ICOs: A call for governance

Initial coin offerings (ICOs) are a relatively new and complex financing phenomenon predicated on distributed ledger and cryptocurrency technologies. They have quickly become viewed as the financing method of choice for companies seeking to build distributed ledger technology-based businesses. Funds raised in ICOs surpassed that raised in traditional venture capital and equity financing for the first time in the second quarter of 2017¹. It is estimated that over $3 billion has been raised in ICOs in 2017 to date².

ICOs at a glance

A company or organisation seeking to raise money through an ICO will create a new digital token of value (token) either on an existing distributed ledger technology network, such as Ethereum, or on its own distribution ledger. The token will be ascribed certain rights and attributes. For example, it may be used as a means of payment, may represent an asset, may give the holder the ability to participate in the token issuer's project and/or may give the holder equity-like rights. The token will be given its own name and be made available at a fixed or floating price. In general, ICOs are offered widely through an online platform, to both institutions and individuals. Tokens are typically purchased by payment in a well-established cryptocurrency, such as bitcoin or ether, but may also be purchased using fiat currency (e.g., US dollars, euro or other legal tender). The number of tokens that are issued may be capped or uncapped.

In addition to enabling the creation and issuance of the tokens, the token issuer will publish a white paper that sets out the idea or business plan that the token issuer proposes to implement using the funds raised from the ICO. In general, most token issuers' white papers involve an early-stage idea or business plan intending to utilise distributed ledger technology, but this is not a requirement. It is not unusual for the token issuer to commence an ICO before they have a functional prototype.

The type of token that is created and issued will influence its value and, in particular, the development of a market in that token. In concept, the value of a token issued through an ICO should increase as the underlying idea or business develops and becomes more attractive to other potential token purchasers. The token, once issued, is freely tradeable and exchangeable.

Cause for concern

Almost as quickly as their prominence has grown, ICOs are becoming a victim of their own success with the lens now focused squarely on the very real pitfalls of these offerings.

In traditional venture capital and equity financing models, investors receive equity in a company. This entitles the investors to protections under various regulatory regimes, which make the company responsible for ensuring that it does not mislead its investors in securing financing. Investors may make certain assumptions about the specific financial returns that they will receive on their investment. If those assumptions are based on false or misleading statements made by or on behalf of the company regarding its future business and performance, the investors may have recourse against the company under various corporate and financial regulations and laws.

In ICOs, purchasers receive tokens which may or may not fall outside existing regulatory regimes depending on their attributes. Some have argued that ICOs are more akin to donation crowdfunding than equity financing³, making the purchase of tokens a donation and not an investment. Under this theory, token purchasers should not expect to receive any benefit from purchasing tokens. However, in many cases, the tokens issued in ICOs are designed to have complex and often hybrid characteristics so as to necessarily given token purchasers an expectation of some form of return—though not purely financial. For example, the token issuer's white paper may outline ways in which token purchasers are to be able to participate in the token issuer's project or to receive other benefits as the project progresses.

There is no guarantee that a token issuer will succeed in implementing its business plan as proposed in the white paper or at all. As the white paper is not subject to any type of standardised disclosure rules, it is not yet clear whether a token issuer will have liability for the claims made in those papers; most token issuers seek to disclaim liability in their purchase agreements. As a result, token holders may have little to no recourse when a token issuer fails to deliver. In addition, paid and fraudulent promotion of ICOs seems to be on the rise⁴, making it more difficult for less tech savvy and/or sophisticated token purchasers to make informed decisions.

Moreover, without sufficient public demand, it is unlikely that a cryptocurrency exchange will enable the new token to be exchanged for other cryptocurrencies or for fiat currency, making those tokens worthless. Likewise, poorly performing tokens face being delisted from cryptocurrency exchanges.

