This post has been written by Founding Editor Viraj Ananth.


In a recent study conducted at the National University of Singapore Business School, it was found that access to capital is the most significant driving force behind innovation in companies. It is, therefore, no surprise that Initial Coin Offerings (ICOs) continue to grow in popularity among technology start-ups, with total capital raised skyrocketing from $151 million in 2014, 2015 and 2016 cumulatively, to more than $6.8 billion in 2017. Across the Globe, ICOs are gradually getting normalized as a legitimate means of raising capital, with numerous jurisdictions enacting enabling legislations, thereby ensuring a fair balance between consumer protection and innovation considerations. Unfortunately, however, the situation in India is far from that described above.

What is an ICO?

An ICO is a quick means of raising capital, typically used by startups that seek to build decentralized applications. The firm raising an ICO creates a whitepaper detailing the technology underlying the project, the investment needed and the characteristics of the token or coin being offered. ICOs, particularly in India, differ from Initial Public Offerings (IPOs), in that they are significantly less regulated. For example, while an IPO must draft a comprehensive prospectus, which must detail its financial statements and be in consonance with established procedures, listing requirements for ICOs presently do not exist in most countries. This lack of disclosure and listing requirements is what leaves investors exposed to risks such as Ponzi schemes.

ICOs and their Legal Position in India

On April 6, 2018, the Reserve Bank of India (RBI) released an order, according to which, entities regulated by it were prohibited from either dealing in virtual currencies (VCs) or doing business with any entity dealing in VCs. While it is technically still possible for a firm to raise an ICO, backed by a foreign bank account, in India, such an ICO, by virtue of the order, would only be able to accept investments in the form of other virtual currencies and not in Indian rupees, thereby making the process largely futile for any such firm. As a result, most Indian VC start-ups have shifted their base of operations to foreign jurisdictions, such as Singapore, Estonia, Switzerland, and Germany, where regulations are more conducive to their operations.

While the majority of focus and emphasis, subsequent to the order, has been on its impact on the blockchain industry in India and its players, little attention has been paid to the impact on the layman investor/consumer. The consumer, who has invested his hard earned money into these “assets” is naturally an important stakeholder. Although the order allows for a three-month window for reconversion into fiat currency, following the order, prices of prominent VCs have plummeted, to say the least, thereby making the same an unduly unfair deal for the consumer. Further, there exists a significant degree of regulatory ambiguity over the question of whether Indians investing their VCs in ICOs raised in foreign jurisdictions would constitute a violation of the Foreign Exchange Management Act, 1956 (FEMA).

While numerous commentators answer the question in the affirmative, a large number of exchanges, which have now shifted base to foreign jurisdictions, continue to advocate that users would still be able to use their VCs in the foreign country. In the absence of clarification by the Judiciary, this situation is problematic since users would often choose to trust their exchanges, as against the RBI, which has proven its lack of knowledge and informed decision making, on the subject, in the past. As a result, having been left with only one other avenue of abandoning their assets, many users may continue to invest in ICOs raised in foreign jurisdictions, which may leave them less protected, depending on the regulatory regime of the concerned jurisdiction.

The primary driving force behind the knee-jerk response of the RBI has been the increasing number of VC related Ponzi schemes. The Finance Ministry has itself remarked that it is these Ponzi schemes which it seeks to tackle, and not Blockchain technology itself. This post asserts that while the Government’s concerns may be legitimate, the solution lies in the regulation of ICO offerings as securities, as against the imposition of a blanket ban on all such activity. This post further argues in support of the United States’ Howey Test and analyzes how, by virtue of the newly added decentralization element, it is a much more appropriate approach to the regulation of ICO offerings than the recent Swiss and German moves.

The German and Swiss Approach

While few jurisdictions across the globe have made their regulatory set-ups accommodative of ICO offerings, the approaches followed by prominent jurisdictions vary. This post seeks to analyze the approach that should ideally be adopted by the SEBI in India.

Both the German and Swiss Guidelines categorize tokens into three main types: payment, utility, and asset tokens. The Swiss Guidelines also recognize ­pre-sale tokens as a distinct class, classifying them as securities, which is a desirable move as firms often seek to pass off such tokens as utility tokens, despite their “underlying economic function and utility”. Both jurisdictions agree that payment tokens do not constitute securities, while asset tokens do. The German Advisory Note prescribes that utility tokens would not be treated as securities since they lack any intrinsic economic value. The Swiss Guidelines take the utility token test one step further by prescribing that first, the utility token should be capable of being used to access rights to the service at the point of issue itself. Secondly, it clarifies that in case a utility token has any investment purpose at this point of issue, it would be treated as a security.

The German approach also provides for the classification of tokens as asset investments, units of account and derivative contracts, each classification, in turn, evoking distinct obligations under separate legislations. In light of the importance of easing compliance and associated costs for start-ups, and further in light of how start-ups would often need to make their own determinations as to the nature of their tokens, and hence the regulations to follow, this approach would not be desirous.

