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Initial Coin Offerings (ICO) Regulation

December 12, 2017

Bitcoin piece on top of coins

Initial coin offerings (ICOs) can be a valuable source of capital for companies, and have recently become a subject of interest for investors across the globe. Companies use cryptocurrencies such as Bitcoin to create models that are similar to initial public offerings (IPOs) or crowdfunding models. In a typical ICO, a percentage of cryptocurrency owned by a company is sold to an investor, who may then exchange the cryptocurrency for legal tender or another form of cryptocurrency. 

Coin (“token”) sales occurred as early as 2013, but the phenomenon became more mainstream in the fall of 2017. Currently, there may be over 50 offerings each month. ICOs have raised more than $3.6 billion in 2017, compared with $295 million in all previous years combined, according to data from CoinDesk

As initial coin offerings become more prevalent, they are raising several fundamental questions in the area of securities law, such as whether or not tokens constitute securities. Jurisdictions around the world are addressing these and other ICO issues, albeit slowly. 

Initial Coin Offering Regulation Hurdles

One of the main difficulties in regulating initial coin offerings is how the tokens are classified. Currently, the main point of contention is whether the issuance of virtual tokens is equivalent to the creation of a new security. 

If courts find that ICOs are comparable to traditional IPOs, they will likely be associated with the strong listing requirements and sale records of IPOs. On the other hand, if they are not found to be comparable, the first legal hurdle will be to create standardized definitions for cryptocurrency and initial coin offering activity. 

These hurdles may be further complicated by the nature of the tokens themselves. For instance, unlike shares in a company, cryptocurrency does not necessarily confer ownership. In some cases, the cryptocurrency can itself be used as currency after a token sale to conduct other transactions.  

Tezos Litigation
Recent litigation may address the question of whether tokens may be considered securities under U.S. securities law. A lawsuit seeking class action status was filed against the founders of the Tezos blockchain project

Specifically, defendants in the lawsuit are being accused a number of securities violations, including selling unregistered securities, false advertising and unfair competition, and securities fraud. The lawsuit may open the door for similar initial coin offering claims to be filed in upcoming months. 

Other Legal Considerations of ICOs 
Due to the lack of clear regulations governing initial coin offerings, the potential is high for fraud and other violations. Operations surrounding ICOs sometimes lack formal governance structures, and many organizations do not have proper auditing and reporting processes in place. 

In September 2017, the Securities and Exchange Commission created a Cyber Unit to regulate initial coin offerings and various cyber-related issues. In December, the Cyber Unit took its first action against PlexCorps, which had been promising investors in its PlexCoin tokens returns of more than 13x within a month.

The unit was able to obtain an emergency asset freeze against PlexCorps over the returns they claimed the investments would yield. The agency warns investors against suspicious ICO activity, especially those promoted by celebrities or those that use the names of publicly listed companies to lure investors to their offerings. 

Singapore’s Central Bank Issues Digital Token Offerings Guidelines

The Monetary Authority of Singapore (MAS), Singapore’s central bank, has issued “A Guide to Digital Token Offerings,” providing an outline for how token sales might be classified under Singapore securities laws.  

The ICO guidelines state, “Offers or issues of digital tokens may be regulated by MAS if the digital tokens are capital markets products under the Securities and Futures Act. Capital markets products include any securities, futures contracts and contracts or arrangements for purposes of leveraged foreign exchange trading."

In determining whether a digital token can be classified as a type of capital markets product, the MAS will “examine the structure and characteristics of, including the rights attached to, a digital token.” The guidelines go on to outline various situations (not exhaustive) where a digital token constitutes a capital markets product. 

Under Section 2.3, a digital token may constitute:

  • A share, where it confers or represents ownership interest in a corporation, represents liability of the token holder in the corporation, and represents mutual covenants with other token holders in the corporation inter se
  • A debenture, where it constitutes or evidences the indebtedness of the issuer of the digital token in respect of any money that is or may be lent to the issuer by a token holder; or
  • A unit in a collective investment scheme (CIS), where it represents a right or interest in a CIS, or an option to acquire a right or interest in a CIS

The MAS has indicated in the guidelines that other Singapore regulations may apply to ICOs, including sales that do not ultimately come under its jurisdiction directly. The guidelines also include a section on money laundering and the financing of terrorism. Lastly, the guide also contains several case studies which provide examples of token sales that would or would not be counted as securities. 

The MAS guidelines could serve as model for other authorities and organizations that are seeking clearer definitions and applications with regards to ICOs. Several governments are reacting to ICOs and are taking steps to implement regulatory schemes for initial coin offerings, including Russia, the U.K., and Australia

The Future of ICO Regulation

As with any new product, technology, or innovation, cryptocurrency has the potential to give rise both to fraud and high-risk investment opportunities. Potential investors can be easily enticed with the promise of high returns in a new investment space, and also may be less skeptical when assessing something novel and cutting-edge. 

As the SEC has indicated, investors should exercise sound judgement when engaging in activity that involves cryptocurrency and ICOs. 

Companies conducting initial coin offerings should be cognizant of new regulations and standards that will be worked out as ICO activity continues. More detailed classification criteria for ICOs as a security will likely be a major theme in legislation and lawsuits to come. In the meantime, companies may benefit from implementing robust corporate governance policies, and ensuring that they are taking steps to avoid abuses and misrepresentation. 

Initial coin offerings are complex and embody many of the legal issues that accompany the digital age. If you have any questions or concerns regarding ICOs, securities regulations, or other matters, contact us today at Kessler Topaz

Our team is a strong voice for shareholders in global companies. We often pursue groundbreaking cases on behalf of investors to make recovery of losses possible in various jurisdictions.