Regulators have rightly indicated their concern where tokens bear the hallmarks of securities⁵, meaning that purchasers of securities tokens should have the protective rights under relevant securities laws. This is a fact-based analysis complicated by the hybrid features of many tokens. Most Western regulators seem to be taking a wait-and-see approach, suggesting that existing regulatory regimes (particularly those for financial services) are sufficient to govern the conduct of ICOs for the time being. This approach is contrasted with that taken by regulators in China and South Korea, who have issued a blanket ban on ICOs⁶. Abu Dhabi's Global Market's Financial Services Regulatory Authority is one of the few regulators to have published specific guidance on ICOs to date, although their guidance largely indicates that token sales will be considered on a case-by-case basis⁷. It is expected this will hold true in most jurisdictions, although the Gibraltar Financial Services Commission has recently announced a new regulatory framework for distributed ledger technology, which it may decide to apply to ICOs⁸. Our work with token issuers indicates that the introduction of the new framework is helping to make Gibraltar an attractive location from which to launch ICOs.

Consensus needed

There exists now an opportunity for participants in the ICO market (particularly token purchasers, advisers and platform operators) to establish a best practices framework on which future non-securities token offerings can be based, the central tenets of which should be transparency and accountability. By borrowing practices well-honed and accepted in the adjacent public and private securities offerings markets, the ICO market can seek to avoid the existing pitfalls and to deter the abuse and fraud which has started to plague the system. This, in turn, may lead the way for regulators to adopt the framework as formal guidance or regulation, or to establish the basis on which market participants can seek no-action comfort from regulators.

First and foremost, there needs to be an adequate and trusted disclosure mechanism. Establishing minimum disclosure requirements, in particular for the white paper published for the ICO, would help ICO issuers to not only manage and avoid risks arising from possible liability claims, but to also differentiate its ICO from other ICOs of low quality or even untrustworthy or fraudulent ICOs. The minimum disclosure requirements should require the token issuer to provide a balanced view of its business plan and the risks relating thereto. Claims made should be verified or verifiable by reference to, wherever possible, third party data. Token issuers should also be required to disclose any significant pre- and post-ICO token holders, including prices paid and discounts applied. Review of white papers by experienced, independent third party advisers should be recommended.

In addition, the structure of the ICO should be carefully considered. The quantity of tokens offered should not be uncapped; it should be based on the actual financial needs of the token issuer or be based on an independent valuation of the token issuer or project. Due to the start-up nature of many companies conducting ICOs, meaning there is a higher risk that the business plan could fail, clear rules or guidelines should be established for enabling token purchasers to withdraw purchase orders during the ICO offering period and to receive a refund in the case of a failure of the project. In instances of fraud, token purchasers should have full recourse to the token issuer.

Finally, persons to whom ICOs are marketed and made available to should be vetted through robust know-your-customer and anti-money laundering checks. The markets in which tokens are offered should be carefully considered to avoid any regulatory pitfalls or enhanced liability. There is a well-established selling restrictions regime in the securities offerings market, and these best-practices would lend themselves easily to the ICO market. For example, filters and geo-blockers should be used for websites and apps, distribution lists should be checked, relevant disclaimers should be used in ICO documentation and relevant securities law-based representations and warranties should be obtained from token purchasers.

Once there is consensus on the best practices framework, self-regulation can be achieved through behaviour. Platforms through which ICOs are made available should adopt baseline requirements in line with the framework to help ensure the quality of ICOs coming to market. Token purchasers should demand high quality disclosure and clear recourse pathways, and advisers should work with token issuers in meeting the baseline standards. Token issuers should invite and encourage dialogue and challenge so that their white papers can be vetted and tested. While individual initiatives towards standardisation are in the works⁹, increased interaction and coordination between those initiatives is needed to establish wider acceptance.

What the future holds

In light of recent news flow, it would not be unreasonable to conclude that ICOs are under attack. Over the recent months ICOs have been banned outright (China¹⁰, Korea¹¹), exposed as frauds (REcoin, DRC¹²), been warned against by a growing list of regulators (the US' SEC^13, Singapore's MAS¹⁴, Canada's CSA¹⁵, the UK's FCA¹⁶, Japan's FSA¹⁷, Australia's ASIC¹⁸, Germany's BaFin¹⁹), and, in what could be a turning point for the ICO market, become the subject of a class action law suit in the United States (Andrew Banke vs Dynamic Ledger Solutions, Inc. et al²⁰).

