivalent value that the Token Holder has to pay for the Utility or Currency Token.

Tokens could also constitute profit participation rights (Genussrechte) within the meaning of section 1 para. 2 no. 5 VermAnlG. However, this depends on the structure of the tokens. Profit participation rights are long-term commitments of a sui generis nature. They are aimed at recurring benefits in the form of a participation in profits and losses of the issuing company. Profit participation rights are not defined by law and are very flexible. Therefore, a classification of tokens as profit participation rights should always be taken into account. An indication for a profit participation right may be the issue of token conditions (such as the typical terms and conditions). However, those must be equal for all and must provide for a revenue/profit share or fixed interests / dividends. Utility tokens or Currency Tokens, on the other hand, should not constitute profit participation rights as they do not provide for any profit rights.

In any case, tokens may also fall under the catch-all provision of the so-called other commercial investments of section 1 para. 2 no. 7 VermAnlG. No. 7 provides for two different alternatives. The first alternative comprises forms of investments that grant or promise both a claim for repayment and interest (loan-like fundings).

The first alternative of commercially comparable investments is likely to include (only) Investment Tokens that grant a loan-like repayment claim and interest over a certain period. However, this catch-all provision only applies if the tokens are not already covered by any other form of investment products.

The second alternative is an investment that provides for an asset-based, cash-settled claim for the temporary transfer of money. In contrast to the first alternative, no interest is paid, but the investor receives a commercially comparable benefit.

Utility Token Issuers usually do not grant a claim for a cash settlement. Rather, they usually do not grant a claim at all or (at least also) a non-cash benefit or service as equivalent value to the transfer of virtual currencies. Such benefit or service can be e.g. discounted goods, or the use of storage space. Therefore, Utility Tokens should not fall under the second alternative either. As a rule, Currency Tokens do not provide for any claim for the Token Issuer. They merely serve as money-substitute created under private law and can be exchanged for goods or services, provided that there is a sufficient market value for the tokens. This may be different for Currency Tokens where a central Token Issuer pays or promises an equivalent value for the "return" of the tokens.

Investment tokens that grant (or promise) a back and forth of cash flows without claims for profit or interest can constitute a commercially comparable investment within the meaning of the second alternative. This is, in particular, the case if the token merely promises (or provides) a repayment of money at a later date or an advance purchase of goods or services (which should at no time actually lead to the delivery or provision of these services).

Regulatory requirements for intermediaries and platforms

In principle, the use of tokens as "substitute money", and also the purchase or sale of tokens that have been mined or purchased is not subject to authorisation under the KWG. However, under certain circumstances, a license is required.

From BaFin's point of view, tokens generally constitute financial instruments in the form of units of account within the meaning of the KWG. A license is required particularly for companies or persons who deal with tokens on a commercial basis.

If tokens are structured as securities and intermediaries who sell the tokens on the secondary market (e.g. via a platform) are involved, these intermediaries require a licence from BaFin for the provision of financial services in within the meaning of section 32 KWG. The type of the licence depends on the type and scope of activity of the intermediary.

In particular, the provision of principal broking services comes into consideration. In the field of virtual currencies, persons or platforms buying and selling virtual currencies (tokens) commercially in their own name for the account of others carry out principal broking services which are subject to a license requirement. In addition, platform operators may operate a multilateral trading facility with tokens. According to BaFin, this requires the operation of a multilateral system that matches the interests of a large number of persons in buying and selling financial instruments. This must take place within a system and according to fixed provisions, and in a way that results in a contract for the purchase of the tokens.

In addition, investment brokering or contract broking comes into consideration.

The commercial matching of token buyers and sellers on the secondary market constitutes, depending on the concrete form, investment brokering or contract broking within the meaning of the KWG. This would result in a license requirement. This may apply particularly to intermediaries who offer trading platforms for buying and selling tokens as messengers or even representatives of buyers or sellers. Examples for such platforms are the typical crypto-currency exchanges Kraken, Tokn, etc.

If the tokens are designed as an investment product, a license pursuant to section 34f of the German Trade, Commerce and Industry Regulation Act (Gewerbeordnung – “GewO”) may be sufficient - instead of a licence pursuant to the KWG. Also, a licence / registration under the German Capital Investment Code could be considered in individual cases.

In addition, the platform or the intermediary must also ensure compliance with any requirements pursuant to money laundering provisions.

Conclusion

All this shows: Unlike numerous reports to the contrary, ICOs are not completely unregulated. The lack of specific ICO laws does not lead to a legal vacuum. In fact, general German (supervisory) law is applicable, provided that (also) the German market is addressed. Generally, this should be at the case if an ICO is conducted via internet. BaFin confirmed this and just recently clarified that the concrete structure of the tokens was decisive for the question whether an ICO is subject to regulation under supervisory or capital markets law. Non-compliance with supervisory regulations will cause administrative measures such as the suspension of business or high fines by BaFin. Due to the enormous sums raised by ICOs, BaFin will probably intervene restrictively. Investors and Token Issuers should therefore not be tempted by "fast money". Rather, they should take ICOs with caution and check the relevant provisions thoroughly in advance (or have them checked).

Moderate regulation of the ICO industry could also mean security and stability for the market and for the investors. This could encourage even more potential investors to invest in ICOs and further fuel the emerging market.

Therefore, it remains to be seen how the ICO market will react under the continuing efforts of various nations to further regulation of ICOs, and whether this can stop the ongoing success story.

*12 March 2018