Token Alliance – an industry-led initiative of the Chamber of Digital Commerce – recently published a report providing market overview data and proposed guidelines for policymakers and practitioners in the digital token space (the Report). In the Report, the Alliance looks at (among other things) data relating to the domiciles of token fundraising. The Report notes that while the United States and Canada appear to be the leading “working centers” for token projects, “their fundraising is often happening elsewhere.”
While the data included in the Report indicates that the Caribbean jurisdictions are by far the frontrunners in the race to become the world’s leading fundraising epicenters for token projects, European destinations are also proving to be attractive destinations for foreign issuers.
The data in the Report indicates that roughly 40 percent of the token sales taking place in Western Europe, and 35 percent of the token sales taking place in Eastern Europe, are being used to fund foreign projects. Switzerland – the famed home of Crypto Valley – is treated in the Report as a standalone category, with the data suggesting that more than 70 percent of the proceeds raised in that jurisdiction are used to fund non-Swiss projects.
With the crypto industry coming under ever-increasing regulatory scrutiny in the United States, it is unsurprising that many token issuers are looking at jurisdictions outside the United States to launch their token offerings. The fact that Europe is generally viewed as a more benign regulatory environment than the United States – combined with the fact that the European Union offers access to a consumer base of over 500 million people, and to the infrastructure and talent pools that will allow a business to build out real substance and operations in the long term – are no doubt key factors in attracting foreign token issuers to European Union destinations.
With U.S. regulators continuing to crack down on token issuers, and the crypto industry generally, it is likely that we will continue to see a significant proportion of U.S. issuers opting to launch their token sales in overseas jurisdictions. For those considering launching in a European Union jurisdiction, here are ten key questions to consider:
1. What is the general financial regulatory environment like in the target jurisdiction?
Despite a high level of harmonization of financial markets’ regulation in the European Union, there is currently no specific EU-wide regime regulating token sales. In the absence of a specific regime at EU-level, certain EU member states have proactively introduced crypto-friendly laws and measures in an effort to reduce uncertainty at national level, and in turn, attract and promote investment in this space.
One such member state is the tiny European nation of Malta - self-proclaimed as the “world’s first blockchain island.” Malta recently passed three bills into law that establish a regulatory framework for blockchain technology and ICOs. The new regime regulates the information to be included in whitepapers and requires issuers to make their financial history public. It also includes a licensing regime for token issuers seeking to list tokens on cryptocurrency exchanges.
Likewise, the British overseas territory of Gibraltar has recently announced proposals for legislation to regulate ICO-related activities conducted in or from Gibraltar. Similar proposals are also being explored in the Eastern European nation of Estonia, which made a splash at the end of 2017 with an announcement that its government proposed launching its own cryptocurrency “Estcoin” for use in connection with the country’s e-residency program.
A number of other Member States have introduced bespoke crowdfunding regimes, which may help to facilitate certain categories of token sale, depending on the particular circumstances and the amounts being raised.
While other European jurisdictions have adopted more of a “wait and see” approach when it comes to blockchain and token regulation, many of these countries have embraced the broader fintech and blockchain movement through the introduction of financial regulatory sandboxes and/or innovation hubs aimed at facilitating and promoting innovation in the fintech space. In the European Commission’s Fintech Action Plan 2018, published in March 2018, the Commission reported that 13 EU Member States have established some kind of “fintech facilitator.”
The most successful and well-known of these fintech facilitators is the UK Financial Conduct Authority’s (FCA) regulatory sandbox – the trailblazing model upon which most other sandbox initiatives across the globe have been based. Of the 29 firms selected for the FCA’s most recent cohort of participants (it is now on its fourth cohort), about 40 percent are blockchain-based.
Another European regulator that has followed in the FCA’s footsteps is the French AMF, which last year announced the launch of its UNICORN program. The program aims to “provide a framework for ICO organizers to develop their transactions and to ensure the protection of participating players and purchasers.” Other jurisdictions following the UK’s example include the Netherlands, Lithuania, and, most recently, Ireland, all of which have launched or announced plans to launch some form of fintech innovation program.
