Initial Coin Offerings: 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 the amount raised
in traditional venture capital and equity financing for the first time in the
second quarter of 2017.[1]
It is estimated that over $3 billion has been raised in ICOs in 2017 to date.[2]

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 (eg, US dollars or euros). 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
financing,[3] 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 give 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 or no
recourse when a token issuer fails to deliver. In addition, paid and fraudulent
promotion of ICOs seems to be on the rise,[4] 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 securities,[5] 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 ICOs.[6] 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 basis.[7] 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 ICOs.[8] 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 not only to 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 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 works,[9]
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 (China,[10]
Korea[11]),
exposed as frauds (REcoin, DRC[12]),
been warned against by a growing list of regulators (the USA’s SEC,[13]^, Singapore’s MAS,[14]
Canada’s CSA,[15]
the UK’s FCA,[16]
Japan’s FSA,[17]
Australia’s ASIC,[18]
Germany’s BaFin[19]),
and, in what could be a turning point for the ICO market, become the subject of
a class action law suit in the USA (Andrew
Banke vs Dynamic Ledger Solutions, Inc. et al[20]).

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 high,[21] bolstered
by more positive news, such as the CME Group’s announcement that it had applied
to enable trading in bitcoin futures contracts.[22]

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.

Tara Waters is a Senior Associate in the London office of
Ashurst LLP

Ian M Maywald is a Senior Associate in the Frankfurt
office of Ashurst LLP