Essay: Initial Coin Offerings ICO lack of regulatory harmonisation

The issuing of shares and debts to investors in exchange for fiat currency in order to raise finance through Initial Public Offerings (IPOs) is regulated by the Financial Conduct Authority (FCA) in the United Kingdom. However, to avoid rigorously regulated processes of capital-raising and because it is arguable a much quicker process, more and more start-ups and other companies nowadays use a new method of raising capital: Initial Coin Offerings (ICOs). With over $6 billion having been raised through ICOs in 2017 and over $18 billion raised so far this year , this new method has emerged as a significant alternative to the traditional fundraising in the past year. The regulatory treatment of ICOs is not tested, but this has not escaped the attention of regulators such as the FCA and the European Securities and Markets Authority (ESMA). The prominent occurrence of ICOs has prompted the FCA and ESMA to examine them and, as a result, statements of warning have been published, alerting consumers that ICO’s are ‘very high-risk investments’ . In the United Kingdom, the FCA maintains a technologically neutral approach towards this new development by looking to apply existing regulation to innovative technologies such as the ICOs, but there is currently no regulatory framework specifically dealing with the concept and terminology of ICOs, leaving a high degree of uncertainty and lack of clarity surrounding this matter.
Although there is no legal or generally accepted definition for ICOs, the FCA defined them as a ‘digital way of raising funds from the public using a virtual currency, also known as cryptocurrency’ . ESMA stated that it ‘can also be referred to as an initial token offering or token sale’.
To launch an ICO, it is currently common practice for an issuer to produce a whitepaper stipulating the terms and conditions pursuant to which investors may purchase the tokens. Such a whitepaper is not currently examined by regulatory authorities. This will be discussed later in this paper. The investors participate in the fundraising by transferring cryptocurrencies such as Bitcoin or Ether to the token seller in exchange for crypto tokens; consequently, the investors are deemed to have accepted the terms and conditions applicable to that ICO and the underlying smart contract technology sends the purchased tokens to the investor’s wallet address instantly.
Crypto tokens are ‘a special kind of virtual currency tokens that reside on their own distributed ledger and represent an asset or utility.’ The transaction usually takes place on blockchains such as the Ethereum network that allows a user to create his/her tokens. Since there is no established standard as to what rights each token gives to a tokenholder and they are not being checked against any regulatory requirements prior to issuance, the ICO issuer has complete autonomy to manage the rights that will be attached to that token and to which the token holder will be entitled immediately or following issuance. A token will usually be ascribed certain rights and attributes and can fall into either or both of the following categories: security tokens or utility tokens . Security tokens are those created in such a way that they grant the investors certain rights similar to those of a traditional security, for example online voting rights or the right against the issuing company to claim a specific benefit such as the right to periodic return resulting from the investment. They do not, however, convey meaningful ownership status or direct rights to the assets held by the company as do shares. Security tokens are then traded on virtual currency exchanges (crypto-asset exchanges), ‘making them fungible in the same way as shares’ . Utility tokens are tokens that give the holder access to use a specific platform or to buy a product or a service, however these do not form subject of this paper’s discussion.
Mark Carney, governor of Bank of England, stated that ‘so-called initial coin offerings will not be allowed to use semantics to avoid securities laws designed to protect retail investors in particular.” The law must consider that one of the main consequences of failing to adequately regulate this area is less protection offered to investors. This paper aims to provide an analysis of whether, under the current legislation, the requirement for an approved prospectus is triggered by ICOs offering security tokens to the public or whether the law needs to be reformed accordingly.
Under section 85(1) of FSMA, it is unlawful for transferable securities to be offered to the public unless an approved prospectus has been made available to the public before the offer is made. Breach of this requirement is a criminal offence . An approved prospectus is “a prospectus approved by the competent authority of the home State” , respectively the FCA in the United Kingdom. The general requirements for the contents of a prospectus are set out in sections 84, 87A(2), (2A), (3) and (4) of FSMA. These mainly provide that the information made available must be comprehensible, easy to read, that it necessarily enables investors to make an informed decision based on the historic financial information of the issuer and of the rights attaching to the transferable securities. The persons responsible for the prospectus are the issuer of the transferable securities and if the issuer is a company, the directors of the company .
The definition of transferable securities is found in section 102A(3) of FSMA as anything which is a transferable security for the purposes of the Markets in Financial Instruments Directive (MiFID II). MiFID II gives an exhaustive list of categories of financial instruments , however, one such category -transferable securities – is defined non-exhaustively in Article 4(1)(44) of MiFID II as those classes of securities which are negotiable on the capital market, and includes: a) shares in companies and other securities equivalent to shares in companies, and depositary receipts in respect of shares; b) bonds or other forms of securitised debt; c) any other securities giving the right to acquire or sell any such transferable securities or giving rise to a cash settlement determined by reference to transferable securities, currencies, interest rates or yields, commodities or other indices or measures (such as warrants, options, futures and convertible bonds ).
