Are you underwater or in hot water? The truth about ICOs www.sakipartners.com.au
The cryptocurrency market has just hit another new low in 2018, valuing the entire market below USD$200 billion for the first time this year. Despite the volatility, investors are still keen to pile in believing the market is bottoming.
There is no shortage of new 'ground floor' opportunities for these investors in the form of new tokens being issued via an evergrowing number of ICOs (Initial Coin Offerings). In fact, during 2018, new ICO's have raised more than USD$15 billion.
Despite the continued positive sentiment from many invetsors and the hype from ICO promoters, the actual historical performance of ICO's is disturbingly woeful.
Consulting firm EY have revisited 90 global ICOs that it first tracked a year ago — and found almost a third were now worthless — while 86 per cent were underwater on their issue prices.
Almost all the gains were made by just 10 of the ICOs — but even the successful companies were “mired in litigation or conflict over broken promises and unexpected changes in business strategy”, reported EY.
In a recent article by Australian publisher Stockhead, journalist Rachel Williamson found that of the 76 Australian ICO's only 16 are still trading and just four of these are trading above their issue price.
As EY blockchain expert Paul Brody says "It is clear that there is a significant lack of understanding around the risks and rewards of these investments”.
Regulatory action in Australia
Last month the Australian regulator, the Australian Securities and Investments Commission (ASIC), intervened and shut down a planned $50 million ICO from a crypto start-up called Global Tech Exchange. The company purported to have links to former Aussie cricket captain Michael Clarke.
This is not the first time ASIC have intervened; rather they have shut down another 5 ICO's since April this year and, given the EY results, this has likely saved Australian investors from losing more capital.
Around the world, regulators are looking closely at this ICO phenomenon not just from a consumer protection standpoint, but also from a range of challenging perspectives including fraud, theft, taxation, anti-money laundering, payment systems, financial services and financial stability.
We have fielded numerous enquiries from companies seeking to raise capital via ICO's and in all cases, these companies were under the misconception that ICO's are not regulated and somehow provided an easier mechanism of capital raising.
While the evidence is clear that there is a significant lack of understanding from investors around ICO's, our experience suggests there is also a lack of understanding from would-be issuers and promoters who are wanting to believe that ICO's are not regulated. This is not the case.
So what is an ICO?
ICOs are not the same as Initial Public Offerings (IPO) or crowd-sourced funding, both of which are regulated under the Corporations Act 2001 (Cth) and offer specified investor protections. Many ICOs do not offer legal rights and protections or claims to underlying assets.
In some cases, the ICO may be subject to the Corporations Act; in others, the ICO will be subject to the general law and the Australian consumer laws regarding the offer of services or products.
This means the ICO would be subject to the prohibition against misleading or deceptive conduct, either under the Australian Securities and Investments Commission Act 2001 (Cth) or the Australian consumer laws. Australian law may apply even if the ICO is created and offered from overseas.
Central to the regulation of an ICO is understanding if the ICO meets the definition of "financial product" under Division 3 of the Corporations Act, where the financial product could be, for instance, a managed investment scheme, a share or a derivative.
For example, an ICO could be deemed to be a financial product, in the following circumstances:
* A managed investment scheme, where the value of the digital coins acquired is affected by the pooling of funds from contributors or they are arranged to be collectively managed.
* An offer of shares, where the rights attached to the token are similar to those attached to a share, such as ownership of the body, voting rights or rights to participate in the profit.
* An offer of a derivative, where the token is priced based on factors such as an underlying market or asset price, and price movements resulted in a payment obligation.
Each of these scenarios are explored below.
When an ICO could be a managed investment scheme
A managed investment scheme is defined within the Corporations Act. The following are basic indicators of whether an arrangement is a managed investment scheme:
- People contribute money or assets (such as digital currency) to obtain an interest in the scheme ('interests' in a scheme are generally a type of 'financial product' and are regulated by the Corporations Act)
- Any of the contributions are pooled or used in a common enterprise to produce financial benefits or interests in property, and
- The contributors do not have day-to-day control over the operation of the scheme but, at times, may have voting rights or similar rights.
