Back in July of 2015, we blogged about “Current Marketplace Trends in Real Estate Crowdfunding”. How young and breathless we were, in hindsight, now that we’re tapped into the Next Big ICO thing. Yes, the “fintech” world has apparently leapt forward into the dawning age of the ICO without so much as a backward glance, still unfettered by the restraining hand of regulation (such as the JOBS Act “exemption”, which seems to have throttled old-world crowdfunding in the cradle).

But wait a sec—just what is an ICO?

ICOs Explained

The acronym stands for “initial coin offering”—“coin”, as in Bitcoin, Bytecoin, Litecoin, Monacoin, Altcoin, REcoin—pick your flavor of the month, there are literally hundreds of these fledgling “cryptocurrencies” floating around in in cyberspace, and ICOs have rapidly become the hottest way to promote and launch a new cryptocurrency. An ICO is simply the initial public sale of a new type of digital “coins”, or “cryptocurrency”.

Judging from the prolific way these new cryptocurrency ICOs are popping up, like mushrooms after a spring rain, one might imagine any clever techie could spin one up at the kitchen table with little more than an internet connection and some well-caffeinated daring-do. Yes, ICOs are easier than crowdfunding, they have that special “blockchain” cachet going for them, and the “regulators talons” have not yet sunk deep.

So, where’s the value in the cryptocurrency “coins” that all these ICOs are hawking? Well, in a nutshell, these “coins” can be used to pay the “fare” that buys access to novel new software applications that only run on blockchain in distributed digital ledger environments. The blockchain / digital ledger technology that cryptocurrency coins buy access to is important because this technology makes it possible to safely transfer valuable digital assets through cyberspace with no risk of the value being intercepted, stolen, co-opted, corrupted, tampered with, controlled, or even seen, by any third party intermediaries (unless, of course, you fall prey to clever “socially engineering” spun up by some poseur techie…). This secure, direct transfer of value is not possible on the conventional internet.

The range and scope of novel software applications that can be created thanks to the ability to securely transfer value across the blockchain-enabled internet is vast. Some of the possibilities include digitally distributing copyrighted material, verifying digital identities in cyberspace, distributing charitable donations to philanthropies in remote parts of the world, collecting and breeding digital “cryptokitties” . . . . Possibilities abound, including applications in commercial real estate.

However, this new secure value transfer feature for the internet isn’t free—in order for a blockchain / distributed ledger network to assure the secure transfer of value, all of the computers that are part of the network need to contribute computing power to check and verify that the blocks that go into the chain are accurate all across the distributed network. And this is where cryptocurrency comes in, because these digital coins are paid to reward network participants for providing the computing power that energizes the blockchain. These coins circulate freely and can be used as a medium of exchange on the blockchain network—people who want to use the blockchain to securely transfer value across the internet need to pay tokens as fare to the network of verifying computers, and these gatekeeping computers can then use the tokens they earn to pay for their own transactions on the blockchain, or sell them for fiat currency to others who want to transact on the blockchain.

Initial Fumbles with ICOs

As mentioned above, an ICO is basically just the initial sale of a new type of cryptocurrency in exchange for fiat cash. People subscribe to ICOs in order to get early allotments of the new cryptocurrency. In some cases, buyers intend to use the cryptocurrency to access the supported software applications themselves. But in most cases, people who buy cryptocurrency through ICOs are speculating that the cryptocurrency will increase in value over time as usage of the related apps increases—in other words, they’re treating the ICO as an initial public offering of an investment security. In theory, the sponsor of an ICO will use the cash raised in the ICO to lease computing equipment and office space and pay the salaries of the software developers who are building the new “killer apps” that the cryptocurrency will support.

But ICOs currently exist in a space that is rife with over-exuberant expectations, hype and “Ponzi”-style “pump-and-dump” schemes. As New York Times writer Kevin Roose facetiously described in a recent cautionary article:

Imagine that a friend is building a casino and asks you to invest. In exchange, you get chips that can be used at the casino’s tables once it’s finished. Now imagine that the value of the chips isn’t fixed, and will instead fluctuate depending on the popularity of the casino, the number of other gamblers and the regulatory environment for casinos.

Oh, and instead of a friend, imagine it’s a stranger on the internet who might be using a fake name, who might not actually know how to build a casino, and whom you probably can’t sue for fraud if he steals your money and uses it to buy a Porsche instead. That’s an ICO.

In a real-life example, on September 29, 2017, the SEC filed a civil complaint in federal district court against ICO promoter Maksim Zaslavskiy and two companies run by Mr. Zaslavskiy. According to the complaint, between July and October Mr. Zaslavskiy and his companies raised at least $300,000 in an ICO touting a new cryptocurrency called “REcoin” — “the first ever cryptocurrency backed by real estate.” According to the SEC complaint, Mr. Zaslavskiy and his companies have been peddling unregistered securities. Furthermore, the complaint alleges, the companies never had any real operations even though Mr. Zaslavskiy told investors in REcoin they could expect sizeable returns from those company’s operations; the securities he sold weren’t backed by any real estate or other assets as he claimed they were; and no “REcoin” digital tokens ever actually existed.

To make matters even worse for Mr. Zaslavskiy, the FBI also became very interested in his REcoin ICO promotions—so interested that on October 27 the Bureau filed a Complaint and Affidavit in Support of Application for Arrest Warrant, generally alleging the same bad acts listed in the SEC civil complaint. Mr. Zaslavskiy was arrested on November 1 and subsequently released on $250,000 bail. Latest word is that on December 1 he plead “not guilty” to all charges in an appearance in Federal District Court for the Eastern District of New York in Brooklyn. He is represented by court-appointed counsel.

