In Germany, companies active in the technology and digitization sector, in particular start-up and emerging companies lacking access to more traditional capital markets, are increasingly looking for financing through the issuance of tokens via an ICO. The first German ICO took place in October 2017 with a volume of €25 million, followed by further ICO activity in the market. The German Financial Services Authority (Bundesanstalt für Finanzdienstleistungsaufsicht or "BaFin") is generally taking an approach to innovative products and services that can be characterized as "technology-neutral", i.e. the existing regulatory framework is applied without differentiating between technologies used for the creation, issuance or offering of a particular product. To that extent, BaFin has issued a regulatory statement that classifies Bitcoin and similar virtual currencies as financial instruments for purposes of the German Banking Act (Kreditwesengesetz or "KWG") as well as recent warnings to consumers on participation in ICOs. In this context, BaFin also published an article in which it describes the nature and the risks of ICOs stating that tokens typically constitute financial instruments for purposes of the KWG and that, depending on the content and structure of the specific token, prospectus requirements as well as investment fund, insurance and payment services regulations may apply. The focus of this country report will be on prospectus requirements relating to the offering of securities (Wertpapiere) and other investment instruments that do not constitute securities (Vermögensanlagen), investment fund regulation, e-money regulation, anti-money laundering regulation and finally licensing requirements under the KWG.
A. Prospectus laws
In Germany, the offering of securities to the public triggers the requirement to publish a prospectus under the German Securities Prospectus Act (Wertpapierprospektgesetz or "WpPG") unless an exemption applies. The WpPG is the statutory law implementing the European Prospectus Directive (Directive 2003/71/EC, as amended, the "Prospectus Directive") into German law.
An offering of digital tokens in Germany would be subject to prospectus requirements under the WpPG if the relevant digital token qualifies as a "security" within the meaning of Section 2(1) WpPG. The key criterion for a "security" is that it must be an instrument that is tradable on the capital market.
By its very nature, a digital token is a dematerialized instrument. In general terms, dematerialized instruments may constitute securities for purposes of the WpPG. However, the starting point for determining whether a dematerialized instrument constitutes a tradable security by its legal nature under its governing law and, accordingly the outcome of the analysis, may be different depending on the governing law of the token. For instance, dematerialized instruments governed by German law may not qualify as a security (except for German treasury bonds, which may be issued in dematerialized form). Therefore, if digital tokens are German law governed instruments, they will not qualify as a security for purposes of German securities laws.
Having said this, digital tokens are innovative instruments and, as a matter of fact, they may be traded on dedicated token exchanges. Given that BaFin has not issued any specific statement in this regard and it seems conceivable that other European authorities may regard certain digital tokens as securities for purposes of the Prospectus Directive, it may also be that BaFin will ultimately conclude that digital tokens may be regarded as a functional equivalent to securities and that therefore the prospectus requirement under the WpPG would apply. The latter seems particularly likely where the digital token is not governed by German law and where under its governing law the token is qualified as a security notwithstanding the fact that it is issued in dematerialized form. If such digital token, which under its governing law is classified as a tradable security, is offered in Germany, then it may well qualify as a security also for purposes of the WpPG and thus trigger a prospectus requirement if such token otherwise is a share or bond type instrument (as many so-called "securities tokens" are). If a prospectus has been prepared for the offering of a digital token and if such prospectus has been approved by another competent authority and notified to BaFin under the so-called "European passport" regime of the Prospectus Directive, such notification arguably has to be recognized by BaFin.
If, on the basis of the above, a digital token in the form of a "securities token" is to be classified as a security for purposes of the WpPG it may not be offered to the public in Germany unless (i) prior approval has been obtained by BaFin for a prospectus, (ii) a prospectus approved by another competent authority has been notified to BaFin under the Prospectus Directive, or (iii) an exemption applies.
