The term “Initial Coin Offering” (ICO) makes reference to the concept of “Initial Public Offering” (IPO). IPO describes the first offering of a stock to the public. This offer leads to an increase of equity for the issuer. IPOs are governed by strict rules on capital market regulation.
ICOs are IPOs’ tech-counterparts. They come in many forms and are usually employed by finance technology start-ups. Instead of stocks, issuers offer a “token” which is utilized by investors to gain a profit due to an increase in value. Whether profits realize, though, depends on the performance of the underlying technology project.
ICOs are continuously gaining relevance. Compared to a figure of 60 million euros in 2016, in 2017, ICOs raised 2.8 billion euros globally. So far, they are rarely used in Spain.
Purposes of Tokens
Cryptocurrency and block chain projects circumvent traditional capital markets by means of ICOs. Just as traditional stocks offer an individual mix of sale profits, dividends and voting rights, the purpose of tokens varies depending on the ICO. Most tokens serve as a currency to the corresponding cryptocurrency project and promise sale profits if the issuer can meet or supersede the market’s expectations. The described purpose has strong parallels to securities trading.
Still, the purpose of a token often goes beyond its mere tradability. For instance, investors were able to acquire voting rights in the DAO, a self-governing digital organisation which is Ethereum-blockchain based. Investors of other projects gain the right to enjoy services in return for their tokens. Accordingly, the decentralized cloud provider Storj.io offered tokens that enabled investors to buy cloud storage once the infrastructure was set up.
Opportunities and Risks
ICOs offer emerging technology companies ways to finance themselves independently from large-scale investors and venture capital firms from Silicon Valley. With the flexibility ICOs provide, entrepreneurs gain freedom in the planning and execution of their vision, which fosters innovation. Moreover, the democratization of investment may nurture competition and thus deter the formation of oligopolies.
However, ICOs are accompanied by significant risks. For example, investors lack statutory protection of share dilution. The absence of relevant regulations for ICO thus diminishes investor protection.
The Prospectus Directive governs capital thresholds for traditional IPOs. Such thresholds trigger prospectus requirements, detailed reporting requirements, to inform investors. Comparable transparency provisions do not yet exist for ICOs, which causes substantial legal insecurity regarding the promised performance of projects. As most projects, at the time of the ICO, only exist on paper, investor protection is an urgent issue. This is exacerbated by the fact that the current ICO craze causes many entrepreneurs to issue tokens haphazardly. Lastly, there have been various scam incidents and growing speculation may create a financial bubble.
Depending on their allocated purpose, tokens can be subject to different regulations that aim to safeguard the protection of investors and consumers. For instance, the US Securities and Exchange Commission (SEC) holds that ICOs are subject to securities regulation or at least liable to registration if they are used to raise financing in a publicly accessible market. Token issuers refute the SEC’s assessment because tokens serve purposes such as usage rights of the platform’s services. Since the described purposes go beyond mere tradability, which is characteristic for traditional stocks, they argue that ICO are exempt from securities regulation.
Despite absence of specific ICO regulation in Spain, issuers should align their use of the token with the existing rules possibly applicable to ICOs. Various regulations are relevant in this context in Spain:
- Provided that investor rights go beyond the mere provision of future services, national securities regulation may be applicable in Spain.
- ICOs resemble crowdfunding, a form of financing through a swarm of internet users. Crowdfunding platforms exclusively offering services in exchange for an investment are exempted from the scope of the relative Spanish law 5/2015 of April 27. However, issuers whose tokens are equity-like, according to Art. 50 (1) (a) of the same law, could face legal restrictions.
- So far, the EU remains silent on the legal categorization of ICOs. This allocates regulation to the member states. Still, the recent securities regulation amendments, inter alia prospectus regulation and MiFID II, may influence ICOs in a harmonizing way across member states.
Aaron Nourbakhsh & Karl H. Lincke
This article is not considered as legal advice