Reading the government complaints with an indulgent eye, one might feel a twinge of pity for hapless Mr. Zaslavskiy, who, the reader may imagine, had just one hell of a good idea, but in his haste to execute on it, threw all caution to the winds in a grandiose attempt to bootstrap from fiction to fact in one fell swoop. Unfortunately, but unsurprisingly, he fell flat.

The SEC’s Office of Investor Education and Advocacy recently issued an investor alert warning about the risks of ICOs. “Investors should be wary of companies touting ICOs as a way to generate outsized returns from novel technology,” said Andrew M. Calamari, Director of the SEC’s New York Regional Office. The novel technology that Mr. Calamari is referring to, of course, are software applications based on blockchain and digital ledger technology.

Federal securities law fraud and conspiracy indictments aside, it’s not uncommon for innovative paradigm shifts to experience a “hype cycle” spanning the first decade or so after they initially catch on. Before ICOs can really come into their own in mainstream capital markets, ICO mania may first need to fall off the Peak of Inflated Expectations and traverse the Valley of Disillusionment, then begin a slow trudge up the Slope of Enlightenment before eventually topping out on the Plateau of Productivity. Assuming sufficient progress and development in the blockchain and digital ledger technology underpinning the ICO paradigm, the ICO concept could eventually mature into a powerful new method to efficiently raise funding in capital markets.

Blockchain Getting Serious

Already, it’s not just hypesters and starry-eyed kids who have been bitten by the blockchain bug—real serious regulators and technocrats are also jumping on the band wagon. For example, the State of Delaware has launched a blockchain initiative focused on porting several types of State and private records—including files in the Delaware Public Archives, UCC filings and the securities registries of Delaware corporations—to blockchain, with the goal of significantly increasing transparency, reducing errors and streamlining process workstreams.

In another example, the Office of the Recorder of Deeds for Cook County, Illinois, recently concluded a pilot program focusing on the use of blockchain and distributed ledger technology for conveyance and recording of title to real property in Cook County. The Cook County Recorder’s project produced a real estate conveyancing software workflow that could become a framework for the first legally effective blockchain conveyance in the United States. The project also built a property information aggregation website based on distributed ledger technology. The website also contains a dedicated landing page containing a digital property abstract for each parcel of land in Cook County, illustrating the benefits of consolidating important property information currently held in various scattered repositories.

Internationally, governments in countries such as Sweden, the Republic of Georgia and Ghana are also conducting studies or pilot programs focusing on conveyancing and recording transfers of real estate title on distributed ledgers. Their objective is to significantly increase market liquidity by improving the transparency, veracity, safety and robustness of real estate title provenance and transfer.

There is also a large cohort of blockchain startups actively looking for opportunities in the real estate space. For instance, startups such as Ubitquity and Factom are launching blockchain-powered real estate title and mortgage data tracking tools, which they hope will create error-resistant and tamper-proof audit trails for title and loan related documents. The offerings are currently in pilot stage, and the companies hope to gradually deploy to clients over the near term. It almost goes without saying that there is huge interest among private investors and speculators in creating more liquid on-line real estate markets.

Title and mortgage tracking applications of this type based on digital ledger technology may also have important implications in the securitization space. For example, automation of work streams in servicing securitization transactions and complying with asset-level disclosure requirements under Reg AB II, among others. Also, recall the robo-signing scandal in the United States, where sloppy and sometimes dishonest record keeping around mortgages leading up to the 2008 financial crisis led to years of lawsuits between homeowners, banks, and investors in residential mortgage backed securities, who in many cases ended up with opaque and error-riddled instruments. Digital ledger technology promises tools for clearing up this type of opaqueness (or, given the predilections of human nature for risky opportunism, may just provide tools to gin up the next generation of sketchy investment instruments, but, hey, that may be progress too, right?)

ICOs and Crowdfunding

Circling back to the original crowdfunding thesis, we should also expect this disruptive new technology to begin surfacing in even more impactful nextgen “killer apps” for commercial real estate investment. That’s right, real estate crowdfunding may actually make a comeback by dint of being co-opted into the blockspace. New-age real estate crowdfunding ecosystems are already forming; for instance, the Real Estate Asset Ledger (“REAL”) is one application currently being talked up as a real estate crowdfunding network built on blockchain infrastructure.

One key breakthrough facilitating online real estate crowdfunding is the “tokenization” of real estate assets on a blockchain. As discussed earlier, “tokens” are like the fare used to access a network. But in the context of online real estate crowdfunding, by “tokenization” we also mean “slicing and dicing” a digital record of title that has been stored on a distributed ledger into numerous small units, or tokens. Each token represents a micro-fractional interest in the property, and in theory, the interests can also be sliced into different “classes” linked to distinct rights and privileges. Since each token is digitally tagged to the underlying property, it can be secured by recourse to the real asset and can also be underwritten with traditional credit metrics. For an income-producing property, it wouldn’t be difficult to wire-in blockchain-based “smart contract” technology to automatically distribute micro-cashflows accruing to each token. Presto! These tokens are now dividend-paying digitized securities that can be sized, priced and sold to just about any investor demographic one can imagine![1] Large projects might even include credit ratings.

In any event, we are looking forward to actively participating in this exciting new market, standing ready to help our clients during all phases of the development cycle, whether it be tempering euphoria on the Peak of Inflated Expectations, helping to pick up the pieces in the Valley of Disillusionment or blazing trail up the Slope of Enlightenment. This will be an epic journey!