Mondaq | By Robert Franklyn and Michael Kingsbury | 18 April 2018

Initial coin or token offerings (ICOs) can provide a great way for blockchain start-ups to quickly raise the capital they need to develop revolutionary new ideas – from decentralised renewable energy trading platforms to an Interplanetary File System. Almost US$5 billion has been raised through ICOs so far this year, following on from US$4 billion in 2017¹. This is huge given the technology is in its infancy. Indeed, research from Ernst & Young, published late last year, suggests that around 84% of ICOs are conducted in respect of projects that have not proceeded past the 'idea stage'².

Therefore, while many of the ideas are inspiring, business failure risk is, inherently high. Moreover, because the technology involved is incredibly sophisticated, analysing that risk is not always easy. It is not entirely clear whether there is protection for the unwary against scoundrels within existing regulatory frameworks.

ICOs may create a new asset class but investing in tokens is somewhat like a holiday to an unfamiliar destination. Sure, there may be attractive upside (escapism and a touch of the exotic) but you really do need your wits about you, especially when wandering the streets late at night. Yes, there may be police around, but the risk profile is different. For instance, the use of a private code base or a centralised consensus mechanism, unclear token distribution and scarcity profiles, or limited token-holder rights, can all create significant investor risks³.

WHAT'S HAPPENING IN THE US?

So, like all new and exciting things, there is a balance to be struck between regulation and innovation – protection and creation. In trying to figure out where the regulators will draw the line, there is sentiment in international blockchain circles that if a token is designed for "utility" and not for investment – that is, it provides rights to goods or services produced by the blockchain platform (eg the right to access a decentralised social media service) – it should fall outside the purview of securities laws, which establish strict (and, for issuers, often burdensome) investor protections.

However, a recent assault by the US Securities and Exchange Commission (SEC) against "dozens" of ICOs reinforces the notion that even utility tokens may be deemed securities⁴, particularly if they are issued in respect of a platform where purchasers are speculating on the token's value. This approach relies on the US-based Howey test for an "investment contract" - a catchall in the definition of a security under US law⁵. In summary, an investment contract is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the managerial efforts of others⁶. The test is one of economic reality and manner of sale is key⁷.

See:  Australian Securities and Investment Commission Partners with Canadian Securities Regulators on Fintech

For example, consider the Munchee Inc case that the SEC settled late last year. The case involved an offer of MUN utility tokens, which provided the right to take part in a to-be-developed, food review "ecosystem"⁸. The SEC noted in a press release that because 'Munchee offered MUN tokens ... to raise capital to build a profitable enterprise' and that the 'promoters emphasized that investors could expect that efforts by the company and others would lead to an increase in value of the tokens', which, importantly, could be traded on a secondary market, they viewed the token as a security. In fact, just the other week, in submissions against Maksim Zaslavskiy for securities fraud over two ICOs that targeted the real estate and diamond markets, the SEC again emphasised that utility tokens issued in respect of undeveloped platforms are in the firing line⁹: Zaslavskiy's plan that the tokens would be useful in an 'ecosystem that he had not built' yet did not change the nature of his promise to investors. He 'offered and sold the investment opportunity to profit from his development of that ecosystem', which 'bears all the hallmarks of a securities offering'¹⁰.

WHAT DOES THIS MEAN IN AUSTRALIA?

For Australia, it is important to note that the test for an investment contract under US law is not too dissimilar to the test for an interest in a managed investment scheme (MIS) under the Corporations Act 2001 (Cth)¹¹. While utility tokens are unlikely to fall within the MIS regime in a traditional sense (they typically deal with rights to participate in profit-sharing schemes – eg real estate investment trusts), in September 2017, ASIC provided ominous guidance that echoes the SEC's views: 'ICO issuers may frame the entitlements received by contributors as a receipt of a purchased service. However, if the value of the digital coins 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 MISs'¹².

Thus, token issuers should be vigilant in how they manage the regulatory environment down under. Yes, there have been a handful of utility token ICOs for early-stage platforms in Australia recently, but these should not be relied on as a guide to ASIC's future policy. Similarly, private token pre-sales to one's closest 400 friends on Telegram is probably not wise either.

A popular US strategy worth mentioning involves the Simple Agreement for Future Tokens (SAFT). SAFT plays on the distinction between utility tokens issued in respect of a 'functional' and non-functional platform. And, while its intended effect has not been put to the test yet¹³, it has been used to support fundraising from accredited investors (who are permitted to receive issued tokens without significant disclosure) prior to a platform's development. Once a platform is "functional", tokens are delivered to those investors and the argument goes that a retail ICO is then possible without those tokens being classified as securities¹⁴. This is because the financial benefits that retail token-holders may receive from buying and selling tokens arguably stem from the forces of demand and supply in the market for the goods or services (ie the "utility") that the token offers, and not the platform developers' managerial efforts in bringing the platform to fruition. Supposedly, retail token-holders are simply taking on product risk not business risk.

See:

• Australia and UK set up FinTech Bridge to deepen collaboration between governments, regulators, and industry bodies

• Australia to Fix Gap in Crowdfunding Regulations as Private Companies May Gain Eligibility in New Legislation

However, adopting the SAFT in Australia has its flaws. The Cardozo Blockchain Project offers a convincing critique¹⁵, pointing out that the legal characterisation of each ICO will not depend on bright-line rules but rather on its relevant facts, circumstances and economic realities. For example, if the focus is on functionality, at what point does a platform become "functional"? Will the MIS regime be triggered if managers use token-holders' funds to perform updates post-functionality?

Manner of sale and the question of whether there is a dominant expectation of consumption¹⁶ are more important focal points than functionality¹⁷. The creator of the Project and leading US crypto-law academic, Prof. Aaron Wright asserts that the 'functionality concept is an artifice'. The "key inquiry will likely turn on whether the tokens are being purchased and 'used' by their target market or are simply being acquired by investors seeking a profit. The SAFT and all of the other pre-sale structures are being sold to investors and thus run the risk of running into a regulatory buzz saw. If a project needs to raise capital, it can sell an interest in a legal entity and the tokens (if they are intended to support an online platform or service) can be sold to end-users."

Wright's view gels nicely with the unregulated crowd-funding market. Consider, a crowd funding campaign for, say, a movie. Funders acquire a right to receive a DVD of the new movie in the future. Although they take on the risk it falls through, most people choose to fund the project because they are keen to eventually see the movie! (Even if there are some wily folks looking to get their hands on a bunch of DVDs to resell if it is a hit.)¹⁸.

Similarly, the offer of utility tokens to mums and dads without a prospectus is more easily digested if their dominant purpose is to use the tokens to access an online platform or service – and not turn a profit. This is more likely, but not conclusive, if the platform is live when the offer takes place.

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