After the Federal Ministry of Justice and Consumer Protection and the Federal Ministry of Finance announced the introduction of electronic securities with the “Key-issues paper on the regulatory treatment of electronic securities and crypto-tokens – Allowing for digital innovation, ensuring investor protection” on 7 March 2019, the two ministries have jointly published the draft law on the introduction of electronic securities (“eWpG-RefE”) on 11 August 2020. The aim of the law is to enable the dematerialisation of securities while maintaining relevant investor protection requirements, and to create the necessary legal certainty and application safety under German civil and supervisory law.
In recent years, digitization and innovative technologies such as blockchain have increasingly impacted the financial markets. In line with this development, it was already set in the coalition agreement of the Federal Government from 12 March 2018 that the potential of the blockchain technology shall be developed, possibilities for market abuse shall be prevented and in particular the role of the Federal Republic of Germany as one of the world’s leading digitalization and Fintech locations should be strengthened. Given that other countries also allow the use of the blockchain technology in relation to financial instruments, the eWpG-RefE is set to secure the attractiveness of Germany as financial location.
The necessity for this draft law also arises from the need for removal of potential obstacles to the use of new technologies in capital market transactions. Under current German law, securities must be represented by physical certificates, mostly global certificates, in paper form. Global certificates are regularly deposited with the Central Securities Depositary (“CSD“), with respect to which the security holders acquire co-ownership interest. Given the fact that in Germany already for some years these certificates are no longer being circulated in physical form and that the transfer of securities is carried out through electronic systems, a legislative reform was necessary to bring the legal framework in line with the digital reality in German financial markets.
2. Scope of the draft law and its impact
In the following, the regulatory scope and the most important impacts of the eWpG-RefE will be outlined.
2.1 Electronic bearer debt instruments
The core element of the draft law is the opening of German law to electronic securities. With the paperless electronic form of issuance, the currently mandatory embodiment of securities by certificate will be abandoned. However, the draft law only refers to the opening for electronic bearer debt instruments; the opening for other securities such as shares or investment fund units has been postponed.
Further, the draft law only provides the possibility, but not the obligation to issue in electronic form. Since the current system of securities certificates works without any significant problems and very effectively, issuers should be allowed to continue using the proven system of securities certificates. This option is merely an extension of the available forms of issuance and not an extension of the numerus clausus of the securities.
2.2 The register
Similar to the concept used by the Federal Debt Management Act (Bundesschuldenwesengesetz, BSchWG), electronic securities are to be issued via an entry into electronic securities register. The draft law specifies two types of registers in which electronic securities can be issued: The central register of electronic securities (zentrales Register über elektronische Wertpapiere) and the crypto securities register (Kryptowertpapierregister). It should be emphasised that the entry in the respective register will replace the securities certificate, but will not change the legal nature of the security itself.
a) The central register of electronic securities
The central register of electronic securities should be maintained by an authorised CSD. The draft law stipulates certain minimum requirements on information to be included in the register, such as total issue volume and nominal amount (Section 13 eWpG-RefE), and limits the possibilities to amend this information (Section 14 eWpG-RefE). The details of the register management as well as technical requirements are to be defined by statutory regulation, which can be adapted more quickly to technical developments.
b) The crypto securities register
Electronic securities created via an entry into a crypto securities register are defined as crypto securities. Aforesaid crypto securities register, whose administration will be subject to mandatory licensing (see under 3 below), must be maintained on a decentralised forgery-proof recording system in which data is to be recorded in the time sequence and stored in a manner protected against unauthorised removal and subsequent modification (Section 16 eWpG-RefE). Despite the fact that described organization of the crypto securities register contains the key features of the Distributed Ledger Technology (“DLT“), the legislator has clarified that requirements on the organisation of crypto securities register are stipulated in a technologically neutral manner; therefore, a limitation to DLT is not intended.
