The ICO boom in 2017 brings with it questions of jurisdiction and compliance, and a need for further guidance
2017 has seen a boom in token presales and “initial coin offerings” (collectively, ICOs), which involve the sale to investors of customized “digital tokens” in exchange for established cryptocurrencies, most frequently Bitcoin or Ether. Many promoters had heralded ICOs as a fundraising method similar to initial public offerings (IPOs) of securities, with the benefit that they were unregulated. However, in the United States and certain other jurisdictions, regulators have now staked out their turf in ICOs, causing sponsors and digital exchange platforms to re-think their approach to compliance.
Digital currencies or “cryptocurrencies” have experienced a wild year. The price of Bitcoin has increased more than sixfold since January 1, 2017, and the price of Ether, the second largest cryptocurrency, has increased more than 38 times in the same period. The recent track record of these and other cryptocurrencies has generated significant interest in new cryptocurrencies, both from existing holders looking to diversify their holdings and from investors new to the space. Ether, and its related blockchain platform Ethereum, in particular, have been in the forefront because the Ethereum platform (an open source blockchain-based distributed computing platform, featuring smart contract functionality) is often used as the technological foundation on which new blockchain networks are built and ICOs are launched. Smart contracts are sets of coded promises and rules, specified in digital form, which can be implemented automatically on blockchain platforms without the involvement of intermediaries.
The total market capitalization of cryptocurrencies has been reported to be in excess of $160 billion, with ICOs generating billions of dollars of proceeds. According to Forbes, at the beginning of October, ICO sales had already exceeded $2 billion in 2017 and at least 400 ICOs had been conducted.
The term ICO has not been strictly defined and has been used to cover a wide range of offering transactions. Generally, an ICO can be thought of as a fundraising method in which a company, sponsor or developer—any cryptocurrency venture—sells the right to receive digital tokens representing a new, customized cryptocurrency in exchange for payment. The term “initial coin offering” was originally created to describe offerings of digital “coins” representing pure digital or virtual currency, without added functionality, other than as a way to pay for goods and services. A digital token, on the other hand, involves a more flexible concept. It can represent a right to an underlying asset to be redeemed sometime in the future (i.e., an “asset-backed token”) or a smart contract that allows the holder to use the token’s network in a beneficial way.
Originally, in order to offer a new digital token, the sponsor had to have already built a functioning network on which the token could be used or sold. However, in many cases, sponsors are looking for the funds necessary to build out a project, asset or smart contract application. 2017 has seen the emergence of ICOs in which investors do not directly receive tokens but instead acquire the right to receive digital tokens when the network is launched. Such tokens can be used to interact with the project, asset or application once it is fully developed. In addition, ownership of a digital token can involve voting rights and rights to distributions (akin to a share). The tokens can be traded on secondary markets and have their own market value, independent of the price of Ether or the cryptocurrency used by the platform on which the token is based, which appreciates if the digital business venture (or, more simply, the demand for the tokens) takes off. In the best case, the tokens become globally and actively traded on various public blockchain platforms or exchanges that handle cryptocurrencies, such as Coinbase, Bittrex or Kraken. As the volume of activity on the exchange increases, the value of the tokens increases; accordingly, early investors have a strong incentive to bring other users onto the digital exchange. By raising funds in this way, startups avoid giving up power in or control of their businesses to shareholders, venture capitalists or other intermediaries. Costs are reduced, the speed of each transaction is faster, and the special security features of a blockchain exchange increase trust.
However, extreme caution is necessary because (i) startups are using ICOs to bypass the highly regulated capital-raising process usually followed by venture capitalists, banks and underwriters with IPOs, and (ii) blockchain technology is in its infancy, surrounded by controversy and confusion, especially with respect to cryptocurrencies (which are considered well-suited to money-laundering and tax evasion). Moreover, the novel and highly complex technologies involved in ICOs create significant informational asymmetries between the sponsors and the investors and thereby increase the potential for fraud. This potential for fraud, combined with the significant potential for disruption to financial market stability, has been perceived to be so great that China and South Korea recently banned ICOs. In China, for example, sponsors who had already raised money were required to provide refunds to investors. Even Japan, which is considered to be one of the most market-friendly nations for cryptocurrencies, is said to be considering an ICO ban.
