What are ICOS 2

Initial Coin Offerings (ICOs) - What is an ICO and how is an ICO to be legally assessed?

14.03.2018

Dr. Oliver Zander, Giulia Kögel


Initial Coin Offerings (ICOs) are a new way of raising capital through crowd financing of entrepreneurial projects. Since the investors get involved in an ICO at a very early stage of the project development, it is an extremely speculative risk business, which is associated with enormous profit opportunities, but also the risk of total loss. The concept is similar to that of a classic IPO (“Initial Public Offering”), but enables its strict regulation to be circumvented.

In addition, ICOs are much cheaper and faster to carry out, offer the provider more flexibility and shift the business risk almost completely to the investors. ICOs are therefore an advantageous alternative to IPOs, especially for start-ups. Small companies or those that work with unknown, unpredictable and therefore particularly risky technologies open up numerous opportunities that were denied to them via traditional financing methods. In 2017 alone, almost $ 3.8 billion (around 3 billion euros) were collected cumulatively through ICOs, and the number of newly launched projects is growing exponentially. [1]

What are ICOs?

With an initial coin offering, a new cryptocurrency is usually issued, which is sold to interested parties in exchange for other cryptocurrencies, state-issued currencies or services. This special cryptocurrency, the so-called token, represents a transferable right created by the issuer for the investor vis-à-vis the provider. The practical design usually takes place using blockchain technology, so that the bundles of rights transferred are cryptographically secured. Theoretically, there are hardly any limits to the content of these rights.

procedure

The projects to be financed are usually business ideas for new blockchain applications. In preparation for the ICO, the provider writes two documents: a so-called “whitepaper”, which focuses on explanations of the technology, the relevant market and the development of the project, and so-called “terms and conditions”, in which the legal framework of the respective project is specified to be discribed. It should be noted in advance that there are no minimum requirements for these documents, so that all of the following information is optional in practice. The whitepaper is often quite comprehensive and technical. As a rule, a general, practical problem is raised first. A solution is then proposed and the product in question is described in detail. At this point, it is usual to deal with current market data and to create growth forecasts. Then the technical details are carried out. There is often a detailed description of the system architecture and its interaction with users, as well as explanations of the technical functionality and use of the tokens.

In addition, it has now become established to name the participating project team members, consultants and in some cases even investors who have already been won in order to convey an impression of personality, responsibility and professionalism. As a rule, this even lists the professional fields, business experience already gained and projects in which the participants have already been involved. Many investors attach great importance to an experienced and multi-professional team, which in the best case already has successes in the blockchain domain, especially because of the early entry into the project.

It is also customary to provide a detailed description of future development plans based on a development roadmap. In the best case scenario, this includes a specific work plan for the next 12 to 18 months and provides for a so-called beta launch, which makes it easier to create initial forecasts and fix errors. If the project is already at an advanced stage, a presentation and analysis of the existing findings and successes is advantageous.

In addition to the whitepaper, the Terms and Conditions regulate the legal background of the project. As a rule, these are general terms and conditions. In practice, in addition to some basic information, this mostly consists of disclaimers.

Often it is initially stated who is carrying out the ICO and which platform is managing it. Due to the international scope, it is particularly relevant which legal system is to apply to the contract. In principle, the law of the country that was agreed in the Terms and Conditions applies. In the absence of an agreement, private international law will be applied so that the local law of the issuer applies.

In addition, it can be determined whether the tokens are refundable and which functions they fulfill, in particular whether they convey voting and participation rights with regard to the project. In the case of tokens that represent certain physical values ​​such as gold or US dollars, their actual deposit must be discussed. If the token sale is to be limited to a certain time window, this will be defined and the right to make changes may be reserved.

Many providers want to achieve exclusions of liability by expressly pointing out the investment risks, recommending advice from legal experts and advising against an investment if they have no experience with high-risk investments or blockchain-based systems and there is no technical understanding of the specific project.

In addition, far-reaching exclusions of liability are often agreed, including claims for damages in the event of financial losses of any kind, the occurrence of tax or legal obligations on the part of investors, as well as any technical errors, legal changes, unforeseeable events and the like.

Otherwise, the Terms and Conditions are similar to ordinary terms and conditions and contain common clauses such as disclaimers, changes to reservations and severability clauses.

