"This article has been co-authored by the team of LexCounsel Law Offices, India and Mr. Teo Doremus and Ms. Courtney Zhou of IPO Pang Xingpu, China".
1. Demystifying ICOs.
Initial Coin Offerings (or "ICOs") as a means of fundraising has steadily becoming the new normal in this digital age for start-ups looking to fund new projects (and sometimes for creation of a new cryptocurrency). One of the most common cited example of successful ICOs is that of the now famous cryptocurrency Ether which was the result of the Ethereum ICO that was floated in 2014.
Simply put, ICOs are a mode of raising capital from the public where the issuer company issue its own (blockchain based) crypto-coins or tokens to the investors (instead of shares) in exchange for financial investment by the investors through other established cryptocurrencies such as Bitcoin, Ethereum etc. (and sometimes even through traditional fiat currencies). The funds raised by the ICO are used by the issuer company to either fund a new virtual currency or a block chain project or simply finance a new project, the details of which are provided in a white paper released by the issuer for the ICO. The white paper contains detailed information on the project for which the funds are being raised, the value of the token, the exchange rate/usage etc. Depending on the terms of the ICO, these tokens, can be used to digitally access the application/product of the issuer company or further traded through exchanges in future in case of a demand. The value of the token is of course dependent on the success of the project for which the funds have been raised, and is thus volatile, subjecting the investors to associated financial risks.
In the recent past, there has been an increasing trend in raising funds through such self-regulated ICOs, as against the traditional funding options which are subject to several regulatory compliances and consequent dilution of equity for the promoters. The ICO's also provides the issuer company with the added benefit of creating a pre-existing eco-system of supply and demand with an already established base of prospective users in the form of investors who have a vested interest in accessing the product being developed. Many start-ups view ICOs as a disruption to the venture capital industry.
However, while ICOs have gained momentum as an alternative means of raising funds, the absence of any regulatory oversight has left them open to risks as well as intense debate across the globe. In this article we give a brief overview of the regulatory regime governing ICOs in India and China.
While certain countries have introduced detailed guidelines regulating ICOs, India presently does not have any regulatory framework governing ICOs. An absence of a clear regulatory regime, has however, left the ICOs, in an uncertain space riddled with regulatory pitfalls.
While the Government has not declared ICO's and cryptocurrencies as 'illegal' per se, the Reserve Bank of India ("RBI") has, over the past few years issued advisories cautioning users, holders and traders of virtual currencies ("VCs") including Bitcoins regarding the potential economic, financial, operational, legal, customer protection and security related risks associated in dealing with such VCs, and stating that creation, trading or usage of VCs, as a medium of payment is not authorized by it. There have also been reports of raids conducted by the Enforcement Directorate against operators of trading platforms of VCs in India (as already discussed in our previous updates1). More recently, taking cognizance of the spurt in valuation and the growth of ICOs, RBI has also reiterated its concerns over the use and trading in VCs in its advisory dated December 5, 2017, and reiterated its earlier press release dated February 1, 2017, that it has not given any licence/authorisation to any entity/company to operate such schemes or deal with Bitcoin or any VCs.
While, an Inter-Disciplinary Committee had been formed by the Indian Government last year to examine the existing framework of VCs in India, the report from the Committee is still awaited. However, in the interim, RBI appears to have adopted a more stringent stand than its earlier position and has moved forward from merely issuing cautionary advisories to the public. While presenting the Union Budget 2018, the Indian finance minister reaffirmed that cryptocurrencies are not legal tender in India and added that the government would explore the underlying technology behind block chain to apply it to payment systems. In its notification dated April 6, 2018 ("Notification"), RBI issued instructions to entities regulated by it (such as banks, NBFCs and payment system providers) to not deal or provide services for facilitating any person/entity to deal with or settle VCs. These entities have been directed not to provide any services related to VCs, including, maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer/receipt of money in accounts relating to purchase/sale of VCs. The entities, which are currently dealing with and/or providing services related to VCs, have been given a time period of 3 months to exit any existing relationship. There have also been reports of several banks suspending and freezing all debit and credit transactions in the accounts of such VC exchanges /companies/firms/individuals.
This restriction on banks and other financial institutions from dealing in transactions related to VCs could very well have a crippling effect on the ICO market and VC exchanges in India as the issuing companies would be restricted from availing any banking facilities. We may however, add that this Notification has reportedly been challenged before the Delhi High Court by Kali Digital Eco Systems, a firm running a VCs exchange platform on the ground of the said ban violates the Constitution of India which grants very citizen the right to carry on any occupation, trade or business. In the interim, the Delhi High Court had issued notices to the RBI, the Union of India and the Goods and Services Tax Council seeking their response in this regard. The said petition along with a few other petitions challenging the Notification have now been transferred to the Supreme Court of India vide its order dated May 17, 2018 and the Court has also directed that no High Court shall entertain any petition relating to the said Notification.
