While ASIC has published information on the issue of coins or tokens in initial coin offerings, other regulators around the world have also been issuing guidance, with some taking a much more restrictive approach. Although Australia remains a relatively friendly regulatory environment for such offerings, there are a number of potential regulatory traps, both here and overseas, that issuers should carefully consider before launch. Managing Associate Simun Soljo, Senior Associate David Rountree and Lawyer Chris Walsh report.
Initial coin offerings (ICOs) (also known as token sales) have been increasing in popularity in 2017, with more than $1.8 billion dollars funnelled through these sales this year. While borrowing the nomenclature of the 'IPO', they are a complex phenomenon, and come in many different varieties. The central tenet is that an ICO often involves the sale (which is generally public) of blockchain-based cryptocurrency tokens. The 'issuer' of the tokens will generally create a new form of token or coin, which is often linked to a particular technology implementation or solution. The tokens may have different characteristics, depending on the nature of the technology. The party selling the tokens generally intends to use the funds received in an ICO to fund further development of the platform or technology solution. Buyers of coins will pay for them by cash or using other cryptocurrencies. The tokens can usually also be traded on third-party cryptocurrency exchanges.
The issuer may make promises about how the coins may be able to be used, or it may promise nothing. Coins or tokens may be able to be used by holders to obtain goods or services or discounts through a platform or marketplace created by the issuer, or have other rights attached to them. Generally, this does not involve the issuer of the tokens parting with any equity in their enterprise. The sale is usually accompanied by a technical white paper, setting out the technology proposal and roadmap, and limited forms of disclosure on risks associated with purchasing tokens in an ICO.
ASIC has now published an information sheet (INFO 225) on the potential application of the Corporations Act 2001 (Cth) to the issue of coins or tokens in ICOs. ASIC's previous regulatory guidance has indicated it does not consider cryptocurrencies to be financial products. This may have created the impression in some quarters that the issue and use of coins is completely unregulated.
ASIC's latest guidance, as well as similar announcements by other regulators globally, is a useful reminder that this is not the case.
Whether ICOs are regulated under the Corporations Act depends on the features and rights attaching to the coins. ASIC's guidance highlights five ways in which the Corporations Act might apply.
Does the ICO establish, or is it part of, a managed investment scheme?
ASIC refers to the Corporations Act definition of a managed investment scheme (MIS), which, in broad terms, is a scheme with the following features:
- people contribute money or money's worth (which may be other cryptocurrency) to acquire rights to benefits produced by the scheme;
- any of the contributions are pooled or used in a common enterprise to produce financial benefits, or rights or interests in property, for members of the scheme; and
- members do not have day-to-day control over the operation of the scheme.
ASIC's guidance notes that the concept of a 'right' in a managed investment scheme is to be interpreted broadly, and may include rights that could arise in the future or are contingent, and rights that are not legally enforceable.
If the ICO creates or is part of an MIS, the issuer (and others who provide services in relation to the ICO) may be subject to licensing obligations and may need to give investors disclosure documents. The promoter of the MIS may also be required to register the MIS with ASIC. Failure to register if required to do so can result in criminal and civil penalties.
Does the ICO involve the offering of shares?
ASIC says that where an ICO occurs in order to fund a company, or something like a company, the rights attached to the coins may be shares. For example, if subscribing to the ICO confers ownership in a body, voting rights, or a right to share in the profits of the enterprise, the coins are more likely to be shares.
If the coins are shares, the ICO would actually be an IPO and the issuer would be required to prepare a prospectus. The content requirements for a prospectus are onerous, and it is unlikely that the typical white paper prepared for an ICO would meet all the requirements.
Does the ICO involve the offering of derivatives?
Some ICOs may involve the issue of derivatives. While ASIC notes the complexity of the definition of 'derivative' under the Corporations Act, for the purposes of the information sheet it says a 'derivative' is a product that derives its value from another 'thing', which is commonly referred to as the 'underlying instrument' or 'reference asset'. This may be a share price index, a pair of currencies or a commodity (including a cryptocurrency), or something else.
A coin could therefore be a derivative if the price payable for the coin at some future date is based on the value of something else, such as the value of another cryptocurrency.
An entity issuing or providing services in relation to derivatives may need to hold an Australian financial services licence and may also need to provide investors with required disclosure.
Does the ICO involve trading coins on a financial market?
