Initial Coin Offerings
An initial coin offering or “ICO” refers to a digital way of raising funds from the public using a virtual digital currency, also known as cryptocurrency. An ICO can also be known as a ‘token sale’ or ‘coin sale’.
Tokens may also be used (exclusively) for payment to the issuing company for its services or products. Contrary to shares offered in a traditional initial public offering (“IPO”), Tokens typically do not represent ownership interests or an entitlement to dividends.
Similarly, to IPOs, the issuer can use the proceeds of the ICO to finance its business operations and future growth. In the event that Tokens are exchanged for other cryptocurrencies, the issuing company can exchange them for fiat currencies.
In contrast to commonly used forms of money such as banknotes or bank deposits, digital currencies are not a claim on anybody. In this respect, they can be thought of as a type of commodity. But unlike physical commodities such as gold, they are also intangible assets, or digital commodities.
Digital currencies have meaning only to the extent that participants agreethat they have meaning. Not being an IOU or liability of a central bank (or the state) does not prevent digital currencies from being used as money, but it does mark an important difference between them and national currencies.
If the target amount is successfully raised at the first stage, the Token’s value may increase dramatically and the issuer can increase its worth incredibly quickly, depending on the initial Token distribution and supply.
A more detailed analysis begins with the fact that a digital currency is an asset that only exists electronically so to participate in an ICO, investors need a secure digital wallet. A digital wallet stores a private key, a secure digital code known only to the investor and his wallet, that shows ownership of a public key, a public digital code connected to a certain amount of currency, and together these keys allow the owner to “send and receive” electronic chains of digital signatures (“Tokens”) within a digital ledger of records, called “Blocks”, in which transactions made in bitcoin or another cryptocurrency are recorded chronologically and publicly (a “Blockchain”). A wallet also acts as a personal ledger of transactions.
Each Block contains a ‘hash’ of the previous Block (that is the unique digital fingerprint identifying the previous Block and all of its contents) as well as its own hash,a timestamp, and transaction data thus creating a chain of Blocks. The first Block in a chain is the ‘Genesis Block’. By design, a Blockchain is resistant to modification of the data. It is an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.
The integrity of the Blockchain records and protection against the risk of digital Tokens being copied and spent a second time relies on a network system of verification. A user, wishing to make a payment, issues payment instructions which are disseminated across the network of other users. Standard cryptographic techniques make it possible for users to verify that the transaction is valid — that the would-be payer owns the currency in question. Special users in the network, known as ‘miners’, gather together Blocks of transactions and compete to verify them. In return for this service, miners that successfully verify a Block of transactions receive both an allocation of newly created currency and any transaction fees offered voluntarily by parties to the transactions under question. When Blocks of transactions are verified, they are added to the ledger. This system has been criticized because it involves an expensive use of computing power by miners.
A Blockchain can be used to store self-executing digital contracts – smart contracts – which are enforceable by the software code itself – rather like a vending machine automatically executing the delivery of a can of coke provided it is functional. Smart contracts can be coded within a Block to automatically represent, regulate and transfer the ownership of hard assets once they are registered as digital assets.Smart contracts can also provide for the issue of Tokens.
The computer code becomes the law.
Whilst Blockchains cannot access external data they can be programmed to receive an external data feed from a trusted third party (known as an oracle) which triggers smart contract executions when certain conditions are met, for example, the completion of a successful payment for a coin sale for example.
So, a fiat currency can be automatically exchanged for a digital currency under a smart contract on a Blockchain which can then keep track of people’s transactions using that digital currency.
An innovation on this basic idea was the Filecoin ICO. Protolcol Labs aims to launch the Filecoin Network using the Interplanetary File System, a peer-to-peer hypermedia protocol. To fund this new network Filecoin collected $257 million in contributions based on Tokens which will be issued in the future if they succeed in building their new platform. Its project is still under development so, as it wasn’t able to issue its own Tokens on a platform, given it has yet to be built, funds were raised by the issue of ‘Simple Agreements for Future Tokens” (or “SAFTS” for short) being a right to purchase, in the future, certain units of Filecoin of the company upon the release of the Filecoin Genesis Block and a fully functioning and secure Filecoin Blockchain.