An assessment of what rights are attached to the tokens issued under an ICO is the key consideration in relation to assessing the legal status of an ICO. These rights are generally described in the ICO's 'white paper', an offer document issued by the business making the offer or sale of an ICO token. What is a right should be interpreted broadly and includes rights that may arise in the future or on a contingency, and rights that are not legally enforceable. If the value of the token is related to the management of an arrangement as described above, the issuer of the ICO is likely to be offering a managed investment scheme.
In some cases, ICO issuers may frame the entitlements received by contributors as a receipt for a purchased service. However, if the value of the digital tokens acquired is affected by the pooling of funds from contributors or use of those funds under the arrangement, then the ICO is likely to fall within the requirements relating to managed investment schemes. This is often the case if what is offered through the ICO has the attributes of an investment.
When an ICO could be a share
A share is a collection of rights relating to a company. There are a range of types of shares that may be issued. Most shares issued by companies that offer shares to the public are 'ordinary shares', and carry rights regarding the ownership of the company, voting rights in the decisions of the body, some entitlement to share in future profits through dividends, and a claim on the residual assets of the company if it is wound up.
Most shares issued in Australia come with the benefit to shareholders of limited liability as well.
When an ICO is created to fund a company (or to fund an undertaking that looks like a company) then the rights attached to the tokens issued by the ICO may fall within the definition of a share.
The bundle of rights referred to above may be used by ASIC to help determine if a token is in fact a share. If the rights attached to the token (which are generally found in the ICO's 'white paper') are similar to rights commonly attached to a share – such as if there appears to be ownership of the body, voting rights in decisions of the body or some right to participate in profits of the body shown in the white paper – then it is likely that the tokens could fall within the definition of a share.
Where it appears that an issuer of an ICO is actually making an offer of a share, the issuer will need to prepare a prospectus. Such offers of shares are often described as IPOs.
By law, a prospectus must contain all information that consumers reasonably require to make an informed investment decision.
Importantly, though an ICO may look similar to an IPO, the ICO may not offer the same protections to consumers and may result in liability for the issuer and those involved in the ICO. Issuers of an ICO need to be aware that where an offer document for an ICO is, or should have been, a prospectus and that document does not contain all the information required by the Corporations Act, or includes misleading or deceptive statements, consumers may be able to withdraw their investment before the tokens are issued or pursue the issuer and those involved in the ICO for the loss.
When an ICO could be a derivative
Section 761D of the Corporations Act provides a broad definition of a derivative and is a product that derives its value from another 'thing' which is commonly referred to as the 'underlying instrument' or 'reference asset'.
The underlying instrument may be, among other things, a share, a share price index, a pair of currencies or a commodity (including a cryptocurrency).
Two examples of derivatives are options and futures. An option is a contract between two parties. The buyer has the right, but not the obligation, to buy (or sell) an asset, at a set price, on or before a specified future date, other than a right to acquire by way of issue a security of the entity, such as a share. Futures are generally contracts to buy or sell a particular asset (or cash equivalent) at some time to come. This may involve the use of intermediaries, who themselves may need to be licensed.
If an ICO produced a token that is priced based on factors such as another financial product or underlying market index or asset price moving in a certain direction before a time or event which resulted in a payment being required as part of the rights or obligations attached to the token, this may be a derivative. For example, payment arrangements associated with changes in the relevant product, index or asset could be structured as a 'smart contract' or self-executing contract represented in the token itself.
It is our view that the market for ICOs is poorly understood by both investors and issuers. Investors are under the false impression that ICO's are low risk-high return investment and issuers are under the impression that ICO's offer some form of regulatory arbitrage for capital raising. Until the ICO market develops (if ever) we will continue to sit it out and watch as the regulator intervene to save investors from themselves.