So you are a tech startup who want to raise funds. You figure that instead of incurring debt, issuing equity, entering into convertible loan agreements (CLA), you will conduct an initial coin offering (ICO) or digital token sale. Not least because the amounts of money which have been raised by recent ICOs are huge. (I am using ICO because it is a shorter well-recognised abbreviation than “digital token sale”, even though the term ICO may be a bit of a misnomer.)
For every ICO that makes headlines, there are probably many ICOs which fall far below the issuers’ expectations. A lot of this of course is based on investors/purchasers’ sentiment and speculation. But some of that is also dependent on a few things like good marketing, viable underlying business model or technology, a credible team, and fair and reasonable terms of sale. If you do wish to build credibility for your ICO, there are some things which you would want to consider from a legal, regulatory perspective.
Your business model or technology
First and foremost, is your business model or technology something which would attract cryptoinvestors to an ICO? This is not a legal question. It is a human question. Imagine a fledgling food truck business selling hotdogs conducts an ICO… You get the idea. Of course there is nothing prohibiting that. But what makes one think that ICO would succeed?
ICOs which have done well have tended to be conducted by issuers who deploy blockchain technology (mostly on Ethereum) to novel applications and business models. For instance, TenX’s technology allows for users to use cryptocurrency in their digital wallets by way of a TenX debit card which you can use like any credit card.
Why is that? Because investors can sniff out a credible issuer from one who is not. ICOs which focus on selling digital tokens which have a clear utility purpose in a blockchain technology application are generally seen as preferable. The utility of the tokens in an application with solid concept and strong potential in widespread adoption means that there would naturally be a demand for the tokens in due course if the application succeeds. If there is demand, initial investors who purchased the tokens would benefit from either using the tokens or cashing out later. If there is no demand, if the business or application flops, then the token is a dud.
How then can you present a case to your potential token purchasers / investors that you have strong potential and solid concept? Most ICOs have white papers with clear and specific details about their issuers’ product or service, operations, and technology, profile on the founders and development team, a comprehensive development roadmap with milestones and funding requirements for each milestone. Further, good ICOs would use open public blockchain platforms, open source software, have conducted independent security audits and reassure investors on why their token sale, platform and network would be secure.
So if you are issuing tokens just as a means to raise funds, but the tokens are not pegged to the underlying business or technology in any way, then it smells like a meaningless thing. If the tokens somehow give token holders rights to some returns, dividends or profits, then you are going to run into some thorny legal, regulatory issues (more below). In sum, do seriously consider whether an ICO is really the best way to successfully raise funds for your business.
Structuring your ICO / digital token sale
There are many ways to structure your ICO or digital token sale. The structure does matter in terms of what you want to achieve, and how potential investors would view your ICO. Some considerations are as follows.
Capped amount of tokens for sale. A cap means there’s only a finite supply of tokens for sale. For you, it means there’s only a finite maximum amount of funds you can raise. For the investors, it could mean signal that you are not being greedy to ask for the sky. It may also mean for them that the subsequent secondary market for the tokens will be more likely to be trading at higher values if your application takes off, though this is probably speculative. Importantly, it may fuel investors’ FOMO-driven purchases. Or it may not.
Setting aside a certain percentage of total token supply for insiders, i.e. founders, development team, advisors, the startup, etc.
Price. You can either let token purchasers decide on the token price, i.e. at market value, or you can fix the price.
Whether tokens are sold on first-come, first-served basis or on some other basis which allows for a wider diversity of buyers.
The most common structure is the capped first-come, first-served structure. Fixed amount of tokens sold at fixed price on a first-some, first-served basis for a given sale period. Usually, a certain percentage of total token supply will be specified to be set aside for insiders.
Another structure is the capped auction. There is a cap of total amount of tokens to be sold. Investors bid for a desired price and at a specified budget. The amount of tokens actually sold would vary depending on the bids. There is also the uncapped version of the same.
