Your CEO walks into your office and says: “We need to raise some money quickly. I’ve been hearing a lot about ICOs, can we do one?”
With reports that more than US$2 billion has been raised through ICOs already this year, it could well be a question you’re asked at some point.
The short answer is that ICOs, or at least the mechanics behind them, are very much here to stay, even if the law is starting to catch-up with them. This is because ICOs offer an easy, technology-enabled, way for companies to raise capital online and across borders.
Over time, the lines between traditional capital raising methods and ICOs are likely to become blurred as we start to see a convergence of the old paper-based financial markets and the new digital economy for money.
What are ICOs?
Similar to an Initial Public Offering in which investors purchase shares, ICOs can raise funds to finance a business, enterprise or project. However, instead of offering shares, an ICO sells digital tokens, also known as ‘coins’, to raise funds for a project – which could be anything from a new web browser or platform to a new digital currency.
Investors pay in fiat (government-issued) money or (digital) cryptocurrencies like Bitcoin. ICOs are not necessarily conducted by a company (or even a legal entity), but can be carried out by a person, an unincorporated body or even a decentralised autonomous organisation.
These tokens can be broken into four classes:
- A User Token provides the holder with a right to access a new product or service that has been, or will be, created.
- An Asset Backed Token is the right to an underlying asset (such as a piece of land or gold) whereby the distributed ledger is used as a record of ownership.
- An Enterprise Token provides the holder with an ownership interest in a project, or an entity carrying out a project, which may include voting rights, and/or where the holder will be entitled to a financial return from the project/entity.
- An Intrinsic Token’s value is intrinsic because it is not backed by any asset and does not provide a right to access a new product or service, nor does it promise any return. Its value is dependent solely on what someone else will pay for it. Intrinsic Tokens include cryptocurrencies such as Bitcoin and Litecoin.
These classes are not meant to be comprehensive and they can overlap, but they are a good starting point to think about how tokens should be treated.
The main appeal of ICOs is just how fast and easy they are to raise funds.
Surging popularity through blockchain
The growth in the popularity of ICOs has been driven in part by the ground-breaking blockchain technology which underlies Bitcoin.
As an open, electronic distributed ledger across a network of users who validate transactions between parties, a blockchain is as easy to use and update as it is difficult to tamper with or manipulate. It is time and cost-effective and requires significantly less effort and resources to manage compared to traditional banking and fundraising processes, which can be by comparison slow, cumbersome, susceptible to hacking, costly to administer and not easily accessible.
The main appeal of ICOs is just how fast and easy they are to raise funds. A company or individual can simply create a short White Paper and within a few weeks raise enough funds (if successful) to greenlight their initiative. They don’t need to create a comprehensive prospectus or go through any of the rigmarole required for an IPO. It has been an unregulated market – a bit of a regulatory Wild West.
DAO: the straw that broke the token’s back?
Last year, a group called 'The DAO' (Decentralised Autonomous Organisation) raised US$150 million through an ICO. The DAO invited people to buy digital tokens in exchange for ‘rewards’ which it likened to dividends.
This caught the attention of the US Securities and Exchange Commission (SEC) who in July this year ruled that The DAO tokens were in fact securities. The SEC isn’t taking any action but, in voicing its standpoint, it put a shot across the bow of the ICO market - and regulators around the world have taken note.
The UK, Singapore, Malaysia, Hong Kong and Canada have since echoed the view that certain classes of tokens may be securities, with China going as far to declare ICOs illegal and requiring issuers to repay investors.
In Australia and New Zealand, however, regulators have yet to express their views on the status of these offers under securities law.
How might ICOs be treated in New Zealand?
As the principal piece of legislation that governs offers of securities within New Zealand, the Financial Markets Conduct Act 2013 has provisions that apply to offers of ‘financial products’, defined to mean: debt securities; equity securities; managed investment products; and derivatives.
In addition, the Act has a broad definition of ‘security’ that covers other financial arrangements. Securities are not themselves regulated. But the Financial Markets Authority, as the New Zealand securities regulator, has the power to declare that a security is a financial product (although not retrospectively) and from that point the financial product is under the regime.
At MinterEllisonRuddWatts, we compared the four classes of tokens to the definitions of what constitutes a ‘financial product’ and ‘security’. We concluded that given the broad definition of a security it is likely that each of the four token classes could, depending on their terms, fit within the definition.
It also our view that each of the token classes could also fall under some of the ‘financial product’ definitions. This is our in-depth report on how digital tokens compare to the definitions of financial products.
Should the Financial Markets Authority (FMA) class a token as a security or a financial product, ICOs would need to meet the more onerous requirements of the Financial Markets Conduct Act if they are to be offered widely to retail investors including disclosure, governance, licensing and financial reporting obligations.
Wild West to mainstream: What’s next?
Within the next month or so, the FMA is set to release some general guidance for offers and investors, providing greater insight into whether the FMA considers tokens to be financial products or securities.
So the bubble of unregulated ICOs could be about to burst, and we could move into a more regulated environment. A tricky balance now has to be struck to protect investors without stifling an innovative new investment technology.
There are of course ways to use ICOs and tokens that are not financial products or securities. We’ve seen them used effectively to create and fund new digital ecosystems, online communities and ways for holders to access goods and services.
We see ICOs, digital tokens and cryptocurrencies as converging with traditional business and financial market operations over time.
So, in to answer your CEO, it may be wise to say: “If we’re going to do it, we should either do it now or wait to see how the regulations unfold. And, in either case, do it right.”
Jeremy Muir is a specialist financial services and investment lawyer and partner at MinterEllisonRuddWatts. He works with retail and wholesale fund managers, trustee companies, derivatives issuers, FinTech (including crowdfunding and peer-to-peer lending platforms), insurers and startups.
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