INITIAL COIN OFFERINGS THE GOOD, THE BAD, AND THE UGLY Guy Morgan and Chris Finney of Fox Williams LLP explain the new fundraising model of initial coin offerings and consider how they fi t into the existing system of regulation. According to the digital currency news site of securities to investors in exchange for • The ease and speed with which tokens CoinDesk, more than $2 billion was raised fiat currency, an ICO involves the issue of can be issued and funds raised, in many by way of initial coin offering (ICO) in 2017. transferable tokens to investors typically cases without the use of intermediaries. But while believers see the development of in exchange for cryptocurrency such as ICOs as an example of technology being used Bitcoin or Ether. • Low transaction and settlement costs. to disrupt traditional venture and equity capital markets funding models, sceptics see Advantages and disadvantages • A perceived lack of regulatory barriers. baseless hype and another fi nancial scandal The rights attaching to tokens vary widely. around the corner. Some tokens may resemble traditional • For many issuers, the formation or securities such as shares or debt securities, augmentation of a wide and motivated This article examines the current trend for while others may represent a right to access user base of the underlying product or ICOs, the regulatory framework surrounding or receive future services, typically on service. ICOs and the risks associated with ICOs. preferential terms. A key appeal of ICOs is that tokens are easily tradeable. This means that Commonly cited disadvantages of ICOs when WHAT IS AN ICO? investors can, assuming suffi cient liquidity, compared to traditional fundraising models buy and sell tokens on cryptocurrency include: An ICO is a low-cost and time-effi cient type exchanges, unlike more traditional venture of crowdfunding which is facilitated through capital investments, which may not be easily • The price volatility of the most the use of distributed ledger technology (see traded. popular cryptocurrencies. ICO issuers box “Distributed ledger technology”). will commonly seek to exchange Other benefi ts of ICOs compared to more cryptocurrencies subscribed by investors In much the same way that an initial traditional fundraising models are seen to into fi at currency following the ICO, public offering (IPO) involves the issue include: therefore incurring substantial exchange © 2018 Thomson Reuters (Professional) UK Limited. This article fi rst appeared in the March 2018 issue of PLC Magazine, published by Practical Law, part of Thomson Reuters (Professional) UK Limited, and is reproduced by agreement with the publishers. 1 rate risk. It may be prohibitively expensive or diffi cult to hedge this risk Distributed ledger technology effectively. The concept of a distributed ledger is that there is a shared database which is replicated • A lack of clarity regarding numerous and synchronised across all of its users over an online peer-to-peer network. There is legal issues relating to the underlying no central administrator or centralised data storage centre or node. distributed ledger technology, including the enforceability of code-based smart The most famous use of distributed ledger technology is Bitcoin. Bitcoin transactions contracts. are recorded on a distributed ledger called the blockchain. As with all distributed ledgers, no one person owns or controls the blockchain. Thousands of computers • An uncertain and evolving regulatory around the world work together to process Bitcoin transactions. position globally. Combined with the absence of any industry standardisation, The growth in initial coin offerings (ICOs) has been particularly facilitated by the this increases the advisory costs and development of blockchain platforms such as Ethereum, an open-source programmable slows the speed at which a compliant platform which lets anyone create secondary digital tokens, in exchange for the primary ICO may be carried out. platform currency Ether. The platform has a built-in crowd sale function enabling issuers to carry out ICOs. • Cyber security risks, compounded by the irreversibility of many cryptocurrency transactions. The white paper will set out the nature of for their subscription, in an ICO the issuer has • Reputational issues. the service or product, what resources are complete discretion as regards the rights to required and the amount of funds that are which the tokenholder is entitled. What ICOs are being used for? required to raise to develop the service or The earliest ICOs were used to launch new product. It will also typically set out the The earliest ICOs were used to launch new cryptocurrencies but increasingly they have minimum and maximum number of tokens cryptocurrencies, where the subscriber been used by early stage companies to the issuer intends to issue and what rights received a new cryptocurrency in exchange fund the development of other projects or each token gives to the tokenholder. However, for the payment of an existing cryptocurrency. services and, in particular, the development unlike a prospectus