Most of the ICOs that have already been carried out use the Ethereum blockchain as a platform, which was originally also financed through an initial coin offering. However, other platforms such as Stellar, Omni or Waves are also gaining popularity. The American company Tezos, which carried out the second most successful ICO of last year with over 230 million dollars, has issued its tokens on its own blockchain, for example.

The time of the actual token sale, also known as the token sale, can theoretically take place at any stage of the project development. In principle, the earlier the token sale takes place, the lower the risk for the provider in the overall project. However, the extremely high overall risk of loss at an early stage of project development often discourages investors and makes financing more difficult.

In many cases, so-called pre-sales are carried out in the early phase of project development, which enable the further development and marketing of the project as well as the acquisition of new investors through an initial capital increase. These pre-sale tokens are offered at reduced prices in order to keep them interesting for early investors despite the increased risk.

The product is launched on the market, regardless of whether an optional pre-sale has been carried out, as a rule only after the ICO has been carried out.

advantages

Initial Coin Offerings offer numerous innovative advantages for both providers and investors.

In contrast to IPOs, they can be carried out relatively quickly, easily and inexpensively. Blockchain technology makes it possible to set up and manage your own system for each project, within which fast and inexpensive transactions are possible. Interactive platforms such as Ethereum are increasingly simplifying the construction of such systems, so that less and less technical affinity is required for implementation. The free design options with regard to the execution as well as the tokens themselves allow maximum flexibility for both sides in every respect.

However, these have other advantages especially for the providers of ICOs. In particular, their own financial risk is reduced, as large amounts of capital can be collected before the project development company has even called in any significant amount of equity. Furthermore, through international marketing and implementation via the Internet, they can reach an almost unlimited group of potential investors. In addition, they benefit from the fact that the investors form a solid customer base even before the product is launched on the market, who, due to their financial participation, are very interested in the progress and success of the product.

Risks

On the other hand, there are also considerable disadvantages and risks, especially for consumers. First of all, it is important to point out the extremely high risk of loss. On the one hand, this results from the fact that numerous inexperienced investors are attracted by the easy access via the Internet and the promise of quick money. Most of the projects consist of complex technical topics, the assessment of which requires an in-depth technical understanding and extensive research. On the other hand, the technical simplification of the ICO process itself is increasingly attracting unprofessional providers. Due to the early financial entry into the project, it is difficult to predict whether it will ever be completed and launched, whether it will develop favorably or later fail. In addition, in the event of a loss it is not uncommon for a total loss to occur, as the crypto market is extremely volatile and unpredictable.

The lack of regulation is also extremely problematic. For example, the information in the whitepaper is not subject to any supervision with regard to its content and its credibility.

Furthermore, due to their internationality, ICOs carry the risk of more difficult legal enforcement, as different legal systems and instances often collide with one another.

International reactions

The swarm financing model through ICOs has caused a stir internationally due to its rapid emergence and the enormous amounts of money that have been collected within a very short time. In particular, the possible circumvention of existing regulations, the high risks for consumers and the dangers of fraud, money laundering (ATM) and terrorist financing (CFT), which arise from the increased anonymity, are criticized.

The People's Bank of China completely banned ICOs in 2017 for all companies and private individuals. Chinese ICOs have been instructed to return earnings from completed funding periods. South Korea also followed the ban in September 2017, pointing out the dangers of fraud and "trickery".

While a legal direction is emerging in Asia that provides for a temporary ban until appropriate regulation has been implemented, the legal situation in Europe and the USA is still quite vague.

The US Securities and Exchange Commission (SEC) issued a press release in July 2017, according to which ICOs may be subject to US securities legislation. Accordingly, the token sales could be sales of shares or securities that are subject to the same laws and tax conditions that also apply on the stock market. However, no clear legal assessments were made. The SEC announced a case-by-case assessment practice. In the USA, this has led to ICO providers deliberately using terms such as “donation” or “crowd sale” in order to avoid future problems with the regulatory authorities. In addition, many ICOs meanwhile generally exclude US investors from participating in the coin offering for the same reason.

Regulation in Germany

The German Federal Financial Supervisory Authority (BaFin) and the European Securities and Markets Authority (ESMA) also issued consumer warnings in November 2017 and announced that they would determine the legal basis in individual cases on the basis of specific contractual arrangements. In the American and European countries, it remains particularly questionable to what extent ICOs are subject to the already existing legal regulations.

