ICO Beyond the Hype: Legal Status, Models, Cases
The first ICO was conducted in 2013. Since then this model has proven itself as a relatively efficient and affordable way to raise funds for product development. In 2018 alone three biggest ICOs have raised approximately $11 billion.
The most well-capitalized of those is El Petro, the oil-backed cryptocurrency issued and backed by the Venezuelan government. It has attracted about $5 billion just over pre-sale. The second place is occupied by the EOS project, which is a blockchain platform for developing decentralized applications (DApps). EOS has raised $4.2 billion over the token sale that started on June 2017. Finally, Telegram (TON), a cryptocurrency and blockchain platform that is being built specifically for Telegram Messenger users, has received approximately $1.7 billion over the private rounds and apparently decided to cancel the public token sale.
ICOs have already collected large sums and attracted much hype, but the procedure itself entails substantial legal difficulties and risks, including lawsuits, fines, or even jail. Regulators around the world closely monitor the situation trying to create rules for the ICO market. It is important to take the hype with a grain of salt, and therefore it’s important to know what is an ICO, what problems may it entail, and how to avoid those.
ICO Legal Status
ICO (Initial Coin Offering) is, first and foremost, a way for a project to raise funds for its development. Typically, a project issues digital tokens and distributes them among interested enthusiasts in exchange for cryptocurrency or fiat money.
According to the SEC statement, ICO is a procedure of selling virtual coins or tokens that are created and disseminated using distributed ledger or blockchain technology in exchange for fiat currency (e.g. U.S. dollars) or virtual currencies.
“The term ICO refers to a digital way of raising funds from the public using a virtual currency, also known as cryptocurrency… ICO issuers accept a cryptocurrency, like Bitcoin or Ether, in exchange for a proprietary ‘coin’ or ‘token’ that is related to a specific company or project.”
The Swiss Financial Market Supervisory Authority (FINMA) in its Guidance 04/2017 defines ICO as follows:
“ICOs are a digital form of raising funds from the public. They exclusively take place using distributed ledger or blockchain technology. Under the usual procedure for ICOs, financial backers will transfer a certain amount of cryptocurrency to a blockchain-generated address supplied by those organising the ICO campaign. In return, financial backers receive blockchain-based coins or other tokens connected with a specific project or company run by the ICO organisers.”
Generally, such definitions are quite broad.
“How ICOs are structured from technical, functional and business standpoints varies markedly from offering to offering,” the Swiss regulator’s guidelines state, “There is no catch-all definition.”
Via an ICO a project can sell:
- The right to receive and thus own digital tokens in the future.
- The right to receive and therefore own digital tokens straight away (usually, once the payment is made).
In both cases, from a legal perspective, what the project actually does is passes the title to digital tokens.
Thus, an ICO can be defined as a process of raising funds for the project’s development via passing titles to digital tokens issued by the project in question and transferred to the ICO participants in exchange for cryptocurrency or fiat money.
As of now, cryptocurrencies are more or less strictly regulated in the most popular jurisdictions, such as the United States, Switzerland, the UK, Singapore, Japan, South Korea, China, and others. A full-fledged regulation of ICOs is closer than it was half a year ago. Yet, in some cases it isn’t as clear as one might like. In this regard, the companies willing to undertake a token sale should pay close attention to their compliance with the existing regulatory frameworks.
There are at least three most widespread kinds of ICOs:
- Utility Token Sale.
- Security Token Offering.
- Donation Campaign.
Each has its own features beneficial for certain projects and goals, while entailing its specific risks and shortcomings.
Utility Token Sale: Easy and Popular
A utility token sale is a sale of the digital tokens (utility or app tokens) required to access the product and/or to use one in exchange for cryptocurrency or fiat money like EUR or USD. Spoiler alert, the significant part of all ICOs are utility token sales.
In legal terms, the seller, a company issuing utility tokens and holding an ICO, passes title to such tokens to the buyer, the ICO participant, for a consideration called price under the sale and purchase agreement published on the website.
ICO participants purchase utility tokens as simply as one shops online. And from a legal perspective, it’s not that different from ordering groceries from your local supplier. As one of the key features, a utility token is easier to sell to a wide audience as it allows a token issuer to mitigate all possible risks related to securities legislation and don’t necessarily exclude citizens of various states from the participation because of imposed legislative restrictions.
