Currency Affairs

From IPO to ICO, the rapid rise of digital cryptocurrencies has led to a new approach to fundraising, which poses challenges for regulators, report Andrew Lumsden and Robert Franklyn.

It could almost be a fiendish puzzle set by The Riddler: What’s everywhere yet nowhere, can be created by anyone, but knows no boundaries? It isn’t owned by a country, a company or a person. Nor does it require a legal structure. But it will turn some into billionaires. Welcome to the dark and mysterious world of cryptocurrency.

Initial coin offerings (ICOs) have emerged as a “funding” mechanism for the nascent distributed ledger technologies, otherwise known as blockchains. Famously, Ethereum raised over US$18 million in 2014 and now has an estimated market capitalisation of almost US$30 billion.In October, Perth-based solar energy trading platform, PowerLedger, raised $34m worth of cryptocurrency. In November 2017, Melbourne-based startup HCash revealed details of its ICO fundraising using Bitcoin, which raised a fiat equivalent of nearly $53m.

Over the past quarter in the US, it’s been suggested more money was raised for startups by ICOs than early stage venture capital offerings for internet companies (CNBC).

Less than a decade since Bitcoin emerged, there are now around 1500 active currencies and the extraordinary surge in cryptocurrency prices over the past year and increasingly volatile market conditions have prompted comparisons to 17th-century “tulip mania”. As more investors have piled in and more cryptocurrencies have been mined, the market has become increasingly volatile (see below).

Only a few years ago, there were thousands of iPhone apps, now hundreds of thousands are launched each year. ICOs could become just as common — eventually.

What is an ICO?

ICOs are a type of fundraising where investors buy into a new venture using cryptocurrencies and receive virtual “tokens” relating to that venture. Tokens are usually structured to give investors rights in the underlying venture or are attached to the token itself. These may include participating in the profits of the project, the rights to a product or service that will be built with the money raised (think cloud data storage), the right to trade a service such as electricity or access rights to a new social network. The tokens or “coins” are recorded on a blockchain ledger.

Disrupting our concept of legal title

Blockchains might represent the next evolutionary step in developing better evidence of title. Examples include our systems of land registration; that model evolved from a feudalism model based on tenure and deriving from monarchs. Today, we have the Torrens land title registration system, which has progressively supplanted general law deeds.

Cryptocurrency issuers can create enormous value without necessarily owning any IP, selling shares or protecting assets in a company structure. We’ve traditionally thought of title and the registries that protect title as rather dull and mechanical; the hull of our modern commercial ship. By linking with smart contracts, blockchains have the potential to change the hull into sails, powering the ship. A blockchain exists simultaneously on every node in its network — the ledger represented by the blockchain is literally everywhere.

Despite numerous claims, we still don’t know who actually created Bitcoin. It isn’t owned by an issuing country, company or individual. Issuers earn capital gains when the coins they have kept for themselves increase in value. Any increase in the value of the coins released into the market flow back to the issuer in a capital gain of their stored, unreleased coins. So how does a regulator control an instrument that has no boundaries, requires no legal structure and can be created by anyone? Plus, cryptocurrency can be held by anyone anonymously and exists everywhere but also nowhere. It is the stuff of a regulator’s nightmares.

Regulators’ challenge

Regulators around the world are struggling to keep up as excited blockchain entrepreneurs engage investors outside the well-trodden paths of prospectuses and product disclosure statements. In 2016, investors who participated in purchasing tokens in the Decentralised Autonomous Organisation (DAO) established by the blockchain-based sharing economy platform, Slock.it, lost US$50m when hackers infiltrated and diverted the assets held by this virtual organisation to their own blockchain address.

During the DAO offer phase, around 1.15 billion DAO coins were sold to investors. These were purchased through the Ethereum blockchain and token holders expected to receive profits from projects approved by a majority vote. The weight of each vote was based on the number of tokens held by the voter. These token holders were effectively shareholders reliant on the managerial expertise of the DAO’s founders and curators, who decided what proposals should be voted on. Following the hacking, the US Securities and Exchange Commission (SEC) investigated and declared that the DAO tokens and similar arrangements may be caught under securities law, regardless of the type of terminology used to evade existing legislation.

In January, Coincheck, one of Japan’s largest digital currency exchanges, froze sales and withdrawals of a cryptocurrency called NEM and admitted it had lost currency worth around $660million after hackers broke into its network.

In Australia, ASIC has said it may intervene if ICOs are structured in such a way that they fall within the classic categories of regulated investments. This would include offers of managed investment schemes, shares, derivatives, financial markets or non-cash payment facilities.

The breadth of the managed investment regime was shown in the Brookfield Multiplex Case. The court found that litigation funding was a managed investment scheme on the basis that there was a pooling of interest towards a financial benefit — a finding that could well catch many ICOs in its net.

It might also be that the ICO has characteristics much like a cooperative, in that it might be an autonomous, self-help organisation controlled by its members. Could future ICOs be styled more like non-distributing cooperatives?

One issue regulators must come to terms with is the jurisdictional questions that are also embedded in blockchain technology. An offer of cryptocurrency can be made anywhere and everywhere simultaneously, as the registry is not kept anywhere. The offer is often denominated in Ether or Bitcoin and the currency offered is not necessarily connected to any jurisdiction. The ledger relies on no government fiat to grant it existence or limit its liability.

Ambiguity

Prospective ICO participants in Australia need to consider the rights that are attached to the tokens they propose to offer and how much they plan to raise. As ASIC has recognised, in some cases, an ICO will only be subject to the general law and Australian consumer laws. In other cases, the ICO may be subject to the Corporations Act. It depends on how they are structured.

One option might be to shape your ICO as a crowdfunding offering. Recent legislative changes now allow unlisted public companies with less than $25m in consolidated assets and annual revenue to raise up to $5m from crowdfunding in any 12-month period without needing to comply with the usual disclosure requirements. However, retail investors are subject to an investment cap of $10,000 per company in a 12-month period. Offers must also be made to investors using an offer document containing prescribed information and must be made on the platform of an intermediary that holds an Australian Financial Services Licence, a potentially problematic issue.

Watch this space

The new fundraising environment provides opportunities to blur the boundaries between investors, donors, consumers and business partners. The law will need to get back to basics to make sure issuers deal fairly with investors, who need to be clear on what they have bargained for.

Labels like debentures, shares and derivatives may struggle to accommodate the new world order that could flow from distributed ledgers, but the basic principles should resonate. Could ICOs be the harbinger of a new model of securities regulation? More likely there will be a series of regulatory bandaids designed to patch the leaky ship.