The ICO rollercoaster - the securities question as seen from Europe
Monique Bachner, Luxembourg
The ICO craze has been wild so far. It is difficult to know for sure where the ride will stop, but there are various indications to help us interpret a sensible path.
For those not following the trend, ICO refers to an Initial Coin Offering — when company sells a token based on a blockchain. If you need to learn more about ICOs generally, and the background to the securities question the report by The LHoFT and Stellar is a good place to start https://medium.com/@The_LHoFT/understanding-initial-coin-offerings-technology-benefits-risks-and-regulations-9880d0e49058
Yes — like the dotcom bubble, it appears that ICOs are over-hyped and in a bubble. The FOMO effect is well illustrated by satirical ICOs (such as the delightfully named “PonzICO”) receiving funding. The fact that the trust issue is pushed so far that millions are thrown as “donations” on the trust that tokens will be reciprocated also questions whether this is rational behaviour.
Yes — there are a fair few ICOs with sketchy white papers or even appearing to be outright scams — some actions for fraud have already started. The lack of product — actual or clearly described should be a red flag in ICOs as in other situations. And many tokens don’t appear to have a blockchain use case at all, nor necessarily lend themselves to decentralisation.
Yet ICOs are nonetheless an important development on the global start-up and fundraising landscape. Like all start-ups, most will not be successful — but the best ones will likely not only survive, but also thrive.
Ignore the ICO trend at your peril. But participate with caution….
ICOs are a minefield to be trodden carefully. Let’s not pretend otherwise. Not all of these rollercoasters have been built with the same standards or safety checks, or within the bounds of relevant regulations.
Much has been written about ICO legality from a US securities law standpoint — but that often neglects the fact that ICOs are truly global. Yet each country in the world has its own set of rules. Over the last weeks, the ride has become less comfortable — with statements from the USA (SEC), UK (FCA), Singapore (MAS), Canada (CSA), Hong Kong (SFC) and Australia (ASIC) warning that some of these might be securities (and hence regulated) and some not. The devil is in the detail. China (PBOC) has made a less grey announcement, simply banning all ICOs. Many continue to refer to Switzerland as the “safe haven”, yet Switzerland’s laws are pretty similar to those of other countries, so silence is not necessarily legality — with important consequences if the winds of tolerance change direction. But in all of this, regulators have shown tolerance and an interest in encouraging innovation — provided it remains compliant with the relevant legal and regulatory environment.
Determining what can be considered as a regulated activity is complicated. And more so due to the wide range of use that can be made of not only virtual currencies and their related protocols, but the types of tokens use cases. Many ICOs have used the Ethereum protocol due to its smart contract capabilities and the ease to using the ERC20 token standard, but this is not the only option. Some ICOS also relate to issuances of entirely new protocols. Payment may be in any cryptocurrency accepted by the entity offering the token.
Some ICOs look less like securities offerings — they launch a protocol, or entitle recipients to use their tokens to participate in online activities just like purchasing (or in most cases pre-purchasing) a service much like they would if participating in a crowdfunding or a loyalty card. However, many others don’t seem to have a clear product yet — only their robust secondary market for the tokens, and seemingly more focused on stressing future profit participation or share of revenue streams — and look uncomfortably close to what one expects when investing in shares or other securities.
The European landscape
Across the EU, securities laws are increasingly standardised these days as a result of EU Directives implemented into each member state’s local legal system. At the EU level, it is ESMA (the European Securities and Markets Authority) and the ECJ (European Court of Justice) who ultimately have the final say on those European rules. In the absence of a statement, one can review the rules that ESMA will be looking at when considering the issue, and then one will also need to look at the interpretations in each relevant EU member state.
EU Payment laws?
Certain European countries have declared that cryptocurrencies be treated as currencies (and not as assets) whilst others have taken a different interpretation. Much like the American situation, often there are diverging approaches by different authorities within a single country. At the EU level, so far the European Banking Authority has issued some documents regarding both virtual currencies and electronic money, whilst the European Court of Justice has declared that for VAT (valued added tax) purposes, no VAT is due on cryptocurrencies as they are recognised as a currency, and not a service.