Are security tokens covered by the transferable securities’ definition?
The important aspect here is that although the definition a transferable security does not seem to be limited to the examples given, theoretically it does not create a far-reaching, flexible enough interpretation that clearly covers security-like tokens. There is a common misconception that all ICOs are unregulated, but this is not what this paper intends to insinuate. Based on the current legislation, security tokens do not explicitly fall within the scope of section 85 of FSMA or the MiFID II definition, yet the FCA stated that ‘some tokens may constitute transferable securities and therefore may fall within the prospectus regime’ . This would imply that tokens that have characteristics of transferable securities are likely to fall within the regulatory perimeter, even though a token does not, in legal terms, constitute equity. Nevertheless, the FCA has also stated that many ICOs ‘will fall outside the regulated space’ . Whether ICOs offering security tokens in return for cryptocurrencies are required to produce a prospectus approved by the FCA must, according to FCA’s statement , be decided on a case-by-case basis.
This lack of clarity in the law leaves a token issuer free to create its offering so that the token delivered under the online transaction does not perform any of the statutory prescribed functions of a security, but the final token that will be issued and functional once the ICO is raised might, so that the issuer easily receives the funds by escaping time-consuming legal requirements, such as the requirement for a prospectus. By the time the regulatory authorities decide whether additional regulatory action is required or expressly how they are regulated, the ICO issuer had already raised large amounts of money.
The MiFID II definition of transferable securities refers to those classes of securities which are negotiable on the capital market. It is not yet certain whether the exchanges on which tokens are traded amount to a capital market within the United Kingdom. Token holders can trade their tokens for other cryptocurrencies and can later trade them into fiat currencies (‘currencies that a government has declared to be legal tender’ ) via digital currency exchanges such as Coinbase, Bittrex, EToro, Poloniex or Bitstamp. There is evidence that digital currency exchanges are increasingly being regarded as secondary markets across both EU and UK. In 2016, amongst other cryptocurrency exchanges operating in the European Union, Bitstamp was granted a license to be fully regulated under the EU Payment Services Directive and the EU Electronic Money Directive , whilst, more recently, Coinbase obtained a license for fiat operations directly from the FCA, becoming trusted intermediaries for online trading, on which digital tokens can also be exchanged . In his speech, Mark Carney, governor of Bank of England, stated that ‘holding crypto asset exchanges to the same rigorous standards as those that trade securities would address a major underlap in the regulatory approach’ . In my opinion, as these exchanges do, either wholly or partly, create a secondary token market . and therefore do amount to a capital market, then issuers that wish to offer security tokens to the public should be automatically required by law to provide an approved prospectus, just the same as companies issuing shares through IPOs.
There are exemptions to the section 85 FSMA, which are laid out in section 86. These include offers that are directed at qualified investors only or directed at fewer than 150 persons . However, as most ICO are open to the public in general and not limited to qualified investors, therefore this exemption would not/rarely apply. Moreover, section 85(1) applies to all transferable securities other than those listed in Schedule 11A of FSMA or that are exempted by the Prospectus Rules . For example, a public offer was exempt if the total consideration of the offer in the EEA States is less than 5 million Euros . However, on 21 July 2018 this amount has been reduced to 1 million Euros to implement and apply the new Article 1(3) of the New Prospectus Regulation. According to the 2018 statistics , most of the ICOs have so far already raised more than 1 million euros. Considering the large amounts of money ICOs have consistently raised within the past year, an ICO will hardly fall within this exemption. Schedule 11A also lists other certain excluded types of securities, but in most of ICO scenarios none of them would apply.
As mentioned above, to launch an ICO, it has been common practice for the issuing company to produce a whitepaper on their website or platform. However, the downside of a whitepaper is that it is not a formal prospectus approved by FCA, but an “unaudited, incomplete, unbalanced or even misleading” document. In a prospectus, the directors of the company are required by law to take responsibility the information they provide in the document . Regardless, token issuers are not bound by any such legal requirement and tend to exclude liability in their whitepaper. As most of the ICOs are addressed to the public in general and not only to qualified or experienced investors, such an informal document comes with the immediate danger of misleading the average, unsophisticated investors.
Transparency and comprehensiveness of the information in a whitepaper are currently not necessarily examined by regulatory authorities. Another factor of risk constitutes the fact that, because ICOs are usually created when a company is still in its early stages of launching, investors might not be able to make a reasonably informed investment decision due to the lack of the company’s historic financial information.
