The increasing popularity of initial coin offerings (ICOs) combined with the predominantly hands-off approach taken by global regulators to date, has contributed to unease among commentators about the level of protection currently afforded to ICO investors. In an effort to clarify the regulatory landscape applying to ICOs, the Australian Securities and Investments Commission (ASIC) recently published a guidance statement (ASIC Guidance) about when ICOs may be subject to current Australian securities laws.
Entities that have or are considering undertaking an ICO should read the ASIC Guidance and consider whether their actual or contemplated ICOs, digital tokens and corresponding projects are compliant with Australian and foreign securities laws.
In summary, ASIC indicates that:
- In determining whether an ICO constitutes a managed investment scheme, ASIC will primarily scrutinise the rights attaching to the digital tokens.
- In determining whether an ICO constitutes an offer of “securities”, ASIC will interrogate any rights of ownership and any rights to profits attaching to the digital tokens.
- Entities considering an ICO should ensure compliance with foreign securities laws.
What are ICOs?
Initial coin offerings, commonly known as “ICOs” or “token sales”, are gaining traction as a niche method for businesses to raise cash and fund projects through the issue of digital tokens, or tokens, constructed using Blockchain technology. The money paid by the tokenholder for the digital tokens is used to fund the issuer’s project(s). For instance, the Ethereum Foundation created Ethereum, an increasingly popular platform upon which smart contract applications are built. Under its ICO, the Ethereum Foundation issued digital tokens, called Ether, which not only served to fund Ethereum but also as the exclusive currency for transactions occurring on the Ethereum platform.
Some tokens issued under ICOs are issued as a receipt for purchased products or services which have not yet been delivered.
Tokenholders usually view digital tokens issued pursuant to an ICO (or otherwise) as investments. That is because the tokens fluctuate in value relative to other digital tokens, cryptocurrencies and recognised state-issued currencies and can be traded on exchanges accordingly.
Importantly, and in contrast to conventional share issues, digital tokens issued pursuant to ICOs do not typically carry a right to ownership in the entity issuing the tokens.
It remains to be seen how the law in Australia will ultimately regulate ICOs and whether or not they can be dealt with under existing regulatory frameworks. That said, the Guidance Statement offers a glimpse into when and how (if at all) it is likely to regulate ICOs under the existing regulatory framework.
Will your ICO be considered a managed investment scheme?
Under the Act, an MIS must be registered with ASIC and be run by a “responsible entity”, which must be a public company. Failure to register an MIS may result in the MIS being wound up, the operators of the MIS being fined up to $42,000 and/or imprisoned for up to five years. The Act may also require an issuer under an MIS to issue a disclosure document prior to issuing securities.
Under the Act, an MIS bears the following features:
1. people contribute money or a valuable equivalent in consideration for the acquisition of units or rights in the scheme;
2. the consideration paid by participants is pooled together and invested in other assets or used in common enterprise at the direction of the responsible entity; and
3. the members of the scheme do not have day-to-day control over the operation of the scheme.
The ASIC Guidance specifies that the key to determining whether an issuer under an ICO is operating an MIS requires an evaluation of the rights attaching to the tokens. The ASIC Guidance indicates that ASIC will interpret rights broadly and that the entitlement to those rights need not be legally enforceable by tokenholders in order for the digital tokens to be considered to be issued under an MIS. If tokens issued pursuant to an ICO bestow rights on the tokenholders (eg interest payments or a right to future profits), the issuer will likely be deemed to be operating an MIS. A token, like Ether, that bears the attributes of a currency (ie used as a valuable medium of exchange) is less likely to be considered an interest in an MIS.
ASIC has indicated that if the value of the tokens is derived from the management or performance of a project or business, the issuer is likely to be operating an MIS. Such management could take the form of the issuer investing the proceeds of the ICO into the projects or businesses of others. The accretion of value of a digital token which is unrelated to such management or performance is unlikely to constitute an MIS.
The circumstances of prospective issuers will vary significantly and issuers wishing to construct a project and an ICO should seek legal advice prior to publishing a “white paper”.
Will the offer of tokens pursuant to your ICO constitute an offer of securities?
The acronym ICO is evocative of IPO, or initial public offering, and, unsurprisingly, the ASIC Guidance suggests that the offer of digital tokens pursuant to an ICO may be equivalent to an offer of securities (similar to an IPO). Under the Corporations Act, the offer of securities requires the offeror to issue a disclosure document unless the offer falls within certain exemptions.
