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THIS ARTICLE DOES NOT CONSTITUTE ANY LEGAL OPINIONS.
READERS SHOULD UNDERTAKE THEIR OWN LEGAL AND REGULATORY RISKS ON INITIATING, INVESTING IN OR ADVISING ON ANY INITIAL COIN OFFERING PROJECTS.
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Decrypting Initial Coin Offering (ICO) regulations in Hong Kong
Initial Coin Offering (“ICO”), or digital token presale, is a heated phrase yet fluidly-defined term – it typically represents a capital-raising model that allows a project undertaken to raise money, normally Bitcoin or Ethereum, by issuing cryptographic tokens to a network of subscribers on the Internet, and the amount collected from the presale would generally be used to fund the developers’ initiatives. It has become a new darling for both the startups as an intermediary-free vehicle of fund-raising (especially for projects that are using cryptographic tokens), and the venture capitalists that see the great upward potential of the tokens (if resold before any likely bubble burst).
Without doubt, its name derives from the traditional Initial Public Offering (“IPO”) model that collect investment funds from the public through issuance of securities. But they simply work so differently that a distinctive combination of regulatory parameters could be imposed on ICO projects. This article would try to dissect ICO activities in a more legal and regulatory sense, and then discuss the potential regulatory approach that would be adopted by the Hong Kong regulatory watchdogs.
The nature of ICO: a DLT-enabled crowdfunding activity
If we take a serious look on ICO projects, it is not hard to associate them with crowdfunding activities, i.e. the use of an online platform to obtain small sums of money from a large crowd of individuals or organisations. Nevertheless, ICO has three major differences from traditional crowdfunding model: (i) the media of communication and fund channeling that enables crowdfunding is usually powered by an online funding portal or a broker-dealer, while that enabling an ICO occurs in a cryptocurrency exchange platform, or even just on a blockchain like a crowdsale on Ethereum without help of financial intermediaries; (ii) the monies collected from investors for crowdfunding are usually legal tenders that are recognized by local or international laws as denomination of exchange, and that for ICOs are virtual cryptocurrencies such as Bitcoin or Ethereum; and (iii) a wide range of forms of items could be given in return to the investors for investing in crowdfunding activities, such as physical products for reward-based crowdfunding, or stocks/ notes for investment-based crowdfunding, whereas newly-issued cryptocurrency is usually the form of reward in return for ICOs, and such token is usually offered with designated usage(s).
Hence, they are the medium of exchange and the vehicle of exchange that differentiate ICO from typical crowdfunding activities. A loosely-held perspective could be that ICO is treated as a distributed ledger technology (“DLT”)-enabled crowdfunding. In this parallel sense, it would be natural to find that ICO could be subject to two major aspects of law and regulations, which are the securities law and the virtual cryptocurrency-related regulations respectively.
Regulatory landscape for ICO in Hong Kong
Securities law
First, to discuss if ICO falls under the scope of current securities law, we need to understand whether the tokens issued to ICO investors could be regarded as ‘securities’. Under the First Schedule of the Securities and Futures Ordinance (“SFO”), the definition of ‘securities’ is wide enough to include many types of financial interests, including shares, stocks, debentures, loan stocks, funds, bonds, notes, rights, options, warrants, interests in collective investment scheme, structured products, etc.. Notwithstanding that cryptocurrencies may not immediately fall squarely into most of these categories in form, the designated use of tokens issued and the structure of the whole ICO arrangement could be determinative in deciding whether they constitute security interests under law in substance.
Borrowing the conceptual framework from crowdfunding, ICO projects could be classified into two major categories in accordance to the token usage, which are ‘community ICO’ and ‘financial return ICO’ respectively. The former category involves ICO projects in which the investors do not seek financial return for getting the tokens issued. Rather they give the money to the fundraiser for either charitable causes (i.e. no return at all) or for reward-based returns by applying the tokens (e.g. merchandises produced from the project, or service provisions by the business). On the other hand, the latter one includes those projects that a prospect of financial return is involved, such as the periodic interest for loans and debt notes, or an equity stake in the business (i.e. giving holder a share of profit and even voting rights).
Whilst a community ICO would generally not be closely scrutinized by the financial regulatory watchdogs as its tokens sold are mostly not be regarded as securities, a financial return ICO could risk regulatory enforcement as it may fall under the scope of the securities law and regulations. At one extreme, tokens that give the holder a right to claim for interest return and principal repayment could be treated as ‘debentures’, and those that empower the holder an equity stake in a company as ‘shares’ in substance – both of which are the typical securities in the SFO as defined under the First Schedule, even though they are not labelled as such security in their white papers.
But what about the ICO projects that fall between this end and community ICO? Depending on the way these tokens are structured, they may constitute a ‘collective investment scheme’ (“CIS”), a widely defined term that is included explicitly as an exemplification of ‘securities’ under First Schedule of the SFO. CIS generally shows the following elements: (i) the scheme involves an arrangement on property; (ii) participants do not do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management; (iii) the property is managed as a whole by or on behalf of the person operating the arrangements, and/ or the contributions of the participating persons and the profits or income from which payments are made to them are pooled; and (iv) profits, income or other returns represented to arise or to be likely to arise from the acquisition, holding, management or disposal of the property. Hence, many forms of ICO project could risk being a CIS arrangement, including an arrangement of profit sharing from a business project, a pooling of funds as loans with pre-determined rate of interest, etc..