As discussed below, in the U.S., federal and state regulators have recently warned the markets that, depending on the circumstances, digital tokens could be securities and if so, ICOs and digital exchange platforms handling secondary trading of tokens will need to comply with securities laws and other laws.
The ICO Process
The first step for any startup planning an ICO has typically been to create a website and a business plan “white paper” describing the project, asset or smart contract application; what purpose it will serve when complete; how much money will be needed; how many tokens will be held by the sponsors; what type of currency will be accepted for the tokens; when the token sale will open; and how long it will remain open to investors. Sponsors post the white paper and their software code publicly, and smart contracts may be peer audited to provide some transparency to potential investors. There are usually discussion threads that develop on industry websites where people can actively debate the merits of the white paper, the project or application protocol, the sponsors and the technical team. On the date that the sale opens, there will usually be a tool on the startup’s website that enables investors to acquire the tokens. Once the funds are collected, the offering will conclude, the smart contracts will be activated, and the tokens will be issued to the investors.
Value for the tokens might initially be stipulated by the sponsors when they explain how the funds will be used in the white paper. For investors, value will be associated with the functionality of the project, asset or application together with the perceived potential for increase in trading value. To date, tokens have been resold freely and there have not been many lock-up periods restricting investor sales, but more are anticipated as transactions get larger. Typically, if the money raised does not meet the minimum required by the sponsors, it will be returned to the investors and the ICO will be unsuccessful. A successful ICO leads to the initiation or completion of the project, asset or application and gives the investors early access to the benefits of the new business.
The largest ICO to date, raising $257 million, was by a startup called Protocol Labs for a planned computer-memory marketplace called Filecoin. Filecoin’s ICO utilized a form of convertible security called a SAFT (an acronym for Simple Agreement for Future Tokens) based on YCombinator’s widely used SAFE instrument. SAFT holders receive tokens once the intended network is functioning.
Most startups are in the cryptocurrency industry sector, and for outsiders it can be quite difficult to understand the nature of the business. On the other hand, some businesses are straightforward; for instance, one startup raised $620,000 in an ICO to build a very large aquarium. Online gaming websites and commerce websites are also using ICOs. In theory, although any business, asset or technology application could be funded in this way, commentators believe that businesses that implement the blockchain and related tokens as an integral part of their business model, rather than simply as a fund-raising mechanism, will be more likely to create value in the tokens themselves.
The Legal Framework in the United States
This year, the U.S. Securities and Exchange Commission (SEC) has taken a number of actions with regard to ICOs. Most significantly, on July 25, 2017, the SEC issued a Report of Investigation (21(a) Report) on The DAO (Decentralized Autonomous Organization). The DAO had sold over one billion DAO Tokens in 2016 in exchange for Ether. The proceeds were to be used to fund various “projects” after they were vetted and approved by curators, who were selected by The DAO’s sponsors. DAO Token holders could vote on which projects to fund, and profits from those projects would be distributed among them. The main inquiry was whether the sale of DAO Tokens was a sale of securities that should have been registered with the SEC under the Securities Act of 1933 (the 1933 Act). Applying the test provided by the Supreme Court in the 1946 Howey case, the SEC concluded that The DAO Tokens were indeed investment contracts and that their sale should have been registered. Important consequences flow from that conclusion, including: investors in a transaction that violate the registration requirement have a rescission right under Section 12(a)(1) of the 1933 Act; violation of the registration requirements of the 1933 Act is itself a civil and criminal violation; the sellers may face claims for misleading disclosures of misleading omissions under both the 1933 Act and there is the potential for fraud claims under Rule 10b-5 under the Securities Exchange Act of 1934 (1934 Act); both the sellers and third-party distributors of the tokens could be viewed as broker-dealers requiring registration under the 1934 Act; and digital trading platforms could be required to register with the SEC as securities exchanges. However, notwithstanding this DAO conclusion, in the 21(a) Report and in subsequent statements by SEC staff members, the SEC has emphasized that the Howey test is highly fact-dependent, and each ICO must be analyzed separately according to the specific facts and circumstances of that ICO. This case-by-case approach requires an extensive legal analysis of each ICO, its tokens, the white paper, the sponsors, the business and all other aspects of the offering. Thus, the SEC staff has indicated that they are unlikely to provide no-action relief on specific proposed offerings given the large amount of resources necessary for the in-depth Howey analysis.
