Written by Urszula McCormack and Evan Manolios
On 19 March 2018, the Hong Kong Securities and Futures Commission (“SFC”) announced that it had taken regulatory action in connection with a token sale for possible contraventions of the Securities and Futures Ordinance (Cap. 571) (“SFO”).
In this post, we explore the details of this regulatory action and its significance for this area of emerging technology.
What you need to know about the case
The SFC’s action relates to token issuer Black Cell Technology Limited (“Black Cell”), a Hong Kong incorporated company, which sought to promote and sell its digital tokens, KROPS or KROPCoins (“KROPS Token Sale”).
Briefly, according to its website, KROPS aims to establish a network for the farming industry, whereby participants can:
- list agricultural products;
- communicate with potential buy / sell-side counterparties; and
- conduct mobile e-commerce payment transactions. It is envisaged that buyers can pay via credit card, bank deposit or the use of the KROPS wallet.
From a review of a publicly available KROPS whitepaper, Black Cell sought to offer purchasers of KROPCoins, the ability to exchange their KROPCoins for a share in Black Cell at a fixed rate. Following the exchange, KROPCoins would be destroyed. In this way, token holders could acquire an equity stake in Black Cell. The whitepaper summarises this as follows:
"The amount of [KROPS] tokens represents company ownership; therefore a KropCoin token holder becomes a BlackCell shareholder. Tokens held by (sic) will be destroyed and share certificates will be issued [if the token holder is eligible and passes necessary KYC /AML]. "
There is also little information in the whitepaper as to whether KROPCoins have any specific utility other than the ability to exchange it for shares in Black Cell. Black Cell also stated that the KROPS Token Sale proceeds would be used to fund the development of a mobile application.
The SFC’s regulatory action
The precise interaction between the SFC and Black Cell is not clear, but the SFC considered that KROPCoins could amount to a collective investment scheme (“CIS”). Black Cell agreed to:
- halt the KROPS Token Sale to the Hong Kong public; and
- refund all transactions for Hong Kong purchases.
Black Cell also agreed not to devise, set up or market any arrangement that constitutes a collective investment scheme unless it complies with SFO requirements.
It has also since posted the following pop-up message on its website:
"The following token sale is not open for American citizens (and/or US residents), Hong Kong citizens and any citizen or resident of a country that does not allow participation.
If ever any Hong Kong Citizen purchased from the Pre-sale of Kropcoins, please email us at [email protected] so that we can make the arrangement on how we can refund your Ether. The deadline for the refund of Ether for Hong Kong Citizen will be available until March 29, 2018. "
The SFC stated that the KROPS Token Sale may be a CIS under Hong Kong law, and accordingly a ‘security’ regulated by the SFO.
More specifically, the SFC noted that where a token sale involved an offer to the public to acquire an interest or participate in a CIS, prior authorisation or licensing requirements under the SFO may be triggered unless an exemption applies.
Why this case matters
There are three significant aspects to this matter:
|First regulatory action in Hong Kong
|The SFC is monitoring the market carefully and has issued numerous circulars to date. This case is not formal statutory enforcement action. However, this is the first public regulatory action of its kind – and, we expect, the first of many.
|Nature of regulatory engagement is swiftly escalating
|The SFC appears to have decided not to exercise formal enforcement powers or take this matter to prosecution. Rather, it focussed on corrective action for now. Importantly, the SFC has not asserted a definitive conclusion as to the regulatory status of KROPCoins.
This is largely consistent with a number of international regulators that have followed the approach of issuing warnings first, then ‘encouraging’ or requiring remediation, then pursuing prosecutions. We are clearly in the second phase now, but we expect rapid movement into the third phase.
|Legal classification open to interpretation
|KROPCoin has clear elements of a security. There are no surprises in this. However, if you dig a little deeper, there are some very interesting legal questions.
In particular, Black Cell is a private Hong Kong company. This is relevant for two key reasons:
- Licensing: There is an exemption from licensing requirements (even in relation to CIS) in relation to private Hong Kong companies, which was recognised in the IPFUND case. Arguably, this should never have been an alleged CIS case at all.
However, private companies are limited to 50 shareholders, meaning that in practice, the sale of USD16 m worth of KROPCoins and the underlying shares would need to be strictly limited, particularly as the offer only covered 16% equity in total. This is often considered unviable for many token offerings. Otherwise the company would be a public company, meaning the exemption no longer applied.
- Offer approval - The offer of shares / KROPCoins would also need to have been undertaken on an exempt basis to avoid prospectus / offer approval requirements. The whitepaper mentions “eligible shareholder with criteria defined by Hong Kong Security Authorities” – perhaps this meant professional investors under the SFO, but this should have been clearer.
It is arguable that additional grounds for prosecution were available, and conversely, that certain defences existed. The SFC’s action does not resolve these issues definitively, but given the circumstances, arguably it did not need to.
Key messages for token issuers
There are five clear messages for token issuers:
- The warnings are over. The SFC is now taking concrete action on specific sales. This is being embraced by the Hong Kong market as it helps provide certainty and starts weeding out bad actors.
- Each token is different. The SFC continues to emphasise that it will look at the underlying nature of the digital asset and token sale itself.
- Offering equity / company ownership is regulated in almost every market. A number of other features can be problematic, including mutualised payment / revenue streams, auction-based pricing, ETH volatility adjustments and staking mechanisms in certain cases. This is not an area to guess or follow market practice, which is often very poor.
- Exemptions need extreme care. If you are seeking to rely on an exemption, ensure you know if / how it applies, make the criteria for purchase extremely clear and then implement commensurate procedures.
- Regulators do not need to prove misconduct before making “please explain” enquiries or seeking corrective action. In practice, the initial burden of proof typically falls on issuers to explain their token and its jurisdictional nexus to Hong Kong.
The same messages apply to exchanges, advisors, marketers and others operating in this market.
What about excluding the Hong Kong market?
For those seeking to avoid the Hong Kong market, you need to be proactive about this. For example:
- adopt proper blocking mechanisms, including both technological (eg geoblocks / IP address checks) and manual screening (AML/KYC procedures);
- include clear disclaimers and selling restrictions on relevant websites and materials;
- avoid any marketing in or to Hong Kong – this includes fly-in / fly-out conferences and meetings; and
- avoid other Hong Kong links that suggest Hong Kong is a target market, such as HKD denomination, local contacts or premises, Chinese language documentation etc.
Finally, the SFC reminded token issuers to seek professional advice about their legal and regulatory obligations, consistent with previous announcements. This is not a commoditised space, so the facts matter. Likewise, even if your sale is “global”, securities and digital asset regulation is jurisdiction-specific, meaning more (and not less) law applies.
HKSAR v IPFUND Asset Management Limited and Sin Chung Yin DCCC 23/2015