If you want to ensure a wider diversity of token purchasers and thus holders, an option is to have a capped amount of tokens to be sold, and investors bid a specified total budget. You then sell the percentage of tokens for sale (the rest kept for insiders) at a fixed price, distributing the tokens to all the bidders according to their bids. If there is oversubscription, those buyers who specified a higher total budget would only get a fraction of the tokens they had wished to purchase.
Another way to ensure wider diversity of token purchasers is to limit each investor to only one (or more) transaction with a fixed maximum amount of tokens one can purchase.
The thing is, how you structure your ICO will affect how potential investors view you and your ICO. If the terms are unreasonable, it will attract criticism. See for example: https://tokeneconomy.co/the-analysis-filecoin-doesnt-want-you-to-read-e60d5243f17c. And if you underlying business or technology is not necessarily views as most promising, you run the risk of public relations issues.
Legal and regulatory issues
Now we consider the legal and regulatory issues with ICOs or digital token sales. The first is whether your ICO or token would be characterised as a security or some regulated scheme which requires regulatory approvals. This would then presumably affect: (i) your decision whether to proceed or not; (ii) your choice of jurisdiction as to where you want to incorporate or register the legal entity issuing the tokens and conducting the ICO; (iii) prohibitions against persons from certain jurisdictions being involved in the ICO.
The second is that regardless of the legal characterisation of your ICO or token, you would want to address anti-money laundering (AML) and counter-terrorism financing (CTF) concerns by ensuring some level of due diligence and Know Your Client (KYC) measures.
The third would be your terms and conditions of ICO / token sale which would itself be affected by the above legal issues.
The United States (US)
In the US, the Securities and Exchange Commission (SEC) issued an investigative report on 25 July 2017 (https://www.sec.gov/litigation/investreport/34-81207.pdf) finding that an ICO by The DAO was subject to federal securities laws and the tokens sold were deemed securities. This is interesting because The DAO is not a registered legal entity but a virtual corporate entity (a Decentralised Autonomous Organisation or Corporation (DAO/DAC)).
Under Section 2(a)(1) of the US Securities Act and Section 3(a)(10) of the US Exchange Act, a security includes “an investment contract.” The touchstone of an investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. This is based on two significant cases: SEC v. Edwards, 540 U.S. 389, 393 (2004); and SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). Substance rather than form matters, so the emphasis would be on economic realities underlying a transaction, and not on the names or labels attached. Profits would include dividends, periodic payments, investment returns or the increased value of the investment.
This does not make any and every ICO illegal. The problem is that “reasonable expectation of profits” can be a pretty broad concept. Of course, a token issuer can apply to the US SEC as an issuer of securities.
This legal position also means that any exchange which facilitates trading of tokens which are deemed under US law to be securities would also be subject to the US Exchange Act. Section 5 of the US Exchange Act makes it unlawful for any broker, dealer, or exchange, directly or indirectly, to effect any transaction in a security, or to report any such transaction, in interstate commerce, unless the exchange is registered as a national securities exchange under Section 6 of the Exchange Act, or is exempted from such registration. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood …” There would be “a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,” if such organization, association, or group of persons: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.
Since the finding, many ICOs prohibit citizens and residents of the US from participating in their ICOs or token sales.
As I am a Singapore-based lawyer, my treatment on this section would necessarily be longer. On 1 August 2017, the Monetary Authority of Singapore (“MAS”) issued a press release “MAS clarifies regulatory position on the offer of digital tokens in Singapore” (the “MAS Clarification”) stating:-
“[the offer or issue of digital tokens in Singapore will be regulated by MAS if the digital tokens constitute products regulated under the Securities and Futures Act (Cap. 289) (“SFA”).
… MAS has observed that the function of digital tokens has evolved beyond just being a virtual currency. For example, digital tokens may represent ownership or a security interest over an issuer’s assets or property. Such tokens may therefore be considered an offer of shares or units in a collective investment scheme1 under the SFA. Digital tokens may also represent a debt owed by an issuer and be considered a debenture under the SFA.
