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].