A great deal has been written about initial coin offerings (ICOs) and other token generation events (TGEs) (collectively in this article "TGEs" and the entities that undertake them, the "Issuer") in terms of ensuring that regulators adequately apply and enforce investor protection measures and protect global capital flows from contamination with proceeds of crime, both issues which many fear may result from the proliferation in use of cryptocurrencies and TGEs.
The attendant scrutiny and debate over the correct classification of digital tokens and the extent to which their offering and issuance should be subjected to traditional securities regulations is understandable and valuable. However, since the fundamental corollary to robust and proportionate external regulatory oversight is robust internal governance, rather than adding to the commentary on this subject, this article instead seeks to look specifically at some of the challenges confronting those who operate entities that undertake TGEs and how they may be addressed.
We have chosen to address three key challenges in this article.
The service provider conundrum
The understandable difficulties confronting regulatory bodies in keeping pace with technological advancements and articulating appropriate guidelines are indirectly jeopardising the ability of businesses conducting TGEs to engage the very service-professionals who can help them with their compliance obligations and put in place good governance frameworks.
For example, obtaining banking services is proving extremely challenging for many crypto-related and blockchain technology businesses. Sophisticated global banks, many of which have the necessary experience to support anti-money laundering and counter terrorism financing obligations to which all global financial businesses are bound, are generally unable to provide their services at the present time because regulatory uncertainty is leading them to adopt very conservative selection criteria.
Additionally, where an Issuer may be within their strict selection criteria, the onboarding process has proven to be slow. This difficulty in establishing the correct banking architecture for these businesses undermines the ability of operators to ensure the integrity of their financial governance and is proving a real obstacle to the growth of the sector . Nonetheless, there are some providers of banking services and AML/KYC tools for the TGE/cryptocurrency sector and this appears to be an area with tremendous opportunity for those willing to confront the challenges of proving source of funds, non-contamination of wealth and ownership of assets.
The capital raise conundrum
Very many TGEs fail to articulate how much capital is required to launch and/or operate their underlying business. Whilst tokenised funds and pure utility token businesses are much less affected by this issue (since for the former, raising more capital than expected simply means more investments may be acquired; and for the latter, raising more capital simply means more users of the underlying ecosystem), TGEs that are undertaken for the purpose of business platform development (whether via SAFTs or otherwise) are all too often poorly defined in terms of business opportunity and capital requirements.
This causes a great many difficulties for the operators and is one reason why legal analysis of an Issuer's Whitepaper at an early stage is of paramount importance. In a similar manner to an investment fund's offering document, an Issuer's Whitepaper forms part of the economic contract between the Issuer and the token-holders. As a result, operators should ensure that great care is taken to provide that the Whitepaper sets forth not only the investment opportunity but also explains clearly certain "what if" scenarios.
For example: (i) what happens if extra capital is raised; (ii) what happens if the contemplated business is ultimately not feasible, whether from a technological, regulatory or economic standpoint; or (iii) what happens if further rounds of fund raising are needed. In terms of handling these issues, we suggest that lessons learned from traditional investment fund structures can guide and govern operators of Issuers. For example, a long-standing investor protection mechanism employed by investment funds involves incorporating into the economic contract a mechanism by which offering terms applicable to investors' interests may be varied. Typically, offering terms may be varied without the approval of investors: (a) by making a change that, in the opinion of the operators, will not adversely affect the investors in any material respect; or (b) by making a change that is necessary or desirable to satisfy any regulatory requirements, provided that such change is made in a manner that minimises, to the extent practicable, any adverse effect on the investors; or (c) by making a change that the operators may consider likely to adversely affect the investors in a material respect, provided that any such amendment does not become effective until after the affected investors have been given written notice of the change and have had the opportunity to redeem their investment.
We submit that ensuring operators understand and can apply the principles of this economic contract (in investment funds parlance) to token issuances is of paramount importance particularly to TGEs that relate to early-stage businesses. Where an Issuer proposes to or has issued tokens in consideration for application fee payments, the operators must have and convey to token-holders a clear understanding of the characteristics of the tokens and the precise nature of the Issuer's obligations to holders of such tokens. This ensures that when operators make subsequent operational decisions that affect token-holders, they can do so within clearly articulated parameters that token-holders can also understand. It would support the overall good governance proposition, if the business needs to change in a material and adverse manner and the token-holders receive an opportunity to exit their investment.
The "non-equity" conundrum
There are very many types of TGEs. For example, some tokens purport to confer upon the holder a profit share via regular distributions or on the realisation of certain assets held by the Issuer. Some seek to link the value of the token to a proportionate share of the Issuer's portfolio of assets with a "redemption right". Some simply give access to services provided within a business ecosystem for a fee. Some may be traded on a secondary market and some are not transferable. However, in almost all cases, none give genuine ownership or control rights on a statutory or contractual basis in the way that holding shares in a company does and, as it currently stands, token ownership is not subject to statutory protection or common law protection in a way similar to holding an interest in a limited partnership or unit trust. For operators, this again poses significant challenges. For example an Issuer will likely raise significant assets through a TGE from individuals who for a substantial period of time may not even be creditors of the Issuer while at the same time,, where an Issuer is a corporate entity, the operators must pay heed to the traditional obligations to act in the interests of creditors and shareholders. This is a complex situation, the effects of which could be very detrimental in an insolvency situation or other business failure.
There is no doubt that the sooner there is clarity as to which types of TGEs should come under the definition of securities, the better it will be for operators who need to ensure that their TGE is compliant in all relevant jurisdictions and also enable service providers to comfortably conduct business with Issuers.
In addition, clarity will enable jurisdictions who have previously placed major restrictions on crypto/TGEs, such as China and Korea, to eventually accept and incorporate them into their financial systems, thus broadening the potential global user-base, which is vital to the sector's long term success.
At the same time, developing standardised documentation with appropriate regulatory and disclosure requirements and offering terms that address the various "what ifs" that confront start-up technology businesses will help Issuers not only to manage and avoid liability claims, but also establish a quality control that token-holders will appreciate. There is no question that operators need to understand and take responsibility for the Issuer providing a balanced view of its business plan and any risks relating to it, and that mere puffery must be avoided in favour of evidence-based claims. For many TGEs, the quantity of tokens potentially to be issued should but not be unlimited, but instead should be based on actual financial needs of the Issuer. Operators should insist that clear guidelines are established and disclosed to enable investors to withdraw orders during the offering period and receive a refund in case of ICO failure. Finally, operators need to understand where an Issuer's token-holders sit within the more established pecking order of secured creditors, unsecured creditors and equity-holders and ensure that they take advice when making operational decisions that affect their token-holders.
This editorial first appeared in HFM Week's Cayman report.
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