We have all seen the rise in the price of Bitcoin in the last year, and may also be aware (at the very least) of the existence of ICOs. But what are ICOs? And what legal framework do they operate in?
Initial coin offerings ("ICO") are gaining traction on a global level. Businesses and start-ups may be anxious to jump on the bandwagon, not least because ICOs give ready access to capital markets globally. It is also a cheaper form of fundraising vehicle as opposed to the more traditional means, such as an initial public offering ("IPO") or bond issuance. In comparison, there is limited regulation on ICOs – at least for now – though many regulators have started looking into how these fundraising activities could and should be regulated, some going so far as to ban the activities altogether.
For those who are not familiar with the concept of cryptocurrencies, it is useful to briefly set out the basic terminologies.
I can do no better than to cite the following definitions:
- cryptocurrencies are "digital… currencies that are encrypted… using cryptography…" ;
- Bitcoin "represents the first decentralised cryptocurrency, which is powered by a public ledger that records and validates all transactions chronologically, called the Blockchain"; and
- a token is a "representation of a particular asset or utility" – it represents, in the abstract, "basically any assets that are fungible and tradeable, from commodities to loyalty points to even other cryptocurrencies."
Dynamics of an ICO
Like an IPO, the issuer of an ICO will issue "tokens" (as opposed to shares) to investors in exchange for fiat currencies (or even cryptocurrencies such as Bitcoin). The proceeds raised will then be used by the issuer to fund the development of, for example, a product, platform, or software, to which the token holders will then (usually) gain access. Liquidity of these tokens is also made possible by cryptocurrency exchanges such as Gatecoin, subject to the tokens being listed on these markets.
Many of these ICOs have proven to be very successful so far, with the top three ICOs raising over US$600 million in 2017, namely:
- Filecoin – a blockchain-based data storage: US$257 million;
- Tezos – a new blockchain aiming to be more reliable than Bitcoin or Ethereum: US$232 million; and
- Sirin Labs – plans to build a blockchain-based smartphone: US$157 million.
Legal and regulatory concerns
Despite the success of ICOs, the ICO market space is not without its legal and regulatory concerns. The intrinsically global nature of this kind of fundraising activity creates additional complexities, as an ICO project may be subject to different legal and regulatory treatments across various jurisdictions. This may be the case even if the issuer is conscious about basing the offering outside of a more restrictive territory, by incorporating the promoting vehicle in an ICO-friendly jurisdiction.
Complications arise because a regulator may decide to look past geographical borders and instead assert jurisdiction over the ultimate beneficial owner or holding entity of the promoting vehicle. For instance, the Secretary for Financial Services and the Treasury of Hong Kong has stated that parties engaging in "regulated activities" (explained below) are required to be licensed by the Securities & Futures Commission ("SFC"), regardless of whether the parties involved are located within the jurisdiction so long as the fundraising activities target the Hong Kong public.
In Hong Kong, the SFC issued a statement in September 2017 sounding a note of caution that digital tokens may be deemed as securities, as defined under the Securities and Futures Ordinance (Cap. 571). Particularly, tokens may be seen as:
- shares where the "tokens on offer represent equity or ownership interests in a corporation";
- debentures where the "issuer creates or acknowledges a debt or liability"; or
- interests in a collective investment scheme where "token proceeds are managed collectively by the ICO scheme operator to invest in projects with an aim to enable token holders to participate in a share of the returns provided by the project".
In these cases, the "dealing in or advising on the digital tokens, or managing or marketing a fund investing in such digital tokens, may constitute a regulated activity", which trigger licensing or authorisation requirements, or both. The SFC appears to have taken a fact-specific inquiry stance (a 'substance-over-form' approach) in this regard.
However, to date the SFC has not published any formal rules as to which ICO structures will fall within the reach of the prevailing securities law in Hong Kong. It is therefore imperative that potential ICO candidates take a cautious approach and seek adequate legal advice before engaging in these activities, whilst the regulatory landscape is still taking shape. This is especially so pending potential SFC enforcement actions against ICO issuers or ICO-related cases being litigated before the Hong Kong courts.
Legal and regulatory issues aside, ICO issuers also face the risk of claims by investors. Take Tezos (referred to above) as an example. Despite its financial success, it is currently the subject of several class-action lawsuits in the US. Amongst other things, it was alleged that its founders were in breach of federal securities law and that they had defrauded their ICO investors. This case may open the floodgates to ICO litigation. And whatever the US court's ruling or the SEC's finding, it may inspire regulatory practices in Asia, making this an important space to watch.
ICOs represent an important and exciting development in capital-raising, and the opportunities they represent cannot be dismissed or ignored. However, given the regulatory uncertainty, any business contemplating conducting an ICO should ensure that it is fully aware of the risks associated with doing so and that it takes steps to mitigate those risks.