From the investors’ protection point of view, one of the strengths of current English law are the common law liabilities that can be imposed on an issuer. ICO issuers tend to include in their whitepapers disclaimers such as stating that their token does not represent a security or investment and that investors take full risks with their money or denying the fact that their whitepaper constitutes an invitation to trade or legal advice. This type of disclaimers’ effect has not yet been fully tested under English law, but will nonetheless be subject to the common law. Examples can be failure to keep a promise of a certain level of return on an investment within a certain period of time, possible misrepresentation as to the issuer’s intentions , failure or refusal to proceed with the promised development of the project or using the proceeds of the ICO for purposes not mentioned in the whitepaper. In these circumstances, investors may seek damages for breach of contract (of the terms and conditions of the whitepaper) or for misrepresentation (innocent, negligent or fraudulent) or deception, therefore criminal as well as civil claims can be brought against token issuers.
However, in the case of Barclays Bank plc v Svizera Holdings it has been previously held that banks’ well-drafted disclaimers which include clauses asking the investor not to rely or not to consider it advice will generally be effective in excluding claims of misrepresentation. It is not clear whether this precedent would apply in ICO cases, but it may be that the investor is only left with claims for fraudulent misrepresentation. This is because such clauses are most likely going to be considered exclusions of liability and therefore be subject to the reasonableness test under section 11(A) of the Unfair Contract Terms Act 1977 and ultimately not considered effective. However, a fraudulent claim for misrepresentation may be difficult to prove and ‘the mere fact that an ICO has turned out disappointingly and has failed to match the optimistic projections in the whitepaper, will be insufficient, without more, to ground a claim in such a case’ .
Another downside for the investors to rely mainly on the misrepresentation claims would be that such claims can be time consuming, uncertain of the outcome, raise tension and represent additional costs for investors. Moreover, such a claim can give rise to potential issues of jurisdiction or choice of law and could also raises more difficulty for the investor to trace the counter party, especially where the issuer is not an identified issuing company.
The company issuing an ICO with tokens of similar characteristics of a security should create a whitepaper in which to disclose to its investors information that is comprehensive and transparent, to provide them with sufficient and accurate details, a balanced view of its project plan, properly identifying the parties behind the project and the possible risks involved that permit investors to make a reasonable investment decision. I believe this outcome can only be achieved if such an ICO’s whitepaper is subjected to the same thorough verification process in respect of the information contained as the prospectus of an IPO issuing securities to the public. For this to happen, I believe it is not enough to rely on each issuer’s best practices, but it must be required by law that its whitepaper is approved by a regulatory authority.
Whilst the English law case-by-case analysis is a practical approach to ascertain the classification of each type of token issued, this categorisation makes the regulatory task more challenging instead of simplifying it in cases where it is clear for the issuer it is going to issue security-like tokens. I propose a law reform that section 85 of FSMA is being extended so that, apart from transferable securities, it also makes it unlawful for security tokens to be offered to the public unless an approved prospectus has been made available to the public before the offer is made and on pre-financing/pre-sale phases. Security tokens can be defined as those digital assets that attach to the tokenholder analogous rights to those of a transferable security and that can be transferred, stored or traded electronically. This change in the law would bring explicit control frameworks and, through the introduction of anti-avoidance language, it will offer more clarity, coherence and will prompt companies that intend to issue security tokens to seek pre-approval of their prospectus from the FCA, automatically making it a criminal offence not to.
Pre-approval of a prospectus and establishing minimum mandatory disclosure requirements can bring the function of screening for untrustworthy, amateurish or fraudulent initiatives and the sooner this can happen, the better it is as it can also help avoiding future risks arising from possible liability claims. Investors need to know they are able to trust the firms they invest in. Compliance and transparency would possibly attract more investors, but also protect the market integrity by bringing some ICOs under the same regulatory requirements and eliminating the current disproportionate difference between ICOs and IPOs. I believe it would be beneficial to have both section 85 covering security tokens and the common law on misrepresentation in place, for the sake of controlling the risks ICOs pose and providing more financial stability, market integrity and, most importantly, a better protection of the investors.
However, besides the common erroneous perception of lack of regulatory barriers, what attracts companies to ICOs is the speed with which tokens can be issued and funds raised. In markets that are so volatile, people want to act quickly. A downside to this proposed solution is that it slows down the process of issuing tokens, so it may easily be said that UK’s current approach of dealing with ICOs on a case-by-case basis is more efficient from this point of view.
In conclusion, in order to deal with such a technological development as an ICO, UK currently turns to the existing legal framework pursuing consistency and a proportionate application of law, but this shows a lack of regulatory harmonisation. FSMA 2000 was not articulated to properly accommodate the development of cryptocurrencies and this unclear and uncertain environment threatens to stifle technological development in the long run. The law is in dire need of being reformed so that it keeps up with the technological innovations.