ICOs are everywhere and nowhere: how do you regulate a blockchain?

It almost sounds like a fiendish puzzle set by The Riddler: what’s everywhere yet nowhere and 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. 

Over the last few years, initial coin offerings (ICOs) have emerged as an accepted ‘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. Meanwhile here in Australia, a Perth-based solar energy trading platform, PowerLedger, recently raised A$34 million worth of cryptocurrency.

Over the last quarter in the US, it’s been suggested more money was raised by ICOs than early stage VC offerings. To date, there are more than a thousand different cryptocurrencies on the market. Only a few years ago there were thousands of iPhone apps, now hundreds of thousands of apps are launched each year. There are those who firmly believe ICOs will be just as common - eventually.

What is an ICO

ICOs are a type of fundraising where investors buy into a new venture using cryptocurrencies like Bitcoin and receive virtual “tokens” relating to that venture. Tokens might give investors certain rights. 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 the right to access a new social network. The tokens (often referred to as cryptocurrency) are recorded on a blockchain ledger.

Disrupting our concept of legal title

Blockchains might just be an evolutionary step in developing better evidence of title. Examples include systems of land law that operate on the basis of registered title. These were, in fact, a movement from a feudalism model law based on tenure and deriving from monarchs. Today, we have the Torrens land title registration system that has progressively supplanted general law deeds. Indeed, Torrens could easily have been speaking of blockchain at the beginning of his Second Reading speech:

“The two great principles of the measure were that not merely the instrument, but the entry in the book shall form the title; and that the certificate, for the future, shall always be deemed evidence of title in a court of law.”

Cryptocurrency issuers can create enormous value without 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, not dragging below deck. A blockchain exists simultaneously on every node in its network - the cryptocurrency 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? Throw in the fact cryptocurrency can be held by anyone anonymously and exists everywhere but also nowhere, and it becomes the stuff of nightmares for regulators. So, is there a superhero on the horizon?

Regulators are playing catch-up

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. Last year, investors who participated in purchasing tokens in the Decentralised Autonomous Organisation (DAO) established by the blockchain-based sharing economy platform, Slock.it, lost US$50 million 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 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 co-operative, in that it might be an autonomous, self-help organisation controlled by its members. Could future ICOs be styled more like so-called non-distributing co-operatives?

Like ASIC and the SEC, the UK FCA, the Monetary Authority of Singapore, the Canadian Securities Administrators, the People’s Bank of China and the Securities and Futures Commission of Hong Kong have all issued bulletins to try to manage a possible wave of crypto offerings.

One issue that regulators will have to 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 that’s not insurmountable

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 really all 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 $25 million in consolidated assets and annual revenue to raise up to $5 million from crowdfunding over 12 months without needing to comply with 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 world of ICOs is exciting and blockchain entrepreneurs have the opportunity to explore new ways to interact with investors. The new fundraising environment provides opportunities to blur the boundaries between investors, donors, consumers and business partners. The opportunities are vast but the law will need to get back to basics to make sure issuers deal fairly with investors. Investors need to be clear as to what they have bargained for.

Labels like debentures, shares, derivatives and financial products may struggle to accommodate the new world order that could flow from distributed ledgers. But the basic principles should resonate. It might also be time to rethink securities regulation. Could ICOs be the harbinger of a new model of securities regulation? More likely that there will be a series of regulatory Band-Aids designed to patch the leaky ship.