ICO AND ITS LEGAL DILEMMAS (INITIAL COIN OFFERING)

It seems that a day cannot pass without reading or hearing about cryptocurrencies, tokens and ICOs.

The term stands for Initial Coin Offerings and it has been hyped a lot in the past few months because of the current frenzy situation around the massive value rise of Bitcoins and other cryptocurrencies.

At the same time, ICOs have become a tool for blockchain start-ups to raise capital in a short period of time, to bypass strict regulations and for speculative investments.

What has been shocking most of the public is the level of success that this kind of operations can reach, especially in the last two years.

Gnosis for example, a decentralized platform for prediction markets based in the Netherlands, was able to collect $12.5 million in 15 minutes, while the Bancor Protocol (known as the biggest ICO to date), raised $150 million in 3 hours (the project is about the creation of a new kind of smart token which could provide for liquidity of other cryptocurrencies.

An ICO is composed of

·     a white paper, which has the role of describing the project and which rights are given to potential investors: the issuer puts in place a smart contract on a blockchain and the investors instruct their digital wallet to subscribe to a certain amount of tokens.

Often the wp determines a soft cap and a hard cap, c’est-à-dire a minimum & maximum amount of issuable coins to be subscribed for the project to take-off.

·     the smart contract, once collected all the subscription, automatically transfers he digital currency into the issuer’s wallet and gives the tokens to the subscribers’ accounts: most of the time the ICO needs a minimum amount of subscription in order to go live, so that if it does not happen it actually just return the digital currency back to the investors’ wallets.

ICOs are structured either as a vehicle to issue a new virtual currency or to finance a project.

The first type is the most common as it is the case of Ether and Bitcoins, which can also be used to buy and exchange new cryptocurrencies.

“Cryptos” are usually needed in order to actually invest in a certain service, since each different blockchain is based on a unique kind of token, which can be used only for that specific network.

The highly speculative nature of ICOs attracts subscribers looking for fast capital gains and most ICOs offer some kind of discount for early investors.

ICOs used to finance a project are more similar to a crowdfunding operation: you have a start-up, based on blockchain technology, and instead of selling shares or securities -like an IPO- you “sell” tokens.

This has determined multiple legal issues,since these issued tokens are treated as bonds or shares, without any legal link: they give voting rights in the project and returns from it.

The most well known example is the ICO for the Decentralized Autonomous Organization -the DAO- a blockchain-based digital organization, founded by a German UG called Slock.it.

The risk of ICOs is underlined by the fact that they are not clearly regulated.

There have been plenty of fraudulent ICOs, with a scheme established to rob subscribers of their money.

It is true that blokchain technology is considered one of the safest protocols, nonetheless some hackers have already managed to break inside the chains.

The DAO for example was hacked after just one month: a safety leak was identified and $53 million in DAO tokens were diverted.

The account on which the money had been placed was frozen and the Ethereum foundation released a hard fork, thus enabling some of the investors to recollect their tokens, by creating a new blockchain.

In order to face the financial and legal problems that cryptocurrencies and ICOs present, it is necessary to understand how to regulate them.

The approach has been different: some Countries have decided to completely ban ICOs, like China and South Korea, whereas others have tried to take a position in order to characterize tokens, but the results are diverged.

What are tokens from a legal point of view?

Currency-like tokens

One way to characterize them is as actual money, since they are starting to be accepted as payment by certain parties or as tool used for goods and services exchange.

Things get more complicated when it comes clear that an unambigous legal definition of money does not exist, but there are rather two different approaches: a legalistic one and a functional one.

The first view is connected to the State’s monopoly issuing money with legal tender and its discharging effect at face value, which clearly cannot let cryptocurrencies to be qualified as money.

On a more functional note, money is based on trust, usually relied on State’s central banks, and general acceptance by the population.

But nothing says that trust cannot be based on a different institution and with cryptocurrencies the trust comes from the inalterability of the code.

The International Monetary Found has also joined the discussion.