ICOs offer a beneficial innovation that should not be unduly burdened by regulation. However, certain regulatory measures are desirable to limit money laundering, terrorist financing and consumer protection risks.

In addition, it should be clear for the providers which legal provisions and authorization requirements they are subject to when carrying out an ICO. Due to the extensive design options for the implementation of ICOs, regulation that treats all cases equally rigidly appears extremely difficult.

It would therefore be desirable to develop a differentiated, case-by-case evaluation matrix. This should (1) identify the regulatory areas against which the legal framework is to be measured, (2) define different types of tokens and ICO structures and (3) enable a specific definition of legal and regulatory responsibilities and framework conditions in individual cases.

In addition, it is problematic that mere national regulation would quickly reach its limits due to the purely digital, international functioning of the ICOs. A functioning concept of international cooperation is required here. The development of case law practice would therefore be of great value.

1. Regulatory Areas

According to German banking supervisory law, initial coin offerings would be particularly relevant from a regulatory perspective if they were associated with a banking transaction or a financial service within the meaning of the German Banking Act (KWG). Furthermore, questions of prospectus law, money laundering law, payment services law and company law could arise. Tax obligations could also arise. Finally, the anonymity or pseudonymity of the investors could be problematic in several respects, in particular with regard to crypto currencies such as Monero or ZCash, which allow the user complete anonymity.

The applicability of supervisory rules depends in particular on which rights the specific token conveys and how the ICO is structured.

2. Different types of tokens and ICO structures

It should be noted in advance that the following token names are neither conclusive nor uniformly defined. Due to the constant individual examination by BaFin, they are of no legal relevance and serve to simplify the presentation.

An ICO token is a crypto currency issued specifically for the project in question, which digitally represents a right or a bundle of rights. The simplest form here is the representation of the mere ownership of the token. This simple so-called utility token does not convey any rights to the company, project or product. Its investment incentive arises from the pure prospect of an increase in value if the associated project is successful and demand for the tokens increases. Similar to a direct investment in existing cryptocurrencies, the token can vary in value depending on the success or failure of the financed project and can be traded for other currencies on secondary market platforms.

In addition, however, a more extensive bundling of rights is possible. In this respect, so-called usage tokens are conceivable, for example, which, similar to a voucher or a license, convey access to or usage rights for a product or service. One example of this is the American start-up Protocol Lab, which in 2017 carried out the most successful ICO of last year with over 250 million dollars. Your Filecoin should become the currency of a decentralized computer network in which users can rent unused storage space to one another. Your tokens represent usage rights to the storage space mediated on your website.

There are also so-called asset tokens that represent assets or products. Such tokens can, among other things, embody ownership of a thing. An example of this is the Chinese company Tether, whose USDT token represents a claim to one of the US dollars that the company holds.

The so-called equity or revenue tokens are of particular interest from a financial law perspective. Similar to a “digital share”, they entitle their owner to receive dividends and / or to exercise voting and participation rights in the organization.

Alternatively, so-called work tokens have also become established, which are not issued by the providers for payment, but in exchange for work. So-called “advisory deals” are particularly common, in which consultants are employed whose advisory services are rewarded as part of the token sale.This model maximizes the employees' interest in the success of the project, but at the same time creates risks for dubious cover deals. So-called “influencers” are often employed as supposed consultants who are actually only supposed to bring marketing advantages. The tokens are also sold to influencers with a discount of up to 90% on the regular ICO price.

3. Legal classification of tokens by type

Tokens as financial instruments, Section 2 Paragraph 4 WphG


In a current notice, BaFin has issued a position on the regulatory classification of ICO tokens as financial instruments in the field of securities supervision. Accordingly, it must be checked on a case-by-case basis whether the tokens are financial instruments within the meaning of the Securities Trading Act.

According to BaFin, the token can be used as (a) security (Section 2 (4) No. 1 WpHG, as (b) a share in an investment fund (Section 2 (4) No. 2 WpHG) or as (c) an investment, depending on how it is structured (Section 2 (4) No. 7 WpHG). In addition, a token can also form the base value for a (d) derivative transaction (within the meaning of Section 2 (3) WpHG), whereby the derivative transaction would be classified as a financial instrument.

