Blockchain technology is transforming entire industries, from enhancing supply chain transparency to improving record keeping in finance, energy, and agriculture.
Entrepreneurs raise money for these projects through an Initial Coin Offering (ICO) or a ‘token sale.’
According to CoinSchedule, there have been 643 ICOs that have raised US$17 billion in 2018.
Despite the hype around this new fundraising mechanism, increased regulatory attention from the Australian Securities and Investments Commission (ASIC) requires developers’ legal diligence.
This article will identify and explain the key questions you should consider before offering any tokens to the public.
Raising Capital: ICO v Startup
During an ICO, a company can raise money by creating a website and publishing a white paper (a document that describes the project). Investors exchange cash or cryptocurrency (e.g. Bitcoin or Ethereum) for digital tokens that the startup has created.
The funds raised allow the business to develop their project, which is usually built on blockchain technology. Because an ICO is borderless, startups can raise money from investors across the globe in a relatively short period.
In contrast, under traditional capital raising models, a startup would approach investors and negotiate the terms of investment based on factors such as valuation, board composition and investor rights. An investor would receive equity or options in exchange for their investment.
Importantly, a token doesn’t usually provide an investor with the same rights as holding shares or options, such as the right to vote or receive dividends. Instead, an investor receives a digital token. The tokens an investor purchases can then be used on the platform to access goods or services (also known as utility tokens). An investor can also hold onto their token, speculating that the business will be successful and they can increase the value of their asset.
Equity Tokens
As the ICO market matures, sophisticated investors are demanding more predictable equity relationships. For example, equity token offerings are becoming common.
An equity token provides an ownership stake in the company, and allows investors to trade tokens before a startup exit (e.g. an Initial Public Offering), providing almost instant liquidity.
Investors can also receive a ‘discount’ on tokens purchased during an ICO pre-sale as a ‘reward’ for their early backing of the project and accepting higher risk.
From our observations of token sale activity, most tokens from Australian issuers are utility tokens.
What Rules Apply to ICOs?
The laws that apply to an ICO will depend, in part, on whether the token is a financial product. The Corporations Act 2001 (Cth) defines a financial product, for instance, a share, derivative or managed investment scheme.
We have summarised the rights and obligations that will apply to some different financial products in the table below.
| Financial Product | What is it? | Features indicating the token is this type of financial product | Obligations placed on the offeror |
|---|---|---|---|
| Share | An interest or collection of rights in a company. | The token carries either:
|
Prepare additional disclosure document. For example, a prospectus, which can dramatically increase compliance costs. |
| Managed Investment Scheme (MIS) |
A group of people pooling assets (e.g.does the investor receive cash or cryptocurrency) for financial gain. Participants don’t have day-to-day control over the scheme, and a responsible entity usually manages the scheme. |
The token’s value is affected by the pooling of funds, and the company’s collective use and management of those funds. |
|
| Derivative | A product that derives its value from something else (also known as the underlying asset). For example, an instrument that is linked to the price of coffee (a coffee ‘future’) or an option which gives the option-holder a right to sell their options for shares in the future. |
An underlying market or asset price defines the value of the token, For example, you buy a coffee future today expecting the price of coffee will increase. You can then sell the coffee future at a higher price. |
|
Application of Australian Consumer Law
If the token is not a financial product, then the general law, including the Australian Consumer Law (ACL), will apply. ASIC recently updated its guidance on ICOs, stating that it can take action against a company for misleading and deceptive conduct connected to an ICO.
This applies to both the white paper and promotional material, for example:
- falsely claiming that you have a partnership with an existing financial institution (for example, a bank or credit card company);
- falsely claiming that the token is backed by another commodity, such as gold, real estate or diamonds;
- publishing misleading information about your advisory board or development team;
- using social media to generate fake hype around your ICO, such as creating fake profiles from which to promote the ICO;
- failing to disclose information in your white paper;
- falsely advertising high returns on your token; or
- coordinating sales and purchases to generate the appearance of high activity for your ICO.
Application of Foreign Law to Australian ICOs
If you’re selling your tokens overseas or a foreign citizen or resident buys your tokens, your ICO may be subjected to foreign securities as well as privacy and consumer laws.
