LPs eye the cryptocurrency opportunity, while testing the legal flavour

The Economic Times published my piece on key legal concerns for venture investing in crypto, blockchain and Web3. Read the full version below:

One-third of surveyed limited partners in a new reported study of 110 investors across APAC, North America and Europe, are committed to funds with a cryptocurrency focussed mandate. Of those, 2o per cent are committing to funds that invest using the cryptocurrency itself but over half of the remaining 80% have already taken a policy decision to never do this. Bessemer Venture Partners, Lightspeed, Quinoa Capital, Sequoia and Accel are the VC firms seen to be developing a concrete crypto investment strategy.

Specifically speaking of APAC around 29% of the LPs interviewed have already committed to funds investing in crypto businesses, as of now. Most recent fund manager queries have focussed on protocols;, meaning: Cryptocurrency, NFT exchanges, decentralized finance applications and token issue investments. Funds want to know how aligned these investments are with fund mandates, purpose clauses and on points of core legality. There are also some concerns around tax and regulatory issues potentially arising from such investments.

Cryptocurrency, blockchain and Web3 are an emerging and an unsettled area on the regulatory front. In the absence of lettered “black and white” regulatory framework, the same must be dealt with through categorisation.

To start with the straightforward: for investments in virtual currency or blockchain servicing

companies, the primary risk is of wildly swinging valuations of such investments. Without actually trading in virtual currencies, the securities acquired are not tokenised. Accordingly, legally this should not be an issue.

To broach the denser forest: Can the fund invest by way of token offerings, and can the fund invest directly in cryptocurrency? These queries trigger several issues, including:

1. Would tokenised investment be consistent with the fund mandate?

For example, a fund held out as a consumer centric fund couldn't be seen dabbling in tokens. Else it may face misrepresentation allegations and licensing concerns, on the regulatory front.

A typical fund document generally states that the fund can trade in “securities of every kind and nature and rights and options with respect thereto, including stock, notes, bonds, debentures, partnership interests, interests in limited liability companies and evidence of indebtedness”. If tokens and cryptocurrencies are securities, they are covered under that language. However, a view may be taken that tokens and cryptocurrencies would not fall within the ambit of securities and accordingly, such funds would be restricted from investment in tokens and cryptocurrencies.

This can of course be addressed by expanding the definition of permissible investments to

include “investments in cryptocurrencies, decentralized application tokens and protocol tokens, blockchain-based assets and other cryptofinance and digital assets, or instruments for the purchase of such, whether issued in a private or public transaction”.

2. The core legality of tokenised investment?

The treatment of cryptocurrency whether as an asset or as a legal tender is still a grey area

across the globe. While smaller countries such as El Salvador and Central African Republic have recognised cryptocurrency as a legal tender, most jurisdictions have classified cryptocurrency as property and imposed taxes accordingly. These jurisdictions include the United States, United Kingdom, Japan, Australia, Singapore, China and now India.

India recognizes cryptocurrency as an asset for the purposes of tax, however, it does not have any specific legislation regulating cryptocurrency. Whilst the Indian Legislature sought to enact the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021, the same is currently pending introduction before the Parliament. As for taxation purposes, the new Finance Bill, 2022 imposes a flat capital gains tax rate of 30% (irrespective of whether long term or short term) on such assets. Further, such capital gains will be determined on the basis of the cost of acquisition will be considered for sale without any deductions. Any losses arising from the transfer of virtual digital assets cannot be set off against any other income (salary, business or capital gains) and such loss cannot be carried forward to subsequent years. Further, payment of transfer consideration through virtual digital assets would be subject to a withholding tax of 1% of the value of such asset which would be applicable on payment to a resident subject to the conditionalities under Section 194S of the Income Tax Act, 1961.

The intention of the Reserve Bank of India (“RBI”) is to keep the economy in check, and it

therefore veers torward a prohibitive stance on crypto. It last issued notification dated 31 May 2021 noting that regulated entities may deal in virtual currency subject to compliance with Know Your Customer (KYC), Anti-Money Laundering (AML), Combating of Financing of Terrorism (CFT) regulations.

At the individual level large private and foreign banks have been keeping a tight watch on crypto- investing by making offshore remittances are subject to undertakings that the investment is not in crypto assets. At the individual level the investment in crypto is happening through the overseas direct investment (ODI) route instead of the Liberalised Remittance Scheme (LRS) under which individuals can freely remit up to $250,000 per financial year  for any permissible current or capital account transaction or a combination of both.

3. Whether an instance of direct crypto investing is seen as commodity trading?

If direct crypto investing is considered as commodity trading, the manager and the fund would be subject to regulatory oversight and the implications of the same would need to be analysed including whether a regulator may consider direct crypto investing as a trade / business; and where applicable to a particular fund, whether this leads to operation and mismanagement issues?

4. Potential reputational issues?

Navigation of client relationships in such a volatile sector is a task especially when today’s

cutting edge undertakings can turn into tomorrow’s invalidated investments through courts or regulators. Direct cryptocurrency investing feels much more like speculation as opposed to a sector where a fund can provide its expertise to benefit the investee entity. Additionally, whilst embedding confidential information, like customer data and trade secrets on a block chain can create efficiencies, it could also lead to a new set of risks.

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