Need for electronic securities to strengthen Germany as a financial centre
In practice, there is a need to arrange for corporate financings also through electronic securities, in particular by using blockchains. However, German securities law still prevents this, since it still requires paper certificates to be issued in order for a security to be issued, which in the case of capital market transactions usually takes the form of a global certificate that is deposited with a central securities depository (in Germany, Clearstream Banking AG) and in which the security holders hold co-ownership interests. In the case of global certificates, it has already long been the case that no physical transfer of the certificate takes place anymore, but only a book-entry transfer by means of an electronic system (Effektengiro). Also, for this reason it is necessary to adapt the legal requirements to reality. Furthermore, since other countries had already regulated the electronic issue of securities – including blockchain securities – the German government saw the danger that the attractiveness of Germany as a financial centre could be diminished if there was no reaction to this.
The solution proposed in the draft law aims to accommodate both consumer protection and the simultaneously required functionality of the financial markets by ensuring integrity and transparency in the creation and transfer of electronic securities. The draft law thereby attempts to make the advantages of electronic securities possible without major adjustment costs for the financial industry.
The new provisions aim to fit into the existing system of civil and supervisory law. They are based on those of the German Federal Debt Management Act (Bundesschuldenwesengesetz – BSchuWG). This stipulates that bonds from the German government are issued as dematerialised securities by registration in the federal debt register and that the securities are treated as physical movables (Sachen). In addition, the ministerial draft makes adjustments to the German Securities Prospectus Act (Wertpapierprospektgesetz - WpPG) and the German Securities Deposit Act (Depotgesetz) in order to ensure that electronic securities are kept in sync with paper securities.
Core of the draft law: Register entry instead of paper certificate
According to the draft, an electronic security is conceived as an additional option for issuing a security besides the written confirmation in a physical certificate, which was previously the only possible option. Paper certificates and electronic securities will thus exist in parallel. The abolition of paper certificates is not linked to the reform, so bonds can still be issued as paper certificates.
How is the electronic security created?
Instead of producing a paper certificate as part of the creation of the (physical) document, the electronic security is recorded in a centrally managed register for electronic securities. Paper-based and electronic securities differ only in their form of issue. However, both securities are created in the same way if two steps have been carried out, i.e. on the one hand an agreement between issuer and holder (usually in a so-called issuance contract) on the creation of the securitized claim has been reached and on the other hand the so-called scripture act has been carried out, i.e. the issuance of the paper certificate or the entry in the securities register.
In the case of electronic securities – unlike existing registers maintained by government bodies – the register is maintained by an authorised central securities depository (for example, Clearstream), which is supervised by BaFin (the German Federal Financial Supervisory Authority, Bundesanstalt für Finanzdienstleistungsaufsicht) in order to establish legal certainty.
Introduction of decentrally deposited crypto securities
"Crypto securities", also known as security tokens, are to be created as a special type of electronic securities. Their design is expressly technology-neutral so that they can adapt to further technical developments and so that they do not favour bonds issued via blockchain over other electronic forms of issue. This should considerably improve the possibilities of also issuing securities on decentralised blockchains as a subset of distributed ledger technologies in the future.
Crypto securities are recorded in a crypto securities register. Unlike the securities register, which is maintained at the central securities depository Clearstream, this is maintained decentrally in a tamper-proof recording system. The data are logged in their chronological sequence and stored protected against unauthorised deletion and subsequent modification. This should prevent manipulations, since each data modification can be tracked externally.
In order to accommodate the decentralised approach of crypto securities and crypto securities registers, issuers themselves can act as the body maintaining the registers in addition to the instructed service providers; the previously necessary complex depositing by a central securities depository is no longer required for crypto securities, although this should also be possible. According to the draft, maintaining a crypto securities register should (in addition to the crypto custody business - Kryptoverwahrgeschäft) become a financial service subject to authorisation under the German Banking Act (Kreditwesengesetz – KWG), although there should be various simplifications in the requirements under the German Banking Act. Even if the issuer himself/herself maintains the crypto security register, he/she might need permission for this. In any case, however, the issuer must publish the registration of a crypto security in the Federal Gazette (Bundesanzeiger) without delay and inform BaFin accordingly. In addition, an extract from the register will be sent to consumers as holders at regular intervals by the registrar.
For both electronic securities and crypto securities, the terms and conditions of issue from which the content of the right of the holders is derived must be recorded before the entry is made in the register. This means that the issuer must make the terms and conditions of issue available to the public at the registrar in a permanent electronic form and with the possibility of direct access to the information that can be repeated at will.
Conversion of a paper security into an electronic security possible
The draft act also explicitly addresses the relationship of electronic securities to securities certificates.