Not all cryptocurrencies rely on their own Blockchains. Instead they can run on top of other more established platforms. This facilitates exchanges between wallets, is cheaper and avoids the risk of bugs.Ethereum is the largest Blockchain platform that’s built specifically for creating smart contracts.
It has its own currency known as ‘ether’ and ‘ERC20 Tokens’ can run on top of Ethereum. An ERC20 smart contract is a standard code which can be used to create a new crypto currency with its own name and symbol and method for creating the total supply of the new currency. Sirin Labs built its new currency on Ethereum. Investors first bought ‘ether’ and then used exchanged their ’ether’ for “SRNs”.
It is interesting to compare the initial SRN Token distribution with the initial Filecoin Token distribution
70% to Filecoin Miners for providing data storage services and maintaining the Blockchain;
15% to Protocol Labs for research, engineering deployment, business development, marketing and distribution;
10% to investors for funding network development, business development partnerships;
5% to the Filecoin Foundation for long term network governance, partner support, academic grants and community buildings
40% to investors in exchange for their contributions;
35% to Sirin Labs to be used for future strategic plans;
10% to the founders and management team to vest over a 12-month period;
5% to professional fees and ‘Bounties’ (whatever they are)
The ERC20 smart contracts aren’t perfect as an investor could only use ‘ether’ to buy the new SRN Tokens. The new ERC223 standard apparently offers a workaround which allows investors to use other crypto currencies to buy Tokens.The Token Factory offers an interface with the Ethereum website for the creation of Tokens; see http://thetokenfactory.com/#/
So, once issued, investors can use their Tokens as currency to purchase goods and services from suppliers who will accept the Tokens.
Investors can also buy and sell Tokens/Tokens if there is demand and Tokens are typically tradable on virtual currency exchanges, creating a secondary Token market, which makes them fungible in the same way as shares.
The vibrant trading ecosystem that has grown up around Tokens, leading to increased liquidity, is one of the most attractive aspects to investors but as the features of Tokens issued in ICOs can vary widely, every Token has to be assessed individually.
Most existing digital currencies incorporate strict rules that govern their creation, following a pre-determined path to a fixed eventual total supply.Some digital currencies are created entirely at their inception (such as Ripple), while a small number of existing cryptocurrency schemes, particularly among those making use of ‘proof of stake’ systems, may allow for permanent growth in the money supply. For example, there are currently a little over 13 million bit Tokens in circulation and that system’s protocol dictates that there will be an eventual total of 21 million, which should be largely reached by around 2040.
The Bank of England Financial Policy Committee announced in April 2018 that it has assessed private digital currencies and concluded that while the underlying technology has potential, they do not currently pose a risk to monetary or financial stability in the UK even if they do pose risks to investors.
Financial Regulation of ICOs
Cryptocurrencies are not currently regulated by the FCA provided they are not part of other regulated products or services. Whether an ICO falls within the FCA’s regulatory boundaries or not can only be decided case by case. Many ICOs will fall outside the regulated space. However, depending on how they are structured, some ICOs may involve regulated investments and firms involved in an ICO may be conducting regulated activities. Some ICOs feature parallels with Initial Public Offerings (IPOs), private placement of securities, crowdfunding or even collective investment schemes. Some Tokens may also constitute transferable securities and therefore may fall within the prospectus regime.Applicable regulations are not necessarily limited to those of the jurisdiction governing the ICO. When marketed to investors residing or domiciled in another jurisdiction, the laws and regulations of such jurisdiction may equally apply to the ICO.
The Prospectus Directive applies to transferable securities (as defined by Article 1(4) of Directive 93/22/EEC: shares in companies and other securities equivalent to shares in companies; bonds and other forms of securitized debt which [in each case] are negotiable on the capital markets and any other securities normally dealt in giving the right to acquire any such transferable securities by subscription or exchange or giving rise to a cash settlement. An offer to the public of transferable securities exceeding €8m in any rolling 12-month period must be by way of a prospectus approved by the UKLA.