Exemptions from the prospectus requirement under the WpPG are the same as provided for under the Prospectus Directive, such as (i) offerings only to qualified investors, (ii) less than 150 (non-qualified) investors per jurisdiction in the European Economic Area that comprises all of the member states of the European Union plus Iceland, Liechtenstein and Norway ("EEA"), (iii) offerings requiring a minimum investment of €100,000, or (iv) de minimis offerings where the total sales price of all securities offered in the EEA does not exceed €100,000, calculated over a period of twelve months. The Prospectus Directive further provides that member states may exempt offerings of securities from the application of the prospectus regime if the total sales price of all securities offered in the EEA, calculated for a period of twelve months, does not exceed €5 million. However, the German legislator has made use of this exemption in a rather restrictive fashion. Under the WpPG, this exemption is only available for securities issued by banks and companies whose securities are listed on a regulated market. In other EEA jurisdictions, this exemption may be available to all issuers of digital tokens.
ii. Other Investment Instruments
The prospectus requirements for the public offering of certain investment instruments (Vermögensanlagen) that are not securities, and to which, as a result, the WpPG does not apply, are regulated under the German Assets Investment Act (Vermögensanlagengesetz or "VermAnlG").
A prospectus requirement under the VermAnlG is triggered if the relevant investment instrument offered to the public falls within one of the seven product categories listed in Section 1(2) VermAnlG, unless an exemption from the prospectus requirement applies. For such investment products and any related prospectus approved by BaFin, the so-called "European passport" feature under the Prospectus Directive would not be available, i.e. it would need to be checked for each individual EEA member state whether the offering triggers any prospectus requirements and, if so, what these requirements are.
(a) Relevant Instruments. The statutory list of product categories that are subject to a prospectus requirement under the VermAnlG if offered to the public includes the following instruments: (i) shares/units that grant a participation in the result of a company; (ii) shares/units that grant participation rights in trust assets (Treuhandvermögen), (iii) profit-participating loans (partiarische Darlehen); (iv) participation rights (Genussrechte); (v) subordinated loans (Nachrangdarlehen), (vi) registered notes that are transferable by way of assignment (Namensschuldverschreibungen); and (vii) other investment products that bear interest and are repayable or that provide for a cash compensation in exchange for making money available on a temporary basis ("Investment Instruments"). Whether or not a digital token is to be qualified as one of the Investment Instrument listed above depends on its terms and the rights granted under the token and thus an individual analysis of each relevant token is required. In our experience, digital tokens that are referred to in the market as "security tokens" (and that do not qualify as a tradable security under their governing law) may typically fall within one of the product categories (i), (iii), (iv), (v) and (vii) above. By contrast, a so-called "utility token" that merely grants a right to receive certain services or goods (or an expectation to receive such services or goods) would typically fall outside the scope of the prospectus requirements under the VermAnlG (but may constitute a financial instrument for purposes of the German Banking Act which regulates licensable banking activities and financial services, as set out under paragraph C. below).
(b) Exemptions from Prospectus Requirements. Section 2 VermAnlG provides for various exemptions from the prospectus requirement including in particular an exemption for offers that are (i) limited to professional investors, (ii) offerings with a total sales price limited to €100,000, calculated over a period of twelve months, (iii) offerings that provide for a minimum investment per investor of €200,000, (iv) offerings that are limited to twenty (20) units, (v) offerings that target only a restricted number of persons, etc.
Furthermore, pursuant to Section 2a VermAnlG, the prospectus requirements do not apply under the so-called "crowdfunding exemption" if (a) the total purchase price of all relevant Investment Instruments issued by the same issuer does not exceed €2.5 million and (b) the relevant Investment Instrument is sold through a regulated internet services platform that checks as a matter of law that the investment by any single investor does not exceed (i) €1,000 or (ii) €10,000 (if the total property of such investor amounts to at least €100,000) or (iii) 200% of the average monthly income of such investor subject to a maximum investment amount of €10,000. This exemption is only available for the following, more debt-type Investment Instruments: profit-participating loans (partiarische Darlehen), subordinated loans (Nachrangdarlehen) and other Investment Instruments of the product category (vii) above. By contrast, more equity-type instruments, such as profit-participation rights (Genussrechte) or shares/units that grant a participation in the profits of a company may not benefit from this exemption.
iii. Investment Funds
As any other instrument, digital tokens may be subject to the regulatory requirements set out in the German Capital Investment Code (Kapitalanlagegesetzbuch or "KAGB") if they meet the criteria of an investment fund. Such criteria in particular include that there is a joint investment made by at least two investors from whom capital is collected with a view to investing such capital in accordance with a specified investment strategy except that the relevant issuer is an operative company outside of the financial sector. Whether these criteria are met, depends on the terms and the structure of the individual token. A potential qualification as investment fund may, for instance, be considered if digital real estate tokens are to be issued providing for the proceeds to be invested into one or more existing real estate assets.
