• Advokat Jeppe R. Stokholm

Practical use of crypto securities - ICO's/TGE's and crypto equity

Updated: Feb 1, 2018


#Cryptolaw

As a starting point, a crypto security can be defined as a token subject to financial laws, that regulate the public offer, sale and/or trade of securities. In the following, the practical use of crypto securities will be investigated in different situations , including:

  1. Initial Coin Offerings / Token Generating Events, and

  2. Crypto equity: Assets and property


1. Initial Coin Offerings (ICO’s) and Token Generating Events (TGE’s)


So, what is an Initial Coin Offering (#ICO) and/or a Token Generating Event (#TGE)?

Well, in the following ICO’s and TGE’s are defined as similar type of events, i.e.:


  • Crowdfunding events, where tokens are generated and sold to investors in exchange for fiat and/or other crypto currencies.


The US Securities and Exchange Commission (SEC) explains the background for these events as follows:


”Promoters may tell purchasers that the capital raised from the sales will be used to fund development of a digital platform, software, or other projects and that the virtual tokens or coins may be used to access the platform, use the software, or otherwise participate in the project. Some promoters and initial sellers may lead buyers of the virtual coins or tokens to expect a return on their investment or to participate in a share of the returns provided by the project. After they are issued, the virtual coins or tokens may be resold to others in a secondary market on virtual currency exchanges or other platforms. Depending on the facts and circumstances of each individual ICO, the virtual coins or tokens that are offered or sold may be securities. If they are securities, the offer and sale of these virtual coins or tokens in an ICO are subject to the federal securities laws”[1].

As highlighted by the SEC, the legal treatment of the #crowdfundingevent depends on whether the tokens generated are to be qualified as:

  • non-regulated tokens, or

  • regulated tokens (crypto securities)?

If the crowdfunding event involves the offering of a regulated token (crypto security), the crowdfunding event must be done in accordance with established securities law requirements (or proceed under an exemption if available), including filing a prospectus distributed by underwriters or brokerages to potential investors etc.


To determine, whether a token is to be treated as a (regulated) token, that trigger US and/or other countries laws on securities, the US #Howeytest can be applied. Due to the Howey-test, an investment contract (defined as an investment of money in a common enterprise with an expectation of profits predominantly from the efforts of others) is a security.


In general, #passivetokens are more likely to be considered securities than #activetokens, i.e. it is always important to investigate, if the generated tokens are:


a) Tokens representing a crypto currency?

Such tokens are most likely non-regulated tokens.


b) Tokens representing an ownership right?

Such tokens are most likely regulated tokens subject to financial laws.


c) Tokens representing a creditor relationship?

Such tokens are most likely regulated tokens subject to financial laws.


d) Tokens representing financial contracts (derivatives)?

Such tokens are most likely regulated tokens subject to financial laws.


It is crucial, that crowdfunding events are subject to strict financial legislation and regulatory constraints, if the tokens generated are subject to financial laws, that regulate the public offer, sale and/or trade of securities. However, even if the tokens generated are non-regulated tokens, i.e. not subject to strict financial legislation, it is still strongly recommendable to follow the industry “best practice” during the crowdfunding event. In this respect, valuable input can be found at self-regulated organizations such as “The ICO Governance Foundation”:

The ICO Governance Foundation (IGF) is a decentralized global organization and Swiss Foundation whose mission is the establishment of a protocol-based global community that performs a self-regulatory function for ICOs in decentralized capital markets. To support this mission IGF provides and maintains an open voluntary public filing and registration protocol called Form IGF-1 as well as a public registration database that performs automated collection, validation, indexing, acceptance, and forwarding of submissions. IGF works with national regulatory agencies to establish global best-practices and standards for ICOs that complement national regulatory organizations such as the SEC, ESMA, CSRC, MAS and others. IGF-1 provides transparency of the token sale custody chain and distribution of ICO proceeds. The foundation and these standard protocols are part of a Global Public Utility and industry self-regulatory function that is needed to align stakeholders and to improve the volume and flow of capital incentives for ICOs from institutional-grade investors[2].

When investigating the use of crypto securities in crowdfunding events, there are both benefits and challenges to be addressed.


The legal benefits are the following:


  • Regulated market: Most countries accept the use of ICO’s / TGE’s, as long as they comply with local laws on securities.

  • Verified ledger: Since a blockchain is a cryptographically list of records secured in a chain of blocks, and since each block is timestamped and referring to a previous block in the chain, each chain of blocks is acting as a verified ledger of records relating to the crowdfunding event, including the launch, sale and after-sale of tokens. Transactions are instantly processed, verified and publicly recorded at a low fee (if any).