In certain circumstances a Token might represent a unit in a collective investment scheme; that is an arrangement with respect to property of any description by which passive participants can participate in or receive income arising from the acquisition, holding, management or disposal of property or sums paid out of such profits or income. If this were the case the issue of such a Token to investors would be restricted. A Token which confers no rights to in a company, present or future, should not be a transferable security. A Token which provides no such income, profit or other participation rights relating to property should not be categorised as a unit in a collective investment scheme. The question is, what is ‘property’ for these purposes.
The FCA is now undertaking a review of the digital Tokens with the UK Treasury and BoE. The UK parliament’s Treasury Committee has also launched an inquiry into digital currencies and the distributed ledger technology underpinning them. The FCA has also flagged the risk of market manipulation and money-laundering in the cryptocurrency markets — as well as the dangers of “exceptional” price volatility for retail investors.
British banks have remained wary of getting involved with cryptocurrencies or businesses dealing with them, in part because of the difficulty of conducting anti-money laundering checks on transactions. However, Barclays recently broke ranks to open a UK account for Coinbase, the US-based cryptocurrency wallet and exchange service.
Initially ICOs were in a grey area of regulation, but regulator after regulator has tightened up its position. This changing political attitude has led many in the ICO world to take self-regulation seriously. For example, the Blockchain platform Waves – with participation from entities like Deloitte CIS, the ICO Governing Foundation, and the Ethereum Competencies Centre – has announced the launching of a self-regulatory body to set standards for legal, tax, accounting, know your customer (KYC), and business due diligence for the industry. Waves offers a platform-as-a-service for the development of decentralized applications (DAPPs) and ICOs.
In most countries ICOs are allowed, subject to future regulation, though ICOs are banned in South Korea and China. In the US, on 25 July 2017, the SEC issued a report into the DAO token sale. This was a controversial ICO in 2016 which was hacked about a month after the token sale closed, with about $50 million worth of ether (the cryptocurrency being raised) siphoned off by the hackers.
The SEC’s report confirmed that the DAO Tokens gave investors a reasonable expectation of profits, which meant they had the same characteristics as securities and were therefore subject to the same regulatory and legal regime as securities. The SEC took the opportunity to assert its authority over token sales where the Tokens had the same characteristics as securities, commenting:
“federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
In response, many ICOs have begun to exclude US investors from participating.
To market an ICO, it is currently market practice that the issuing company publishes a whitepaper (“Whitepaper”) on its website and certain virtual platforms. In the Whitepaper, the issuing company describes its business operations as well as the structure and features of the Tokens. The transaction documentation may also include a Token purchase agreement stipulating the terms and conditions pursuant to which investors can purchase the Tokens.
Even when Tokens are not qualified as securities, ICOs and Whitepapers have to conform to certain anti-fraud and information requirements. Information requirements may apply to the issuer and any other party involved in the sale and marketing of Tokens.
Generally, transaction documentation must include all necessary information to allow an average investor to make a reasonable investment decision. The documentation must be accurate and not misleading, comprehensive, transparent and include potential risk factors as well as a description of the characteristics of the Tokens and the business of the issuer. Statements on future developments must be reasonable, and disclosure on the use of proceeds is required. If qualified as general terms and conditions, the terms of the sales documentation must comply with certain local requirements.
Transparency and comprehensiveness of a Whitepaper are currently not necessarily examined by regulatory authorities. Risk factors, if included, are frequently limited to vaguely standardised descriptions of potential conflicts. In addition, (audited) historic financial information may not be available to investors who might therefore not be able to make a reasonable investment decision. However, ICOs frequently occur in the early stages of launching a business. There is currently no established case law available regarding inaccurate, incomplete or misleading ICO documentation. But this may change soon.
ICOs are an innovative and appealing method for companies to raise capital. Although there is currently no specific ICO regulation in place, a diligent analysis of the regulatory framework is necessary to identify and ensure legal compliance with all applicable laws and regulations prior to launching an ICO. Legal challenges arise especially if an ICO targets investors globally. Regardless of the Token structure, the issuing company needs to provide investors with sufficient and accurate information and disclose such information comprehensively and transparently to permit average investors to make a reasonable investment decision.
For further information contact:
RW Blears LLP
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