If the token is characterized as an investment fund, then the regulatory requirements set out in the KAGB for establishing a German fund or for the distribution of a foreign fund to German investors would apply.
iv. Regulatory Consequences
If a prospectus has not, or not properly or not fully, been published or if an investment fund has been distributed without complying with the provisions of the KAGB, the following regulatory consequence may apply:
(a) Securities prospectuses. If a securities prospectus has not been published as required under the WpPG, BaFin may impose a fine of up to €500,000. Further, BaFin may take administrative measures such as enjoining the offering. In addition, the issuer and the offeror of the securities would be subject to a specific prospectus liability (in addition to any general contractual or tort liability) vis-à-vis investors, which would in particular include that, within six weeks following the first public offering of the securities, the investor is entitled to return the securities against repayment of the purchase price and reimbursement of its costs associated with the acquisition of the securities. If the investor has sold the securities, the investor may alternatively claim the difference between the purchase price and the price at which the investor has sold the securities plus all costs associated with the acquisition and the sale of the securities. If the issuer has its seat outside of Germany and if the securities were offered also outside of Germany, the specific prospectus liability described above would only apply if the purchase of the securities was concluded in Germany or if the investor acquired the securities on the basis of financial services performed in Germany.
(b) Prospectuses for Investment Instruments (Vermögensanlagen). If a prospectus had to be published pursuant to the VermAnlG and if such prospectus has not, or not properly or not fully, been published, BaFin may impose a fine of up to €500,000 and take administrative measures such as enjoining the offering. In addition, the issuer and the offeror of the Investment Instruments would be subject to specific prospectus liability vis-à-vis investors, which in substance is the same as the securities prospectus liability described above except that the period during which the investor may return the Investment Instruments against repayment of the purchase price is two years.
(c) Investment Fund. There is a broad range of regulatory measures BaFin may take depending on whether the token is deemed to be a German fund or a foreign fund distributed to German investors and depending on the relevant circumstances. In general terms, BaFin may take administrative measures against the distribution of the investment fund and impose fines if the relevant investment fund may not be distributed to investors in Germany. Furthermore, if the business of an asset manager is operated without the necessary license or without prior registration, this may be sanctioned by imprisonment of up to five years or by a fine.
B. Money Regulations
i. Electronic Money
In particular, in the area of e-gaming and virtual sports, tokens have surfaced that are issued by a centralized counterparty to enable platform users to purchase and obtain digital goods and services on the issuer's platform either from the issuer itself or third-party participants on the platform. Under German law, a token allowing to make payments as a means of exchange to purchase and obtain, inter alia, goods and services may be regulated as electronic money.
Electronic money means electronically 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.
The issuance of electronic money requires a license by BaFin as the competent regulator. The license will only be granted if the issuer meets certain prudential requirements, in particular, relating to capitalization, risk management and reliability and competence of its senior management. In addition, the issuer must comply with anti-money laundering and counter-terrorist financing obligations. The holder may request at any time that the issuer converts the electronic money back into fiat currency.
In practice, electronic money regulations oftentimes do not apply because the tokens do not represent a claim against the issuer but only serve as a means of trading. In addition, in many cases the issuers are able to avail themselves of certain exceptions, especially if the tokens can only be used to acquire a limited range of goods or services.
Issuing electronic money without the necessary license is a criminal offense and may result in significant fines. In addition, BaFin may take administrative actions, including imposing an administrative order on the issuer to wind down the electronic money business. Further, investors may have claims for damages against the issuer and involved individuals.
ii. Anti-Money Laundering Regulations
German anti-money laundering regulations primarily apply to regulated businesses, such as banks, investment firms, payment service providers, investment fund managers and e-money issuers. In the context of ICOs, the anti-money laundering obligations, therefore, generally only apply if a regulated service provider is involved in the ICO (e.g., a licensed investment firm as placement agent) or if the issuer itself is a regulated business (e.g., an e-money issuer or a payment services provider). From a practical point of view, issuers in an ICO will face considerable difficulties when opening a bank account in order to pay in proceeds (converted into FIAT currency) from an ICO conducted without performing due diligence on the respective investors.
Anti-money laundering obligations entail, in particular, certain requirements to carry out due diligence on customers, certain systems and controls and record-keeping requirements as well as obligations to report suspicious activity and to cooperate with any investigations by relevant authorities
It should be noted that in July 2016, at a European level, the European Commission published proposals for amendments to the anti-money laundering regulations, inter alia, a proposal to bring virtual currency exchange platforms and custodian wallet providers directly within scope of anti-money laundering requirements. It was expected that the proposals will be adopted by the end of 2017. It is not yet clear what the timeline will be for member states' implementation of the proposals.
