The Law and Finance of Initial Coin Offerings

The rise of new technologies is changing the way companies raise funds. Along with the increase of crowdfunding in recent years, the use of Initial Coin Offerings (ICOs) has emerged more recently as a new form to raise capital. Companies in the United States raised more than $4 billion in 2017 and over $6.3 billion were raised through ICOs in the first three months of 2018. In a typical ICO, a company receives cryptocurrencies in exchange for certain rights embodied in “tokens”, whose nature, treatment and implications are generating controversy among securities regulators around the world.

In a recent paper, entitled The Law and Finance of Initial Coin Offerings, we address the primary legal and finance issues raised by ICOs. In our view, the first challenge for securities regulators should consist of clarifying the nature of tokens in order to determine whether, and if so when, they should be subject to securities laws. For that purpose, we propose a definition of tokens based on both their function and their legal nature. As to their function, we follow the classification suggested by FINMA. Therefore, we distinguish between asset tokens (those that resemble shares, bonds, etc.), utility tokens (those that offer access to goods and services) and payment tokens (those that represent cryptocurrencies). As to their legal nature, we distinguish between security tokens (those that qualify as “securities” under a particular country´s securities laws) and non-security tokens (everything else). We argue that the legal classification of the token, which should be the relevant one for securities regulation depends on the features, structure, distribution, and marketing of the issuance of tokens, as well as a particular country´s securities laws. Hence, even though the function of the token may help determine its legal nature, a further analysis will be required.

Second, regulators should decide how to deal with ICOs. For example, while some countries, such as China and South Korea, have prohibited ICOs, other jurisdictions (e.g., Mexico) require authorization for any issuance of tokens (no matter whether they are security or non-security tokens), and other countries, including the United States, Singapore, and Switzerland, subject ICOs to a selective control ex ante to determine whether the offering involves security tokens and, if so, whether it complies with securities laws. In our paper, we explain that all of these regulatory models have pros and cons. For this reason, we propose a new system built on the approaches of the United States, Switzerland, and Singapore. Therefore, our proposal consists on a selective control ex ante. However, since this model does not easily allow regulators to investigate ex post whether an issuance of non-security tokens may end up being considered security tokens, or even if the issuance of these tokens (which was not authorized by the securities regulator) was a fraud, we argue that this system should be enhanced by requiring issuers to disclose any issuance of tokens through an electronic form disclosing key information about the ICO. Thus, securities regulators should be able to investigate any issuance of tokens, what in return may give issuers incentives to avoid opportunistic (or even fraudulent) behavior when issuing tokens. Moreover, in order to enhance both investor protection and the stability of the financial system, our model suggests two additional measures. On one hand, we propose that the purchase of pre-sale tokens (which are even riskier due to the early stage of the project) should be prohibited to pension funds and commercial banks, since they invest money from the general public and their potential failure could have severe consequences for the stability of the financial system. On the other hand, while we do not prohibit the sale of tokens to retail investors, we encourage regulators to provide information about the risks of purchasing tokens, given that the evidence suggests that more than 80 percent of ICOs are scams.

Third, regulators should also determine the treatment and implications of tokens from an accounting and finance perspective. For this purpose, our paper argues that, while it seems clear that cryptocurrencies received in an offering should be registered among the issuer’s assets, it is not clear how issuers should register the issuance of tokens. In our opinion, tokenholders who receive rights similar to those of shareholders should be considered equityholders. By contrast, tokenholders who are granted rights to receive services or fixed payments should be considered debtholders. In our view, even if tokenholders and shareholders are entitled to similar rights, a tokenholder should not be considered a shareholder. On the basis that they are functionally equivalent investors. To support our argument, we use the example of commercial banks and shadow banks. Even if they performed similar functions, they should not be considered similar entities from a legal perspective. Nevertheless, they should be subject to similar regulations And implications. In our opinion, this is the correct way to interpret the functional approach that should prevail in financial regulation.

The accounting and financial classification of tokens may have several implications for issuers. On the one hand, it may affect the company´s capital structure, and therefore its governance, value, and cost of capital. On the other hand, it may affect the company´s financial ratios (e.g., leverage, liquidity, solvency, etc.), since the registration of tokens can be classified as debt or equity. Therefore, the way issuers classify tokens may affect any covenants potentially existing between issuers and lenders. Another critical aspect of ICOs from an accounting and finance perspective involves the risk of owning cryptocurrencies on the issuer´s balance-sheet, due to the volatility of these assets. Therefore, regulators should pay close attention to the registration and valuation of tokens. Otherwise, we might observe something similar to what occurred in the 2008 financial crisis: an unexpected decline in value of these assets may generate a significant amount of losses that may undermine the stability of the financial system.

Fourth, tokenholders are subject to the risk of opportunism by issuers. Therefore, the use of ICOs involves some corporate governance challenges for policy-makes. In our view, several factors make tokenholders particularly vulnerable to founder´s opportunism. These factors include the high asymmetries of information probably existing between tokenholders and issuers (due to the complexity of the technology beyond an ICO), the higher risk of irrational behavior potentially existing in ICOs (as a result of the market euphoria that seems to exist in the crypto market), and the lack of governance mechanisms to protect tokenholders (due to the lack of many market and corporate law devices generally existing to protect shareholders which do not exist in the context of tokenholders). Therefore, regulators should promote measures to protect tokenholders. In order to do so, we do not suggest, as other authors have done, to empower tokenholders. In fact, we argue that this approach could create principal costs and it can lead to other problems, such as the risk of considering tokenholders as de facto directors if they were given strong rights to make key managerial decisions.

Our paper proposes an alternative way to protect tokenholders. First, as it as it has been suggested by some authors, we propose that securities regulators should impose some minimum requirements for white paper. By doing so, regulators would promote a higher level of harmonization of white paper that may favor comparability and therefore some market mechanisms to protect tokenholders. Second, we also propose to protect non-security tokenholders (that is, the holders of those token that do not have to comply with securities laws) through a variety of devices generally existing to protect consumers. First, regulators can promote a system of smart disclosure. Thus, by focusing on how the information is provided rather than just imposing disclosure obligations, tokenholders will be able to make better decisions. Second, regulators could impose “cooling off” periods that allow non-security tokenholders to return tokens within a given period and without cost. Thus, the possibility of returning the token could correct some irrational behaviors potentially existing at the moment of purchasing the token. Third, regulators could impose standards of behavior aiming to prevent expropriation by founders—that is, to follow the so-called “conduct regulation”, which has proved to be more efficient and effective than prohibiting terms or products, as it happened with the so-called “product regulation”. Fourth, policy makers should also establish a legal presumption stating that any ambiguous provision in the white paper should be interpreted in favor of non-security tokenholder. Finally, we suggest that more resources should be spent to investigate fraudulent issuance of tokens. Otherwise, not only the protection of investors may be at risk but, perhaps more importantly, we face the risk that the existence of fraudulent behaviors in the ICO market may end up harming investor´s trust in the regulator, the financial system, and the use of new technologies.

Fifth, the issuance of tokens may also arise a variety of issues in bankruptcy. On one hand, it is not clear the position of tokenholders in the ranking of claims. On the other hand, the cryptocurrencies received by the issuer may face some valuation problems in bankruptcy.

Finally, our paper explores some further issues arising in ICOs, including those associated with anti-money laundry, data protection, international cooperation, and the implications of the tokenization of assets for capital markets and the future of financial regulation.

The full paper is available here.