Will Initial Coin Offerings fall under new European Crowdfunding rules?

The EU Parliament has proposed to bring ICOs under its Crowdfunding rules. The new ICO rules come with several caveats and a number of flaws.

When the European Commission published its proposalfor a “Regulation on European Crowdfunding Service Providers (ECSP) for Business” as part of a package of measures to deepen the Capital Markets Union, the foremost question was whether it was the breakthroughthat would transform the patchwork of crowdfunding regulations in the different member states and create a level playing field across the Union to finally help this form of financing to fulfil its potential. The objective of the proposal is to change the current framework, so that platforms will have to comply with only one set of rules, both when operating in their home market and in other EU Member States instead of having to comply with different regulatory regimes. As a result this should to widen the pool of investors and the number of projects to pick from, as well as provide legal certainty as regards the applicable investor protection rules.

As part of this legislative initiative, the proposal has been passed to the European Parliament and its Committee on Economic and Monetary Affairs for review. The committee chaired by Ashely Fox, an MEP from the UK has produced a draft reportthat makes various amendments to the proposal and maybe most significantly but certainly somewhat surprisingly extends its scope to include initial coin offerings (ICOs). The explanatory statement of the report highlights that “this regulation is an opportunity to provide regulation for initial coin offerings” since “At present initial coin offerings are operating in an unregulated space and consumers are at risk from fraudulent activity taking place in this market. This Regulation gives the opportunity to ICOs that want to prove their legitimacy to comply with the requirements of this regulation”.

Regulatory Requirements

What would the regulatory requirements for crowdfunding platforms be that would want to add ICOs to their offering? To start with, crowdfunding service providers would have to “provide prospective investors witha key investment information sheet (KIIS) drawn up by the project owner”, i.e. the people responsible for the ICO. The key investment information sheet shall be “drafted in at least one of the official languages of the Member State concerned or in English. The key investment information sheet shall be fair, clear and not misleading and shall not contain any footnotes, other than those with references to applicable law”, limiting the small print.

It also sets the table for an intermediary that has an active interest in the correctness of the information provided by the issuer of the ICO, unlike the current rating platforms that simply a bogus validation of an offering in exchange for a fee without conducting any due diligence on the project. The draft proposal makes this clear since all crowdfunding service providers shall have in place and apply adequate procedures to verify the completeness, the correctness and the clarity of information contained in the key investment information sheet. The KIIS would also need to contain certain information, such as details of the identity, legal status, ownership, management and contact details of project owners, their principle activities and products or services offered, a link to their most recent financial statement and a description of the crowdfunding project, its purpose and main features as well as a range of further disclosures that should help fight fraudulent behaviour as seen in the recent SEC decisionagainst Tomahawk Exploration where the company tried to hide the criminal background of its CEO

There is always a “but”

What sounds like a revolution of the European regulatory framework comes with a number of caveats plus it needs some explanation to be understood properly and put in perspective:

The lengthy road

First of all, the Draft resolution is proposed response to a proposal. That already tells you that this legislative initiative like most if not all EU legislation will have to cover a lengthy road before. In this case it needs to be approved by the committee itself and then by the Parliament. And then the European Council will of course also have a say…

Good intentions, more patchwork?

The authors rightly point out that “in order to allow for a competitive Union framework, crowdfunding service providers should be permitted to raise capital through their platforms using certain cryptocurrencies. Initial Coin Offerings (ICOs) offer new and innovative ways of funding but can also generate substantial market, fraud and cyber security risks to investors. Therefore, crowdfunding service providers that wish to offer an ICO through their platform, should comply with specific additional requirements under this Regulation.“

This only one side of the regulatory medal though since the limitation of the proposal follows straight away: “However, private placements, ICOs raising in excess of €8million or ICOs that do not use a counterparty do not fall within the scope of those requirements.”

That means that a significant number of ICOs will not fall within the scope of this regulation and kind of defeats the purpose of creating a comprehensive EU wide solution. Instead, it creates legal requirements for some ICOs, while others apply as well to an extent or completely, in short, far from the level playing field the EU Crowdfunding Regulation has in mind.

No lawless land

The report speaks of ICOs operating presently in an unregulated space and consumers are at risk from fraudulent activity taking place in this market. Now, while there clearly is a risk of fraudulent behaviour as it is well documented by a number of ICOs that are simply fraud, the first part of the statement is simply not correct. Of course, existing laws do apply to token sales, it is only always the questions which and how exactly. Take the clarification provided by the German regulator BaFinrecently: while the watchdog stressed that each case is different and needs to be evaluated separately, several German laws could be applicable to an ICO depending on the respective case, namely provisions from the German Banking Act (KWG), the German Securities Trading Act and the German Securities Prospectus Act (WpHG, WpPG) or the law on investment products, the “Vermögensanlangengesetz” (VermAnlG). In addition, numerous other elements of financial regulation come into consideration, in particular the Money Laundering Act (GwG), the Payment Services Supervision Act (ZAG), the Capital Investment Code (KAGB), but also directly applicable European secondary law such as the Market Abuse Regulation (MAR) of the European Union. And that is just what’s happening in Germany.

Conclusion

Firstly, the initiative should be welcomed despite its flaws. It should trigger a discussion within the different European institutions and though this proposal cannot be the regulatory solution, it can contribute to the dialogue between all stakeholders to find one that does work. The authors of the report are clearly aware of this as they point out that “whilst this regulation may not provide the solution for regulating the ICO market, it takes a much-needed step towards imposing standards and protections in place for what is an excellent funding stream for tech start-ups”.

Secondly, it shows that the European lawmakers are conscious of the need to provide a regulatory framework  – see above. It may have taken some time and more will pass until we see something concrete, but this still shouldn’t be disregarded.