Introduction

Initial Coin Offerings (“ICOs”) have become immensely popular in the recent months together with other buzzwords in fintech. The legal status of ICOs in Hong Kong is under spotlight, following the issuance of a statement by the Securities and Futures Commission (“SFC”) on 5 September 2017 (the “Statement”). The Statement represents the first official publication by the SFC on their views on ICOs. In particular, the Statement indicates the possibility for parties engaging in ICOs to obtain licences.

How ICOs work

ICOs come in various forms, and their structures can be complex. One typical form of ICOs, which is the focus of this Newsletter, is investment funding involving the issuance of digital coins (i.e. cryptocurrencies) created and disseminated using blockchain technology. In the transaction, the startup companies usually offer a new type of cryptocurrency in exchange for cash or other cryptocurrencies such as Bitcoin or Ethereum. This means that the subscribers “invest” cash or other cryptocurrencies into the company through purchasing the cryptocurrencies issued by that company.

In order to attract subscribers, most issuers would promote their ICOs in cryptocurrency forums and websites, and provide online access to a “whitepaper” describing the project and key terms of the ICO issue (e.g. scale of the ICOs, subscription details, timeline etc). The whitepaper is a prospectus-like document which may set out the technological, commercial and financial terms on which the ICO should operate. The whitepaper usually outlines how the funds raised in the ICO would be utilised (usually to develop a business) and depending on their structure, may or may not offer a return to the holders of the cryptocurrency to be issued. An extreme example to illustrate the flexibility of ICOs is the Useless Ethereum Token (“UET”). UET conducted its ICO this summer, where its promoter expressly stated that the UET would offer no value and all the proceeds would go to him and he would probably buy some flat screen TVs and electronics. Thus he urged that no people should buy the UET. In a strange twist of events, the UET eventually raised more than US$200,000 and is currently traded at a market capitalisation of around US$48,721 for the 4 million UETs in circulation. After the cryptocurrencies are issued in an ICO, they may be resold to others in a secondary market on virtual currency exchanges or other platforms.

Could cryptocurrencies be securities?

In the Statement, the SFC expressed its views that the cryptocurrencies could be regarded as shares or collective investment schemes (“CIS”) and accordingly, they may fall within the definition of “securities” under Schedule 1 to the Securities and Futures Ordinance (“SFO”) (Cap. 571).

The SFO defines “securities” broadly. Among other things, securities include shares, stocks, debentures, loan stocks, funds, bonds or notes of (or issued by) a body (whether incorporated or unincorporated) and interests in CIS. Securities also include rights, options or interests (whether described as units or otherwise) in, or in respect of, such shares, stocks, debentures, loan stocks, funds, bonds or notes.

Shares?

In simple terms, “share” is defined by the SFO as any share in the share capital of a corporation. In the same legislation, “share capital” refers to a class carrying rights to vote in all circumstances at general meetings. In the case law, the general position of the meaning of share is that a share is an interest measured by a sum of money and made up of various rights contained in the contract, evidenced by the articles of association of the company (e.g. see Borland’s Trustee v Steel Brothers & Co., Farwell Limited [1901] 1 Ch. 279). Therefore, an instrument can still be regarded as a “share” depending on the rights and liability conferred by it, even though it is not termed as “share”. As for cryptocurrencies in ICOs, although they are not called a share, they could still be regarded as shares under the SFO depending on the rights attached to the holders (e.g. entitlements to the distribution of funds generated from the issuer’s underlying projects).

CIS?

Many investment products offered in Hong Kong are CIS. Common types of CIS familiar to investors typically include mutual funds and unit trusts, mandatory provident fund schemes and real estate investment trusts. The definition of CIS under the SFO generally has four elements:

• It must involve an arrangement in respect of property;
• The participants in the arrangement do not have day-to-day control over the management of the property (whether or not they have the right to be consulted to give directions);
• a.    The property is managed as a whole by or on behalf of the person operating the arrangements, or
• b.   The contributions of the participants and the profits or income from which payments are made to them are pooled; and
• The purpose or effect (or pretended purpose or effect) of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.

It can be seen that the definition for CIS under the SFO is very broad. In particular, even if there is no pooling of funds, an arrangement can still be regarded as a CIS as long as the property is managed as a whole by or on behalf of the person operating the arrangement.

Currently, it appears that there are no reported decisions in Hong Kong to test the definitions of CIS under the SFO. However, the case law in the UK suggests that the English courts seem to interpret the term CIS as broadly as possible. In particular, they considered the practical and intended operation of the arrangements, and the anticipated expectation of how such arrangements might be managed in deciding whether a particular investment arrangement is a CIS (e.g. see Financial Conduct Authority v Fradley and Woodward [2004] EWHC 3008 (Ch); Financial Conduct Authority v Capital Alternatives Limited [2015] EWCA Civ 284; and Asset Land Investment Plc v Financial Conduct Authority [2014] EWCA Civ 435). It remains to be seen how the Hong Kong courts may interpret the scope of CIS under the SFO. Nonetheless, given the broadness of the definition and the variety of ICO structures, one may not disregard the likelihood of an ICO being regarded as CIS. In particular, ICOs which promise a return to the investors are likely to be regarded as a CIS under the SFO.

