Traditional capital investments under the German Capital Investment Act (Vermögensanlagengesetz - VermAnlG) are not usually considered securities within the meaning of the German Securities Prospectus Act (Wertpapierprospektgesetz - WpPG) or the German Securities Trading Act (Wertpapierhandelsgesetz - WpHG).¹ This is because they cannot be compared with securities in terms of transferability, standardisation or negotiability (on the capital market). However, this is changing due to blockchain technology (see info box and BaFinPerspectives 1/2018). As a result of these changes, the two different financial instruments may even merge together.

This can be explained as follows: if a financial instrument, the content of which is structured or described as a capital investment under section 1 (2) of the VermAnlG, is converted into a freely transferable and negotiable digital token (see info box), then this financial instrument is not a capital investment within the meaning of the VermAnlG, but a security within the meaning of the WpPG and WpHG. This is at least the case if rights are attached to the financial instrument that are similar to shares or membership rights or a property right of a contractual nature and if the financial instrument is freely transferable.

Tokens as a separate class of securities

Tokens of this type represent a security class of their own (sui generis) because they have been converted into investments which can be traded on the financial market by tokenisation (see info box), and they must therefore be classified as securities. The “substance over form” approach, which was developed by the European Securities and Markets Authority (ESMA), further clarifies this. According to this approach, the material components, rather than the formal name of a financial instrument, are always the decisive factors.

This administrative practice applies in particular to shares which grant participation in the profits of a company or which constitute participation rights and registered bonds. These instruments were previously covered by the VermAnlG and not by the WpPG, as they were not negotiable on the financial markets. If they are not converted into freely transferable digital tokens that can be negotiated on the financial markets, they remain classified as a capital investment within the meaning of the VermAnlG.

Criteria for classification as a security

The general rule for classification of a financial instrument as a security within the meaning of section 2 no. 1 WpPG is that it be transferable, negotiable on the financial market and encompasses rights comparable to securities. A securitisation in the form of a certificate, which ensures the marketability of financial instruments in the case of traditional securities, is not required for a token to be classified as a security.

The term “securities” is to be interpreted uniformly due to the desired EU-wide supervisory convergence; both the WpHG and the WpPG use the term „securities“ as defined by the second European Financial Markets Directive (Markets in Financial Instruments Directive II - MiFID II ), thus transposing this legal definition into national law (Article 4(1) no. 44 of the MiFID II). If rights comparable to those associated with securities are attached to a token, then the token facilitates increased marketability through simplified transferability and greater negotiability (but without necessarily being a certificate in the legal sense).

Transferability

In technical terms, token transferability requires that the token can be transferred to other users. For a security to be transferable in terms of its class it is also required that the legal content or technical nature of the security remains unchanged when it is transferred to another acquirer. This is generally not a problem for common token standards.

Negotiability

The deciding factor for negotiability on the financial markets is that a token is sufficiently standardised and homogenously designed. The type of transfer is not relevant to the “negotiability” criterion. The rights attached to the token must remain the same and must be identifiable in transactions by type and quantity. A standard such as the legal protection of good faith (Gutglaubensschutz) (see info box) is not necessary for the assumption of the status of a security – at least for the supervisory concept of negotiability on which the WpPG and WpHG are based. Crypto trading platforms are also considered financial markets as regards the term “securities”, since the term “financial market” is to be interpreted broadly in accordance with European law.

The key issues are the rights associated with the tokens, which must be membership and/or property rights in accordance with the WpHG and MiFID II. This means that a token must either embody a membership right similar to a share or another property right comparable to the examples of transferable securities (e.g. debt securities) set out in section 2 of the WpPG.

It is important to note at this point that BaFin's assessment only refers to the security status in the supervisory sense in accordance with the provisions of the WpPG and other relevant supervisory legislation. It is the issuer's own responsibility to comply with any legal requirements that may arise along the value, transfer and negotiating chain for the relevant security. This includes safe custody in accordance with the German Safe Custody Act (Depotgesetz - DepotG) as well as clearing and settlement under the European Central Securities Depositories Regulation (CSDR).

First securities prospectus approved for security token

The legal paradigm shift described above is already having an effect on operational supervision. At the beginning of 2019, BaFin approved the first securities prospectus for a security token offering in Germany. The underlying instrument was originally designed as a registered bond, i.e. a capital investment, and would have been subject to the VermAnlG. However, the transfer to the blockchain significantly increased its negotiability on the financial market. The capital investment tokenised in this way had to be classified as a sui generis security and assessed in accordance with the WpPG. The issuer therefore was not required to prepare a prospectus in accordance with the VermAnlG, but rather a securities prospectus in accordance with the WpPG. Securities prospectuses for other security token offerings are still under review.

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