As you raise funds and (depending on your business plan) ultimately grow out your business in a particular jurisdiction, there will be obvious benefits to choosing a jurisdiction that offers a progressive legal regime and a crypto- and blockchain-friendly regulator. It can provide you with a level of certainty around the legal treatment of your token sale (albeit in that jurisdiction only – see further question 10 below). A “crypto-friendly” regulatory environment may also be helpful in the longer term if you are planning to build out a substantive cryptocurrency business and operations in that jurisdiction.
2. Will my tokens be classified as “transferable securities” or some other form of “financial instrument” in the target jurisdiction?
In the absence of a specific EU-wide regulatory regime, token sales potentially fall within the scope of a wide range of EU and national laws and regulations (both financial and non-financial). While all of these laws and regulations may have important implications for a token sale, one of the key questions a token issuer will need to consider is whether its tokens could be classified as “transferable securities” or some form of financial instrument, such that the token issuance could potentially fall within the scope of financial markets’ regulation at EU or member state level. One of the most important pieces of legislation a token issuer will need to consider in that context is the EU Markets in Financial Instruments Directive (MIFID II) and its relevant implementing legislation in the jurisdiction(s) in question.
MiFID II is the cornerstone of EU financial markets’ regulation, setting out a regulatory framework for firms that provide services linked to “financial instruments.” “Financial instruments” for the purposes of MiFID II broadly includes: “transferable securities,” money-market instruments, units in collective investment undertakings, and various forms of derivatives, futures, swaps and options.
“Transferable securities” is in turn defined as:
“those classes of securities which are negotiable on the capital market, with the exception of instruments of payment, such as:
a) shares in companies and other securities equivalent to shares in companies, partnerships or other entities, and depositary receipts in respect of shares,
b) bonds or other forms of securitised debt, including depositary receipts in respect of such securities, or
c) any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures.”
While European regulators have generally been less aggressive than their U.S. counterparts in terms of their appetite to assume regulatory authority over token sales, most of the major European regulators - including the European Securities and Markets Authority (ESMA – the EU financial markets watchdog) have issued some form of public statement indicating that “depending how the ICO is structured,” a coin or token could potentially qualify as a transferable security or other form of financial instrument for the purposes of MiFID II and/or national laws.
A token issuer will need to carefully consider, in conjunction with their legal counsel, whether their coins or tokens potentially qualify as “transferable securities” or another form of “financial instrument” in the fundraising jurisdiction(s). This will require a case by case assessment of the substance and features of the token, taking into account the above MiFID II definitions and any nuances that may apply under the national laws of the member state(s) in which they are raising funds. The German regulator, BaFin, has emphasized that “the mere labelling of a token as a utility token” is not relevant to the outcome of this assessment.
If a token constitutes a “transferable security” or otherwise qualifies as a “financial instrument” for EU law purposes, issuers may be regarded as conducting certain regulated investment activities under EU law, such as placing, dealing, or advising on financial instruments or managing or marketing collective investment schemes. In those cases, they may need to comply with specific regulatory requirements under MIFID II, the Alternative Investment Fund Managers Directive (AIFMD) and the Fourth Anti-Money Laundering Directive (4AMLD). Moreover, if the token issuance involves an “offer to the public,” it would be subject to the prospectus requirements set out in the EU Prospectus Directive (in the process of being replaced by the EU Prospectus Regulation), unless an exemption applies.
3. Will I be subject to AML requirements in the target jurisdiction?
Like other aspects of EU financial regulation, anti-money laundering (AML) requirements in the EU are governed by a patchwork of EU legislation and member states’ national laws. While the cornerstone of the current EU anti-money laundering framework is the Fourth Anti-Money Laundering Directive (4AMLD), certain EU member states have yet to fully implement its provisions and others have introduced ancillary or supplementary national laws that co-exist alongside the relevant EU rules. To further complicate matters (and with several member states as yet to implement the provisions of 4AMLD), the EU formally adopted a Fifth Anti-Money Laundering Directive (5AMLD) in June 2018.
