Initial Coin Offerings (ICOs) involve issuers offering virtual coins or tokens that are created and disseminated using distributed ledger or blockchain technology. The capital raised from the offer will fund the development of a digital platform, software, or any other project. Holders of virtual coins or tokens may have additional rights over and above those of a cryptocurrency, such as rights to access the platform, use the software, or otherwise participate in the project. In some cases, holders may also have rights to a return on their investment, or rights to participate in a share of the returns provided by the project or by the company backing the project. Post-issuance, holders may resell virtual coins or tokens in a secondary market on virtual currency exchanges or other platforms. ICOs are typically announced on cryptocurrency forums and websites through a white paper describing the project and key terms of the ICO, subscription details, timeline, etc.
To date, an estimated 100 ICOs have raised over US$1.2 billion, with a plethora of prospective ICOs frequently reported in industry publications. In June and July this year, ICO funding surpassed that of angel and early-stage VC funding combined.
As companies increasingly turn to ICOs as a funding mechanism, regulatory scrutiny is intensifying. Regulators in the United States (US), Singapore, and Canada have made public statements reminding issuers and investors that coins or tokens issued via an ICO will fall within the full scope of securities law in those jurisdictions if they meet the relevant characteristics for a security, no matter how those coins or tokens are labelled. The UK’s Financial Conduct Authority (FCA) previously identified this re-characterisation risk in its Discussion Paper on Distributed Ledger Technology, published in spring 2017. Other regulators across the globe are likely to follow suit as regulators in the key global fintech hubs typically take a technology neutral approach to regulating new technologies and new applications of technology, and consequently seek to apply existing regulations to innovative tech developments, such as ICOs.
The tests for determining whether a coin or token fall within the definition of a security differ depending on the jurisdiction of the issuer, and the jurisdiction(s) in which the offer is made. There is, therefore, no single test on which issuers can rely to determine whether a coin or token will be treated as a security in circumstances where the ICO has a cross-border element. In the US, the so-called “Howey Test” focuses on whether the coin or token is an “investment contract”. This depends on whether there is: (a) an investment of money; (b) in a common enterprise; (c) with a reasonable expectation of profits; and (d) derived from the efforts of others. Conversely, in the European Union (EU), a coin or token will be considered a security if it falls within the scope of a list of broadly defined financial instruments (such as shares, debt securities, units etc.), or if it falls within any category of security defined in the domestic legislation of an EU Member State that has gold-plated the MiFID requirements. A similar theme prevails in Asia where a number of regulatory authorities, including those in Hong Kong and Singapore, have issued public statements to emphasise that digital coins or tokens are vulnerable to money laundering risks and that domestic laws and regulations relating to public offers of securities, structured products or collective investment schemes could apply to coins or tokens offered in an ICO. The Chinese Government has taken the additional step of announcing a ban on fundraising through ICOs and has proclaimed that funds raised through completed ICOs should be repatriated to investors.
Generally, most regulators will be interested in whether the coin or token gives the holder a right to share in the capital or participate in the profits of the projects derived from the efforts of others, or whether the coin or token creates an instrument in favour of the holder that is transferable in the secondary market. In other words, does the coin have an investment purpose?
ICOs as a Security — Considerations for Issuers
The impact of a coin or token falling within the definition of a security is generally threefold. Firstly, the issuer may need to be licensed or registered in a jurisdiction, or engage a licensed financial institution to handle the offering, or otherwise seek a valid exemption. Secondly, the issuer may need to comply with certain disclosure requirements, such as publishing a regulator-approved detailed prospectus or disclosure document, or the issuer may need to limit its offering to certain types of investors. Finally, if the issuer wants to perform a custody function in relation to the coins or facilitate secondary market trading in the coins over a platform operated by the issuer, the issuer may need a separate licence or registration to do so. The issuer may also encounter tax implications.
Crucially, any prospective ICO issuer must consider in advance the legal implications and structuring options of the ICO. Key structuring questions include:
- What is the issuer’s target market/jurisdictions? How can the issuer ensure that its offering will only be made to that target market, to avoid triggering the securities laws of unintended jurisdictions? Determining in which jurisdictions an issuer is to make an offer may be difficult if an issuer publishes a public whitepaper over the internet, so password protection and IP address verification may become the norm.
- Does the issuer want the coin or token to fall outside the definition of a security, recognising that this may limit the purpose of the coin or token?
- Alternatively, if the issuer wants the coin or token to have an investment purpose:
- Can the issuer rely on an exemption or combination of exemptions in the target jurisdictions to limit the impact of the securities laws/requirements (e.g. through structuring the ICO as a private placement)?
- Does the issuer want to make a public offer and comply with the full scope of securities laws/requirements?
- Are there other innovative structures that might achieve the issuer’s aims?