It actually declared that money has three economic roles:

·     money is a medium for exchange,

·     a unit of account and

·     a reliable store of value.

Virtual currencies are too volatile when it comes to their price, which is also not linked to economic factors, impeding the ability to serve as store of value.

One could add though that high volatility is a feature of fiat currency as well.

The value of goods and services are not directly measured by cryptocurrencies, but on a exchange rate instead, and that means they are not an independent unit of account.

Finally, their size of market is too small for being considered as a medium of exchange.

Judges, on the other hand, have tried to be more elastic.

In the USA, the most important case has been Sec v. Shavers, where the judge characterized Bitcoins as money since “it can be used to purchase goods or services (…) the only limitation of Bitcoin is that it is limited to those places that accept it as currency”.

The year 2015 saw the first pronunciation by the European Court of Justice, which, in the ruling C-264/14 Skatteverket v. David Hedqvist, which established that since Bitcoins have the purpose to be a contractual means of payment, it is to be considered as a financial transaction (it also means VAT exemption).

One last interesting point to rule out is whether cryptocurrencies can be classified as e-money with regards to Directive 2009/110/EC of on electronic money.

An e-wallet –electronically- stores the monetary value of a fiat currency, thus giving the holder a claim against the issuer.

Mainstream cryptocurrencies do not give any claim against the issuer.

On a purely theoretical basis, the only kind of token that would give the holder a claim of this kind would be in case of a Blockchain-based Startup project finance, where tokens were given with a right to be redeemed after a specific period of time.

Tokens as securities

Security-like tokens are pretty common: one of the most famous examples are the DAOs.

These tokens have been shaped like a share and they are qualified as securities in the US jurisdiction, as it has been described as such in one investigation report released by the Securities and Exchange Commission (SEC from now on) this past summer.

The term security can be described as an investment contract, four requirements have to be met, as outlined by the renowned 1946 case SEC v. Howey.

The first is an investment of money, which can also be not limited to cash or currency and another case, SEC v. Shavers in 2014, already stated that a Bitcoin investment is to be considered as an investment of money.

The second is that the investment must be done in a common enterprise, and that is clear.

Following this criterion is the reasonable expectation of profits, and the DAO’s white paper already underlined the fact that the organization was an entity created to generate profits.

Lastly, and more difficult to prove, is that the profits have to be realized from the entrepreneurial or managerial efforts of others; the above-mentioned wp indicated for certain figures who had to preselect projects for financing (together with the founders of the protocol from Slock.it) and investors relied on these figures, satisfying the last criterion.

Since this first application, it seems that in the US every single ICO will be regulated by the SEC, with two characterizations for tokens: they are either to be considered securities or commodities (as it happens with Bitcoins in the Commodity Futures Trading Commission).

What comes clear from this focus is that virtual currencies cannot be identified objectively from a legal point of view.

Statements on them and on ICOs are taken case by case, some nations have already developed a set of rules, while others have not.

Some regulators –like Germany- characterized even currency like tokens as securities. The Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) characterized cryptocurrencies “not subject to any centralised form of management” as units of account, which are juridically qualified as financial instruments (according to the German legislator)

The BaFin defines cryptocurrencies as “units, similar to foreign currencies and not of legal tender. They include value units having the function of private means of payment in barter transactions, as well as any other substitute currency used by virtue of private-law agreements as a means of payment in multilateral settlement accounts. This makes a central issuer obsolete”

The German regulator specifically says that neither the simple use of “crypto” as a fiat-currencies substitute with legal tender, nor mining and selling are subject to authorization.

Nonetheless, the commercial use of cryptocurrencies may constitute different kinds of financial services such as brokerage, operating a multilateral trading system or engaging in proprietary trading, all these services requiring express authorization from the supervisory authority.