The ASIC Guidance suggests that digital tokens are more likely to be considered securities if the token bestows upon the tokenholder:
1. ownership in the entity issuing the digital tokens;
2. voting rights in decisions of the entity; or
3. some rights to participate in profits of the body.
In light of the ASIC Guidance, entities contemplating an ICO should ensure they are not offering securities unless they have first issued a prospectus or the issue falls under an exemption. Under the Act, an entity deemed to be offering securities may also be prohibited from engaging in any advertising or promotion of digital tokens prior to preparing and lodging a prospectus with ASIC. As a consequence, such entities should only issue a white paper once satisfied that their tokens are not securities.
Token issuers should also bear in mind that they may be required to comply with securities laws in other jurisdictions. The United States’ Securities and Exchange Commission (SEC) recently determined that tokens issued by the Decentralised Autonomous Organisation (DAO), an application built by a German company atop the smart contract application platform, Ethereum, are “securities” under the US’ Securities Act of 1933 (US Act). The DAO sought to use the proceeds of its ICO to fund the projects of other entities. The tokenholders then stood to profit from the earnings of the projects by way of their tokens increasing in value. The tokenholders could then realise this gain by selling their tokens in a secondary market.
Had the offer of the DAO tokens occurred in Australia or to Australian investors it is possible that ASIC may have also viewed the DAO as either an MIS or an offering of securities and, therefore, subject to the Act.
Will the offer of tokens pursuant to your ICO be considered an offer of derivatives?
The ASIC Guidance describes a derivative as 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).”
If the rights or obligations attaching to a digital token permit or require the tokenholder to make a payment, the value of which is derived from, or determined or varied by reference to, amongst other things, an underlying asset or commodity, then the digital tokens may be considered a derivative. If that is the case, the issuer may be required to hold an Australian Financial Services Licence (AFSL). For instance, a business offering a token which represents a futures contract or an option will likely be required to operate under an AFSL.
In particular, the ASIC Guidance has noted that traditional financial services businesses are known to be interested in offering derivatives via a digital token to streamline their products and services. Given the specific attention by ASIC, these businesses should be particularly aware of the law relating to AFSLs.
Platforms for the trade of digital tokens may be required to be licensed
It remains an open issue, but operators of digital token and cryptocurrency exchanges will need to consider whether any of the tokens traded on their platforms are securities, grant rights or benefits under an MIS or are derivatives as, in such circumstances, the exchange may be operating a financial market (similar to the ASX, NSX or Chi-X) and be required to obtain a licence.
Will your digital token issued under an ICO be considered a non-cash payment facility?
ASIC has signalled that ICOs are unlikely to be implicated under current laws in respect of non-cash payment facilities, however, they may if:
1. the issue of the tokens is used as form of payment for “a number of payees”; and
2. the payment is contingent upon the conversion of the digital tokens to recognised state-issued currency.
ICOs must not be misleading or deceptive
Most businesses are aware of prohibitions on engaging in misleading and deceptive conduct in trade or commerce. These prohibitions extend to the issue of digital tokens pursuant to ICOs. Given the relatively unfamiliar and complex nature of the offering, the risk of consumers being misled (unwittingly or otherwise) is an important consideration. Issuers should bear this in mind when describing their ICOs, the digital tokens and the associated project in any white paper or in dealings with recipients of the tokens.
Businesses wishing to undertake an ICO should:
- consider whether their digital tokens qualify as securities under the Act;
- consider whether their ICO may be regulated in a foreign jurisdiction;
- consider whether their digital tokens might be issued under an MIS;
- consider whether the token derives its value from another asset in which case it is more likely to be considered a derivative under the Act;
- confirm that any white paper complies with prohibitions on misleading and deceptive conduct; and
- seek appropriate professional advice in relation to their ICO.
Coghlan Duffy & Co
 ASIC Information Sheet 225, available at: http://asic.gov.au/regulatory-resources/digital-transformation/initial-coin-offerings/
 In short, Blockchain is a technology in which ledgers that are distributed across a network are simultaneously and automatically updated to reflect transactions occurring on that network. In effect, this means that the network participants do not have to rely upon an intermediary that maintains an official ledger to determine the veracity of any given transaction.
 It is common practice for entities undertaking ICOs to publish a “white paper”. A white paper usually details the project in respect of which the ICO is undertaken, the intended use of funds raised through the ICO and the rights attaching to the digital tokens.