For the classification as a financial instrument within the meaning of the WpHG, the classification of the token as a unit of account within the meaning of Section 1 (11) sentence 1 no. 7 KWG is not decisive.

Token as a security, Section 2 Paragraph 4 No. 1 in conjunction with Section 2 Paragraph 1 WpHG


According to the wording of Section 2 (4) No. 1 in conjunction with Section 2 (1) WpHG, the classification of a token as a security depends on the following requirements: The token must (1) be transferable and (2) tradable on the financial or capital market . In addition, he must embody (3) rights. If the token is a payment instrument, this excludes the security property.

BaFin generally regards cryptocurrency platforms as financial or capital markets. Every token that can be traded on secondary market platforms can therefore meet this requirement.

With the exception of the utility tokens, which do not convey any rights, every token can in principle be a security within the meaning of the WpHG. In this regard, according to BaFin, it is sufficient for the fulfillment of the requirements if the token conveys shareholder rights, contractual rights or rights comparable to both. A securitization of the token is not required for classification as a transferable security, as long as the holder is otherwise documented. Documentation using distributed ledger technology is sufficient for this, which also includes blockchain technology, which is widely used in practice.

If the token is to be classified as a security within the meaning of Section 2 (1) WpHG according to the requirements mentioned here, this property is also decisive for the opening of the scope of further relevant capital market laws and EU regulations (e.g. MAR), which refer to the term discussed here Refer to "Transferable Security". In addition, the above statements also apply with regard to classification as a security within the meaning of Section 2 No. 1 WpPG.

Token as a share in an investment fund, Section 1 Paragraph 1 KAGB


In addition, depending on the individual circumstances, the token can also be classified as a share in an investment fund (Section 1 (1) KAGB). This would be the case if the token confers a right to an organism for collective investment that invests the money collected from the token holders according to a certain investment strategy and does not itself represent an operational company.

If the token therefore represents a portion of an asset that invests in shares or in real assets (e.g. real estate), the investor would be involved in an investment fund via the token, so that the provisions of the KAGB would apply.

Token as an investment, § 1 Abs. 2 VermAnlG


In individual cases, tokens can also be classified as assets within the meaning of Section 1 (2) VermAnlG and thus as a financial instrument within the meaning of the WpHG. This requires that the token is neither regarded as a security nor as a share in an investment fund, and that the acceptance of the funds does not qualify as a deposit transaction (Section 1 (1) Sentence 2 No. 1 KWG). Depending on the legal structure, the token can also be used as a company participation (Section 1 (2) No. 1 VermAnlG), profit-sharing loan (No. 3), subordinated loan (No. 4), profit-sharing right (No. 5) or as another investment (No. 7) to be seen.

Token as a billing unit, Section 1 (11) KWG


Up to now, BaFin has defined as financial instruments in the form of units of account in accordance with Section 1 (11) Clause 1 No. 7 Alt. 2 KWG “all units of value not denominated in legal tender that have the function of private means of payment in ring swap transactions, as well as any other substitute currency that is used as a means of payment in multilateral accounting groups due to private law agreements. ”Tokens could consequently be viewed as units of account and thus as financial instruments under the KWG if they are accepted as means of payment by third parties in addition to the issuer. However, even according to the BaFin definition, this would only be the case if the specific token has been sufficiently widely accepted as a currency. At most, this is worth discussing with regard to Bitcoin. In any case, tokens created by individual providers are currently not accepted as a means of payment and therefore do not represent a financial instrument in the sense of units of account.

4. Legal consequences of the classification

If a token is classified as a security, as a share in an investment fund, as an asset or as a derivative transaction according to the above principles, the relevant legal regulations must be observed for the implementation of the ICO.

Depending on how they are structured, all matters requiring authorization such as banking (e.g. in the form of issuing business), financial services (e.g. in the form of financial portfolio management), investment business, the provision of payment services and even insurance business come into consideration.

The regulatory requirements for these businesses are very different. Depending on the design of the ICO, it may be necessary to apply for approval as a financial services institution in accordance with Section 32 KWG or to manage the investment assets formed by the tokens by a capital management company in accordance with the rules of the KAGB. Particularly for the phase of collecting the capital, prospectus obligations will have to be observed.