Following the European Securities and Markets Authority (ESMA) , that recently issued a warning on ICOs (along with many warnings on consumer protection with Cryptocurrencies) the BaFin pointed out several European key directives without exempting further regulatory provisions to be observed by participants of ICOs and specifically addressed KEY RISKS OF ICOs:

• Total loss: Investments in ICOs are particularly prone to the risk of total loss due to the risky and speculative nature of coins and tokens.
• Regulatory risks: Up until now, most ICOs are operated in regulatory vacuums and issuers have neither been regulated nor adequately supervised.
• Lack of investor and consumer protection: Due to the absence of specifically addressing regulation, the status quo of ICOs do not provide for sufficient investor information or other protective measures.
• Information insufficiency: Whitepapers and term sheets of ICOs do not provide sufficient information for investors which are comparable to prospectuses or KIIDs.
• Opaqueness and complexity: Based on complex technological mechanisms and lacking information, ICO structures remain opaque for most investors.
• Volatility and liquidity risks: The value of coins and tokens is highly volatile and potentially illiquid as there are no secondary markets available.
• Operational risks: ICOs are particularly prone to fraud, from wrongfully drafted smart contracts, theft of private keys to abuse of relevant program codes.

In France, the AMF (Autorité des marchés financiers) -the French Financial Markets Supervisor- in late 2017 released a discussion paper on ICOs, stating that “In view of the absence of specific regulations governing all new fundraising activity based on cryptocurrencies and Blockchain technology, the French Autorité des Marchés Financiers (AMF) wishes to gather the views of stakeholders on the different means of supervision and launches a programme involving the support and analysis of these transactions, called UNICORN”

AMF specifies that ICO transactions are intended to finance technological projects at an early stage of their development and that this type of fundraising is by nature intended for a technologically-oriented and informed audience.

AMF has carried out an initial high-level study of these transactions and their legal implications.

This first assessment indicates that while some of the ICOs identified may be covered by existing legal provisions (regulation applicable to intermediaries in miscellaneous assets, to the public offering of financial securities, or to managers of alternative investment funds, in particular), most of these issues would fall, in the current state of the law, outside of any regulation for which the AMF ensures compliance.

It is in this context, and in a forward-looking approach, that the AMF publishes its consultation document, in which three options for supervising ICOs are envisaged:

• Promote best practices without changing existing legislation;
• Extend the scope of existing texts to treat ICOs as public offerings of securities;
• Propose ad hoc legislation adapted to ICOs.

Conflict of jurisdictions

One of the biggest legal issues that ICOs and cryptocurrencies have to face is to understand which jurisdiction and which law could be applied.

Difficulties arises from two different point view: firstly they are based on public blockchains, which means the ledgers are distributed in a virtual space without any boundary and secondly ICOs’ participants subscribe from all over the world.

In the European Union, if the defendant is domiciled in a Member State, then the conflict of jurisdiction rules are established by Regulation Brussels II: when it comes to extra-contractual liability, jurisdiction goes to the court of the place where the harmful event took place.

Speaking of ICOs, the subscriber’s wallet is where the damage would occur: as we pointed out, the wallet is completely digital and it exists only on the blockchain.

Some says though that there could be some third parties that would administrate the digital wallet of the investors, making it like a bank that manages a bank account.

In this way the place where the harmful event materialized is the one where the company is established.

Conclusions

It is clear how divergent national regulations are: it is technically impossible at the moment of this writing- to have an ICO able to comply with all these different rules.

Some countries will regulate ICOs on the currency-like ground and some on the share-like ground.

Even though ICOs developers need to establish trust in order to find subscribers, enforcability is going to be a seriously crucial issue, considering how a developer can remain undetected through proper use of a Blockchain anonymity.

On the other side, it is -once again- necessary to stress how overregulation has never been a good solution with new technology, usually being applied as a tool for “innovation slaughtering”.

A right step into the creation of a shared regulation of ICO would be to agree on a certain amount of basic rules regulating ICOs and the only legislator capable of accomplishing such a task appears to be the European one, considering how even the conception of a unified worldwide global set of rules appears to be unachievable.