Crypto Assets: To Disclose or Not to Disclose

It’s time to get serious about DeFi. If you’re unfamiliar with the concept, a decentralised finance application (“DeFi”)  involves a software protocol that operates on a public blockchain and allows users to undertake direct transactions that are recorded and verified on the blockchain without the involvement of a centralised authority or financial intermediary. DeFis are underpinned by a series of self-executing smart contracts that automatically process the various transactions that occur on the platform.

DeFi is more than a mere concept. Although it is still in its infancy, the space has grown over recent months to a combined market cap of over $165 billion. With immense potential to decentralise and transform traditional finance, banks, financial institutions and sceptics are now being forced to take DeFi seriously.

The global conundrum

In the United States, the Securities and Exchange Commission (“SEC“) has long contended over whether the creation and offer of crypto-assets such as tokens in exchange for fiat currency is capable of satisfying the Howey test and falling within the scope of US securities law. Although the position remains somewhat unclear, the SEC has seemingly adopted a more aggressive approach toward the regulation of crypto-assets. In a recent testimony before the Senate Banking Committee on 14 September 2021, the SEC chairman, Gary Gensler, suggested that only a small number of tradeable digital assets would not be classified as securities under US law.

In Australia, the position is no clearer. Although ASIC has indicated that it does not classify widely dispersed – i.e. “decentralised” and “autonomous” systems such as Bitcoin and Ethereum as financial products under the Corporations Act 2001 (Cth) (“the Act”), we cannot use this as a blanket approach for all digital assets. While pure digital cryptocurrencies like Bitcoin and Ethereum do not fit the mould of a financial product under the Act, ASIC has indicated in INFO Paper 225 that other forms of crypto-assets such as tokens are capable of being classified as financial products based on their characteristics and the particular rights that attach to them. In many cases, the two most relevant asset classes of financial products which could apply to the creation and offer of digital assets are:

1. Securities as defined under sections 92, 700 and 761A of the Act (as applicable); and
2. Interests in a managed investment scheme as defined under section 9 of the Act.

For more information on how the managed investment scheme regime could apply to digital assets and DeFi, see our previous article.

Regulatory framework

In INFO Paper 225, ASIC comments that its experience suggests that initial coin offerings (“ICO”) by DeFis commonly seek to raise capital from the public to fund a particular project through the issue of crypto-assets such as tokens. The significance of this commentary is that, in most ICO cases, the fundraising provisions under Chapter 6D of the Act would be triggered and the definition of securities under section 700 of the Act would apply.

The definition of securities for the purposes of fundraising through the issue or sale of securities in section 700 includes:

1. a share in a body; or
2. a debenture of a body; or
3. a legal or equitable right or interest in a security covered by paragraph (a) or (b); or
4. an option to acquire, by way of issue, a security covered by paragraph (a), (b) or (c); and
5. a simple corporate bonds depository interest, other than a simple corporate bonds depository interest in simple corporate bonds where the simple corporate bonds were issued under a 2-part simple corporate bond prospectus.

In most cases, the two most relevant classes of securities which could apply to digital assets created or offered are:

1. a share in a body; or
2. a debenture in a body.

If a particular digital asset is found to be a security under Chapter 6D of the Act, the issuing DeFi may need to comply with various disclosure obligations, including the preparation and issue of a prospectus or offer information statement. Further, if a particular digital asset or token is deemed to be a security under Chapter 7 of the Act, falling within the definition of a financial product under section 763A, the issuing DeFi may need to comply with various disclosure and licencing obligations and may need to issue a product disclosure statement and obtain an Australian Financial Services Licence with the appropriate authorisation conditions allowing it to appropriately deal in that security.

Can a DeFi be a body for the purposes of the Act

The first issue to consider whether a digital asset is capable of being classified as a share in, or a debenture of, a body is whether the particular DeFi creating or offering the token is a body within the meaning given in Act. A body is defined broadly under section 9 of the Act as a body corporate or an unincorporated body and includes, for example, a society or association. If a particular DeFi is unincorporated and has adopted a decentralised autonomous organisation (“DAO”) entity structure, it may be capable of being classified as an unincorporated association if it is made up of a group of members who have come together to further a common purpose without incorporating or forming any separate legally-recognised entity. This point may prove to be moot in the near future, as the Australian Senate Select Committee recently released its final report, detailing recommendations for the Australian Government to establish a new DAO company structure, which would place a DAO within the definition of a body under section 9 of the Act.

Can a digital asset/token be classified as a share?

When considering whether a particular digital asset is capable of being classified as a share, ASIC will take into account the various rights attached to those assets and will consider whether those rights are similar to rights commonly attached to shares. In INFO Paper 225, ASIC comments that “if the rights attached to the crypto-asset are similar to rights attached to a share… then it is likely the crypto-asset is a share”. These rights may include:

1. a right to a share of any revenue/profits generated (similar to a shareholders right to participate in dividends whilst the company is a going concern);
2. a right to participate in any governance processes (similar to a shareholders right to participate in corporate governance by attending shareholders meetings and voting on various resolutions); and
3. any other rights to remedies in respect of holding a particular digital asset (similar to a shareholders right to remedies against a company).

Can a digital asset/token by classified as a debenture?

When considering whether a particular digital asset is capable of being classified as a debenture, ASIC will also take into account the various rights attached to those assets and will consider the nature of the transaction to acquire them. If a user lends fiat currency to a DeFi in exchange for a digital asset and there is some form of undertaking to repay that amount once the digital asset is redeemed, that the digital asset may be classified as a debenture.

A clearer future

The Australian Senate Select Committee recently released its final report, detailing recommendations for the Australian Government to conduct a token mapping exercise to determine the best way to characterise various types of digital asset tokens in Australia. The Committee heard submissions from a number of persons with respect to bringing classes of crypto-assets directly into the Corporations legalisation and expanding the existing definition of financial product to expressly include digital assets. DeFis may find comfort in the fact that the Committee referred to its recommendation as the “first step” into expressly catering for digital assets as financial products and implementing new licence authorisation classes. On this note, we may see greater certainty regarding the need for an Australian Financial Services License to cover digital assets as these legislative and licencing changes are likely to be implemented in the near future.

For more information on the recommendations made by the Australian Senate Select Committee, see our previous article.

Queries

For more information, please contact an author or any member of our Fintech, Privacy and Emerging Technologies team.

Disclaimer

This information and the contents of this publication, current as at the date of publication, is general in nature to offer assistance to Cornwalls’ clients, prospective clients and stakeholders, and is for reference purposes only. It does not constitute legal or financial advice. If you are concerned about any topic covered, we recommend that you seek your own specific legal and financial advice before taking any action.