or admission document, More commonly, the rights attaching, and of decentralised software applications there are no content requirements or value attributable, to a token fall into either that run on existing blockchain platforms, minimum standards for white papers and this or both of the following two categories: such as Ethereum (see box “Decentralised can contribute to the common misconception applications”). that all ICOs are completely unregulated (see Security tokens. Security tokens have rights “The UK regulatory position” below). akin to those of a traditional security, such However, an ICO can be executed by any as a share or debt security. These rights may company looking to issue tradeable rights to Token issuers frequently seek to disclaim include voting rights or the right to participate investors in exchange for capital, regardless liability in their terms and conditions, unlike a in profi ts. They may also include rights in a of the sector in which it operates or the prospectus where the company and directors particular asset. product that it wishes to develop (see box are required as a matter of law to take “KodakCoin”). responsibility for the information contained A pure security token will not have any in the document. additional use. In September 2017, Kik, an established social media platform, raised approximately $98 A subscriber will typically subscribe for tokens Utility tokens. There are also tokens that million through an ICO of “Kin” tokens to by transferring consideration to a specifi ed give the holder the right to “buy” a product support the development of its existing account, and in doing so it is deemed to have or service, perhaps on preferential terms, messaging ecosystem. accepted the terms and conditions applicable such as a discounted rate or exclusive access. to that ICO. These tokens are commonly referred to as It remains to be seen whether other non utility tokens. A useful analogy used to blockchain-centric businesses will use ICOs The tokens themselves are typically explain the purpose of utility tokens is that as a means of raising funds. created, allocated and distributed through of a fairground or a food fair. On entry to the a pre-existing blockchain platform, such as fair, visitors have to buy a number of tokens LAUNCHING AN ICO Ethereum, in each case without requiring an for cash. Once inside the fair, visitors can use intermediary. the tokens to go on various different rides, To launch an ICO, an issuer will typically to buy food or drink or to play the arcades. produce a white paper, which is analogous Types of token Each transaction is settled using the tokens to the prospectus or admission document There is no market standard as to what rights and within the fair visitors do not use any that a company is required to produce in each token gives to a tokenholder, which other currency. connection with the admission of securities vary widely in design. Similar to reward- to trading on the Main Market of the London based crowdfunding, where each issuer The most common form of utility token allows Stock Exchange or AIM. decides what it gives the investor in return the user to access and use a specifi c software © 2018 Thomson Reuters (Professional) UK Limited. This article fi rst appeared in the March 2018 issue of PLC Magazine, 2 published by Practical Law, part of Thomson Reuters (Professional) UK Limited, and is reproduced by agreement with the publishers. relates to the carrying on of regulated Decentralised applications activities, the publication of a prospectus and the making of fi nancial promotions. Blockchain is a type of distributed ledger. However, the use of distributed ledger technology for the Bitcoin payment ledger is only one particular use of distributed In addition, because blockchain platforms such ledger technology. as Ethereum operate without geographical borders, issuers must carefully structure ICOs Historically, programmes and applications have been centralised. In this context, to be compliant with regulations in relevant centralised means that the relevant programme or application is stored on, and overseas jurisdictions. This may include controlled by, a central server. A decentralised application or “DApp” relies on a taking steps to ensure that an investor is decentralised network to move functions, powers and processing away from a central not investing from a jurisdiction that does server to a peer-to-peer network. Conceptually, a decentralised application cannot not permit ICOs. The Chinese government be changed without the consensus of the majority of its users. declared ICOs illegal in September 2017, and a similar approach has been taken in Twitter is an example of a centralised application. Twitter Inc has the power to delete South Korea (see box “Overseas regulatory or censor messages. If Twitter were a decentralised application, then Twitter Inc would position”). not be able to delete or censor any messages. Regulated activities Under the general prohibition in section 19 of the Financial Services and Markets Act platform, such as a decentralised application.