Where digital tokens fall within the definition of securities in the SFA, issuers of such tokens would be required to lodge and register a prospectus with MAS prior to the offer of such tokens, unless exempted. Issuers or intermediaries of such tokens would also be subject to licensing requirements under the SFA and Financial Advisers Act (Cap. 110), unless exempted, and the applicable requirements on anti-money laundering and countering the financing of terrorism. In addition, platforms facilitating secondary trading of such tokens would also have to be approved or recognised by MAS as an approved exchange or recognised market operator respectively under the SFA.
1 Examples of schemes falling under the revised definition of a collective investment scheme are found in Section 3 of the Consultation Paper on Proposals to Enhance Regulatory Safeguards for Investors in the Capital Markets, July 2014. [Emphasis added.]”
It is clear from the MAS Clarification that MAS will look into the substance of the arrangement to consider whether it would amount to securities or collective investment schemes presently regulated by MAS, and not merely the labels or mode of arrangements.
Then on 14 November 2017, MAS issued a Guide to Digital Token Offerings (the “DTO Guide”). It stated that it would examine the structure and characteristics of, including the rights attached to, a digital token in determining if the digital token is a type of capital markets products regulated under the SFA. Capital markets products means “any securities, futures contracts, contracts or arrangements for the purposes of foreign exchange trading, contracts or arrangements for the purposes of leveraged foreign exchange trading, and such other products as MAS may prescribe as capital markets products”.
In particular, MAS highlighted that a digital token may constitute a share, a debenture or a unit in a collective investment scheme (“CIS”).
Generally, when a person wishes to make an offer of investments or securities to the public, he would need to comply with certain rules and regulations, including the issuance of a compliant prospectus (section 240 of the SFA). Section 239(1) of the SFA defines the following terms:-
“securities means –
- shares or units of shares of a corporation;
- debentures or units of debentures of an entity;
- interests in a limited partnership or limited liability partnership formed in Singapore or elsewhere; or
- such other product or class of products as the Authority may prescribe,
- but does not include such other product or class of products as the Authority may prescribe as not being securities; …
“debenture” includes debenture stock, bonds, notes and any other debt securities issued by a corporation or any other entity …”.
Section 239(3) of the SFA further provides:-
“(a) any invitation to a person to deposit money with or to lend money to an entity shall be deemed to be an offer of debentures of the entity; and
(b) any document that is issued or intended or required to be issued by an entity acknowledging or evidencing or constituting an acknowledgment of the indebtedness of the entity in respect of any money that is or may be deposited with or lent to the entity in response to such an invitation shall be deemed to be a debenture.”
The DTO Guide suggests that a share “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”.
The SFA and its subsidiary legislation, the Securities and Futures (Offers of Investments) (Collective Investment Schemes) Regulations (“CIS Regulations”), also regulates CIS. The CIS Code will apply if an arrangement falls within the meaning of a CIS. A CIS must be authorized (if constituted in Singapore) or recognised (if constituted outside) by MAS.
A CIS is defined in section 2(1) of the SFA as follows:-
“‘collective investment scheme’ means —
(a) an arrangement in respect of any property —
(i) under which —
(A) the participants do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management; and
(B) the property is managed as a whole by or on behalf of a manager;
(ii) under which the contributions of the participants and the profits or income from which payments are to be made to them are pooled; and
(iii) the purpose or effect, or purported purpose or effect, of which is to enable the participants (whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise) —
(A) to participate in or receive profits, income, or other payments or returns arising from the acquisition, holding, management or disposal of, the exercise of, the redemption of, or the expiry of, any right, interest, title or benefit in the property or any part of the property; or
(B) to receive sums paid out of such profits, income, or other payments or returns; or
(b) an arrangement which is an arrangement, or is of a class or description of arrangements, specified by the Authority as a collective investment scheme by notice published in the Gazette…”
It should also be noted that the Securities and Futures (Amendment) Act 2017 recently passed, but not yet come into force, would do away with the requirement that “the contributions of the participants” are pooled with “the profits or income from which payments are to be made to them” as an independent criteria for the definition of the CIS. All that is needed for an arrangement to be deemed to be a CIS is that “the property is managed as a whole by or on behalf of a manager”. In other words, the definition of CIS would become broader once this amendment comes into force.