Pursuant to Section 3 (1) eWpG-RefE, the ownership of crypto securities must be recorded in the register, so that the person in whose name crypto securities or a certain percentage of the total issue is entered in the crypto securities register is to be considered as the owner of crypto securities. Accordingly, a deemed owner of legal title (Rechtsscheinträger) in the securities allows for an acquisition of such securities in good faith (gutgläubiger Erwerb). Due to the mentioned immutability of data in decentralised recording systems, the ownership must be recorded solely in pseudonymised form for data protection reasons.
2.3 Harmonisation with German property law
Also based on the BSchuWG, electronic securities are deemed to be moveables (Sachen) within the meaning of Section 90 of the German Civil Code (Bürgerliches Gesetzbuch) by virtue of legal fiction according to Section 2 (3) eWpG-RefE. By that, all regulations on the protection of the property ownership will automatically apply in full and will provide the owners of electronic securities with the comprehensive protection in the same way as the owners of certified securities. As part of the issuance agreement, the issuance of electronic securities also requires the transfer of ownership on the security from the issuer to the first owner. This in turn requires, among other things, the transfer of direct ownership.
Furthermore, the draft law provides special provisions for dispositions, including the transfer of ownership (Section 24 eWpG-RefE) and, in particular, acquisition in good faith (Section 26 eWpG-RefE), as it is necessary to take into account the special features of electronic securities by individual registration (Einzeleintragung). For collective registration, this is done in accordance with Section 6 (2) BSchuWG by equating registration with a collective security holding.
The legislator emphasised that no decision has been made on the question of whether electronic securities should be declared as a new sui generis right under property law. Rather, this decision is reserved for a comprehensive reform of German securities and depository legislation.
2.4 Obligations of the issuer and extraordinary termination right of crypto securities
Pursuant to Section 21 eWpG-RefE, issuers of crypto securities are obliged to take appropriate technical and organisational measures to ensure the necessary integrity and authenticity of the crypto securities issued throughout their entire registration period. Given that bearer debt instruments are quite often issued via special purpose vehicles (“SPVs“), it remains questionable how the issuers will meet the new requirements in such cases. It should be noted that many SPVs will most likely not dispose over sufficient technical and organisational resources for this purpose and that, in practice, other companies are and will remain involved in the issuance and sale of securities. In addition, holders of bearer securities issued in the form of crypto securities should benefit from a statutory right to extraordinary termination where the issuer does not manage to restore the functionality of the crypto securities register within the time frame set by the security holder (Section 30 eWpG-RefE). The obligation imposed on the issuers of crypto securities is insofar remarkable as the respective issuer of crypto securities and the company operating the crypto securities register are not necessarily the same person and may not even be part of the same group. Therefore, it seems questionable whether the issuer can take the necessary precautions to eliminate the malfunctions of the crypto securities register, which may not be operated directly by it.
2.5 Impacts on issuances; change of the form of issuance
The draft law on the eWpG also regulates the relationship of electronically issued securities to securities certificates. As it was already customary in the past for securities issued by means of a global certificate, there is no entitlement to the delivery of individual securities certificates pursuant to Section 6 (1) eWpG-RefE. While the conversion of electronic securities into securities issued by means of a physical certificate is only allowed with the consent of the beneficiary (Section 6 para. 2 eWpG-RefE), the conversion of collectively deposited securities into a collective entry in the central electronic securities register shall be possible at any time without the consent of the beneficiary, unless otherwise agreed (Section 6 (3) eWpG-RefE). In this respect, the legislator privileges the form of electronic securities. However, an exception applies with respect to change to form of crypto security. Since the technology associated with the crypto securities register is new and may involve certain risks, it may only be used if the use is also desired by the securities beneficiary.
2.6 Transitional provision
Pursuant to Section 33 eWpG-RefE, issuers of certificated debt securities in collective safe custody issued prior to the coming into force of the new law shall have the option of converting them into electronic securities by entering them in the securities register.
