Ending the Anarchy of ICOs: Legal Risks for ICOs from Recent Developments in the U.S. (Taiwan)

Sean Liu and Wei-hsing Chuang

If cryptocurrencies are the most unexpected breakthrough to the legal tender currency system of a nation, token funding or initial coin offering (ICO) derived from cryptocurrencies are no less prominent in the degree of innovation to fundraising.

ICO might become a important fund raising channels in a few years

ICO means that an enterprise issues virtual tokens or coins based on blockchain technologies to contributors in exchange for fiat money or other types of cryptocurrencies (usually those with higher liquidity, such as Bitcoin or Ether [1]). An enterprise usually explains about the purposes of the funds so raised (e.g., for use in a specific development project) and the rights represented by the cryptocurrency via a “white paper.” The nature of the rights represented by each cryptocurrency varies from enterprise to enterprise. Normally, an enterprise will promise that a cryptocurrency may be used in exchange for services or goods provided based on a specific project after its development is completed.  In this connection, such cryptocurrency carries characteristics of investment. In addition, a cryptocurrency can usually be resold for fiat money or exchanged with other types of cryptocurrencies in cryptocurrency exchanges after it is issued.  To wit, if a cryptocurrency has greatly appreciated after issuance, the contributors (i.e., investors) may not necessarily have to wait for the recuperation of their investment until the successful development of the project.

As of September 2017, a total of around US$2.5 billion has been raised by enterprises through ICOs since Mastercoin launched the first ICO in 2013. In merely the first three quarters of 2017, up to US$2 billion was raised from ICOs [3].  Currently, ICO has been the most important funding channel for blockchain-related start-ups.  However, theoretically enterprises not relating to blockchain technologies may also raise funds through ICO.  Although the overall scale of ICO at the present time is still no match for venture capital (VC) (which exceeds US$100 billion each year) [4],  it has progressed so fast that no one can turn a blind eye.  If sound investment protection regulations are put in place in the future, ICO may become one of the major funding channels [5] in a few years.

Main reasons for the rise of ICO

It is not difficult to understand why ICOs can emerge as a trend over a short period of time. As compared with VC fundraising, ICOs are handled through Internet platforms with a population of investors from all over the world far exceeding that of  venture capital.  In addition, ICO issues virtual tokens and usually does not promise the grant of any equity right.  Therefore, when an enterprise raises funds through an ICO, the equity of the founder (i.e., the control over the enterprise) will not be diluted [6][7].

Moreover, securities authorities of various countries did not state their opinions concerning ICOs before the middle of 2017. Therefore, many people joked that such period was the Wild West of ICO, meaning a state of anarchy in the Wild West.  Unlike VC fundraising, an enterprise which conducts an ICO is not required to hire experts to review contracts and investment terms or to comply with requirements under securities laws and regulations such as an upper limit of fundraising, investor qualifications or information disclosure when conducting crowd funding [8].

However, with incessant outbreaks of ICO-related fraud and in view of compliance with existing securities and financial laws and regulations, competent authorities in various countries are beginning to reveal their attitudes towards ICOs. Thus the above advantages will have to be re-examined even if they are not wiped out entirely.  Until September 2017 with the exception of mainland China and Korea, which have specifically banned ICOs, securities authorities in various countries have considered some virtual tokens as securities and shall be subject to security laws and regulations.  To wit, control is imminent and the state of anarchy of ICO is inevitably coming to an end.

Application of the Howey test to determine if tokens are securities by the SEC of the U.S.

Take the U.S. for example. The Securities and Exchange Commission (SEC) issued an investigation report on an information security incident relating to The DAO, a virtual token [10], in July 2017 and expressly indicated that the SEC will apply the Howey test [11], a determination standard established by the U.S. Supreme Court, to determine if a virtual token is a security under the Securities Exchange Act of the U.S.  The Howey test is used to determine if a virtual token is a security by the following criteria: (1) whether it is an investment of money; (2) whether the investment is in a common enterprise; (3) whether there is a reasonable expectation of profits from the investment; and (4) whether any profit comes from the efforts of others.  According to the SEC, since The DAO token is obtained by investors in exchange for Ether, which has property value, it constitutes an investment of money in a broad sense.  In addition, the investors expected that the various projects under The DAO network would be profitable and thus returns on their investment could be achieved; and the success of The DAO depended on the professional work of its research and development team – Slock.it. According to the Howey test, the SEC concluded that The DAO token was a security whose issuance and circulation were both governed by relevant security laws and regulations of the U.S.

Emergence of SEC compliant ICOs

The release of the above SEC report triggered bipolar reactions. Some ICO cases have excluded investors in the U.S. by screening IP addresses or have specifically prohibited investment by U.S. citizens to avoid violations of securities laws and regulations of the U.S. [12].  However, some people believe that it is not a bad thing to regulate ICO under relevant security rules because investor confidence may be enhanced instead.  Therefore, SEC compliant ICOs have gradually emerged.  Such ICOs stress compliance with Rule 506 of Regulation D of the Securities Exchange Act by limiting investor qualifications to “accredited investors,” meaning personal annual income in excess of US$200,000 (or US$300,000 of combined income with the spouse) or personal net worth over US$1 million, either alone or together with a spouse (excluding the value of the person’s primary residence [13].  FileCoin, which aims to provide blockchain cloud storage, is a famous SEC compliant ICO case.  Although investor qualifications were constrained, FileCoin still rapidly raised around US$257 million in two rounds of fundraising around August 2017, making it the ICO with the largest fundraising amount at the time [14].

In addition to “issuance,” with respect to “transaction” of ICO tokens, there have been enterprises (such as Overstock) which have announced that they will set up a virtual token exchange that complies with the regulations of the SEC and the Financial Industry Regulatory Authority (FINRA) of the U.S.   Such exchange primarily follows the requirements for alternative trading systems (ATS) under the Securities Exchange Act of the U.S.  ATS is a type of off-market trading system.  ATS operators are required to be approved by the SEC and to comply with requirements for information disclosure and filing, etc.

Do legal risks still exist?


The above complaint ICO cases all involved operators who voluntarily issue virtual tokens in compliance with the Securities Exchange Act of the U.S. based on their own interpretation of relevant U.S. laws and regulations. The SEC only indicated in its July 2017 report on The DAO that the Howey test would be applied to determine if a specific virtual token is a security in individual cases but did not provide a conclusion as to whether other tokens are securities.  In addition, with respect to how tokens which are securities should be issued or circulated, the SEC only generally stated that existing laws and regulations should be referenced but did not provide specific instructions.  Therefore, from a nit-picking perspective, the practices of the above ICO entrepreneurs are not entirely free from legal risks under the U.S. law.

Moreover, since ICO is conducted through the far-reaching Internet and an ICO conducted in any place is equivalent to fundraising to all countries in the world, thus it has to comply with laws and regulations of each individual country. With respect to securities exchange laws and regulations, it is necessary to at least confirm if a token to be issue is to be determined as a security in a given country, if application for approval of issuance is required, what information disclosure requirements should be complied by the issuer, and how to trade legally in the market of such country.  To ensure that there is no legal risk, it is necessary to exclude investors in countries which have banned ICO (such as mainland China and Korea) and to conduct legal consultation or research for the countries or regions where ICO is intended to take place..

Finally, legal issues concerning anti-money laundering, personal information protection or information security may be involved, depending on the different nature of ICO cases. Therefore, the above legal consultation and research should also cover such legal domains to truly reduce and eliminate legal risks of ICO.