4AMLD does not expressly impose AML requirements on token issuers. However, depending on the nature of your tokens (for example, if they qualify as “financial instruments” or “e-money” – discussed at questions 2 and 4 respectively) and the nature of your proposed activities (for example, if you will be providing banking or payment services), you may fall within its scope.
Once 5AMLD is implemented into national law, “providers engaged in exchange services between virtual currencies and fiat currencies,” as well as custodian wallet providers, will be expressly brought within the scope of the EU anti-money laundering requirements set out in 4AMLD. Depending on how a particular token sale is structured (in particular, if tokens are issued in exchange for fiat currencies), and how these provisions are ultimately implemented into national law in each member state, this may be broad enough to encompass certain token issuers. EU member states have until January 20, 2020 to implement 5AMLD’s provisions into their national law. Refer to this Bloomberg Law Insight for more information on 5AMLD and its potential impact on ICO issuers and cryptocurrency exchanges.
Even if you do not fall within the scope of 4AMLD (as extended in due course by 5AMLD), there may be requirements that apply at national level in the jurisdiction(s) in which you are raising funds that require you to carry out AML checks. It is critical to confirm these in advance with local counsel.
4. Will my token issuance be regarded as involving the issuance of “e-money” or the provision of “payment services” in the target jurisdiction?
The EU’s Second E-Money Directive currently regulates the activity of issuing electronic money in the European Union and sets out requirements for the authorization of “e-money institutions.” “E-money” is defined in the Directive as “electronically, including magnetically, stored monetary value as represented by a claim on the issuer, which is issued on receipt of funds for the purpose of making payment transactions […], and which is accepted by a natural or legal person other than the electronic money issuer.” If a token qualifies as “e-money,” the E-Money Directive would require that the token issuer be authorized as an e-money institution by a competent authority in the EU, unless an exclusion applies.
The EU Payment Services Directive 2 (PSD2) regulates payment services and sets out rules relating to the authorization of payment service providers in the EU. Activities that typically require authorization under the Payment Services Directive include services relating to the operation of payment accounts, execution of payment transactions, issuing payment instruments, merchant acquiring, and money remittance.
The European Central Bank (ECB) has previously commented that “virtual currencies” are “not scriptural, electronic, digital or virtual forms of a particular currency. They are something else, different from known currencies.” Accordingly, the ECB has indicated that “in the EU, virtual currency is not currently regulated and cannot be regarded as being subject to the (current) Payment Services Directive or the E-Money Directive.” This position was reiterated in a joint opinion issued by the European Banking Authority, ESMA and the European Occupational Pensions and Insurance Authority in February 2018.
It is likely, given these statements from various EU regulators, that most token sales should fall outside the scope of the E-Money Directive and PSD2 (unless, for example, the tokens are issued in exchange for, and are redeemable for, fiat currency so that the fiat element of the transaction could fall within scope). Nevertheless, this is something to discuss and confirm with legal counsel, on a member-state-by-member-state-basis, having regard to your specific business model and the structure of your token sale, and taking into account any nuances that may apply under the national payments and e-money laws of the jurisdiction in question.
5. How will the proceeds of the fundraise be treated from a tax perspective?
One area of regulation that is not harmonized across the EU is the area of corporate taxation. The tax treatment of your token sale may therefore vary considerably depending on the EU jurisdiction(s) in which you are raising funds.
The designation of tokens as “transferable securities” or “financial instruments” for regulatory purposes (as discussed above) is likely to be a relevant factor in determining how a token is treated under the applicable tax rules. However, given the lack of standardization, a one-size fits all approach for assessing EU tax implications is not possible. As such, it would be critical to carry out a country-specific analysis, in conjunction with experienced tax counsel, to determine the tax consequences of your fundraise. If you are an issuer based in the United States, this analysis should consider the impact of the U.S. Tax Cuts and Jobs Act, and, in particular, its provisions around global intangible low-taxed income (GILTI), on any funding raised.
6. How will local and EU consumer protection, e-commerce and data protection laws impact the token sale and my underlying business?
