Author: Patrick Leyden
As many as 80% of ICOs are either outright scams or fail to result in any working product, according to recent reports.
At the height of its bull run in December 2017, the combined cryptocurrency market capitalisation was more than $800bn. In little more than a year the value of bitcoin had surged from $952 to just less than $20,000, a market cap rivalling most multinational companies.
As the market charged forward so did the number of initial coin offerings (ICOs). In 2018 there were about 1,250 ICOs, which collectively raised more than $7.8bn in capital. Among them was EOS, a blockchain platform for the development of decentralised applications tipped to rival ethereum, which is reported to have raised more than almost all of the IPOs on Wall Street that year. EOS managed to raise this capital despite not having a working product at the time of its ICO.
But what is an ICO? It is similar to an initial public offering (IPO) in that it is used by companies to raise working capital for the development of their projects. However, that is where the similarities end.
In an IPO, investors subscribe for shares in an established company that entitle them to receive dividends and, depending on the number of shares acquired, a certain amount of influence over the operations and management of the company.
In an ICO, investors receive virtual tokens that generally do not give the holder any rights in the company that issued them. Instead, some investors in ICOs speculate that these tokens will derive future value once a working product has been developed, while others hope to make a quick return on their investment by selling these virtual tokens to another investor at a higher price — something that many cryptocurrency detractors have said bears a striking resemblance to a Ponzi scheme.
The price of these virtual tokens is determined by the basic economic principle of supply and demand. ICOs differ from their IPO counterparts in that investors are not confined to specific markets but are instead able to extend the offering to a global investor audience.
Unlike IPOs, which are strictly regulated in most jurisdictions, ICOs generally remain unregulated. The result is that companies with a “white paper” (a very basic form of prospectus providing details of the project) and a website can raise capital through an ICO quickly, efficiently and with minimal cost.
Due to this lack of regulation ICOs are open to abuse. Recent media reports have indicated that as many as 80% of ICOs are either outright scams or fail to result in any form of working product. It was reported in 2018 that a company based in Vietnam launched two ICOs and, after raising $660m from about 32,000 investors, vanished with the investors’ funds.
Legislation in most jurisdictions does not provide adequate protection to investors participating in ICOs. The difficulty regulators face is that ICOs operate on a global level and the virtual tokens offered through ICOs could potentially be classified under various economic functions. In response to these challenges, some jurisdictions such as China, Nepal and Bangladesh have simply imposed an outright ban on any domestic companies offering ICOs and on all citizens participating in ICOs.
SA, with a number of other jurisdictions, has opted for a more progressive approach. Although cryptocurrency and ICOs in SA remain largely unregulated, they have been on the Reserve Bank’s radar since 2014, when it released its position paper on virtual currencies.
Earlier in 2018 an intergovernmental fintech working group — consisting of the Financial Intelligence Centre, Financial Sector Conduct Authority, Treasury, the SA Revenue Service and the Reserve Bank — released a consultation paper, “Policy Proposals for Crypto Assets”. The working group identified a number of use cases for cryptocurrencies, including the raising of capital through ICOs, but did not elaborate on them.
It was concluded in the consultation paper that an appropriate regulatory framework should be developed through the registration of crypto asset service providers, a review of existing legislation and an assessment of regulatory actions implemented.
The Companies Act prohibits any person from offering securities to the public unless the offer is accompanied by a registered prospectus. The purpose of this provision is to protect investors by ensuring that they are provided with sufficient information to make an informed decision as to whether to take up the offer. A failure by an offeror to comply with these requirements can result in criminal sanctions and personal liability for any losses suffered by an investor.
Although many jurisdictions offer similar protections for investors, regulators appear to be confronted with the same issue: whether the virtual tokens being offered through the ICO fall within the definition of “securities” as defined in domestic legislation. This is not a straight-forward analysis as virtual tokens have many different use cases.
The US Securities and Exchange Commission (SEC) has used the Howey Test, with varying degrees of success, to assist it with this assessment. The test, which was formulated by the US supreme court in 1946, states that an instrument will be considered a security if “the contract, transaction or scheme involves a person investing his money in a common enterprise and that person is led to expect profits solely from the efforts of the promoter or a third party”.
While many have drawn comparisons between the dotcom bubble of the late 1990s and the rise of bitcoin and cryptocurrencies more generally, the market has shown an incredible resilience lately after rebounding from recent lows.
As we potentially move towards mainstream adoption and the possibility of financial institutions and investment funds entering the market, regulators will be forced to take a position. Legislation may need to be amended to specifically address this new form of raising capital.
A heavy-handed approach by regulators would significantly increase the costs and administrative burden associated with ICOs, thereby removing the very factors that lead to the rapid growth of the ICO market in the first place.
In the short term cash-strapped tech start-ups (and scammers) will probably persist with ICOs. More sophisticated investors and established companies may be inclined to wait until the market has become better regulated.
For more information, please contact Patrick Leyden or your usual Herbert Smith Freehills contact.