While the replacement of an electronic security by a paper-based security with the same content requires the consent of the owner or express permission in the terms of issue and subsequent deletion from the register, a security issued in collective custody may be replaced by an electronic security with the same content at any time and without the consent of the owners. The only condition is that this is neither excluded in the terms of issue nor made dependent on the consent of the owners.
For paper securities that have already been issued, the change of their scripture, i.e. the way in which the security is issued, into an electronic security is therefore quite possible for the simple reason that their terms of issue understandably do not (cannot) make any statements about a later conversion into electronic securities. However, the replacement of a certificate-based security with a crypto security is only possible with the express consent of the owners. The consent requirement derives from the changed risk structure resulting from the use of the new technology used for the crypto securities register.
How is ownership in the electronic security transferred?
In the case of securities confirmed in writing, the certificate is the starting point for the transfer of ownership under property law, after which the change of ownership of the certificate takes place. In addition to an agreement on the change of ownership, this also requires the handover of the certificate. In order to achieve a synchronisation of paper-based and electronic securities, electronic securities are treated as a physical moveable ("Sache") under civil law according to the concept of the ministerial draft (so-called "fiction"). As a result, the acquirers and holders of securities receive property protection comparable to that of physical securities certificates under the German property law. For the transfer of ownership of an electronic security, the draft provides for the creation of a separate element of transfer of ownership supplementing the civil law provisions of the German Civil Code (Bürgerliches Gesetzbuch – BGB). According to this, the ownership is transferred cumulatively through
- agreement that the right to the security should pass over, and
- the transferral of entry, meaning the deregistration of the holder of an electronic security and the entry of the acquirer as the new holder in the securities register. The transfer must be made on the instruction of the previous holder.
The principle generally applying to bearer securities under German law that when handing over the bearer instrument to the purchaser, the right evidenced by this instrument is automatically transferred to that purchaser, is thus also applicable to electronic securities.
Extensive good faith protection facilitates fast circulation
At the same time, the marketability of electronic securities is increased by the fact that entry in the securities register ensures extensive protection of the acquisition of ownership in good faith. The acquirer of an electronic security should also be able to rely on his/her ownership if he/she has been entered in the register, even if he/she has acquired the security from someone who does not hold title in the security, for example. For this purpose, the draft makes use of a whole series of fictions which, in contrast to the general provisions of civil law, are not linked to the seller's position as owner, but to the power of the seller or someone acting on his/her behalf to obtain a legal registration. In addition to the assumed completeness and correctness of the securities register, third parties acting as representatives will be deemed to be authorised and the seller or representative will be deemed to have legal capacity. The background for these far-reaching fictions is to ensure fast and legally secure securities trading. Moreover, this is the only way to make it work, since a comprehensive examination of restrictions on disposal or authorisations that do not arise from the register is not appropriate and would considerably delay trade.
Supervision of the registers
The draft also aims to create clarity with regard to supervisory law. As a supervisory authority, BaFin is to supervise the provision of the issue and the maintenance of central and decentralised securities registers as new financial services under the Electronic Securities Act, the German Banking Act and the Central Securities Depositories Regulation (Zentralverwahrer-Verordnung). It must be taken into account that the depositing and administration of electronic securities – in contrast to maintaining the register – as well as the depositing and administration of securities confirmed in writing are subject to the custody business.
In addition, BaFin independently maintains a public list on the Internet for the crypto security registers notified to it, containing information on issuers, the registrar and the entry in the register as well as any changes affecting them, including their contents.
Draft is a step in the right direction
The draft law for the introduction of Electronic Securities, which was already expected last year following the key issues paper of 7 March 2019, and the German government's blockchain strategy, has already attracted widespread attention and was mostly positively received.
For the block chain community in particular, the draft is a real step forward, as they will benefit from the planned change in the law by putting crypto papers on an equal basis with (other) electronic securities. In any case, the draft heralds a new era in German securities law that will strengthen Germany's position as a competitive location for new digital financial products. The draft does not come too early, however, because similar legislative projects have already been planned or implemented at both European and national level.
Overall, the draft act is successful and thoroughly drafted, even if there are still a few inconsistencies and a need for clarification in some areas, which should be cleared up in the further procedure. For example, it is not yet entirely clear what happens in the event of the insolvency of the registrar and what actual role in the case of decentrally stored crypto securities is to be played by a body maintaining the register apart from serving as the standard addressee for the planned provisions. At first glance, the approach of a central registration responsibility seems to contradict the approach of a decentralised recording (ledger) system. The legal fiction of the authorisation of a representative to attain a strong good faith protection is also not to be viewed completely without criticism.
Comments on the ministerial draft are still possible until 14 September. The German government plans to pass the law this year. While this is desirable, the timeframe is also ambitious.