  • Rights and limitations can be implemented as smart contracts: In traditional funding events, a lot of contracts are issued, e.g. Letter of Intents (LOI’s), Share Purchase Agreements (SPA’s), Shareholder Agreements (SHA’s) etc. On the blockchain, such agreements can be implemented as smart contracts, giving investors absolutely transparency regarding registration of ownership, payment in tranches due to fulfilment of milestones, registration of pledges etc.


The legal challenges are the following:


  • Not all jurisdictions accept ICO’s/TGE’s: On the 4th of September 2017, China’s Central Bank declared Initial Coin Offerings (ICO’s) illegal on Chinese soil, and asked all Chinese related fundraising activities to be halted immediately. The Peoples Bank of China said that those who had already raised money through Chinese ICO’s should provide refunds or face being “severely punished” according to the law. This ban is only effective in China, but is an example of the fact, that some jurisdictions have a very closed approach to the acceptance of ICO’s / TGE’s. South Korea has followed the example of China and banned all ICO’s/TGE’s.

  • Caveat emptor (investor be aware): Information asymmetry during crowdfunding events, where tokens are generated and sold to investors in exchange for fiat and/or other crypto currencies, has led to several examples of Ponzi schemes. Both the US Securities and Exchange Commission (SEC) and the Swiss Financial Market Supervisory Authority (FINMA) have taken action against such schemes, and follow market transactions very tight. Due to the SEC, fraudsters often try to use the lure of new and emerging technologies to convince potential victims to invest their money in scams. These frauds include “pump-and-dump” and market manipulation schemes involving companies, that claim to provide exposure to these new technologies. Investors who are performing a due diligence need to understand the new technology and the emerging business models based on this technology. In general: If the technology and business model is not transparent, stay away.

  • Law enforcement is challenged in a free and anonymous market: Crowdfunding events, that can be carried out peer-to-peer without any involvement of intermediaries and with the use of anonymising software such as Tor, constrains the ability of law enforcement to track down IP addresses. This combined with the use of crypto currencies, opens the market for funding and investing in illegal business activities.


2. Crypto Equity: Assets and property


Crypto Equity is in the following defined as:


  • An ownership interest to assets and property in a distributed ledger system.


Tokens representing the following ownership interests are most likely to be deemed as securities:


a) Private property: Ownership interests to private property investments, including access to economic profit (and losses) from legal entities and partnerships, such as shares etc.


b) Personal property: Ownership to personal property investments, such as negotiable instruments and intangible assets, if they give access to economic up- or downside (profits and losses) and/or grants and option to sell or buy such instruments or assets (call or put options) etc.


c) Real property: Ownership interests to real property investments, including access to economic profit (and losses) from real estate, land etc.


d) Intellectual property: Ownership interests to intellectual property investments, including access to economic profit (and losses) from patents, copyrights, trademarks, design rights, trade secrets etc.


When investigating the use of crypto equity, there are both benefits and challenges to be addressed.


The legal benefits are the following:


  • Not the wild-west: Most countries treat crypto equity with the same laws, that can be applied to non-crypto equity, e.g. criminal law provisions can also be applied to Ponzi schemes.

  • Verified ledger: Since a blockchain is a cryptographically list of records secured in a chain of blocks, and since each block is timestamped and referring to a previous block in the chain, each chain of blocks is acting as a verified ledger of records relating to different kinds of ownership interests in assets and property in a distributed ledger system.

  • Rights and limitations can be implemented as smart contracts: Ownership interests, options to sell and buy, pledges etc. can be implemented as smart contracts, giving investors absolutely transparency regarding registration of ownership, payment in tranches due to fulfilment of milestones, registration of pledges etc.


The legal challenges are the following:


  • Law enforcement is challenged in a free and anonymous market: Ownership interest to asset and property, that can be transferred peer-to-peer without any involvement of intermediaries and with the use of anonymising software such as Tor, constrains the ability of law enforcement to identify the involved parties, including the ultimate beneficial owners before and after the transaction. This combined with the use of crypto currencies, opens the market for illegal business activities, including tax fraud, creditor shelters etc.


Advokat Jeppe R. Stokholm is based in Zürich, Switzerland. The area of expertise is corporate affairs, including M&A, Venture Capital, Private Equity and Crypto Law. Advokat Jeppe R. Stokholm represents several international oriented Law Firms, Auditors and Family Offices on a case-by-case basis and provide discretionary counselling to global operating companies and private UHNW clients. 



NOTES:


[1] The US Securities and Exchange Commission (SEC): “Investor Bulletin: Initial Coin Offerings”, (July 25, 2017), found at: https://investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-initial-coin-offerings


[2] Found at: https://icogovernance.org/


​Zürich, Switzerland