27 June, 2018
The world economy has long been trying to crack the enigma around virtual currency (“VC”). On one hand, trading and dealing in VCs which is not uniformly recognized and/or regulated globally, is constantly challenged by uncertainty.
Subsequently, on the other hand issue of VCs based initial coin offerings (“ICOs”) are gaining momentum among start-ups and new blockchain projects similar to Bitcoins, Litecoins, etc.
That said, several past advisories given by the Reserve Bank of India ("RBI") have time and again clarified that the creating, trading, or dealing in VCs, or using them as a medium for payment are not authorized by it, but
has always stopped short of declaring VCs as illegal.
However, RBI’s recent statement on Development and Regulatory Policies1 announced that RBI regulated entities shall not engage with individuals or business entities dealing with or engaged in settling VCs; those regulated entities already providing such services shall exi t the relationship within a specified time.
While in this unsettled milieu, some crypto-entities have challenged this position in the Delhi High Court, some other VC exchanges have reportedly decided to launch their in house crypto to crypto trading facility to minimize their dependency on RBI regulated entities.
Even in this nebulous juncture surrounding VCs, ICOs are gaining popularity as alternate fundraising medium. The VC
driven ICOs may either be issued only as a means to fundraising, similar to crowdfunding, angel investments, venture capital funding, or Initial Public Offers (“IPOs”); or the issuer of ICOs may also issue its own VCs for purchasers in exchange for already existing VCs or against a legal tender.
Basis this, the instrument issued in an ICO may fall within the gamut of securities or deposits depending on the nature of the issue.
A. Dissecting ICOs
Functionally, investors investing in ICOs purchase cryptographic tokens which entitle them to a share of income
generated by the issuer company.
These ICO tokens are kept either in the issuer’s blockchain or on a pre-existing blockchain and can be sold and traded on VC exchanges if they are in demand.
The issuer must in relation to the issue of ICOs release a white paper plan with the details of the project for which funds are being raised through the ICO. Also, this whitepaper must highlight the purpose the project seeks to fulfi
l upon completion, and also contain other important details such as the duration of the project, etc.
Owing to lack of dedicated legislation and a universally acceptable guideline on ICOs, it may be pertinent to refer to the ICO Guidelines2 released by the Swiss Financial Market Supervisory Authority (“FINMA”) that points out four broad categories of ICO tokens based on their economic function adding certain amount of shape to the undefined and ununderstood ICOs.
Those points are summarized below.
(i) Payment Tokens
Payment tokens are treated synonymous with VCs under the FINMA guidelines and are categorized as tokens intended to be used, now or in the future, as a means of payment for trading in goods and/or services or as a means of money or value transfer.
Under this category of tokens, the re is no rise of claims on the issuer.
(ii) Utility Tokens
Utility tokens are intended to provide digital access to an application or service by means of a blockchain-based infrastructure.
They are thus a kind of access code having no inherent value per se.
(iii) Asset Tokens
Asset tokens are like debt or equity claims on the issuer. Asset tokens promise, for example, a share in future company earnings or future capital flows. In terms of their economic function, therefore, these tokens are like securities issued in an IPO and comparable to equities, bonds or derivatives. Tokens which enable physical assets to be traded o
n the blockchain also fall under this category.
(iv) Hybrid Tokens
The individual token classifications are not mutually exclusive; meaning that, an issued token can be an amalgam of all the above mentioned kinds of tokens. For instance, asset and utility tokens can also be classified as payment tokens, thus hybrid tokens. In such scenarios, the tokens are considered as both, securities and means of payment.
The FINMA guidelines also state that in some ICOs, tokens are put into circulation at the stage of fund-raising on an existing blockchain.
However, in other variants of ICOs, investors are assured to receive tokens in the future;
this is referred to as pre-financing or pre-sale.
B. Possible Implications: Indian Perspective
It is pertinent to note that the most challenging aspect of ICOs is the lack of legal support around its existence and operation. In the given scenario references may be made to various other legislations depending on the nature and treatment of ICO tokens being issued.
Therefore, investment in ICOs could be categorized as a security and/ or deposit.
The basic criteria to categorize any token as security is dependent upon how well a token falls within the meaning of ‘security’ under the Securities Contract Regulation Act, 1956 (“SCRA”)3; then obligations under the Companies Act, 2013 (“Companies Act”), and Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulation, 2009 (“ICDR”) may also arise.
Asset Tokens:
if an asset token represents a derivative, it may be treated as a security.
Pre-Sale:
if these tokens confer claims to acquire tokens in future, such claims may/ are likely to fall under securities.