Implications for regulatory compliance

For participants

In the Statement, the SFC emphasized that where the cryptocurrencies or the ICO arrangement fall under the definition of “securities”, dealing in or advising on the cryptocurrencies, or managing or marketing a fund investing in such cryptocurrencies may constitute a “regulated activity”. The SFC further stressed that parties engaging in a “regulated activity” are required to be licensed by or registered with the SFC irrespective of whether the parties involved are located in Hong Kong, so long as such business activities target the Hong Kong public.

Generally, unless certain exceptions apply, a license is needed if a party is not an authorised financial institution, and:

• it is a corporation carrying on a business in a regulated activity in Hong Kong;
• it is a corporation actively marketing, whether by itself or another person on its behalf and whether in Hong Kong or from a place outside Hong Kong, to the public any services that it provides, which would constitute a regulated activity if provided in Hong Kong; or
• he/she is an individual performing a regulated function for his/her principal which is a licensed corporation in relation to a regulated activity carried on as a business. In such case, he/she has to be a licensed representative accredited to his/her principal. In addition, if he/she is an executive director of that corporation, he/she also needs to be approved as a responsible officer.

Schedule 5 to the SFO stipulates the list of regulated activities and provides a detailed definition for each of them. The type of license required in an ICO transaction may vary depending on the structure of the transaction, but broadly speaking the relevant licenses in an ICO transaction may include licenses for “Type 1 – dealing in securities”, “Type 4 – advising on securities” and “Type 9 – asset management”. Likewise, the parties participating in an ICO may vary depending on the structure of the transaction. For example, where an intermediary is involved, that party may be required to obtain a license as someone dealing in securities. And cryptocurrency exchanges may require a license in automated trading services. Section 114(8) of the SFO stipulates that it is a criminal offence to carry on (or hold out as carrying on) a business in a regulated activity without a license, and that the person committing this offence is liable to fine and imprisonment.

For issuer

In cases where the ICOs involve the offer of shares to the public, the detailed prospectus (e.g. form, contents and registration) requirements under the Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32) (“CWUMPO”) would apply, unless the offer falls within any one of the twelve “safe habours” set out in 17th Schedule to CWUMPO. Among others, these safe habours include:

• offers to investors falling within the definition of “professional investors”;
• offers to not more than 50 persons;
• “small-scale offers”, i.e. where the total consideration payable for the relevant shares does not exceed HK$5,000,000 (or its equivalent in another currency); or
• offers where the minimum denomination of the shares or consideration payable by any person for the shares is not less than HK$500,000 (or its equivalent in another currency).

Further, in cases where the ICOs involve an offer to the public to participate in a CIS, SFC authorisation would be required unless exemption applies. Section 103 of the SFO stipulates that, unless the issue is authorised by the SFC or an exemption applies, it is a criminal offence to issue an advertisement, invitation or document which is or contains an invitation to the Hong Kong public to invest in a CIS, and that the person committing this offence is liable to fine and imprisonment. Thus issuing advertisements, invitations or documents to invite the Hong Kong public to invest in an ICO which constitutes a CIS is a criminal offence.

Conclusion

ICOs have now attracted the regulators’ attention and we cannot rule out the possibility that, depending on the facts, circumstances and the economic realities of the transaction, cryptocurrencies may be regarded as securities under the SFO regardless of the terminology or technology used. If so, participants may be required to obtain a licence, and the issuer may be required to issue a prospectus which complies with the statutory requirements or to obtain the SFC’s authorisation. Furthermore, the SFC reminded parties engaging in the transaction to seek legal or other professional advice if they are in doubt about the applicable legal and regulatory requirements.

Explanations for terminology used

Blockchain

A blockchain can be described as an electronic database or list of entries that is maintained by various participants in a network of computers. Blockchains use cryptography to process and verify transactions on the ledger, providing comfort to users and potential users of the blockchain that entries are secure.

Cryptocurrency

A cryptocurrency is a digital or virtual currency that uses cryptography for security. In general, a cryptocurrency is difficult to counterfeit because of this security feature.

Cryptography

Cryptography involves creating written or generated codes that allows information to be kept secret. Cryptography converts data into a format that is unreadable for an unauthorised user, allowing it to be transmitted without anyone decoding it back into a readable format, thus compromising the data.

Digital coins

It is also known as virtual currency, which is a digital representation of value that can be digitally traded and functions as a medium of exchange, unit of account, or store of value. Virtual tokens or coins may represent other rights as well.

Virtual currency exchanges

A virtual currency exchange is a person or entity that exchanges virtual currency for fiat currency, funds, or other forms of virtual currency. Virtual currency exchanges typically charge fees for these services.  Secondary market trading of virtual tokens or coins may also occur on an exchange.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.