The tokenisation of rights in capital procurement heralds a new era in securities issues. / By Jörg Baumgartner and Markus Kaulartz
At the beginning of the year, when you read that the Federal Financial Supervisory Authority (BaFin) has approved the first securities prospectus for the issue of so-called security tokens (STOs), you were perhaps reminded – maybe with mixed feelings – of blockchains, cryptocurrencies and the so-called initial coin offerings (ICOs). During 2018, companies all over the world have pulled in billions during ICOs. ICOs have since gained a bad reputation due to several cases of fraud. Nonetheless, the comparison of ICOs with STOs is unjustified. With ICOs, issuers create their own cryptocurrencies and sell them to interested investors. In the process, these investors are buying the mere hope that these cryptocurrencies will one day increase in value – nothing more than that. By contrast, with security token offerings (STOs) as presently being discussed, investors acquire a right and not just a purely speculative object.
These are often participation rights that grant an entitlement to the issuer’s profits, for example. That in itself is nothing new. The particular feature of STOs is that these participation rights are not sold in the form of a document, but using a token based on a blockchain. In simplified terms, a token is an entry in a database that is unique and cannot be reproduced. The underlying technology in the blockchain ensures that any manipulation of the token is immediately apparent. The token itself is only the carrier medium. Compared to the right embodied in it, it fades into the background and has only a formal role.
ICOs versus STOs
Although ICOs and STOs represent opportunities for companies to raise capital, an ICO only makes sense where the token has a specific function, for example as a means of payment in a future business model. That is rarely the case, which is why many ICOs are susceptible to allegations of fraud. An STO, on the other hand, could be an option for any company that wishes to acquire cash on the capital market through the sale of entitlements to profits or other participation rights.
The combination of such rights, regardless of what they are, with tokens is described as tokenisation. It represents a new form of rights trading: To date, it has not been possible to transfer rights in a transparent and verifiably way among participants who do not know one another without intermediaries such as custodian banks. Tokens functioning as the carrier medium make that possible. Because they work based on a blockchain and are unique, that is to say they cannot be reproduced, the legal positions can be transferred between participants without requiring an intermediary.
Security tokens as securities
However, like ICOs, STOs also do not exist in a rights-free space. The German Financial Supervisory Authority BaFin has clarified that the use of blockchains and the issue of tokens do not lead to a circumvention of the regulatory rules in Germany. Although the supervisory and regulatory environment for this field has not yet been settled, BaFin has given clear indications on their legal classification.
How the token concerned is classified must be examined depending on the specific case. At the same time, the important factors are the specific design of the token and the rights associated with it.
If a security token is linked to an entitlement to profit distributions, for example, or the exercise of participation rights, the security token may constitute a security. This model is similar to that of a “digital share”. In Germany, the public offering of such tokens that are classifiable as securities requires the preparation of a securities prospectus in accordance with the Securities Prospectus Act (§ 3 (1) WpPG) and the European Prospectus Regulation.
For it to be classified as a security, the token must be transferable according to the definition in § 2 no. 1 WpPG, which in turn is based on the European MiFID II Directive, and by its nature it must be tradeable on the financial markets. It must also embody participation rights based on membership or property rights under the code of obligations, and must not be a pure payment instrument.
In capital markets law, a security paper is a distinct term based on European law. In contrast to the name itself, it does not have to exist in paper form. It is also not necessary that the certificate must be able to be acquired in good faith by unauthorised parties. It is sufficient that transactions of this kind, using blockchain technology, can be documented in such a way that the rights embodied in the tokens can be allocated clearly to a recipient. This need not necessarily be a name. This is the case with tokenised participation rights that are designed as debenture bonds and participation certificates.
Security tokens can thus generally be classified as securities and so fall under the rules laid down in WpPG – this is also the opinion of BaFin – unless they are designed to be non-transferable in the individual case.
Compulsory prospectuses for STOs
If tokenised participation rights are offered to the public, i.e. an indefinite group of investors, a securities prospectus must be drafted unless certain exceptions apply, for example if investors may acquire tokenised participation rights only in amount of at least EUR 100. The issuer must have this prospectus reviewed and approved by BaFin. The prospectus shall also provide comprehensive information about the token as it is classified as a security. The minimum requirements for the contents of this prospectus depend on the type of the security – an equity or debt capital instrument – and are precisely regulated by the European Prospectus Regulation.
In addition to a summary at the beginning, the prospectus must contain information about the issuer itself. This primarily includes information about the business model and the associated risks, and a precise description of the securities and how they are being offered.
In practice, it is also essential that the prospectus discloses the issuer’s annual financial statements for the last two or three years. The relevant figures must also be shown depending on whether the tokenised participation right is classified as equity or debt capital. These annual financial statements must be furnished with an auditor’s report (§ 322 of the Commercial Code). If the figures are older than nine months at the time of the production of the prospectus, unaudited interim financial information must also be included. These must cover at least the first six months of the current financial year. Similar to classical public offerings, early in the year or early autumn might therefore be the best times for an STO.
BaFin checks the securities prospectus for completeness, comprehensibility and the absence of internal contradictions. However, it does not evaluate the company or the investment in the tokenised participation rights. It neither checks the creditworthiness of the issuer nor the accuracy of the statements. The issuer is liable for any false or incomplete statements in accordance with the provisions of WpPG. The entire approval process generally takes around six weeks. The prospectus must then be published on the issuer’s website.
Security tokens can generally be classified as transferable securities. In Germany, a public offering of such is only permissible with an approved securities prospectus unless exceptions apply. BaFin is currently in the approval process for other STO securities prospectuses. The authorities are not all resistant to innovative developments in this sector and recognise the potential of blockchain technology, including for securities trading. For young companies, for which classical capital market financing still involves overcoming too many hurdles, an STO can be a good start to raise capital. In principle, companies regard the ease of trading as a major plus point for tokenisation.
Jörg Baumgartner and Dr Markus Kaulartz are lawyers at the law firm CMS and work in the fields of capital market law and IT law respectively.
First published in FAZ Einspruch, 2/2019