Initial Coin Offerings – increasing regulatory risk
Initial Coin Offerings (ICOs) are increasingly coming under the spotlight of regulators. The U.S. SEC has already taken legal action against the sponsors of two ICOs. China has banned ICOs. We take a look at regional regulatory responses to ICOs, and, with a focus on Hong Kong we consider the key issue of whether "coins" or "tokens" are regarded as securities, and the repercussions if they are. ICOs are an innovative way of raising capital, but their future success will depend on a coordinated and proportionate regulatory response.
Regulation tends to take into account "unknown unknowns", as well as what is currently happening in the markets. However, new products and technologies continually evolve and surface, often side-stepping regulations intended to protect markets and investors.
ICOs – initial coin or token offerings – are a good example. They are something of a novelty in an otherwise crowded financing environment. Their proponents promise a swift and easy method of capital raising as a credible alternative to more traditional venture capital avenues.
What are ICOs?
Utilizing public blockchains1 such as the Ethereum network's ERC-20 token, issuers can issue digitally-scarce tokens and sell them to investors in exchange for crypto currencies such as Bitcoin or Ether, or cash. Using blockchain technology provides enhanced security because no single person has editorial or other control of processed information constituting the overall rights, records and documentation.
On their face, ICOs are offerings of coins – also known as tokens – to the public. The coins may or may not be exchangeable for services offered, or other rights granted, by the issuer. Some coins can be redeemed, eg at a preferential rate for goods and services, bolstering and encouraging demand for the particular products or future services. They can also be used as an alternative form of fundraising by an issuer or fund, with the token carrying rights of return. Others can be redeemed for value depending on the performance of underlying investments. The coins are often sold on in the secondary market. Some tokens don't expressly offer any rights. The value of the coins will fluctuate according to, at best, the success of the business and, at worst, pure speculation. Many ICOs fund projects at a very early stage of development.
Innovative capital raising strategy or risky unregulated investments?
Regulatory responses to new products and technologies involve a delicate balancing act between protecting investors and markets, on the one hand, and not stifling innovation, on the other. If ICOs are left unregulated, there is a danger they may become a "shadow" capital-raising environment in which investors do not have the protections that they would have in a more traditional capital-raising setting. In the case of ICOs, there are already regional variations in the outcome of this regulatory balancing act.
A key regulatory question boils down to a matter of definition. Are tokens "securities" or the equivalent? If they are, there would be significant consequences for ICOs, either drawing them and their issuers into the full regulatory net or allowing them to have a separate development curve.
In Asia, Hong Kong and Singapore have left the question open as to whether coins would fall within the definition of securities. The Securities and Futures Commission in Hong Kong has made it clear that it does not wish to act as a block to innovation, so appears to be taking a wait and see approach. Australia has taken a similar approach to Hong Kong and Singapore.
China has banned ICOs, viewing them as overly disruptive to the market and investigations have been launched into a large number of ICO platforms. Korea has banned ICOs, and expressed concerns regarding anti-money laundering and foreign exchange control issues, eg where anti money laundering restrictions may be compromised by lower disclosure requirements and funds could (especially in the case of foreign-based ICOs) flow in a less controlled manner out of Korea.
Japan also warned investors of the risks relating to ICOs, although it has also taken initiatives to regulate crypto currency exchanges generally (which appears to be the most progressive approach so far). Indonesia, Thailand and the Philippines are considering their positions on the issues raised, very much as with most Asian regional regulators, who are principally in information-gathering and policy forming mode at this stage.
The U.S. SEC has warned potential issuers and investors in ICOs and token sales. On 25 July 2017, the SEC issued an investigative report cautioning market participants that ICOs and token sales may be subject to the registration and other requirements of U.S. federal securities laws. Most recently, on 29 September 2017 the SEC filed a civil complaint in the U.S. District Court for the Eastern District of New York against the sponsors of two ICOs for alleged violations of U.S. securities laws. This is the SEC's first enforcement action against sponsors of an ICO, and it highlights the SEC's increasing awareness of potential violations of securities laws involving this emerging technology. We expect to see much more U.S. enforcement action in this area from both the SEC, as well as potentially aggrieved investors who may have a private claim (including for rescission or to recover financial losses), against issuers who engaged in an unregistered securities offering in violation of the relevant federal securities laws. More information on these developments is available here.2
The UK FCA has not to date been active in this area, and has left open the question of whether tokens are outside the securities regime. The FCA has made it clear, however, that existing securities laws apply to any tokens that have security-like features. In a consumer warning on 12 September3 the FCA warned about the high risk and speculative nature of ICO offerings, saying that:
"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.