The extent to which such sobering news will ultimately affect the ICO market remains to be seen. What does seem clear, however, is that while the market is taking notice and watching these events unfold with bated breath, investment and excitement in cryptocurrencies shows no sign of waning. For example, the price of bitcoin has recently soared to a record high²¹, bolstered by more positive news, such as the CME Group's announcement that it had applied to enable trading in bitcoin futures contracts²².

It seems likely that ICO issuers and purchasers alike have been, and may continue to be, emboldened by the success of foundational cryptocurrencies bitcoin and ether, whose values have grown at astounding rates, making millionaires (and likely billionaires) of early adopters. However, as more and more token issuers fail to deliver on the promise of their white papers, and in light of the growing uncertainty as to how tokens fit within existing regulatory regimes and the seemingly increased potential for ICO-related litigation, the amounts raised through ICOs may start to taper off.

Market participants should take this opportunity to make ICOs safer and more accessible by injecting governance and, thus stability, into the ICO market.

1. See https://www.cbinsights.com/research/report/blockchain-trends-opportunities. 

2. See https://www.coinschedule.com/stats.php

3. See https://standardcrypto.wordpress.com/2015/06/13/ethereum-deputy-calls-investors-donors-in-leaked-skype-chat.

4. See e.g., https://www.sec.gov/news/public-statement/statement-potentially-unlawful-promotion-icos; http://fortune.com/2017/11/01/bad-news-for-mayweather-the-sec-is-cracking-down-on-celebrity-icos; and https://www.financemagnates.com/cryptocurrency/news/ethereum-founder-vitalik-buterin-calls-misleading-ico-marketing.

5. See e.g., https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings; http://www.sfc.hk/web/EN/news-and-announcements/policy-statements-and-announcements/statement-on-initial-coin-offerings.html.

6. See http://www.circ.gov.cn/web/site0/tab6554/info4080736.htm; and http://www.fsc.go.kr/info/ntc_news_view.jsp?bbsid=BBS0030&page=1&menu=7210100&no=32085

7. See https://www.adgm.com/media/192772/20171009-fsra-guidance-for-icos-and-virtual-currencies.pdf.

8. See http://www.gfsc.gi/news/statement-on-initial-coin-offerings-250.

9. See e.g., https://blog.coinbase.com/2016-12-07-blockchain-token-securities-law-a66ef03c383f; https://financialcommission.org/2017/08/29/financial-commission-extends-technology-certification-service-issuers-icos; http://www.trustnodes.com/2017/10/02/ethereum-based-icos-launch-self-governance-initiative.

10.  See http://www.circ.gov.cn/web/site0/tab6554/info4080736.htm.

11. See http://www.fsc.go.kr/info/ntc_news_view.jsp?bbsid=BBS0030&page=1&menu=7210100&no=32085.

12. See https://www.sec.gov/news/press-release/2017-185-0.

13. See https://www.sec.gov/oiea/investor-alerts-and-bulletins/ib_coinofferings.

14. See http://www.mas.gov.sg/News-and-Publications/Media-Releases/2017/MAS-clarifies-regulatory-position-on-the-offer-of-digital-tokens-in-Singapore.aspx

15. See http://www.osc.gov.on.ca/en/SecuritiesLaw_csa_20170824_cryptocurrency-offerings.htm.

16. See https://www.fca.org.uk/news/statements/initial-coin-offerings.

17. See http://www.fsa.go.jp/policy/virtual_currency/07.pdf.

18. See http://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings.

19. See https://www.bafin.de/SharedDocs/Veroeffentlichungen/EN/Meldung/2017/meldung_171109_ICOs_en.html.

20. See http://www.almcms.com/contrib/content/uploads/documents/403/4319/tezos-sfo-complaint.pdf.

21. See https://charts.bitcoin.com/chart/price.

22. See http://www.cmegroup.com/media-room/press-releases/2017/10/31/cme_group_announceslaunchofbitcoinfutures.html.