Ritvij Ratn Tiwari

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SEBI has implemented ICDR Regulations to protect investors’ interests in Initial Public Offerings (IPOs). However, there is currently no safety net for investors in Initial Coin Offerings (ICOs) due to Indian Securities Law not being tailored for virtual digital assets. This poses a significant risk for investors in ICOs. This article highlights the dangers of ICOs and emphasizes the necessity for regulatory and judicial actions to address the issue

Introduction

An initial public offering (‘IPO’) is the process by which a private company raises capital by issuance of securities for the first time. The Companies Act 2013 (‘Companies Act’) calls it issuance through the prospectus. Very similar is the idea of an initial coin offering (‘ICO’). ICO is a method of raising capital for new or existing projects, typically using cryptocurrencies such as Bitcoin or Ethereum. Unlike an IPO where stocks are sold, in an ICO, a certain number of tokens or coins are traded to early supporters of a project in exchange for various forms of currency (e.g. fiat currency or cryptocurrency). These tokens or coins represent a stake in the project and can be traded on cryptocurrency exchanges. The proceeds from the ICO are typically used to fund the development and growth of the project. ICOs are often used to launch new cryptocurrencies.

While IPOs are heavily regulated in India, ICOs go entirely unregulated. This raises a concern relating to investor safety. In this piece, I shed light on the total lack of  regulatory framework for ICOs. I discuss this as a serious repercussion of not deeming digital assets as securities under the Securities Contract (Regulation) Act of 1956 and the consequent inability of the Security and Exchange Board of India (‘SEBI’) to regulate the process of an Initial Coin Offering (‘ICO’) and protect the interests of the investors.

To this end, I highlight the conventional safety checks available for an initial public offering. Thenceforth, I shed light on the non-inclusion of cryptocurrency in the definition of securities and the absence of a workable standard in India. Finally, I conclude with the suggestion of a resilient statute. 

Framework for Initial Public Offerings (‘IPOs)

When it comes to public offerings, section 24 of the Companies Act empowers the Security and Exchange Board of India (‘SEBI’) as the governing authority. Moreover, section 30 of the Companies Act talks about the advertisement of the prospectus. To this end, SEBI has issued the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘ICDR’). The ICDR regulations cover various aspects of an IPO such as the eligibility criteria for issuing securities, the disclosure requirements for issuers, the rights of security holders, and the process for issuing securities. The main objective of the ICDR Regulations is to ensure the protection of investors’ interests, promote transparency and fairness in the securities issuance process, and enhance the efficiency of the capital market. ICDR sets a high standard for a company to go public and indulge itself in the process of an IPO. The absence of ICDR regulations raises concerns of investor safety. It is apparent that companies not involved in the cryptocurrency business have also started raising money through this route. Thus, it is important that there be some regulation.

The Barrier of Absence of a Litmus for Securities in India

Section 23 of the Companies Act specifically deals with the issuance of securities through a public offer.  It states that “a public company may issue securities….” This implies that only a public offer of securities falls under the jurisdiction of the Securities and Exchange Board of India (SEBI). Therefore, the applicability of ICDR depends on whether cryptocurrencies are considered securities or not.

Notably, the U.S. employs the Howey test to ascertain if an investment is a security. The Howey test is a four-part test used by the Securities and Exchange Commission (‘SEC’) to determine whether a transaction involves the offer and sale of a security, such as a stock or bond. The test was established in the 1946 case of SEC v. W. J. Howey Co. Per the test, a transaction qualifies as an investment contract and, thus, a security if it is: (1) an investment; (2) in a common enterprise; (3) with a reasonable expectation of profits; and (4) to be derived from the entrepreneurial or managerial efforts of others. It will be noted that, in analysing whether something is a security, form is disregarded for substance, and the emphasis instead is on the economic realities underlying a transaction, and not on the name appended thereto.

Many jurisdictions have adopted the Howey test. India does not have a test like Howey and courts still have to rely on the definition of securities under the Securities Contract (Regulation) Act 1956 (‘SCRA’). Interestingly, a plethora of Indian literature on the subject has misinterpreted the judgement of the Allahabad High Court in the case of Paramount Bio-Tech Industries v. Union Of India and has arrived at the wrong conclusion of importing the Howey standard to India. 