Reasons for such exclusion may vary but the most prominent example is that many projects have forbidden the participation of Chinese and Korean citizens in their ICOs as soon as those jurisdictions have banned ICO.
An ecosystem with app tokens is more attractive to potential users, since such tokens will be useful within a product, will remain in circulation (otherwise users won’t be able to access the platform or network in question), and will barely entail any legal complications. These are the most obvious reasons of the model’s popularity
Security Token Offering: Complicated But Reliable
To put it simply, a security is a financial asset or instrument of any kind that can be traded. Therefore, a security token offering is a sale of digital tokens (security tokens) that are backed by a tradable asset or constitute attributes of a security (like interests, shares, ownership rights etc.) in exchange for cryptocurrency or fiat money.
Securities tokens seem to be a more attractive as they give their holders some specific rights regarding the issuer company and potentially may bring a higher profit. Token issuers still should know that an offering of such tokens requires more legal work to ensure compliance with the existing legislation and take all necessary precautions due to potential securities laws risk.
A security token offering entails additional risks related to compliance with the securities legislation. Financial regulatory authorities of many jurisdictions have already acknowledged that the digital tokens sold over ICO might be deemed securities. Moreover, such authorities probe tech companies and advisors involved with the cryptocurrencies. There’s been numerous subpoenas and informational queries over the recent months addressed to such companies and individuals.
However, if a given ICO procedure is held in full compliance with the securities legislation, it is even safer than the utility token sale described above. After all, the fact that the issuer-company calls its token a utility one, doesn’t necessarily mean that the SEC or another regulator will think the same.
In case the project doesn’t abide by the prescribed offering procedure, its token sale might be seized or even stopped, a company and a project’s team might get fined for violations and become embroiled in litigation by the regulators or the project’s own token holders.
Notable examples of such litigations include the following lawsuits:
- Token holders vs. Tezos (Dynamic Ledger Solutions, Inc., Tezos Foundation and others). In October and November of 2017, four class action lawsuits were filed against the token issuer. Tezos ICO has raised approximately $232 million but because of internal conflict, the Tezos platform development was delayed and token sale should has been registered with the SEC as a securities offering. Tezos hasn’t done such a registration, so Tezos has violated the U.S. Securities Act.
- Token holders vs. Centra. In December, 2017, a class action against Centra Tech, Inc. was filed. A plaintiff alleged that the Centra ICO was an unregistered securities offering.
- Token holders vs. ATBCoin. On December 21, 2017, a class action was filed against ATBCoin LLC and others. The lawsuit was based on allegations that ATBCoin has violated the U.S. Securities Act by issuing unregistered securities.
- Token holders vs. Paragon. In January, 2018, Paragon Coin that has attracted $70 million, faced a class action stated the company violated the securities laws of the USA during the token sale.
As for now, to minimize the risks projects seek to use existing exemptions that grant permission to conduct a securities offering without being registered with financial / securities market authority. In case of the U.S. securities laws, projects mostly use SAFT (Simple Agreement for Future Tokens) framework that uses Regulation D and Regulation S to conduct a legitimate and compliant offering. The framework will be reviewed in detail in subsequent entries in this series.
Donation Campaign: Non-profit Only
A donation campaign is a process of distributing digital tokens issued by a non-profit foundation in exchange for donations received from individuals and entities for the purposes of charity or other declared goals.
Participants of a donation campaign are voluntarily supporting the team and its idea, receiving no profit or other material benefits for their contribution. A distinctive feature of this token sale model is that the project establishes a non-profit foundation to collect funds from the ICO, in contrast to a utility token sale or a security token offering, where all funds are collected by an LLC or another type of entity.
It’s worth saying that establishing a non-profit foundation is a long, complicated and expensive process. Many jurisdictions have set the strict requirements for non-profit foundations, and for centralized business-oriented projects the tax relief and other benefits of creating such an entity may be dwarfed by the complexity of its establishment process.
In the next articles all ICO models will be thoroughly analyzed and clearly described.
Follow us on Twitter to stay tuned on the recent developments in regulation of new technologies, and be the first to read expert opinions.