Moreover, we should not neglect the fact that the Financial Secretary of the Hong Kong Special Administrative Region Government has power to prescribe a particular financial interest as securities, or particular arrangement as CIS by notice published in the Gazette. The legislative intent is to allow flexibility and to cater for financial innovations, thus it may be likely for those ICOs with investment features to be prescribed as securities or CIS for the sake of investor protection, especially in light of their public nature through the dissemination on the Internet.
For ICO projects that involves securities, they may fall into the ambit of three different regulatory regimes: (i) pursuant to section 103 of the SFO, a person commits an offence if he issues an advertisement or invitation to the public to purchase securities unless one of the safety habour in section 103 applies (see more below); (ii) any offer of shares or debentures of a company (no matter it is incorporated in Hong Kong or elsewhere) to the public are deemed to be prospectus, and thus it must comply with the requirements prescribed under Companies (Winding Up and Miscellaneous Provisions) Ordinance under Schedule 3; and (iii) any intermediaries involved between token issuers and crowd investors are required to hold licenses for carrying out regulated activities under section 114 of the SFO, and even authorisation as an automated trading services under Part III of the SFO section 95.
Virtual cryptocurrency-related regulations
In Hong Kong, cryptocurrencies are considered not as legal tenders but virtual commodities as advised in the Hong Kong Monetary Authority (“HKMA”) in its April 2014 notice, which are not backed by any physical properties or real economy and hence with no ascertainable value. Under the same notice, the then Executive Director (Banking Supervision) of the HKMA has warned the Authorized Institutions (“AI”) to prudently manage the associated risks with virtual commodities like Bitcoin, including money laundering and terrorist financing (“ML/TF”) risks in light of the anonymity of users under the blockchain usage. On this line of reasoning, it is clear that the regulatory watchdogs could possibly associate the investment or subscription of cryptocurrencies with ML/TF, and thus be subject to related legislation pieces such as the Drug Trafficking (Recovery of Proceeds) Ordinance (“DTROP”), the Organized and Serious Crimes Ordinance (“OSCO”), the United Nations (Anti-Terrorism Measures) Ordinance (“UNATMO”) and the United Nations Sanctions Ordinance (“UNSO”).
Apart from ML/TF issue, some suspect that the cryptocurrencies may be regarded as stored value facilities (“SVF”), which is broadly defined as ‘storing the value of an amount of money’ under the Payment Systems and Stored Value Facilities Ordinance (“PSSVFO”) when ‘money’ in the PSSVFO means ‘money in any currency; or any declared medium of exchange’. And no person shall issue or facilitate to issue any multi-purpose SVF, both device-based and non-device-based, in Hong Kong unless he is licensed by the HKMA.
How to structure an ICO to minimize regulatory enforcement risks?
Prospectus exemptions
Easiest way for Issuers of ICO tokens to avoid the prospectus regime would be to structure it as a community ICO with the investors of which do not seek financial return as explained above. Otherwise for financial return ICO, relevant issuers should reply on any one of the twelve safe habours specified under Part 1 of Schedule 17 to the C(WUMP)O. Exemptions that are most likely-relied include (in descending order of likelihood):
- An offer in respect of which the total consideration payable for the shares or debentures concerned shall not exceed HKD $5 million (para. 3);
- an offer to professional investors only (para. 1); and
- an offer to not more than 50 persons (para. 2).
Section 103 public invitation exemptions
Again, structuring an ICO as community-based may exempt section 103 of the SFO from application as mentioned above. Yet if an ICO is financial return-based, it is possible for issuers to rely on the existing exemptions under section 103 as well. Relevant safe habours include (in descending order of likelihood):
- Issue or possession for issue of a prospectus which complies with or is exempt from the prospectus regime above (section 103(3)(a)); and
- Issue or the possession for the purpose of issue, of any advertisement, invitation or document made by intermediaries licensed for Type 1, 3, 4, 6 regulated activity for securities, or made by or on behalf of an authorized financial institution (section 103(2)).
Some commentators believe that a ‘non-public’ offer is theoretically probable for being not regulated by section 103 of the SFO. Yet there is no definite test for differentiating non-public offers from public ones when ‘public’ is widely defined as ‘the public of Hong Kong, and includes any class of that public’ under Schedule 1 to the SFO.
AML/KYC compliance
Issuers of, or intermediaries dealing with, cryptocurrencies should bear in mind that pursuant to Section 25(1) of the OSCO, a person who deals with any property while knowing or having reasonable grounds to believe that the property represents any persons’ proceeds of an indictable offence is itself an offence, and the Hong Kong Court of Final Appeal has made it clear that any ‘far-fetched and bizarre’ beliefs of the defendant are of no defence and may be substituted by the objective beliefs that would be held by a reasonable person, which constitutes ‘reasonable grounds’. This could levy a considerable burden on the issuers or intermediaries receiving funding from online investors, including Know Your Client (“KYC”) rules and transaction monitoring controls.
SVF licensing exemptions
It should be noted that some ICOs are exempt from the licensing requirement, if the SVF, with a float size not larger than HKD 1 million, will not involve money payment by the customers, or that only single and limited purpose is served by the SVF. This exemption will be applicable on specific tokens that function like loyalty bonus scheme with little money elements, or tokens that can be used only within specified and limited basket of goods and services within certain premise, among other things.
Written by,
David Lam
NewLaw Hub 
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