2.7 Governing law
Pursuant to Section 32 eWpG-RefE, the law of the state under whose supervision the body maintaining the securities register in which the electronic security is registered will apply. This rule is consistent with Section 17a of the German Custody Act (Depotgesetz) and results from the fact that the determination of the applicable law according to the location (ius situs) of the moveable asset (i.e. the securities certificate) is not possible in the case of electronic securities and that the securities register is difficult to locate in the case of electronic register maintenance.
3. Licensing requirements with regards to the administration of electronic register and safekeeping of cryptographic keys
For the purposes of investor protection, market integrity and transaction security, the administration of a crypto securities register is defined as financial service within the meaning of Section 1 (1a) of the German Banking Act (KWG). Future administrators of crypto security registers will be supervised by the German Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht) and will be subject to numerous regulatory requirements, that among others require an initial capital in the amount of EUR 730,000 as well as general organizational and reporting obligations that apply to financial institutions. Furthermore, the administrators of crypto securities registers are to be regarded as obliged entities within the meaning of Section 2 (1) of the Money Laundering Act (Geldwäschegesetz), which are also subject to corresponding regulations on prevention of money laundering.
The custody of crypto securities, which is part of the custody business in the same way as custody and administration of securitised securities, should not be confused with the crypto custody business within the meaning of Section 1 (1a) sentence 2 no. 6 KWG. The proposed extension of the scope of crypto custody business only refers to the safekeeping of cryptographic keys. Given that custody of crypto securities also includes the safekeeping of related cryptographic keys, according to the intention of the legislator no additional license, other than the license for the custody business, shall be required for the separate safeguarding of such cryptographic keys.
4. Impacts on the German Securities Prospectus Act
Article 3 of the draft law provides for an amendment of the German Securities Prospectus Act (Wertpapierprospektgesetz, “WpPG“), which applies to electronic securities within the meaning of the eWpG-RefE provided that they are in the scope of WpPG. As a result of the fact that the regulatory definition of security is wider than the term security as defined under civil law as used by the eWpG-RefE also so-called securities tokens, which are neither securitized nor considered to be electronic securities within the meaning of the eWpG-RefE are in scope of the additional provisions. Accordingly, Section 4 (3a) eWpG-RefE extends the catalogue of minimum information in a securities information sheet for the issuing of uncertificated and digital securities to include specific information on the technical form of the security, the technologies underlying the security as well information with respect to transferability and tradability of the security. This extension is necessary due to the digitisation or so-called “tokenisation” of securities in order to ensure greater transparency for potential investors and to increase overall investor protection.
5. Impacts on the Pfandbrief Act
Covered bonds within the meaning of the Pfandbrief Act (Pfandbriefgesetz) are generally covered by the new definition of electronic securities. Therefore, new covered bonds can also be issued electronically and already existing Pfandbrief issuances can be converted to electronic form. Nonetheless, in such cases, the certification of the trustee on the Pfandbrief as provided in Section 8 (3) Pfandbrief Act would no longer be possible, since the securities issued no longer have a physical representation in the form of a global certificate. Against this background, the eWpG-RefE will require further adjustments in order to ensure that the new regime on electronic securities is fully applicable to covered bonds under the Pfandbrief Act.
It is welcomed that the German legislator has now also taken the initiative to enable the issuance of securities under German law in a way that is open to technology and to improve the position of Germany as a financial centre in digital context. In view of the expected effort and expenses involved in setting up the infrastructure and converting existing processes, it seems understandable to initially restrict the scope of application of this law to bearer debt instruments. The legislator leaves it open as to whether it will propose a more comprehensive reform in the future, which will also include the law on securities custody. Other countries such as Switzerland have already been relying on book-entry securities for some time. Although a comprehensive reform could offer advantages from a legal point of view, as the current complex justification for the transfer of ownership of bearer securities could be simplified, the legislator would be well-advised to reform securities law step by step and to wait and see what experience is gained with electronic securities.