D&O FOR ICO?

A number of people have asked me about launching a D&O insurance product for companies looking to offer an ICO (Initial Coin Offering).  Here are my thoughts…

For those unfamiliar with the ICO, it is a fundraising mechanism where an organization releases new virtual tokens in exchange typically for Ethereum (ETH) or Bitcoin (BTC) -- highly liquid and valuable crypto tokens.  The new tokens may represent an interest in different types of projects:  new blockchains and distributed ledgers, or other assets such as interests in a decentralized casino, or bank.   ICOs are international, effectively unregulated (in spite of the SEC’s recent bulletin), and subject to very little coordinated investor scrutiny.  

For those unfamiliar with D&O (Directors and Officers) insurance, this is coverage bought by boards of directors to cover their individual liability associated with the management of a company. The legal responsibility associated with D&O varies greatly based on the country in which you operate and the associated regulations, the size of your company, how much money you have raised, etc. In the U.S. it is often associated with an IPO (Initial Public Offering) when a private company becomes listed on a public stock exchange for individual investors to trade. At that point of time, liability increases greatly for the board of directors and D&O insurance is paramount.

The comparison between an ICO and an IPO is logical.  Raising capital increases liability, so those offering an ICO might have an interest in insurance. Insurance companies may also wish to offer coverage as a new market emerges.  Nevertheless, at least for now, offering true D&O insurance that covers claims deriving from an ICO is unlikely, in my opinion. 

First, the potential liability is very complex when considering geography. This is a new area that is reminiscent of the early internet. Offerings are global and arguably subject to the most restrictive laws of any jurisdiction.  In the early days of the Internet companies were concerned about their web page showing up in France. All “publications” in France also needed to be published in French.  Obviously, in the context of the Internet, this is not practical, and many laws worldwide had to change to accommodate a new publishing paradigm via the Internet. These changes take some time and in the short-term are highly unpredictable. Similarly, in the context of ICOs and things that look a great deal like securities, we are not certain what liabilities or regulations may be incited globally.  As an insurance Underwriter, it is difficult to assess the risk as such. 

For a company to IPO and receive financial market support of an offering they must have at a minimum: successful management, a somewhat proven business model, meaningful financial traction or growth, a “product” that is functioning or well developed with upside potential. Additionally, there is an efficient market that gives a relative basis as to the proposed IPO’s valuation. 

Conversely, many ICOs have fairly inexperienced management (on a relative basis), a whitepaper  (no proven business model), little traction (maybe social media hype and a beta test), and there is really no efficient market which might otherwise dictate what the tokens ought to be worth.  In my opinion, other than for reasons of speculation (which has investor merit) very few savvy investors would touch many of these entities if they were analyzed outside of the context of an ICO. D&O underwriters are similarly sophisticated in their analysis, and on these merits, most ICOs would not pass their scrutiny from a quality standpoint.   While there are good projects and ICOs associated with them, there are many others that appear less clean or even pump and dump scams.  

Next, IPOs must jump through known regulatory hurdles that apply to security offerings, which add another layer of security for investors and Underwriters. At this time, however, ICOs remain effectively unregulated and many will work to keep it that way. Further, due to their distributed and nebulous nature, the SEC, Canadian and other regulators, who are attempting to define these as “securities” will have to adapt as their jurisdiction is limited. Recently the SEC went after a few current public companies (where they do have jurisdiction) engaging in questionable crypto related activities, for example.  Again, D&O underwriters would generally be left without regulatory oversight of the entity and the individuals they are looking to insure, which is not appealing.  

Looking further at the valuation question is also interesting as many of the ICOs are now starting to raise huge amounts of money.  Underwriters understandably don’t like anything that appears overvalued as angry investors lead to D&O lawsuits.   While valuation in the ICO crypto space is complex and not the point of this paper, when ICOs started well-known names raised relatively small amounts of capital. Ethereum raised about $18 million in their ICO in 2014 and Vitalik Buterin had been a Theil Fellow with a $100k grant.   This sounds somewhat reasonable on the surface. Recently, ICOs have been raising far more: Tezos ($222 million), EOS ($183 million), Bancor ($153 million).  For a conservative D&O underwriter gambling with their company’s money, these are tough to rationalize.

Finally, an ICO is not always like an IPO in that an ICO can represent the issuance of tokens for different purposes, from different entities or as a subset to an existing entity. Some of the “organizations” having ICOs are not entities in a traditional sense. The DAO, for example, raised $120 million last year, but as their name implies, they are a Distributed Autonomous Organization.  It has no formal location or formal leadership. Therefore, who is being protected from a proposed insurance contract?   ICOs are also being offered as an alternate vehicle for financing for existing entities.  Therefore, the ICO profile has much broader potential implications than that of the traditional IPO – some of which offer no logical buyer for an ICO insurance product.

All of these “underwriting concerns” have led to some having fun with the space, and appropriately so.  My favorite is the Useless Ethereum Token, which “offers investors no value, so there will be no expectation of gains”.  It is currently trading with a market cap of $52,000.   Others like the FOMO coin also now exist (Fear of Missing Out). Generally, underwriters look to avoid areas that are becoming the focus of systemic sarcasm so I think they will generally shy away from this area for the time being. 

And under what circumstances would I underwrite an ICO? 

The largest exposure to a traditional D&O loss is the shareholder class action lawsuit. This typically happens after a meaningful stock decline where all impacted shareholders combine to form a single class and litigate the merits of the investor losses.   These are most common in the United States with public U.S. companies traded on U.S. exchanges by U.S. shareholders.  Not surprisingly, United States courts have jurisdiction.  In the context of ICOs this does not work. No jurisdiction likely works.  Here is a good article looking at a parallel context where: In June 2010, the U.S. Supreme Court definitively rejected the securities class action plaintiffs bar’s request to permit foreign securities claims with tenuous connections to the U.S. to be litigated in the U.S.  

So, if an Underwriter decided that they would like to take a flyer on an ICO, which did operate with a somewhat traditional organizational entity, with good fundamentals, and exhibited efforts to be compliant from a regulatory standpoint in their operating country, etc, etc, one might be safe in knowing those coin holders will largely be unable to form a meaningful consolidated class action against the management of the entity after its valuation tanks.  Individuals will have to pursue their losses on their own, or perhaps smaller classes could form where there is some common jurisdiction. These cases will likely amount to far less than a traditional class action and can easily be mitigated with an appropriate retention.     

For the time being, ICOs are exciting and will continue to raise large amounts of capital.  Still, they may be viewed as either too risky or simply inappropriate for D&O coverage at this time.  For those looking to purchase insurance, it may be difficult to find.  For those looking to sell an insurance product, and if you can find an insurer, you might find that not many ICOs are actually appropriate for this type of coverage – at least as ICOs and D&O function today.