There has been a sharp increase in interest from fund-raisers, investors, and regulators in initial coin offerings (ICOs) over the past year, but the conundrum of how to deal with ICOs seems set to continue into 2018.
ICOs have been used by businesses as an alternative way to fund-raise. Some current estimates indicate that around US$ 3 billion has been raised in 2017 through ICOs. Instead of issuing traditional forms of equity, blockchain technology enables businesses to issue digital 'tokens' or 'coins'. What differs in each case, expressed as part of the relevant offer, are the entitlements attaching to the coins and their stated use case. Some coin offerings align more with traditional securities, others with a means of payment in the context of a given good or service, and others with utilities, in the sense of being able to use the businesses' services.
ICOs will usually be marketed via a white paper, which sets out the features and characteristics of the deal. Buyers can then use cryptocurrencies, like bitcoin or ethereum, to purchase the tokens.
Existing securities law
The first question from a regulatory perspective in an ICO is: what does a token represent? Depending on the characteristics of the tokens and/or how they can be used, there is potential for them to qualify as regulated investments, e.g. shares, units in a collective investment scheme or fund, e-money, deposits, futures or debentures. This list of potential instruments is broad because the legal categorisation of a coin will depend on its precise entitlements and use case - and there is a high degree of variety here.
To the extent the tokens qualify as regulated investments, the activities of issuers and other parties involved in marketing, advising on, dealing in and/or managing the ICO could trigger regulatory licensing and marketing requirements (including, as has recently occurred, where celebrities endorse the ICO).
Similar regulatory and legal questions arise in most jurisdictions – this is far from being only a UK or EU matter.
Even where the ICO is not regulated in the jurisdiction where the fundraising is taking place, issuers and other participants need to consider the legality of marketing the ICO in each potential buyer's territory.
An increase in regulatory scrutiny
ICOs are attracting the scrutiny of regulators from the leading international financial centres, a number of which have issued formal statements or taken action in relation to ICOs. In China, ICO activity has effectively been banned. The US Securities & Exchange Commission (SEC) has brought enforcement action in respect of ICOs – suspending trading of three public companies even before they had engaged in ICOs, and filing a civil complaint in respect of two companies that had already taken part in ICOs, allegedly in breach of securities legislation and without having started the business operations investors had been promised were ongoing.
In Europe, the French regulator has launched a consultation into supervising ICOs, with options they are looking into including promoting best practice, extending legislation to treat ICOs as public offerings of securities, or adapting legislation suited to ICOs. Although the German regulator has said that ICOs will be considered on a case by case basis, it has also said that tokens amount to financial instruments, so commercial arrangers, sellers and buyers or operators of trading platforms will generally need a licence.
In the UK, the Financial Conduct Authority (FCA) released a consumer warning about ICOs on 12 September 2017. While acknowledging that many ICOs will fall outside the UK-regulated space, the FCA noted that whether an ICO falls within its regulatory boundaries or not can only be decided case by case. The FCA does not yet have plans to consult on this topic, but it has issued a discussion paper on distributed ledger technology, and is expected to publish its findings at the end of this year.
Other legal and regulatory risks in offering tokens through ICOs
In its ICO warning, the FCA also emphasised the "very high-risk, speculative" nature of ICOs, and, in particular, the risk that investors (especially those without a sophisticated technical understanding of the underlying projects) might lose their whole stake, as typically ICOs are launched in a very early stage of development of experimental business models. ESMA also issued a similar warning on 13 November 2017, adding that there may be flaws in the blockchain technology underpinning ICOs, which may affect the tokens' functionality and leave it susceptible to hackers.
The FCA is also keeping an eye on cryptocurrencies, and on 14 November 2017, issued another consumer warning about the risks of investing in cryptocurrency contracts for differences (CFDs), which allow investors to speculate on the price of a cryptocurrency. Although firms offering cryptocurrency CFDs must be regulated by the FCA, the regulator warns that due to the price volatility of cryptocurrencies, the high leverage being offered by firms, and charges (including lack of transparency of), these are another form of "very high-risk, speculative" investment.
On the market side, trading exchange GDAX (targeted at institutional investors) has stated that it is resisting pressure to expand its ICO listings, and will assess the experience and success of businesses' founders, among other factors, before accepting an ICO to the exchange. It will be interesting to see whether this is an early indicator that the market is beginning to regulate itself.
Existing equity Investors
Shareholders, both founders and those external to a business proposing an ICO, have a number of important issues to think through. They will want assurance that the ICO does not dilute their interest, does not prejudice a valuation of the business or their potential profits/revenues as shareholders, and that it will not interrupt an exit/liquidity event.
There will also be issues to think through for the business in terms of accounting, taxation, and governance over any funds raised by an ICO – the business will need to be clear in its strategy and representations as to how the funds can be used, as well as give detailed consideration to whether a finance provider can/should be able to take security/lien over funds, and whether a creditor can/should be able to claim against them.
Misrepresentation and fraud
Any form of offering involves statements to potential investors who may rely on them. Regulators will be alive to this and issuers should be careful, even where they are not required to publish a regulated prospectus, that statements made are accurate in order to avoid the risk of opening up claims for misrepresentations, fraud etc. We can see that this could be a concern where ICOs are made at particularly early stages of development. If the white paper sets out some compelling ideas but falls short of a workable business plan, what happens if it doesn’t end up being implemented? Should it be as simple as investors losing their money, or should ICOs offer more governance around the use of funds raised?
Diligence on the part of issuers and investors is necessary in these cases, to establish what investors will or should get for their cryptocurrency, and we can see that this will take on a larger focus in the coming months, especially given the regulatory action by the SEC in the US, and the comments from GDAX on the industry side.
Even though issuers may not be subject to anti-money laundering compliance requirements, its advisers are likely to be, and this will need to be incorporated into the ICO planning. Further, they will still be subject to sanctions rules and, as part of running a successful business, more attention might be paid to financial crime risks arising due to the anonymous nature of cryptocurrencies in the future.
Any ICO or token system will involve the capture of personal data. With the GDPR coming into force in 2018, and penalties for data protection breach on the increase, this is an area that is very likely to affect ICOs next year (see our article for more on data protection in 2018).
Future of tokens
ICOs are an innovative new way to use cryptocurrencies and distributed ledger or blockchain technology, and the level of interest shows no signs of slowing, despite increased scrutiny from regulators which may have been viewed as hindering growth. The role of self and/or centralised regulation in moderating the expansion of this new form of fundraising, will be crucial to market development in 2018.