Payment Tokens:
in case of issue of payment tokens, if a payment system is formed by blockchain relating to ICO tokens, it may require the RBI approval if the blockchain operates a payment and settlement system falling under the ambit of Payments and Settlements Act, 2007.
Utility Tokens:
such tokens could be seen as deposits or advance for services to be rendered in the future.
The Companies Act defines a deposit as “includes any receipt of money by way of deposit or loan or in any other form by a company, but does not include such categories of amount as may be prescribed in consultation w ith the
Reserve Bank of India.”
The Companies (Acceptance of Deposits) Rules, 2014 identifies deposits as already stated in the Companies Act but provides several exceptions to the Companies Act provisions which inter alia excludes from the gamut of deposits any amount received from the national or any international government or local authorities or any multi-lateral financial institutions; and any advance for supply of goods or provision of services accounted for in any manner whatsoever provided that such advance is appropriated against supply of goods or provision of services within a period of 365 days from date of acceptance of such advance.
Further, the Draft Banning of Unregulated Deposit Scheme Bill, 2018 (“Bill”)4 if becomes effective as it is would curb the menace of unregulated deposits taken by a deposit taker in a business which is not a regulated deposit scheme; or is an unregulated deposit scheme or not falling within the scope of a legitimate scheme under the Prize Chit and Money Circulation Schemes Banning Act, 1978. Therefore, to steer clear of the provisions as mentioned in this Bill, a company has to ensure it does not fall within the definition of deposit under its provisions and ensure that the sum taken by the deposit taker is not returnable whether after a period or otherwise Anti-Money Laundering Obligations:
Practically, issuance of a token as a means of payment on blockchain infrastructure that may or may not have anti money laundering (“AML”) implications if the tokens (like Utility Tokens) issued have no financial application on the blockchain.
However, for instance, if an ICO constitutes a payment System, it would need permission from the RBI under the Payment and Settlements Act, 2007 and thereafter, it the RBI may call for the requirement of its registration as a payment and settlements system.
Then in such case, complying with the KYC Requirements and Anti Money Laundering provisions of the Regulations would become necessary.5
However, owing to the lack of dedicated legislation to squarely cover anti money laundering for ICOs, it is likely that a new regulation on VCs when passed would call for stringent KYC norms and Anti-Money Laundering Policies for participants trading in VCs, including its issuers, exchanges, and purchasers. Collective Investment Schemes:
It is also pertinent to note that under the Securities Exchange Board of India Act, 1956 (“SEBI Act”)6 and the SEBI (Collective Investment Scheme) Regulations, 1999 (“ CIS Regulations”)7 where contributions are pooled in and solely used for the purposes of the scheme or arrangement by the investors with a view to receive profits, income, product or property, whether movable or immovable from such arrangement or scheme would fall within the crevices of a Collective Investment Scheme (“CIS”).
Therefore, if the investment through ICO is utilized in the above manner, it would require the company to mandatorily registered with the SEBI and comply with the requirements stipulated under the SEBI Act and the CIS Regulations.
Comment
In the backdrop of the regulatory limbo surrounding VCs and the treatment of ICOs, it is notable that India based blockchain startups are moving base to overseas markets or are registering companies in countries where trading in VCs is legally acceptable in order to be able to raise ICOs.
Thus, owing to lack of clarity on treatment of ICOs and/ or the factum of unidentified risks are leading small blockchain companies to take their feet out of India Inc. and/ or maybe have presence in India from afar as dealing in legal complications is the last of all problems they want to face.
So long as the unidentified risks are concerned, it is understood that since the concept of ICOs itself is at a nascent stage on the world platform, it will take a good amount of time and resources to just understand its economics, risks and map its promised potential as compared to IPOs.
This rickety bridge between VCs and IPOs loom in ambiguity, which is yet to find clarity from a legally affirmative standpoint.
Until then, the position will remain murky and the status of VCs and ICOs indeterminate.
For further information, please contact:
Vineet Aneja, Partner, Clasis Law
vineet.aneja@clasislaw.com
Mustafa Motiwala, Partner, Clasis Law
Mustafa.motiwala@clasislaw.com
1 Press Release dated April 5, 2018 accessible at https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=43574
2 Accessible at
https://www.finma.ch/en/~/media/finma/dokumente/
dokumentencenter/myfinma/1bewilligung/fintech/wegleitungico.pdf?la=en
3 Under Section 2(h) of the SCRA.
4 Accessible at
http://www.prsindia.org/uploads/media/draft/Draft%20