Unfortunately, for now, India only has the standard of Section 2(h) of the SCRA that defines securities. S 2(h) states that securities include “shares, scrips stocks, bonds, debentures, debenture stock or other marketable securities of a like nature.” The only way to read crypto assets as securities is by deeming them as “other marketable securities.” One can argue on semantics that coins or tokens issued in an ICO are easily marketable, and thus these issued crypto-coins should be deemed as securities. However, it is pertinent to honour the idea of the statute and read the proper meaning of the term “other marketable securities of a like nature” ejusdem generis with shares, stocks, bonds and debentures. Reading it thus, i.e., in the broader context of Section 2(h) and also in keeping with the scheme of the Companies Act as a whole, rather than in isolation would lead us to the conclusion that it is too stretched to read crypto-assets as security. This is because crypto assets are built on software and by mining, which involves solving complex mathematical problems and are, to that extent, fundamentally different from traditional securities. Moreover, digital assets have distinctive qualities not present in conventional securities, such the capacity to be held in digital wallets and the application of blockchain technology to assure the transparency and immutability of transactions. Finally, they are decentralised unlike conventional forms of securities. They run on a peer-to-peer network, therefore eliminating the need for intermediaries because transactions are carried out directly between parties. The decentralised nature of digital assets distinguishes them from traditional securities, which are often issued by centralised organisations like governments, or financial institutions. 

Need for Regulatory and Judicial intervention, and a Resilient Statute. 

The Indian context is filled with cases that depict that investors are always at risk.  Most infamous perhaps was the case of Sahara, where investment bonds were sold as savings instruments. Millions of people are still embroiled in a legal battle to regain their investments. ICO scams are no rarity. They are used frequently to defraud investors who are especially eager to ride the crypto wave. Scammers use fancy whitepapers and professional-looking websites to lure investors into subscribing to ICOs. SEC and Commodity Futures Trading Commission (‘CFTC’) in numerous cases have called out scam ICOs. China and South Korea have banned raising money through ICOs altogether. Although a similar crackdown is not suggested for the Indian context, some level of regulation is required.

To prevent situations like these, it is expected that the Indian regulators and the courts import a test to assess if a token is a security and should therefore be regulated or not. This could be done by creating a judicial standard to assess if the token in question resembles a security or not. To this end, courts can look at the nature of the token i.e, whether it is a security or utility token. A security token represents an ownership stake in a company whereas a utility token is used to create an internal economy of the issuing company by granting holders special access to products or features. Now, a token resembling a security could be regulated and a token for a utility related to the issuing company could be left unregulated. The regulatory bodies and the courts can take inspiration from the USA. A simple analysis of SEC and CFTC guidelines and enforcement actions shows that these bodies have intervened not only at a policy level but have even dealt with individual cases. For instance, the SEC ordered an ICO rating platform to cease and desist. It has frequently asked investors to be wary of celebrity promoted ICOs and the risks associated with them. 

The fact that instruments like crypto-assets do not strictly fall under the mentioned categories of securities under section 2(h) raises a deeper concern. This concern is of the continuous challenge that newer technologies are creating for the current conceptions of law. The legislature needs to work on a resilient statute that envisions not just conventional form of securities but newer constructs as well. It is clear that Section 2(h) does not create a dynamic standard, unlike the Howey test. An additional change needs to be made to ICDR regulations to screen ICOs differently from IPOs as well.  

Conclusion

ICOs are largely unregulated and carry a high degree of risk for investors, so it is important to exercise caution and thoroughly research any potential investment before participating. However, the safety check of ICDR regulations is completely missing in ICOs. SEBI plays a crucial role in protecting the interests of investors in the Indian capital market. SEBI’s role in regulating and supervising the Indian capital market helps to promote investor confidence and protection and contributes to the growth and stability of the market. When it comes to investor protection, the Supreme Court has time and again expanded the mandate of SEBI. For instance, in the case of SEBI v. Pan Asia Advisors, the court upheld the extra-territorial jurisdiction of SEBI as long as it protects the interest of Indian investors. Until lawmakers come up with a concrete amendment to the statute, the judiciary should evolve a standard and involve the SEBI at all stages of an ICO to protect investor interests.

The author is an undergraduate student at NLSIU, Bangalore and Editor, LSPR.