In addition to the aforesaid, implications under taxation laws and securities laws of India are a growing area of concern for the stakeholders in an ICO. For instance, there have been reports of the Income Tax authorities conducting surveys across Bitcoin exchanges, to undertake a preliminary assessment of inter alia the sources of funds, the identities of counter parties, bank account details and the underlying transactions dealing in trading of Bitcoins, to determine any related instances of tax evasion. In the wake of these surveys, the tax authorities are reportedly intending to issue notices for tax evasion charges to high net-worth individuals, who continue to be operational in transactions taking place in the surveyed VC exchanges. As it appears that the IT department may impose capital gains tax on the sale/purchase of Bitcoins or such other crypto currency and therefore the tax implications related to issuance and sale of ICOs is quite uncertain for both the issuing company and the investors.
In the realm of securities laws, it appears that Securities Exchange Board of India ("SEBI") too is deliberating upon a regulatory regime governing ICOs. However, whether this regime would take the form of an absolute ban on ICOs or a guiding framework regulating ICOs (like is the case for IPOs) is yet to be seen. Further, the issuing companies floating ICOs in India could also come under the scanner vis-à-vis compliances required under the Companies Act, 2013, which prescribes a rigid set of compliances to be followed by companies while issuing securities to the public and accepting deposits from the public. The future of ICOs can also be impacted by the new Banning of Unregulated Deposit Schemes Bill, 2018 proposed to be introduced in the Indian Parliament. As per the Government's press release this bill will provide a comprehensive legislation to deal with illicit deposit schemes through inter alia a complete prohibition of unregulated deposit taking activity and deterrent punishments for promoting or operating an unregulated deposit taking scheme. Although, the text of the Bill is not available in the public domain, and it is too early to say that the bill would directly ban or impose restrictions on ICO's, but the possibility of the prohibition on unregulated ICOs within the proposed enactment cannot be ruled out
In view of the foregoing discussions, till such time the Government legal position on VCs and ICOs is made clear, it is advisable for both the issuing companies and the investors to exercise caution and carefully assess the risks involved in participating in ICOs under the existing laws and the possibility of future regulatory regime declaring such ICOs as illegal or heavily regulated.
3. Initial Coin Offering(s) in China.
In China, there is no legislation on virtual currencies, although the property attributes of tokens have been recognized in judicial practice. In this sense, an ICO may constitute a form of financing, similar to advancing an IPO. China views that the substance of an ICO, not its concept and form, is what should be used to determine its legal nature.
On September 04, 2017, the People's Bank of China (the "PBOC"), along with six other state administrations, jointly issued a complete ban on domestic ICOs2. In a strongly worded statement, the PBOC declared coin offerings as an illegal fund-raising activity. It stated that virtual currencies like Bitcoins and Ethereum do not constitute legal tender and cannot be used in lieu of currency in the market. Individuals and organizations have been prohibited from participating in ICOs. Funds raised from any previous ICOs were required to be returned to investors. For instance, four ICO startups, namely UIP, LLToken, CCC and HMS, have since refunded money to the investors.
Platforms have also been banned from all activities concerning virtual currencies, including trading, acting as information intermediary and providing pricing service. Platforms that had participated in these activities face sanctions from administrative departments, including suspension of website platforms and mobile apps. For instance, BTCCHina, one of the largest bitcoin trading platforms in China, has been shut down3. Financial institutions and non-bank payment institutions have been prohibited from providing any services or products involving virtual currencies. All market participants including the public have been directed to report any transgressions of these rules to the relevant authorities for further action.
However, while trading through platforms and exchanges were banned, over-the-counter transactions have not been prohibited4. Further, following the domestic ban on ICOs, some firms opened offshore platforms to facilitate investment by Chinese citizens in ICOs outside China, thereby, to some extent, bypassing the domestic ban.