The primary issue with the approach of pre-classification is that offerings which do not fall squarely within these classes are left in regulatory limbo. Further, such classification appears to prioritize form over substance, despite it being clearly established that in the determination of whether an instrument is a security, substance must always be prioritized over form. Most importantly, since utility tokens are highly fungible, they are often traded on secondary exchanges. This implies that while such tokens may provide access rights at the point of issue, they may very easily be converted into an investment at a later stage, by selling the same in a secondary market. In such cases, such tokens would pass the Swiss utility token test and would not constitute securities, despite the fact that the tokens clearly have an investment purpose and should hence be subjected to securities regulations.

The United States Howey Test and the Recently Added Decentralization Element

In 1946, in the case of SEC v. W.J. Howey Co., the United States Supreme Court developed a four-pronged test to determine whether an instrument would constitute an investment contract and therefore, be subject to securities regulations. Interestingly, the Indian Courts have looked upon this test favorably, as was seen in Sahara India Real Estate v. Securities & Exchange Board of India (SEBI). In order to satisfy the test, and constitute a security, there must be an:

  1. Investment of money,
  2. In a common enterprise,
  3. With an expectation of profits,
  4. Coming solely from the efforts of others.

Earlier this month, the Securities Exchange Commission Director, William Hinman, built upon the Howey test, prescribing that if the network used to disburse tokens is sufficiently decentralized, such tokens would not constitute securities. The importance of this added element lies in the fact that it is perfectly aligned to the objective of securities law: to balance out information asymmetry and eliminate misrepresentations and fraud in securities offerings. From this characterization, there emerge two broad scenarios with respect to the regulation of ICO offerings.

The first is where the network on which the token functions is sufficiently decentralized. Since operational and managerial efforts are distributed across the network, questions of information asymmetry and fraud are cropped out at the first instance itself, for which reason, it is unnecessary to subject such offerings to securities regulations. In such networks, the absence of a central entity playing a key role in the success of the enterprise implies that there no longer exists the material information asymmetry that securities law seeks to counter-balance. There would now no longer exist a single entity whose managerial efforts have been relied upon by investors. Moreover, in the absence of such central entity, questions of fraud and Ponzi schemes are eradicated, making this element particularly relevant in the Indian context, providing the Government with a significant solution to the problem it seeks to remedy, without it needing to resort to an overly restrictive ban.

The second type is where the network is not sufficiently decentralized and there exists a discernable third party/common enterprise upon whom investors rely for the expectation of profits. In such a case, as long as the other prongs of the test are satisfied, the offering would constitute a security. As a result, questions of Ponzi schemes and related risks to investors would all fall within the ambit of securities regulations, as these fears only arise when there is a central entity which has not yet been sufficiently decentralized, upon whom investors rely.

The decentralization element essentially encapsulates the second and third prong of the Howey test, hence simplifying the process by which investors and start-ups are able to make determinations about the nature of tokens offered. This encapsulation also crops out numerous ambiguities that have plagued the US Courts judgements, primary examples of which are the tripartite interpretations of the term ‘common enterprise’, which have resulted in varying standards of satisfying the test.

Moving Forward

Classifying tokens as securities will bring with it numerous disclosure, listing, and other obligations, thereby ensuring that investors are protected from the very risks the Indian Government is concerned with. Listings by ICOs would be governed by the Companies Act, 2013, the Securities Contracts (Regulation) Act, 1956 (SCR), the Securities Contracts (Regulation) Rules, 1957 and the SEBI’s Disclosure and Investor Protection (DIP) guidelines. Additional obligations would include KYC requirements and the establishment of grievance redressal mechanisms.

In India, the definition and therefore, the scope of securities, is limited to the instruments and activities listed in the SCR. As noted in M/s. Integrated Amusement Ltd. v. SEBI, the SCR exclusively accords the Central Government with the power to amend the definition and does not allow for the Courts or the concerned regulator to add or remove instruments from the same. Hence, prior to such a move, it would be essential for the Central Government to widen the scope of securities, as prescribed in the SCR, to include ICO offerings which pass the necessary tests.

In March 2018, the Finance Ministry constituted a Committee on FinTech, two of the primary objectives of which were to promote ease of doing business in India and to develop regulatory interventions that allow for the same. In light of this identified need to provide for an environment of innovation and ease of doing business in India, it may be desirous for the SEBI to follow the approach of the Ontario Securities Commission (OSC). The OSC prescribes staff to first, guide start-ups on the applicability of securities laws to their offerings and secondly, discuss with them steps to facilitate compliance with such laws.


While in agreement with the risks identified, with respect to VCs, this post disagrees with the approach followed by the Indian Government in tackling said risks. This post argues that instead, we must bring ICO offerings within the ambit of our securities regulations, as this simple move will allow us to eliminate Ponzi schemes, and ensure significantly higher standards of investor protection. In regulating these offerings as securities, the approach followed is determinative of not only the degree of compliance, but also the ease with which start-ups are able to identify the nature of their offerings, and consequently the obligations they are subject to.

The implementation of a test in India, similar to the Howey test, with its recently added decentralization element will provide for an investor and start-up friendly regulatory environment, one that prioritizes substance over form and perfectly tackles exactly that which securities law is concerned with. Most importantly, this test will ensure that the SEBI does not overstep and regulate even those entities which are beyond the scope of securities regulations, while at the same time ensuring that investors, who rely on a central entity for profits, are protected. Such an enabling move will allow for the flourishment of the blockchain and VC industry in the nation and allow us to avoid the dreaded “blockchain brain-drain”.