1 November, 2017

Avv. Francesco Dagnino (Partner LEXIA Avvocati – www.lexia.it)

Blockchain technology (or distributed ledger technology) could assume great significance for financial markets, understood in the broad sense. Among the many economic transactions that can be done through blockchain technology, the so-called initial coin offerings (ICOs) are spreading. ICOs represent a digital form of raising financial resources through the offer to investors of a certain amount of newly issued cryptocurrencies (called digital token) – which can be easily generated by anyone through the open source Ethereum platform – in exchange for other cryptocurrencies (typically bitcoin or ether) and / or currencies with legal tender such as euros and dollars, based on a predetermined conversion ratio. Since the “good” offered to subscribers consists of “digital tokens”, ICOs are also called token bids.

Although there are numerous ways of structuring such operation, the scheme is generally the following:

  1. The issuer, which intends to obtain funds through an ICO, promotes to the “public” a business project by publishing and disseminating a so-called white paper – often similar to a short prospectus – on a dedicated website and creates a new project-based cryptocurrency through the Ethereum Platform (digital token);
  2. digital tokens grant, to holders, economic rights (such as dividends, rights to the issuer’s assets, etc.) related to the performance of the business – essentially reflecting the typical features of “financial instruments” – or various kinds of rights relating to a software or platform or technology that the issuer intends to develop with the resources collected (e.g. usage rights, etc.);
  3. the token holder – unlike subscribers of an IPO – does not become a shareholder of the company or issuer;
  4. digital tokens are offered for subscription to the public for a specified period of time, usually through a pre-sales phase and a sales phase. Anyone who subscribes the offer during the pre-sale phase has the right to buy tokens based on a conversion ratio more favorable than that of the sale phase;
  5. To subscribe the offer, subscribers transfer to the Ethereum wallet of the issuer the requested cryptocurrency (e.g. ether or bitcoin) and receive at the same time in exchange the digital tokens issued at the predetermined rate;
  6. if the offer reaches the minimum quantity required, it closes, and the issuer can use the financial resources collected to develop the project described in the White Paper; if the minimum quantity is not reached, the issuer should return the resources collected to subscribers.

The relationship between the issuer and the subscriber is governed by the so called digital token agreement, which is digitally underwritten by the subscriber by accepting the offer on the issuer’s website.

Those who buy digital tokens on the primary market through membership to an ICO are basically gambling on their value increase. Digital tokens can be sold and traded on the many cryptocurrency exchange platforms available on the Internet.

From a regulatory point of view, the legal problem of digital token sales lies in the fact that the economic rights marketed can be considered – on a case-by-case analysis – as stocks, bonds, derivatives, units of collective investment undertakings or more generally financial instruments or products. Since investors generally do not acquire any right on the issuer’s business or on the issuing company, ICOs can easily be used as tools to cheat investors.

The exponential increase of the cryptocurrency market and of savings accumulated through ICOs (over 2 billion € in the last twelve months) has attracted the attention of financial market Supervisory Authorities of different countries, which – on the basis of the principle of technological neutrality of the regulation – essentially abstained from uniquely characterizing ICOs and digital tokens, noting that, depending on the concrete structure of the ICO and the rights incorporated in the tokens, the latter may fall within the scope of the regulation of public offers of financial instruments, provision of services and investment activities, collective asset management, or equity crowdfunding.

The US Securities and Exchange Commission has expressed itself in the specific DAO / Slock.it case with communication no. 81207 of July 25, 2017, stating that tokens represented securities under federal law and that the general principles of financial instruments regulations also apply to those who collect savings through distributed ledger technology. Additionally, with communication dated September 25, 2017, the SEC announced the establishment of a new organizational unit, called “Cyber Unit”, which will have the task of hindering fraudulent conduct perpetrated by online traders through IT platforms (peer to peer platforms), including ICOs.

Similarly, the British Financial Conduct Authority, as far as the UK market is concerned, also warned investors of the high risks associated with the subscription of digital tokens, and prepared an online form and a webpage to report frauds.

With communication dated September 29, 2017, Swiss FINMA found that: (i) if digital tokens present typical features of securities (e.g. in the form of derivatives), there may be an authorization obligation; (ii) if assets collected under ICOs are managed by a third party, the rules on collective asset management could apply and (iii) if the token constitutes a means of payment, anti-money laundering provisions will apply. FINMA also stated that it initiated investigations on many ICOs, and, in the event regulatory violations are found, it will initiate enforcement actions.

Hong Kong’s Securities and Futures Commission reiterated that it should be assessed on a case-by-case basis if the ICO entails the conduct of a regulated activity and, therefore, if the subjects involved need the relevant authorizations.

A similar position has been taken by the Canadian Securities Administrators, which has stated that it will adopt a substantive and non-formalistic approach to qualify digital tokens as financial products.

The Monetary Authority of Singapore, instead, in its communication dated August 10, 2017, focused mainly on reporting the risks associated with ICOs and the purchase of tokens.

In Italy, CONSOB has not yet issued any communication. However, in our view, the applicability to ICOs of the supervisory provisions provided for by TUF, and the obligation to publish a “prospectus”, must be assessed on a case by case basis.

The investigation should be aimed at verifying:

  • the qualification of digital tokens as “financial products” pursuant to art. 1, paragraph 1, lett. u) of TUF, which includes both “financial instruments” and “any other form of financial investment”;
  • the existence of a communication aimed to enhance the purchase or subscription of these financial products and, consequently, at least to represent the main features of the same;
  • if the offer at issue is directed to investors residing in Italy.

If the offer meets all three of these requirements, the ICO will have to be treated as a public offer of financial products, as defined in art. 1, paragraph 1, lett. t), of TUF, resulting in the obligation to publish a prospectus.

In many cases the qualification of tokens as “financial products” will depend on the possibility of framing them in the residual category of “financial investments”. On this point, it is appropriate to recall CONSOB’s consolidated position based on which the concept of “financial investments” implies the coexistence of three elements:

  • capital investment;
  • expectation of a financial return; and
  • assumption of a risk directly connected to the capital investment.

From another perspective, the qualification of an ICO as a “public offer of financial products” could also result in the application of the provisions on “investment services and activities”, the provisions on collective asset management (in case of upstream management of resources collected by third parties), as well as the authorization requirement for trading platforms engaging in cryptocurrencies.

 

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