C. Licensing requirements under the German Banking Act
i. Relevant Licensable Activities under the German Banking Act
Entities involved in the offering and placement of digital tokens may undertake activities licensable under the KWG. If the offering of the token in substance means that money is accepted from the public which is to be repaid to investors then this may constitute licensable deposit-taking business. Furthermore, if the token is a financial instrument as defined in the KWG, relevant licensable activities of an entity distributing such tokens may include the placement of financial instruments (Platzierungsgeschäft), brokerage activities where the relevant entity acts an agent/intermediary (Anlage- oder Abschlussvermittlung), or as principal for the account of the client (Kommissionsgeschäft). In certain circumstances, in particular if there is secondary trading and market-making, also licensable financial services in the form of proprietary trading for third parties (Eigenhandel für andere) may be performed.
ii. Digital Tokens as Financial Instruments
The activities outlined above would be licensable under the KWG if they relate to financial instruments. Financial instruments for purposes of the KWG include securities, Investment Instruments (Vermögensanlagen) and investment fund units (see paragraphs A.1 through A.3 above). This means that, in many cases, "security tokens" would constitute financial instruments under the KWG.
Furthermore, BaFin has issued a statement that Bitcoin and other virtual currencies constitute financial instruments in the form of units of account (Rechnungseinheiten) within the meaning of the KWG, which are treated in the same way as foreign exchange. As a consequence, digital tokens including "utility tokens" that are used as a cryptocurrency may qualify as a financial instrument for purposes of the KWG, and may therefore trigger a licensing requirement for any person that undertakes any of the licensable activities described above. This includes cryptocurrency tokens that are used as a virtual currency having the function of a private currency or that are otherwise used as a replacement of fiat currency in multilateral settlement circles.
iii. Regulatory Consequences
Where a licensable activity is carried out without obtaining a license first, this may constitute a criminal offense by the individuals involved in performing the relevant licensable activities. This may be sanctioned by imprisonment of up to five years or a fine. In addition, BaFin may take administrative measures enjoining such activities.
D. Consumer protection
While there are no consumer protection rules that apply specifically to digital tokens as such, the general German consumer protection law applicable to the relevant product or financial services does apply. If, for instance, the token is associated with financial services, certain consumer information requirements may apply. Irrespective of the content of the digital token, the terms set out therein would be subject to the consumer protection rules relating to standard business terms, i.e., terms that are not individually negotiated among the parties. The rules contain rather restrictive requirements as to the clarity and transparency of the terms used in a contract or other terms and conditions and comprehensive protection against unfair terms. The same rules also apply to contractual terms agreed among companies although the level of protection of counterparties may be slightly lower.
Critical Thoughts and Comparative Analysis
On the one hand, Germany's seems to take a rather strict approach to dealing with initial coin offerings and cryptographic. Many cryptographic assets which are not regulated in many other European jurisdictions, such as Bitcoin and Ether, are regulated financial instruments under German law. While these assets fall without the scope of financial instruments in many of its neighbouring countries, Germany's BaFin deems such crypto-assets to be units of account with many regulatory requirements in regards to the issuance of and trading in such crypto-assets ensuing as a consequence. After all, this might be the reason why Europe's largest economy and an important financial center has seen very little ICO-money flowing into its many crypto-startups (some people argue, Berlin is Europe's undisputed crypto-hub).
On the other hand, Germany's securities law rests on such a narrow definition, that a token issued in Germany and governed by German law can per definitionem not be qualified as a security, due to its dematerialized nature (provided, BaFin will not apply a functionally equivalent perspective to token issuances). Hence, German law does not contain a dynamic, flexible approach to determine a token's classification as a regulated financial instrument. As displayed hereinabove, the issuers of Wys promise an increase in value in their token, something which potentially could turn the token into security under US law but does not change the classification of such a token under German financial market law.
Due to the fact that both the primary market and the secondary market for tokens which qualify as investment instruments and units of account respectively are already regulated, it is not too probable that Germany will position itself as an ICO-hub within Europe any time soon.
Dr. Marcus C. Funke, Axel Schiemann, Frank Bierwirth (Latham & Watkins)