In Luxembourg, for example, the regulator (CSSF) declared in early 2014 that virtual currencies shall be considered as money, as they are accepted as a means of payment for goods and services. Due to their nature, virtual currencies may be considered as electronic money, but not necessarily within the meaning of the EU E-money Directive (2009/110/EC), which defines ‘electronic money’.
A case by case analysis still needs to be made, and whilst tokens will rarely fall within the definition of a currency those launching a protocol may be caught if it is intended to be used to make payments. Currency exchanges are the most obvious candidates for regulation, with cryptocurrency exchanges being regulated — usually under the Payment Services Directive. In Luxembourg, BitStamp was the first such exchange to be regulated, receiving its licence as a fully regulated payment institution in early 2016.
EU Anti-Money Laundering and Know Your Customer rules apply to all such exchanges, with current rules including customer due diligence requirements on all virtual currency exchanges, as well as custodian wallet providers.
EU Securities laws? Some will, some won’t…
As in other parts of the world, it is the question of securities law application or not which appears to be the most relevant for ICOs and their token issuances.
The Prospectus Directive defines securities in relation to their being capable of negotiation on capital markets. If there is a “public offer” in any EU country, then the local provisions of the Prospectus Directive may apply, including the prior publication of a prospectus, and fair and equal treatment of all investors (including in terms of access to information). There are exemptions, but these are generally restricted to sophisticated investors and require large minimum investment sizes.
The Prospectus Directive applies to ”transferable securities” — defined in MiFID (the Markets in Financial Instruments Directive ) as those classes of securities which are negotiable on the capital markets (with the exception of instruments of payment).
The definition of securities contained in the relevant European legislation is broad and encompasses the following three concepts:
(a) ‘securities’ meaning transferable securities as defined in MiFID ;
(b) ‘equity securities’ meaning shares and other transferable securities equivalent to shares in companies, as well as any other type of transferable securities giving the right to acquire any of the aforementioned securities;
(c) ‘non-equity securities’ means all securities that are not equity securities
The definition is broad, and non-exhaustive. Whether or not a token falls within this definition needs to be looked at on a case-by case basis. Some will, some won’t.
There is no specific EU test such as the now-famous Howey Test which was referred to by the US SEC regarding The DAO token and hack. The EU Directives do however set out a list of considerations. In the absence of an EU-wide interpretation, local interpretations are also likely to differ slightly.
The EU provisions apply equally to re-sales on secondary markets — a crucial consideration for future token use (and value).
Other EU laws?
Crowdfunding and consumer protection laws may apply in certain circumstances. Whilst there are not yet any EU-wide rules on crowdfunding, these are expected soon. The EU has encouraged innovation in this area, and has followed the trend under the broad banner of its FinTech initiatives — often looking at these in terms of investor protection and financial stability. In the meantime, crowdfunding is practiced in most EU member states, and several EU member states have implemented their own crowdfunding regimes (again usually focused on investor protection — often by setting ceilings on amounts that may be contributed). Certain types of crowdfunding platforms may need to be authorised under MiFID or under local frameworks. On the VAT front, in contrast to virtual currencies, crowdfunding is generally subject to VAT due to its participative nature and the implication that the funder will receive an asset (and not a currency).
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In all the hype, and between the scams, it is important to view ICOs as an important development. The lack of a coherent legal treatment so far, their global nature and the number of scams lurking between the gems all combine to make this a very risky game — with each token offering needing to be looked at on a case by case basis.
The global nature of token offerings means that even if launched from a particular country (with wording purporting to exclude other countries) if any tokens are purchased by residents of those other countries, those other country’s laws will often also apply. There is no single safe haven country if the offer is global.
In the meantime, err on the side of caution. If the features of your ICO token look more like a security, assume you need to ensure it is issued in a securities-law compliant manner (including creating a prospectus). Try where possible to anticipate requirements which might come, and consider how you will deal with them — token holder identification requirements might be an example of a potential future requirement.
The importance of this new trend mean clearer guidance will come soon as all major financial centres are already working on clearer guidance. In the meantime, ICOs remain impossible to ignore, but should be approached with caution.
 Markets in Financial Instruments Directive — Directive 2014/65/EU)
 (with the exception of money market instruments as defined in Directive 2014/65/EU , having a maturity of less than 12 months, which defines transferable securities’ as: those classes of securities which are negotiable on the capital market)