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The approval of the first security prospectus for a security token offering by BaFin at the beginning of this year came like a thunderbolt to German capital markets regulation. The Authority proved itself open for innovations. At the same time, the German legislator is laying the groundwork for facilitating the emission of security tokens in the future. In March 2019, the Ministry of Finance and the Ministry of Consumer Protection released a joint paper on the subject outlying the problems and possible solutions for the emission of security tokens in accordance with German law. The phenomenon of blockchain based capital markets emissions offers the long-awaited opportunity to reform and adjust the outdated German debenture bonds regulation and the corresponding civil law in order to adapt these important regulative tools to the technical and digital possibilities of our time.
Do Securities Require Paper Documents under German Law?
The German securities laws developed over a long period of time. The German legislator failed for decades to adjust the substantive law to the changing technical circumstances and developments. The market therefore had to adjust its systems with an array of legal constructions that including indirect security custodies and transfer statements in order to legally enable the nowadays common practice of transferring securities electronically. The end product of aforementioned constructions is always a global certificate in paper form that certifies the security. That it is, at least according to BaFin, indeed possible to create securities in accordance to German law without a paper document is displayed by the above mentioned approval of the securities prospectus for a security token offering in which the offered securities only exist in the form of token from a smart contract that is mounted on the Stellar blockchain. From a legal perspective, there are good arguments for and against non-paper-based securities under German law. A definitive legislative regulation would however be the only possibility to eliminate the legal uncertainty and would therefore be much appreciated.
What is Investor Participation According to the German Debenture Bond Act?
Emitters usually choose to issue a bond, e.g. a profit participation right, if they do not want the investors to have a say in the company decisions. Bond investors obtain only contractual claims versus the issuer like a fixed or variable rate of return and a repayment claim. They cannot interfere in the corporate decisions of the issuer. On the other hand, it might be desirable for an emitter to grant investors participation rights that go beyond the aforementioned contractual claims. According to the German Debenture Bond Act emitters can decide that the conditions of the issued security may be changed with a majority vote of the investors. Especially for emitters that plan to issue bonds in the form of a security token the possibility to change the token conditions after the token is issued can be a desirable and decisive advantage. Without this possibility the emitter would have no option to adjust the token conditions to e.g. a legislative change. Also, a lifetime extension of the token in order to long-term finance the company and a postponement of the repayment claim or an adjustment of the rate of return are de facto impossible without this option because an individual agreement with every security token holder to individually contract these changes is unrealistic.
Is the German Debenture Bond Act Applicable to Security Token Offerings?
The ministries in their paper as well as numerous authors in the legal literature assume that the German Debenture Bond Act in its current version is only applicable to bonds that are certified in a paper document. They refer to the so-called principle of scripture that is stated in sec. 2 of the German Debenture Bond Act. According to this principle, the conditions of a bond must be laid out in the document of said bond. The amendment of the German Debenture Bond Act and the abolition of the principle of scripture would be a much-appreciated project. However, it can already be argued with good reasons that the German Debenture Bond Act in its current form is already applicable to security tokens. The German legislator explicitly stated in the justification documents for the last amendment of the Debenture Bond Act in 2009 that this law is supposed to be applicable to all bonds regardless of the form of the certification. This argument of the legislator can be understood as an indication that blockchain based bonds should be included in the scope of the German Debenture Bond Act as well.
Attorney Lutz Auffenberg, LL.M. (London)