Offerors should then limit their offer to a certain country or type of investor by:
- including a term in their white paper that explicitly excludes certain citizens from participating in the ICO;
- geofencing to exclude citizens from countries with unfriendly or uncertain ICO regulations (for example, citizens from China or South Korea that have banned ICOs); and
- requiring investors to provide proof of citizenship through a Know-Your-Customer application to participate in the ICO.
You should also seek legal advice in the countries you intend to offer your token. For example, in the United States, if your ICO is considered a security, you will need to register with the Securities and Exchange Commission and, possibly, the Financial Crimes Enforcement Network (if you are exchanging tokens for money or virtual currency).
What Are My Legal Obligations When Issuing Tokens?
The following questions can help determine your legal obligations.
| Issue to Consider | Questions to Ask |
|---|---|
| The structure of the ICO |
|
| What does the investor receive for their investment |
|
| What rights attach to the token |
|
| How you will use the funds moving forward |
|
The rights that attach to the tokens will determine the legal obligations you may need to comply with. It doesn’t matter if you call your asset a ‘token’ — if it has the hallmarks of a financial product, such as a share or managed investment scheme, then the laws that apply to financial products will apply to your token.
Know-Your-Customer Obligations
Australia’s anti-money laundering (AML) and counter-terrorist financing (CTF) regulator, the Australian Transaction Reports and Analysis Centre (AUSTRAC), recently amended the Anti-Money Laundering and Counter-Terrorism Financing Act 2006.
The amendment, which came into effect in April, expands AML and CTF regulation to digital currency exchange providers. It requires a digital currency exchange provider to:
-
- register on the Digital Currency Exchange Register;
- adopt and maintain an AML/CTF program to identify, mitigate and manage the risks;
- identify and verify the identities of their customers;
- report suspicious matters that exceed $10,000 or more; and
- keep certain records related to transactions for seven years.
The Act will impact businesses that convert digital currency to money, or vice versa. So, if your project accepts fiat currency in exchange for a token, like Filecoin, you may need to register.
Even if the Act does not apply to your ICO, it is best practice to Know-Your-Customer (e.g. by requiring proof of citizenship). You should also prepare a written AML compliance program to guard against bad actors using your platform to launder money or finance criminal activity, including terrorism. This will bolster public and consumer confidence in both the project and sector.
How Do I Launch an ICO?
- A blockchain startup releases a white paper. A white paper should:
- describe where the company and management team are located;
- include a plain English description of the problem and the proposed technology solution;
- identify a clear and compelling reason for why the token exists;
- set clear expectations for the total token supply and distribution;
- explain how you will make governance decisions and other decisions affecting the network (e.g. software upgrades);
- explain how the blockchain startup will use the funds; and
- introduce the founding team, including their qualifications and business experience.
- Issuers market the token on platforms such as Reddit and Slack. Investors will ask the team questions about the technology and token.
- Token sales begin.
- Tokens are deposited into a purchaser’s digital currency wallet.
- Proceeds from the token sale are distributed to the organisation or developers selling the token. Token-holders are incentivised to use the platform as adoption drives up the price of crypto tokens.
- Purchasers can trade tokens on secondary cryptocurrency markets around the globe.
Key Takeaways
ICOs provide blockchain startups with an exciting new avenue to access capital for their projects. We expect that, as the industry matures, sophisticated investors will be attracted to this space, but demand predictability and more traditional equity arrangements.
However, regulatory uncertainty remains a challenge for token offerors. Because an ICO is borderless, it’s hard to know which countries’ laws will apply, yet the consequences for selling an unregistered security are severe. You should speak to a specialist ICO lawyer early to help structure your token offering and navigate the murky legal space so you can continue building a community of users and elevating your business.
If you are looking to raise funds through an ICO, get in touch with LegalVision’s capital raising lawyers.
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Madeleine Hunt contributed to this article. Madeleine is a lawyer in LegalVision’s Business Structuring and Capital Raising teams. She provides end-to-end guidance for companies as they scale, from choosing the right corporate structure to deciding on funding options.
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