EU and member state consumer protection, e-commerce and data protection laws may impose requirements on token issuers. You will need to consider with local counsel how these requirements will impact your token sale, in particular in relation to the information to be included in your whitepaper and other marketing documentation.
For example, tokens sold over the internet must comply with the European Consumer Rights Directive and the EU E-Commerce Directive which lay down certain information requirements for contracts concluded over the internet. In addition, the EU Directive on the Distance Marketing of Consumer Financial Services imposes certain information requirements in relation to financial services.
If you will be obtaining personal data relating to EU data subjects (which is likely if you are raising funding from EU investors) or you will otherwise be processing data relating to EU data subjects as part of your business activities, you will be subject to the EU General Data Protection Regulation (GDPR). GDPR imposes a wide range of obligations on businesses within its scope to safeguard the personal data of EU data subjects and imposes serious sanctions for non-compliance. Refer to this Bloomberg Law Insight for more information on GDPR and its impact on fintech businesses.
7. What corporate structures are available in the target jurisdiction?
With Crunchbase reporting a drop in the value of the entire cryptocurrency market from just under US$800 billion in January 2018 to around US$200 billion in August, the past six months have not been kind to the price of cryptocurrencies. Quoting from the results of a study conducted by Boston College in June 2018, Crunchbase reported that, out of a dataset of 2,390 ICOs, just 44 percent of those startups were still active 120 days following the end of their fundraise.
The cryptocurrency industry is a particularly volatile sector. In addition, international regulatory requirements for the industry are still in a state of flux, resulting in a high risk profile for startup businesses in this space. It is critical in that context that founders can protect themselves from potential personal risk by using appropriate corporate structures that offer them the benefit of limited liability.
Within the EU, most countries allow the formation of some kind of a limited liability company. The primary benefit of a limited liability company is that the shareholder(s) (for example, U.S.-based founders) will, in the ordinary course, have limited liability with respect to the liabilities and debts of the company if the business does not ultimately succeed according to plan.
The corporate formation requirements relating to the incorporation of a limited liability company can vary considerably from country to country across the European Union. For example, in the United Kingdom and Ireland, a private limited company can be incorporated with a share capital of as low as US$0.01 (assuming the entity is unregulated – see further below at question 8 for additional requirements that may apply to regulated entities). In Germany, by contrast, a limited liability company (GmbH) must have a minimum share capital of EUR25,000. Certain EU member states may also impose specific regulations or restrictions around foreign investment in entities in the jurisdiction, and these would need to be confirmed on a member-state-by-member-state basis.
Likewise, the ongoing corporation governance requirements applicable to limited liability companies can vary considerably across the European Union. While there are a number of ongoing corporate compliance requirements that apply generally at EU-level (for example, obligations around the filing of annual financial statements and the disclosure of beneficial ownership), for the most part, corporate governance is left to the discretion of member states. There may, for example, be specific member state requirements around physical presence, corporate decision-making and company meetings, restrictions around cash repatriation, etc. These should be confirmed in advance with local counsel to determine the impact for your business and corporate structure.
8. Will my ongoing or future activities require a license in the target jurisdiction?
Even if your token issuance does not of itself fall within the scope of EU financial regulation, you should consider whether your underlying (present or future) business may be subject to regulatory oversight or licensing requirements in the jurisdiction in question. For example, many blockchain businesses involve the provision of traditional financial services activities albeit through a non-traditional, decentralized model. If your business involves the provision of banking-type services (e.g. deposit-taking, lending, payment and investment services, etc.), you may be subject to licensing requirements (and related organizational and capitalization requirements) in the European Union.
Of course, not all blockchain businesses necessarily involve the provision of financial services. Examples of other businesses that may require licensing at EU and/or member state level include property services businesses, transport services businesses, businesses dealing in tobacco and/or alcohol, gaming and gambling businesses, and various businesses in the medical/life sciences field.
9. What is my future plan for Europe and will the target jurisdiction facilitate that plan?
In selecting a European jurisdiction, you should think about the role the jurisdiction will play in your overall business plan. You may simply be choosing the jurisdiction for fundraising purposes, with plans to have little or no physical operations in the target jurisdiction (which, for example, is true for most of the ICOs that take place in the Caribbean jurisdictions). If that is the case, it may make sense to select a “crypto-friendly” jurisdiction, as discussed at question 1.