Businesses involved in an ICO should carefully consider if their activities could mean they are arranging, dealing or advising on regulated financial investments. Each promoter needs to consider whether their activities amount to regulated activities under the relevant law. In addition, digital currency exchanges that facilitate the exchange of certain tokens should consider if they need to be authorised by the FCA to be able to deliver their services."
Spotlight on Hong Kong – are ICO coins 'securities'?
Hong Kong, as a case study, provides a useful insight into the definition issue in relation to ICOs. The Hong Kong definition of "securities" under the relevant legislation – the Securities and Futures Ordinance – includes:
- shares, stocks and debentures;
- rights, options or interests (whether described as units or otherwise) in, or in respect of, such shares, stocks, debentures, loan stocks, funds, bonds or notes;
- interests in any collective investment scheme;
- interests, rights or property, whether in the form of an instrument or otherwise, commonly known as securities;
- interests, rights or property which are interests, rights or property, or are of a class or description of interests, rights or property, prescribed by notice under section 392 of this Ordinance as being regarded as securities in accordance with the terms of the notice; and
- a "structured product" (which is very widely defined, covering instruments linked to an extremely broad range of property and rights) which does not fall within any of the above categories and essentially relates to an advertisement to the public for the sale of securities or structured products.
There are numerous excluded items, such as instruments that are specifically excluded by subsidiary legislation from the definition.
So far, the Hong Kong SFC has indicated that it may be minded to regard coins as "shares", where for example coins are given shareholders' rights, such as the right to receive dividends. Also, where digital tokens are used to create or to acknowledge a debt or liability owed by the issuer, they may be considered as a "debenture".
In our view, it is less likely that ICOs would be viewed as creating "shares", but there is potential for treating them as rights or interests in shares. In addition, if token proceeds are managed collectively by the ICO scheme operator to invest in projects with an aim to enable token holders to participate in a share of the returns provided by the project, the digital tokens may, depending on the particular structure, be regarded as constituting an interest in a "collective investment scheme" (CIS). Shares, debentures, and interests in a CIS are all regarded as "securities".
Whether coins could be viewed as property, rights or interests "commonly known as securities" is debatable, certainly at this stage of market development, but in the future, given the broad similarities between ICOs and IPOs, and depending on how the market starts to regard ICOs in practice, they may fall under this provision. It is to be hoped that this would not be allowed to act as a "sweeper" provision as a last resort to catch coins, given the difficulties of interpretation as regards this somewhat imprecise statutory definition. Coins could also perhaps fall under the heading of structured products – again, this would be dependent on the precise arrangements.
Effect of coins being categorized as securities
If ICOs were categorized as securities this would have an immediate knock-on effect for the licensing of issuers and sponsors and for the level and quality of disclosure materials required for prospective investors (whereas before there may have been none). In some jurisdictions (for example the U.S.) the exchanges which list the tokens may also incur liability if they list a token without the appropriate registration or exemption.
There would be increased reporting requirements to assist with upholding the financial integrity and stability of markets. There is a perceived need for authorities to obtain and maintain appropriate levels of information and scrutiny as an overall picture in local and international markets, to avoid financial crises.
A coordinated approach
The regulatory response to ICOs needs to be mapped out carefully to ensure a coherent position within, and between, markets. ICOs are inherently highly mobile across borders. A coordinated approach would minimize cross border arbitrage. International regulatory organizations, particularly the International Organization of Securities Commissions (IOSCO), will need to resolve issues of definition and regulatory treatment before the response becomes one of urgent necessity rather than measured integrated planning.
ICOs are undoubtedly attracting increased attention from regulators. Companies seeking to raise funds through an ICO will need to take into account legal developments in this area in the way they structure and market their offering and to comply with the evolving and differing regulatory treatment of ICOs around the world.
A&O client seminar: ICOs: all hype or the future of capital raisings
On Friday 24 November from 08:00-10:00 at Allen & Overy’s office at One Bishops Square, London E1 6AD, Simon Toms and Michael Bloch will be leading a breakfast briefing on ICOs. They will review the recent regulatory interventions, consider the key legal and regulatory issues relating to token issuances and look to how the market for ICOs will respond and mature over the coming months and years.
If you would like to attend please register by emailing email@example.com
This case summary is part of the Allen & Overy Legal & Regulatory Risk Note, a quarterly publication. For more information please contact Karen Birch – firstname.lastname@example.org, or tel +44 20 3088 3710