Governments worldwide are struggling to keep up with the regulatory challenges surrounding blockchain technology and cryptocurrencies.
Initial Coin Offerings or token generation events (ICOs) leverage blockchain technology as an innovative means of raising funds for various types of projects via investors online. Investors use cryptocurrency to purchase digital “coins” or “tokens” from the issuer. Throughout the world, the regulation of this form of fundraising is in its early stages and fundamentally uncertain, with the result that entities wishing to engage in this early stage funding mechanism are doing so in what must be regarded as a grey market.
ASIC has recently released guidelines about the application of existing regulations, specifically the Corporations Act 2001 (Cth) to ICOs. This will inform the drafting of “white papers” and investment documents for ICOs and determining the scope of obligations and liabilities under the general law and more specifically, the Corporations Act.
To read more about ICOs generally, please refer to our previous article.
An opportunity for Australia
This new form of funding presents a once in a generation opportunity for Australia to build an innovative industry around a sustainable and proven technology that has a real world application. An ICO is fundamentally different from a share issue governed by the Corporations Act and should be treated as such. Australia should look to establish a favourable regime for cryptocurrency offerings to take advantage of this progressive form of fundraising. Provided that ICOs are conducted responsibly and with proper regard for risk disclosure, governance and adequate know your customer/anti-money laundering procedures (KYC/AML), ASIC should explicitly acknowledge the value ICOs have in facilitating enterprise and innovation in Australia.
ASIC should consider the example of Singapore and the attitude that the Singapore Monetary Authority (MAS) has taken toward token offerings in their guide released in November. Of particular note in our view are the case studies that provide real world examples and how they will be regulated.
Singapore is now the third largest ICO market in the world and has emerged as the hub for ICO activity in the Asia Pacific. The opportunity is there for Australia to keep pace with Singapore but positive action should be taken now.
Another ICO friendly jurisdiction that has seen increased activity is Gibraltar, which has released Regulations that will provide for issuers of distributed ledger technology (DLT) (which may include issuers of coins or tokens) to be able to apply for a licence to be a DLT provider. That DLT provider is then exempted from certain provisions of the governing corporate law in Gibraltar.
It appears to us that the approach taken by Gibraltar is progressive and acknowledges the potential of the ‘new’ digital economy to offer alternative means of providing early stage funding. The country is looking to establish what amounts to a certification process for ICOs – a proposal that has a lot of merit and falls somewhere between full on government intervention and self-regulation.
We believe that a similar system could be implemented in Australia.
A basic framework of considerations
The following is a proposed framework of considerations that could form the basis for a certification board (or similar) to take into account. A certification board could comprise of industry participants, legal and accounting experts and government representatives.
1. Jurisdiction: consider the jurisdiction of the issuer and the regulatory environment in which the issuer operates. For example, does the jurisdiction have robust consumer protection laws and a strong judiciary capable of enforcing contracts and agreements?
2. KYC/AML/Privacy: consider whether the issuer has disclosed its intention to comply with KYC and AML laws and if it has agreed to protect the personal information of participants.
3. Founder/employee tokens: all tokens/coins issued to founders and employees should be locked up by an audited smart contract and be subject to a strict vesting schedule which must be properly disclosed.
4. Company tokens: all tokens held by the issuer should be locked up by an audited smart contract and be subject to a disclosed vesting schedule.
5. Cap the amount of tokens: the total number of tokens should be subject to a hard cap and the amount should be reasonable with a view to ensuring that the token is deflationary in nature – whether the token is to be publically traded or not.
6. Smart contract audit: the applicable smart contracts must be audited and the auditors of the smart contract should be disclosed to participants. Appointed auditors should be reputable and technically competent.
7. Legalities and terms and conditions: have the terms and conditions of the issue been reviewed by appropriate legal representatives and have they been determined to be legal? Are the terms and conditions clearly disclosed in clear language that is easily understood?
8. Distribution, allocation and timetables: is the distribution timetable clear and fairly balanced where tokens are issued to different participants at different points in time?
