How to tackle ICOs to avoid regulatory issues

In an alarming but long-feared move, Chinese authorities announced on September 4, 2017, that from then on fundraising Initial Coin Offerings (ICOs) will not be allowed to take place on the domestic market. ICO technology can be used as a tool to collect funds from backers to launch new blockchain projects.

The Chinese regulators instructed companies that have already completed their fundraising ICOs to refund the payments to their backers, and the public and financial institutions are asked to report to the authorities all suspicious fundraising activities involving ICOs and cryptocurrencies. Naturally, this development threw the Chinese blockchain community into disarray.

Many market experts agree that it will hinder the advance of blockchain-based innovations as access to funds to bring new ideas to life will be problematic. There is also a well-founded belief that many Chinese startups will start fleeing to other countries where ICOs can be conducted legally. It is still too early to know the precise implications but it fairly obvious that they will be significant.

Although the Chinese sanctions appear excessively harsh, the caution is not entirely misplaced. In recent times there have been numerous projects that have intentionally or unintentionally deceived their backers. In a famous case of an entity called the DAO, which collected about $150 million in ETH but then was attacked by hackers who stole roughly $60 million, the US regulator Securities and Exchange Commission had to step in and conduct an investigation.

For the most part the agency takes a relatively permissive and nuanced "wait and see" approach to the ICO market, but in this case many people were affected, and the situation called for scrutiny. SEC prepared a report on the results of its investigation in which it stated that "all offers and sales of digital assets by 'virtual' organizations are subject to the requirements of the federal securities laws… the DAO tokens were, in fact, securities and, therefore, subject to federal law."

In this case, the logic behind the regulator's decision is completely understandable: if a startup conducts its token sale with the sole purpose to raise funds to pay for its operations, it is most likely offering its tokens as a veiled security to attract investments -- a process that is tightly regulated in most of the world, and which must be conducted in strict compliance with the law.

To determine whether a particular token may be a security, the US regulator relies on several legal tests, most notably the Howey test. If a token passes these tests, it is likely a valid product or service and consequently can be legally sold to the public. If it offers its backers a useful and usable advantage -- for instance, a subscription, a discount, or a private club membership, it makes an important contribution to the market and can legally be issued.

Eric Ly, co-founder of LinkedIn and advisor to ICOBox said:

"Many companies are contemplating holding an ICO and they need regulatory certainty to be able to feel comfortable with their decision. Attracting support through a token sale is a wonderful way to involve regular people in the early stages of a company's business. It leads to more innovation. The Chinese ban might hurt China more than the ICO market at large as it will force innovators planning their ICOs to turn to other markets."

The Chinese ban had immediate international reaction because many ICO candidates and their attorneys are afraid of exactly this happening in other counties. It’s useful to note that legal systems are different around the world, and wholesale reversals of laws are very rare in the Western legal practice. On top of that, the Chinese ruling is open to interpretation and is not as black and white as a lot of coverage suggests.

Katrina Arden, Blockchain Law Group founder and advisor to ICOBox said:

"I am not entirely in agreement with the ban being interpreted as total. The Chinese financial regulator clearly banned only 'fundraising activities performed through token issuance,' identifying token fundraising as 'a process where fundraisers distribute digital tokens to investors who make financial contribution in a form of cryptocurrencies.' Selling a product via a token sale is not a fundraising activity; therefore, ICO of the product tokens should not fall under the ban. Maybe I am too optimistic and more research is needed here, but this is what the English translation of the Chinese regulator’s decision appears to imply."

Also, many executives -- and, evidently, Chinese authorities -- are concerned that they can't control token owners. Publicly traded companies fear that their tokens, traded on exchanges regardless of their wishes, will lead regulators to conclude that the product classification of their tokens should be revoked. Governments fear that tokens offer a backdoor to circumvent their authority on currency control and regulation. Many of these fears stem from not understanding the nature of blockchain technology underlying token infrastructure.

In the words of Arden:

"Not all tokens are securities. Tokens can represent a great variety of products as well. Sale of the company’s product through distribution of tokens is also regulated by applicable law in each country but the securities law will not apply. The same goes for a resale of the product tokens. For example, in the US the SEC does not restrict the resale of concert tickets on StubHub or other secondary marketplaces, even when the tickets are originally purchased by some buyers to be resold there at the inflated prices. Tokens are no different and don’t need new laws or regulations; they just need to be recognized and included into the legal system of any given country."

Taking into account all the regulatory questions, it is extremely important to pay very close attention to the legal side of token concept development. Startups are recommended to consult with attorneys experienced in all aspects of ICO campaigns. The choice of language in which the project and its token is described to the public in the White Paper and on the company's website should be clear, transparent, should not rely on investment and securities-related terminology, and should not raise any expectations of profit, offering instead access to certain interesting benefits and opportunities.

Keith Teare, co-founder of TechCrunch, and also an advisor to ICOBox said:

"The emergence of full-service ICO advisory platforms will help address the quality issues surrounding ICOs."

As ICO best practices continue to evolve, in addition to legal resources a host of other services is forming an ecosystem to help startups interested in the process. These resources include advisory firms with their dedicated marketing expertise and technology tools comprised of many important elements to effectively help startups prepare and conduct their token sales. New projects considering an ICO should secure the appropriate mix of resources to advise and support their efforts.

ICOBox is developing an end-to-end ICO process which, relying on its token holders to serve as a jury, will filter the demand from companies seeking to conduct an ICO, zeroing in on only the best qualified candidates. Other ICO advisory firms with similar capabilities are slowly popping up on the market. As a result of these developments, the quality of projects looking to hold an ICO is bound to improve over time.

With all these considerations in mind, and conscious of the need to stay within the reasonable boundaries, many ICOs can be conducted legally, safely, and successfully.

Nick Evdokimov, co-founder of ICOBox.

Published under license from ITProPortal.com, a Future plc Publication. All rights reserved.

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