Prospects of Regulation of Initial Coin Offerings by SEBI

[Aishwarya Singh is a 5th year law student at Jindal Global Law School, Sonipat]

The Reserve Bank of India (RBI) had, by way of a circular, ring-fenced banks from dealing with cryptocurrencies. However, the status of cryptocurrencies in India is far from decided. The RBI circular has been recently challenged in the Supreme Court. On the other hand, the Government had also constituted an Inter-Disciplinary Committee in 2017 with various stakeholders, including the RBI and the Securities Exchange Board of India (SEBI), to evaluate the existing legal regime on cryptocurrencies and to propose measures for dealing with them. This post discusses the application of the existing securities law to initial coin offerings (ICO) in India. Further, it compares the treatment of securities in India and United States. Finally, the post proposes certain measures SEBI can adopt to regulate ICOs that offer coins analogous to securities.

Initial coin offering is a method of fundraising driven by cryptocurrency. The entity wishing to raise funds or the issuer makes available for purchase a coin or a token, which is a virtual currency or a cryptocurrency in exchange for cryptocurrency (e.g. Bitcoin or Ether) or fiat currency. These coins are maintained on a blockchain or through smart contract on a pre-existing blockchain.

Treatment of Coins as a Security

SEBI regulations may apply to ICOs if the coins offered satisfy the definition of “securities” under section 2(h) of Securities Contract (Regulation) Act, 1956 (SCRA).  The SCRA provides an inclusive definition of security. The term securities includes:

i. shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

a. derivative;

b. units or any other instrument issued by any collective investment scheme to the investors in such schemes;

c. security receipt as defined in clause (zg) of section 2 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;

d. units or any other such instrument issued to the investors under any mutual fund scheme;

ii. Government securities;

iii. such other instruments as may be declared by the Central Government to be securities;

iv. rights or interest in securities.

The instruments mentioned in the definition above have an underlying capital asset. Although not all coin offerings are accompanied by an underlying asset, there are certain ‘asset coins’ that provide a debt or equity claim against the issuing entity. These asset coins are analogous to the instruments mentioned above. Even if the coins or tokens do not strictly fall under the terms “shares” or “debentures”, they may fall under the expression “other marketable securities of a like nature in or of any incorporated company or other body corporate”. The Supreme Court has held in Bhagwati Developers Pvt. Ltd. v. Peerless General Finance That “marketable securities of a like nature” means that the securities should be freely transferrable. The same was upheld in the case of Sahara India Real Estate Corporation Limited v. Securities and Exchange Board of India wherein the Court held that a marketable security will clearly fall under the ambit of section 2(h) of SCRA and that marketable means “capable of being sold”. Hence, there should be no restriction on the transfer of these asset coins offered through the ICOs for SEBI to have jurisdiction over the same.

Further, these coins should be issued by an incorporated company or a body corporate to come within the ambit of securities under section 2(h) of SCRA. A body corporate has been defined inclusively under section 2(11) of the Companies Act, 2013 and includes company incorporated outside India. However, there are instances where coins are issued by unincorporated entities, and coins issued by such entities may fall outside the purview of securities under SCRA.

The definition of securities is quite restrictive in India. As a result, most ICOs will fall outside the ambit of the SEBI regulation. It will be interesting to compare the treatment of securities in India with that of United States. In the United States, security is defined as an “investment in a common venture premised on a reasonable expectation of profits to be derived from entrepreneurial or managerial efforts of others” (SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946)). Further, the “issuer” under section 2 of the Securities Act, 1933 has been defined as “any person who issues or proposes to issue any security….”. The definition of “person” under section 2 of the Securities Act, 1933 includes unincorporated organisation. Hence, securities can be issued by even unincorporated entities in United States.

The United States Securities Exchange Commission in its Report 21(a) concluded that coins or tokens offered by a certain organisation DAO are securities. DAO refers to Decentralized Autonomous Organization, which is a virtual organization borne out of a computer code and executed on a blockchain protocol. Hence, such organisations are not incorporated in any jurisdiction. DAO was a creation of and its co-founders. DAO would hold a corpus of assets through the sale of tokens to investors. These assets would then be used to fund certain “projects”. These investors would also get dividends from the anticipated earnings from the projects. The investors also had limited voting rights. They could vote on whether funds should be spent on a specific project. and its co-founders, and the DAO Curators  monitored the operations of the organisation and decided which proposed projects should be put up for a vote. DAO tokens are an interesting example because the token holders could re-sell the tokens on online platforms, hence allowing secondary trading of the tokens. DAO tokens satisfied the definition of securities under the United States law. The tokens represented an investment in DAO, a common enterprise, with reasonable expectation of a dividend. Further, a significant managerial effort of DAO’s Curators, and its cofounders, was essential for running the enterprise. However, it is likely that the DAO tokens will not be treated as a security within the Indian laws and regulations. Though the DAO tokens are marketable and have an underlying asset, section 2(h) of SCRA requires the issuer to be an incorporated company or a body corporate.

Future Possibilities

As discussed, the current legal framework will not cover most ICOs leaving investors at a risk of fraud and manipulation, often associated with ICO markets. There is a need to expand the definition of securities under section 2(h) of SCRA to account for the new ways in which entities are issuing securities to raise funds. Further, the securities regulators over different jurisdictions have adopted two approaches to regulate security offerings through ICOs. Jurisdiction like United States apply federal securities laws to ICOs. However, start-ups may find it challenging to navigate these extensive regulatory requirements with their limited legal and financial resources. The second approach is to create a regulatory sandbox as it has been done in Singapore and United Kingdom, where certain regulatory requirements are relaxed and the entity is allowed to experiment and scale its business model subject to certain conditions. The second approach facilitates the usage of ICOs by small businesses to raise the much-needed funds and allows the regulator to keep a track on the activities of the issuer. India will benefit from following the second approach as it will give impetus to the entrepreneurship and innovation in India, otherwise Indian entrepreneurs may start choosing foreign jurisdictions for ICOs.

Aishwarya Singh

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