9. Liquidity: disclosure should be made as to the intentions of the issuer to place tokens on to exchanges.
10. Background checks of board/advisers: board and advisers should be of good fame and character and the issuers should disclose this to participants. The issuer should state that they have verified the identity of all board members and advisers and believe them to be appropriately fit for purpose.
Current ASIC guidance
At present, whether the Corporations Act will apply to an ICO will depend on the details of the ICO itself and what rights attach to the ‘coins’ or ‘tokens’ issued to investors. These details are generally articulated in the ICO white paper (similar to a prospectus) issued to potential investors about the project.
ASIC has advised that the Corporations Act will apply to an ICO when it is a:
- share offering;
- management investment scheme; or
- derivative offering.
A share is a collection of rights relating to a company. There are a range of types of shares that may be issued by a company and many and carry rights regarding:
- ownership of the company;
- voting rights;
- entitlement to share in future profits through dividends; and
- a claim on the residual assets of the company if it is wound up.
The ASIC guidelines provide that an ICO may be considered a share offering where an ICO is created in order to fund a company (or to fund an undertaking that looks like a company).
The bundle of rights attached to the coins issued under an ICO may be used to help determine if a coin is a share. If the rights attached to the coin are similar to rights commonly attached to a share – i.e. if there appears to be ownership, voting rights or some right to participate in profits of the body shown in the white paper, then it is likely that the coins could fall within the definition of a share.
Where it appears that an issuer of an ICO is actually making an offer of a share, the issuer will need to prepare a prospectus. Such offers of shares are often described as initial public offers (IPOs).
Importantly, although an ICO may appear to be similar to an IPO, the ICO may not offer the same protections. Where a prospectus for an IPO does not contain all the required information, or includes misleading or deceptive statements, investors may be able to withdraw their investment before the shares are issued. No such protection exists for the majority of ICOs, though it should be noted that following the release of regulation in China, a number of companies that undertook ICOs refunded monies to investors.
Managed investment scheme
Managed investment schemes (MIS) are also known as 'managed funds', 'pooled investments' or 'collective investments'.
The ASIC guidelines provide that an ICO may be considered a MIS where:
- people contribute assets (or in this case, cryptocurrency) to obtain an interest in the scheme (”interests” are generally a type of ”financial product” and are regulated by the Corporations Act);
- the assets are pooled together with one or more other contributors or used in a common enterprise to produce financial benefits or interests in property; and
- the contributors do not have day-to-day control over the operation of the scheme but, at times, may have voting rights or similar rights.
The “rights” attached to the coins issued under an ICO are to be interpreted broadly and include rights that may arise in the future or on a contingency, and rights that are not legally enforceable. If the value of the coin is related to the management of an arrangement as described above, the issuer of the ICO is likely to be offering an MIS.
In some cases, ICO issuers may frame the entitlements received by contributors as a receipt of a purchased service. However, if the value of the coins acquired is affected by the pooling of funds from contributors or use of those funds under the arrangement, then the ICO is likely to fall within the requirements relating to a MIS. This is often the case if what is offered through the ICO has the attributes of an investment.
If an MIS is being used there are a range of disclosure, registration and licensing obligations under the Corporations Act.
Generally, a ”derivative” is a product that derives its value from another “thing” which is commonly referred to as the ”underlying instrument” or ”reference asset”. The underlying instrument may be, among other things, a share, a share price index, a pair of currencies or a commodity (including a cryptocurrency).
If an ICO produced a token that is priced based on factors such as a financial product, underlying market or an asset price moving in a certain direction before a time or event which resulted in a payment being required as part of the rights or obligations attached to the coin, this may be a derivative. Due to the broad application of section 761D of the Corporations Act many proposed ICOs may be considered offers of derivatives and as such would require the issuer to hold an AFSL.
In our view, ASIC should be wary of over-regulating an industry still in its infancy and that is born out of the use of innovative and new technologies that have the potential to benefit the wider community. The information sheet released by ASIC rightly urges caution as (not unlike any other speculative investment) an investment in an ICO carries risk and there have been examples of investors losing all of their investment.
We are currently acting for entities considering ICOs and are active in the space so if you need further advice about whether or not obligations under the Corporations Act or the general law might apply to an ICO or token event.