Sources from the PBOC said that the Chinese government will launch a series of regulatory measures to curb the deals, considering various risks faced by domestic investors if they are involved in such deals through overseas platforms.5 The regulators warned investors that they shall be fully aware of risks on overseas platforms for ICO and the trading of virtual currency. Further, investors shall increase risk prevention awareness and not participate in activities in violation of laws and regulations.6 According to the sources, China will launch a series of regulatory actions, including the ban on businesses in relevant forms, and the crackdown upon and disposal of domestic and foreign platforms and websites engaged in virtual currency deals, in order to prevent financial risks associated with ICOs, and maintain the stability of the financial sector.7 Any platform of this nature will be closed down immediately when it is discovered. Indeed, in 2018, China began cracking down on these offshore platforms by blocking domestic access8 and by also targeting domestic assets of these offshore platform owners9. Non-market activities to acquire virtual currency have also been targeted. For instance, in January 2018, China planned to limit power supply to prevent bitcoin mining.10 We expect more regulatory measures to be introduced depending on how this will develop in the future.
4. Concluding Remarks.
Across the globe, cryptocurrency attracts concerns of money laundering and tax evasion. Additionally, it is frequently used to finance illegal activities such as drug trade11 and arms trade.12 In China particularly, a sudden dramatic increase in the number ICOs had also raised investor protection concerns. China's strict ban against cryptocurrency serves the dual purpose of ensuring financial security and investor protection. All activities and intermediaries vis-a-vis ICOs have been prohibited. Even past ICOs have been invalidated and the funds collected have been refunded to investors. In fact, nearly all funds raised via ICOs have since been refunded.13 However, despite its strong stance, China does not harbor objections against the concept of cryptocurrency, or its underlying technology. In fact, the Chinese Government is aggressively adopting blockchain technology.15 In a recent speech, Chinese President, Xi Jinping, lauded blockchain and deemed it to be a technological breakthrough.
China is proactively chasing gains in efficiency provided by the technological innovations around cryptocurrency while prohibiting cryptocurrency itself. This approach by the Chinese Government has led the PBOC to conduct trials for its own cryptocurrency based on blockchain technology.16 A government propagated cryptocurrency can be effectively monitored while at the same time allowing efficiency gains available to cryptocurrency. Therefore, although we may see the Chinese Government-owned cryptocurrency introduced in the future, the ban against other cryptocurrencies in China is likely to continue for the foreseeable future.
As far as India is concerned, while, on the one hand the Indian Government concurs with the view that technological innovations, including those underlying in VCs, such as the blockchain technology, have the potential of improving the efficiency and inclusiveness of the financial system, the recent developments prohibiting banks and other payment system providers from dealing with and/or providing services related to VCs (which as a consequence also affects ICOs) have triggered further uncertainty in an already cloudy regulatory framework governing VCs and ICOs in India.
The RBI's strict stand possibly emerges from its long-drawn concerns inter alia of consumer protection, market integrity and money laundering vis-à-vis VCs, however, the fact still remains, that many countries have moved ahead from their initial hesitancy and gone forward with recognising VCs and ICOs albeit under a proper regulatory regime. Already, the climate of regulatory uncertainty towards VCs and consequently ICOs, has resulted in many issuing companies floating their ICOs in foreign markets and shifting their operations base to jurisdictions which are more receptive to ICOs. For instance, Mumbai-based online car rental platform Drivezy, which has reportedly raised $5 million from its first security-based ICO offering, had registered its parent company in the US to offer the ICO. Drivezy did not offer its ICO in India and China because it was unsure about laws regarding cryptocurrencies in these countries. Going by the current trends indicating that VCs and ICOs are generating a lot of interest, an unambiguous stand of the Government of India on the legitimacy and legality of VCs and ICOs is important to bring clarity and transparency.
1 "Future of Virtual Currencies in India" http://www.mondaq.com/india/x/608424/fin+tech/Future+Of+Virtual+Currencies+In+India; "Legal Status of Virtual Currencies/ Cryptocurrencies in India" http://www.mondaq.com/india/x/583670/fin+tech/Legal+Status+Of+Virtual+CurrenciesCryptocurrencies+In+India; "Virtual Currencies - An Enigma For Indian Authorities" http://www.mondaq.com/india/x/660310/Financial+Services/VIRTUAL+CURRENCIES+AN+ENIGMA+FOR+INDIAN+AUTHORITIES.
2 People's Bank of China, Public Notice of the PBC, CAC, MIIT, SAIC, CBRC, CSRC and CIRC on Preventing Risks of Fundraising through Coin Offering, http://www.pbc.gov.cn/english/130721/3377816/index.html.
3 BTCChina, https://www.btcchina.com.
14 South China Morning Post, http://www.scmp.com/news/china/economy/article/2136551/china-open-idea-digital-currency-long-its-efficient-and-safe.
15 South China Morning Post, http://www.scmp.com/tech/enterprises/article/2142962/chinas-local-governments-ramp-blockchain-projects-amid.
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