So if a token is deemed to be a security or a unit in a CIS, the entire arrangement has to be registered with MAS or otherwise, it would fall afoul of the law.
Further, exchanges or platforms which facilitate secondary trading of such tokens (which are deemed to be securities or units in CIS) would also have to be approved or recognised by MAS as an approved exchange or recognised market operator respectively under the SFA.
Also, any person who provides any financial advice in Singapore regarding any such token must be authorised to do so as a financial adviser or exempt financial adviser under the Financial Advisers Act (“FAA”).
The case studies in the DTO Guide are very helpful in illustrating MAS’ position on whether certain scenarios fall within regulated activities under the SFA or FAA.
- Case study 1: tokens only give access rights to token issuer’s platform and pay for services on the same (utility tokens)–not subject to SFA or FAA.
- Case study 2: tokens to represent share in company which plans to develop property. Will constitute securities under SFA. Company may need to apply to be licensed financial adviser. Company will need to comply with prospectus requirements.
- Case study 3: tokens enable holders to receive profits from company’s investments in a portfolio of shares in companies. Token holders have no powers relating to operations or management. Will constitute collective investment scheme (CIS). Company will need to comply with prospectus requirements, and likely will need to apply for capital markets services (CMS) licence.
- Case study 4: token holders receive profits from investment in shares of portfolio of companies. Token issue not available to persons in Singapore. Part XIII of SFA will not apply. But company may be carrying on business of fund management in Singapore and may thus need to apply for CMS licence.
- Case study 5: tokens represent loan by investor to startup. Token will be deemed a debenture and thus securities under the SFA. Company facilitating purchase or sale of token may require CMS licence.
- Case study 6: company plans to set up virtual currency exchange platform. On the premise that no products regulated under SFA will be traded, SFA will not apply. If any token constitutes securities under SFA, then company may be operating a securities market and thus need to be approved as an exchange by MAS.
There is a further spectre of a token issuer being deemed to be a stored value facility (“SVF”) holder if the issuer promises to do certain things regarding the tokens, e.g. buyback of the tokens from third party vendors of goods or services on the application platform. Section 2(1) of the Payment Systems (Oversight) Act (Cap. 222A) defines “stored value” and “stored value facility”:
““stored value”, in relation to a stored value facility, means the sum of money that—
has been paid in advance for goods or services intended to be purchased through the use of the stored value facility;
is available for use from time to time for making payment under the terms and conditions applying to the stored value facility; and
is held by the holder of the stored value facility;
“stored value facility” means —
a facility (other than cash), whether in physical or electronic form, which is purchased or otherwise acquired by a person (referred to in this Act as the user) to be used as a means of making payment for goods or services up to the amount of the stored value that is available for use under the terms and conditions applying to the facility, and payment for the goods or services is made by the holder of the stored value in respect of the facility (rather than by the user); or
all the facilities referred to in paragraph (a) provided under the same terms and conditions; …
“holder”, in relation to a stored value facility, means the person who holds the stored value and makes payment for goods or services referred to in the definition of “stored value facility”; …”
It is evident then that token issuers who intend to issue tokens other than utility tokens should be mindful of possible application of the SFA and other MAS laws and regulations.
MAS has stated in the DTO Guide that digital tokens which may not be within MAS’ regulatory purview may nonetheless be subject to other legislation for combating money laundering and terrorism financing, and in particular, Obligations to report suspicious transactions with the Suspicious Transaction Reporting Office, Commercial Affairs Department of the Singapore Police Force pursuant to section 39 of the Corruption, Drug Trafficking and Other Serious Crimes (Confiscation of Benefits) Act (Cap. 65A) (“CDSA”); and prohibitions from dealing with or providing financial services to designated individuals and entities pursuant to the Terrorism (Suppression of Financing) Act (Cap. 325) (“TSOFA”) and various regulations giving effect to United Nations Security Council Resolutions.