Startups and their sponsors also need to be advised about the securities laws of each state in the U.S. (i.e., “Blue Sky” laws). A token that is not a security under federal law may be subject to regulation in one or more states with different legal tests for what is considered a “security”, such as the “risk capital test” used in California and some other states. This test considers whether there is an attempt by an issuer to (1) raise funds for a business venture or enterprise (2) through an indiscriminate offering to the public at large, (3) where the investor is in a passive position to affect the success of the enterprise and (4) the investor’s money is substantially at risk because it is inadequately secured.
In addition, on October 17, 2017, the LabCFTC office of the U.S. Commodity Futures Trading Commission (CFTC) published “A CFTC Primer on Virtual Currencies” in which it defines virtual currencies and outlines the uses and risks of virtual currencies and the role of the CFTC. The CFTC first found that Bitcoin and other virtual currencies are properly defined as commodities in 2015. Therefore, the CFTC has regulatory oversight over futures, options, and derivatives contracts on virtual currencies or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. Beyond instances of fraud or manipulation, the CFTC generally does not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage or financing.
Startups and their sponsors will need further guidance on other legal frameworks, including tax laws (as revenue generated by ICOs may be taxable), state consumer protection laws (related to misleading statements in white papers), federal unfair advertising laws (related to deceptive information released in fund raising campaigns) and anti-money laundering laws requiring registration with federal bank regulators and “know your customer” compliance programs. Beyond that, legal advice will be needed with respect to the underlying business of the startup; for instance, if a token can be used to “win” something of value, it could be subject to gambling regulations and any transmission of personal data could be subject to privacy laws. (For a more complete discussion, see 3 Common Misconceptions about ICO Law by Lindsay Lin, August 31, 2017.)
Often ICO promoters have sought to stay outside of the jurisdiction of the U.S. federal and state governments by conducting the ICO outside of the U.S. In such situations, careful attention should be paid to the safe-harbors of Regulation S, and startups and their sponsors must also consider the range of laws described above in the countries where the investors reside. Switzerland is currently viewed as a supportive jurisdiction, but the Swiss Financial Market Supervisory Authority announced in late September that it was looking into a number of ICOs for breaching regulations combating terrorism and money laundering. The agency wrote that “given the close resemblance, in some respects, between ICOs/token-generating events and conventional financial-market transactions, one or more aspects of financial market law may already cover ICO campaigns.”
Other jurisdictions, including Canada, welcome digital innovation and are working on new regulations for ICOs. A notice published by the Canada Securities Administrators (CSA) not long after the release of the SEC bulletin in July outlined the requirements for startups involved in an ICO launch and for the digital exchanges that list the tokens for trading. The notice also observed that “many” of the token sales investigated in Canada fall under the definition of a security. Firms are invited to sign up for a so-called regulatory sandbox to test new financial products. Singapore is another popular jurisdiction for ICOs, but it has also recently announced that the central bank will continue to monitor ICOs and publish advisories related to scams.
Compliance Considerations for ICOs
While some efforts will continue to be focused on establishing that a particular ICO does not involve an offering of a security, many promoters of ICOs will decide to proceed in a manner that complies with existing securities laws and other laws. The pressure to improve standards is evident. As mentioned in an article in coindesk by Jacek Czarnecki on October 1, “How to Legitimize the ICO Market (Crypto Lawyers Take Note),” it is too often the case that ICO terms and conditions are not publicly available immediately after the offering is completed. Investors are forced to remember to save them locally during the ICO. Mainstream institutions and their legal counsel will not tolerate that and, for the most part, large pension funds, insurance companies and mutual funds have not participated significantly in ICOs. The involvement of risk adverse and expensive lawyers may not be welcomed by some startups and sponsors and many legal rules and standards will need to be crafted and tested if the ICO boom is to continue.
The benefits of ICOs in raising capital, as well as in providing a marketing push for a new business model, are so significant that it is difficult to foresee them disappearing. It is likely that the large offerings backed by knowledgeable law firms and wealthy Silicon Valley backers will have a big advantage over smaller ICOs offered by startups unwilling or unable to pay the associated compliance costs. However, it is in the best interests of all legitimate and honest ICO sponsors that they do not operate in a gray market. Regulators have been paying attention and will continue to act.
 Under Howey, an arrangement constitutes an “investment contract” (and thus “a security” under Section 2(a)(1) of the 1933 Act) when there is (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) which are derived solely from the efforts of the promoters or third parties.