If the coins are financial products, providing a platform through which the coins can be issued or traded may involve operating a financial market. The operator of a financial market may be required to hold an Australian market licence under the Corporations Act.
Does the ICO involve a 'non-cash payment facility'?
ASIC notes that some types of facilities for making non-cash payments are financial products that are regulated under the Corporations Act. While coins themselves are not likely to be non-cash payment facilities, they may form part of a broader arrangement that is such a facility.
ASIC's guidance indicates that an ICO may involve a non-cash payments facility if it includes an arrangement that allow payments to be made to a number of payees, or if payments can be converted to fiat currency to enable completion of the payment.
ASIC notes that Australian law prohibits misleading or deceptive conduct in various circumstances. Even if coins are not financial products and the ICO is not regulated by the Corporations Act under any of the above categories, an ICO will still be subject to the misleading and deceptive conduct regime in the Competition and Consumer Act 2010. Therefore, no issuer should consider that an ICO falls entirely outside of all regulatory scrutiny, and coin issuers should ensure publicity materials and white papers do not include false or misleading statements.
ASIC's guidance comes in the wake of a number of global regulators making announcements around the applicability of local regulatory regimes to the ICO market. Some regulators, such as the Monetary Authority of Singapore (MAS), the Canadian Securities Administrators and the UK Financial Conduct Authority (FCA), have identified that ICO sales may involve the application of local securities law, and that ICOs need to be considered on a case-by-case basis. This is a similar approach to ASIC's. Some, including MAS and the FCA, have also issued consumer warning guidance on the risks involved in purchasing tokens in an ICO.
The US Securities and Exchange Commission (SEC) has issued some of the most comprehensive analysis in this space. The SEC conducted an investigation into the incident involving the 'virtual corporation' known as the 'DAO' in 2016. The SEC's report concludes that the tokens issued and sold in connection with the DAO were securities, and that US securities law should have applied to the creation and sale of the token in the DAO. While the SEC declined to take enforcement action, the report acts as a warning to any ICO looking at marketing into the US that US securities law may apply.
While the SEC's analysis provides a clear example of an ICO token as a security, it still leaves considerable uncertainty for other variants of tokens sold in ICOs, such as where the token operates as an access right or licence to a particular technology solution.
The most drastic measure regarding ICOs has occurred in China, which declared a ban on ICOs, alongside restrictions on cryptocurrency exchanges and individuals involved in activities related to cryptocurrencies, including 'mining' of cryptocurrency – an activity critical to the cryptocurrency ecosystem, which has a significant base of operation in China. This has had a ripple effect through the ICO market and general cryptocurrency ecosystem, raising questions about its long-term viability. The full effect of these moves is still yet to be understood.
These announcements have forced issuers to consider the jurisdictions they wish to sell into; and seen moves to geoblock certain jurisdictions, in order to avoid being captured by overseas jurisdictions such as the US.
Some issuers may assume, or may have assumed in the past, that ICOs are essentially unregulated if the coins themselves are not financial products (which is often the case) or securities. However, ASIC's guidance, and the various overseas scrutiny, is a clear reminder that this is not necessarily the case.
Ultimately, whether the coins and the ICO will be regulated in Australia depends on the rights that attach to the coins. However, the analysis in Australia may not be the same as that in overseas jurisdictions. As such, issuers cannot afford to be blasé about potential regulatory consequences in any public internet-based sale of tokens or coins in an ICO .
ASIC is clearly concerned about the potential of ICOs to result in financial losses for investors. Its MoneySmart website has been updated to provide consumer advice on ICOs, labelling them as 'high-risk speculative investments', and highlighting the risks of loss of investment due to fluctuations in coin value, scams run by unscrupulous issuers or theft of coins by hackers. We expect that ICOs will come under increasing regulatory scrutiny from ASIC, as they have internationally.
While language is important, ICOs will not escape regulatory scrutiny simply by avoiding references to 'investments' and 'securities'. Any company or enterprise considering undertaking an ICO should closely examine its product or offering, to consider how it fits within the existing regulatory regime. This will involve examination of the function of the token in the context of its implementation, as well as the rights granted at the time of its purchase. It remains to be seen whether the views of regulators (and legislators) on ICOs remain static going forward, or trend towards the view taken in China. An event with significant consumer impact could potentially change the landscape.
ICOs are a fascinating development in technology implementation and capital raising. However, they remain a phenomenon that issuers and consumers should approach carefully.