It is therefore important that a token issuer conducts the necessary due diligence measures to verify the identity of token purchasers before executing a sale of tokens.
In September 2017, China’s central bank issued a statement (http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3374222/index.html) banning ICOs and digital token trading, forcing all cryptocurrency exchanges to close. The statement also prohibited financial institutions like banks from doing business which conducted ICOs. It also required those who have completed their ICOs to protect the rights and interests of investors.
The legal position on ICOs and digital tokens in several other jurisdictions are not so clearly stated by the relevant regulatory authorities as yet.
In the United Kingdom (UK), the Financial Conduct Authority (FCA) issued a consumer warning about ICOs in September 2017 (https://www.fca.org.uk/news/statements/initial-coin-offerings). Pertinently, it stated 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.”.
In Hong Kong, the Securities and Futures Commission (SFC) issued a Statement on ICOs (http://www.sfc.hk/web/EN/news-and-announcements/policy-statements-and-announcements/statement-on-initial-coin-offerings.html). The Statement states that, “depending on the facts and circumstances of an ICO, digital tokens that are offered or sold may be “securities” as defined in the Securities and Futures Ordinance (SFO), and subject to the securities laws of Hong Kong”.
In Australia, the Australian Securities and Investments Commission (ASIC) has stated in their website (http://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings/) that “[w]hether the Corporations Act applies to an ICO will depend on the type of ICO offering and what rights attach to the coins from the ICO itself, underlying coins or tokens used in the ICO…” The ASIC then considered several possible analyses in terms of managed investment schemes (MIS; like a CIS), offer of shares, derivatives, and financial market operator.
MIS: “If the value of the coin is related to the management of an arrangement as described above, the issuer of the ICO is likely to be offering an MIS. In some cases, ICO issuers may frame the entitlements received by contributors as a receipt of a purchased service. However, if the value of the digital coins acquired is affected by the pooling of funds from contributors or use of those funds under the arrangement, then the ICO is likely to fall within the requirements relating to MISs. This is often the case if what is offered through the ICO has the attributes of an investment.”
Offer of shares: “When an ICO is created in order to fund a company (or to fund an undertaking that looks like a company) then the rights attached to the coins issued by the ICO may fall within the definition of a share. The bundle of rights referred to above may be used by ASIC to help determine if a coin is in fact a share. If the rights attached to the coin (which are generally found in the ICO’s ‘white paper’, a document issued by an ICO which may appear to be similar to a prospectus) are similar to rights commonly attached to a share—such as if there appears to be ownership of the body, voting rights in decisions of the body or some right to participate in profits of the body shown in the white paper—then it is likely that the coins could fall within the definition of a share.”
Derivatives: “If an ICO produced a coin that is priced based on factors such as a financial product or underlying market or asset price moving in a certain direction before a time or event which resulted in a payment being required as part of the rights or obligations attached to the coin, this may be a derivative.”
Market operator: “In the event that the ICO (or underlying) coin is found to be a financial product (whether it is a managed investment scheme, share or derivative), then any platform that enables investors to buy (or be issued) or sell these coins may involve the operation of a financial market.”
In Thailand, the Securities and Exchange Commission has issued a general statement offering a tentative non-definitive position on ICOs, encouraging stakeholders to engage with them (http://www.sec.or.th/EN/Pages/FinTech/ICO.aspx).
Your startup could be at the forefront of the next wave of novel blockchain technology applications. You need funding. Sure, there will be people who would want you to succeed. But in order to reach these people, you need to navigate some minefields of legal and regulatory issues, structure your ICO / digital token sale in a way that is credible, present a case for your team and your business that is compelling, and market well.
It is important that you consider these factors seriously and build up strong teams both internal and external who can construct these fundamental pillars to ensure that your ICO / token sale will succeed, and you can then take your tech and product development to the next stage of growth. All the best!