It is therefore essential right at the beginning of an ICO project to structure it with regard to the relevant capital market regulations in such a way that only the supervisory regulations apply that can be fulfilled by the initiators of the ICO. For example, the establishment of a financial services institute for the implementation of an ICO is usually disproportionate, as the costs of setting up and managing an institute are considerable. The management of an investment fund formed by tokens by a service KVG or the issuance of an investment, on the other hand, appears more cost-effective and therefore more realistic.

Since non-compliance with the regulatory requirements is sanctioned by penalties in banking and capital market law, one should also take care of the regulatory issues early on in an ICO planned in Germany or Europe.

If a token is to be classified as a security, as a share in an investment fund, as an asset or as a derivative transaction according to the above principles, the relevant legal regulations must be observed for the implementation of the ICO.

Depending on how they are structured, all matters requiring authorization such as banking (e.g. in the form of issuing business), financial services (e.g. in the form of financial portfolio management), investment business, the provision of payment services and even insurance business come into consideration.

The regulatory requirements for these businesses are very different. Depending on the design of the ICO, it may be necessary to apply for approval as a financial services institution in accordance with Section 32 KWG or to manage the investment assets formed by the tokens by a capital management company in accordance with the rules of the KAGB. Particularly for the phase of collecting the capital, prospectus obligations will have to be observed.

It is therefore essential right at the beginning of an ICO project to structure it with regard to the relevant capital market regulations in such a way that only the supervisory regulations apply that can be fulfilled by the initiators of the ICO. For example, the establishment of a financial services institution for the implementation of an ICO is usually disproportionate, since the costs of establishing and managing an institution are considerable. The management of an investment fund formed by tokens by a service KVG or the issuance of an investment, on the other hand, appears more cost-effective and therefore more realistic.

Since non-compliance with regulatory requirements is sanctioned by penalties in banking and capital market law, one should also take care of the regulatory issues early on in an ICO planned in Germany or Europe.

5. Liability

Since ICOs are usually carried out via the Internet with a global audience, the question arises for the initiator of an ICO whether he can move his ICO to a country that provides no or only minor regulatory rules for the ICO. Insofar as the ICO is also aimed at investors in Germany or Europe, the relevant actions are also subject to German or European supervisory law. As long as the initiator is not in Germany or Europe, the supervisory law can only be enforced with difficulty. This changes, however, if, for example, the initiator's assets are located in Germany or Europe.

In addition to the regulatory rules, the question of civil liability must be taken into account. Even if there is currently no German case law on ICOs, it stands to reason that the rules on prospectus liability that have been applied since the 1970s and developed by courts can be applied to ICOs without any problems. According to this, the initiator and the people behind the offer ("backers") are liable for the completeness and correctness of the prospectus they have published. The fact that the prospectus is now called “white paper” does not change anything in terms of its liability as a prospectus. Because the whitepaper informs the potential investor just like a prospectus (for example in the case of the former closed funds) about the investment opportunity. If the whitepaper turns out to be incorrect or incomplete, the initiators and all those persons who have an economic interest in the ICO and who were able to influence the design of the whitepaper would be liable. This is particularly important for people who can be represented on the website of an ICO initiator, for example as "Senior Advisers" or the like. According to the rules of prospectus liability in the broader sense, liability for the use of personal trust comes into consideration.

It is therefore advisable to carefully draft the white paper in accordance with the rules developed by case law on the correctness and completeness of prospectuses - at least if the initiators or senior advisers are based in Germany.

Summary

Contrary to the often-expressed opinion that ICOs move in a quasi-lawless area, numerous legal regulations must be observed in any case if the ICO takes place from Germany or Europe. The question of the applicability of the supervisory rules is decided by the structure of the ICO, which is to be determined in detail. In this respect, it is crucial to also take supervisory law into account at an early stage.

In addition to regulatory law, however, it is also advisable to take a look at the case law on prospectus liability, for example in the case of closed-end funds. Even if the supervisory law does not contain any prospectus law requirements, it is to be expected that the case law will apply very similar principles to the whitepaper in the expected liability cases.

[1] “Coin Desk Tracker”, https://www.coindesk.com/ico-tracker / https://www.coinist.io/cumulative-ico