However, if you envisage building out substantive operations in Europe in the future, you should consider whether the jurisdiction in question also offers the infrastructure and practical benefits you will need to build out your operations in line with your plans.
Consider, for example, whether the jurisdiction has a track record for similar projects. If there is an existing ecosystem of businesses operating in your space in a particular location, it will be easy to tap into local resources and talent pools and find the experience and expertise that you will need to make sure your business succeeds.
You should also consider the general tax environment in the jurisdiction in which you are locating. Does the jurisdiction offer a competitive corporate tax rate? Does the jurisdiction allow for tax-efficient repatriation of profits? If you have plans to acquire or develop intellectual property, does the jurisdiction offer any additional incentives, such as a capital allowance regime for intangible assets, research and development tax credits or a patent box regime?
You should find out whether the jurisdiction offers any other incentives or practical supports that may be relevant to your business, for example, government grant aid or regulatory sandboxes for businesses operating in your space.
Lastly, if you will be using the jurisdiction as a base to access the European Union market of 500 million consumers, you should consider whether the jurisdiction in question will facilitate that access. In particular, you should consider how Brexit and the United Kingdom’s departure from the European Union will impact your planning, particularly if you will be establishing operations in the United Kingdom or Gibraltar (the latter being the United Kingdom’s only overseas’ territory which is currently part of the European Union).
10. What advice do I need from advisors in other jurisdictions?
Irrespective of where you select as your fundraising domicile, you are likely going to need advice from advisors across a number of jurisdictions, unless you are only planning to raise capital from investors based in the fundraising jurisdiction. The founders of the blockchain company, Tezos, learned this the hard way in the ongoing class action initiated against them in California for U.S. securities law violations relating to their Swiss-based ICO. The Tezos founders argued that their ICO did not fall under the SEC’s jurisdiction because it was administered by the Tezos Foundation in Switzerland. U.S. District Court Judge Richard Seeborg had no difficulty rejecting their argument, noting that their lead investor had participated in the ICO using a website hosted on a server in Arizona, run by a company founder in California, and based on marketing that almost exclusively targeted U.S. residents.
The Tezos case underlines the fact that, from a regulatory and compliance perspective, the key is not simply where your fundraising structure is based, but where your investors are based. If you are marketing to or targeting investors in jurisdictions outside your fundraising domicile, it is critical to work with local counsel to confirm the legal and regulatory risks in those jurisdictions. There is clearly a significant cost and effort involved in this, but it is a necessary process to avoid unforeseen legal issues cropping up later and to mitigate your overall risk.
The North American Securities Administrators Association (NASAA) recently announced that there are currently “more than 200 active investigations” by state or provincial-level agencies into ICOs and other crypto-related investment products in the United States and Canada.
Commenting on the North American investigations - dubbed “Operation Cryptosweep” - NASAA president and Alabama Securities Commission director, Joseph Borg, recommended that:
“sponsors of [cryptocurrency] products should seek the advice of knowledgeable legal counsel to ensure they do not run afoul of the law. Furthermore, a strong culture of compliance should be in place before, not after, these products are marketed to investors.”
With the continued regulatory clamp down on token sales in the United States, it is likely that we will continue to see a significant proportion of U.S. issuers opting to launch their token sales overseas. For issuers that decide to launch their token sales in Europe, there will be a range of issues and legal frameworks to consider at both EU and member state level. Engaging with knowledgeable legal counsel before, not after, you market your token sale in the European Union, and working closely with counsel to determine the applicable legal and regulatory analysis, will be key to ensuring that your token sale does not run afoul of the law in the fundraising domicile or elsewhere.
Gina Conheady is a Partner in the Corporate and M&A practice and Head of A&L Goodbody’s San Francisco Office. Gina advises US companies on EU and Irish corporate law, with a principal focus on international expansion, cross-border mergers and acquisitions, international corporate reorganisations and corporate governance.