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BaFin expressed its new, general administrative practice concerning the qualification of security tokens in an article in the BaFin journal of April 2019. Under this new administrative practice security tokens, meaning all tokens granting its owner membership or equity-like rights and that are freely tradable and transferable will be qualified as securities sui generis. This qualification by BaFin will lead to a supervisory handling of these tokens which is at odds with the wording of the law. The law differentiates between securities which are freely tradable and transferable on the capital markets on the one hand and investment products like GmbH shares, non-securitized participation rights or individual contractual subordinated loans which all lack this feature on the other hand. BaFins administrative practice does not make this differentiation. The ascertainment of this administrative practice is another example of BaFins dangerous tendency to exceed its authority as an executive organ and to create de facto obligations for emitters that have no legislative basis.
What are BaFins Arguments?
BaFin is right to the extent that new financial phenomena like STOs need to be regulated in a way that will continuously ensure the important purposes of regulation – primarily protecting investors and the stability of the financial markets – in the future. BaFin apparently felt prompted to quickly adapt its administrative practice in regard to security token offerings. The key argument for the creation of a new class of securities for security tokens is that the tradability of any capital market product is increased as soon as it is shifted to a blockchain solution because then it is easily transferrable between emitters, investors, exchanges and any other intermediary. BaFin further argues that the creation of a new form of securities is also covered by the European Securities and Markets Authority (ESMA) principle of “Substance over Form”. This principle means that not the naming of a capital markets product is the decisive factor for the regulatory categorization of that product but rather the way it is designed and its functions. Conversely the “Substance over Form” principle can of course not justify the qualification of a capital markets product as a security if it is designed as an alternative non-security investment product.
Is BaFin’s Administrative Practice appropriate?
The new regulatory approach by BaFin has two major flaws. First of all, it violates the principle of separation of powers according to which public authorities like BaFin as part of the executive branch of government carry out the rules and regulations that are resolved by the legislative branch of government. They have a certain leeway when it comes to the interpretation of these rules and regulations, but they cannot form a legal interpretation that leads them to carry out their regulatory duties in a way that contradicts these very rules and regulations. In this respect ESMAs “Substance over Form” principle could not justify the administrative practice of BaFin, not even if it was just about the misleading naming of a capital markets product because ESMA as well is not a legislative body but an executive authority.
Second of all, this practice by BaFin bears unpredictable legal risks for STO emitters. Civil courts that in the course of a prospectus liability litigation might have to decide if a security token is a security or an alternative investment asset could very well disagree with BaFin on this matter. The courts could use the aforementioned separation of power argument and the wording of the law to come to a different legal interpretation and qualify the security token as investment asset. The STO emitter would then be in danger of not having published the correct prospectus and therefore being liable.
Is a Tokenized Investment Asset No Longer Possible?
The administrative practice of BaFin does not necessarily mean that designing a tokenized investment asset will be impossible in the future. The key argument of BaFin revolves around the free tradability and transferability of the token. There are legal means to restrict these features. Security tokens which e.g. cannot be transferred without the prior consent of the STO emitter have still to be qualified as investment assets, even according to the new administrative BaFin practice. A security token that is designed as a tokenized investment asset can be advantageous for STO emitters if they plan an emission that is limited to Germany and if the emitter wants to facilitate the distribution of the token via non-BaFin licensed investment intermediaries.
Attorney Lutz Auffenberg, LL.M. (London)