ICOs Facing an Uncertain Future in China and the U.S.
This week, in a joint statement issued by the People’s Bank of China, the securities and banking regulators, and other government agencies, the Chinese government declared that initial coin offerings (ICOs) constitute “illegal open financing behavior” and immediately froze all ICO activity. The joint statement explained that the tokens issued in ICOs do not have legal and monetary properties, do not have the legal status equivalent to money, and cannot be circulated as a currency in market use.
Moreover, the Chinese government also ordered that companies should repatriate all funds received from past ICOs to investors, and the companies were further warned that the relevant investigative agencies would ensure compliance. Interestingly, the joint statement did not specify the method of repatriation. This raises a thorny issue of how to refund investors that paid in other virtual currencies (e.g. Bitcoin) for their tokens because the refund transaction in Bitcoin is seemingly prohibited by the joint statement as well.
This is a stark contrast with the approach by the United States’ Securities and Exchange Commission (SEC) which, this past July, released a report outlining how ICOs could qualify as securities under the US securities laws, thus requiring registration or an exemption. The combination of investors depositing funds and expectation of profits from the efforts of others drew the scrutiny of the SEC because this process mimics the main characteristics of securities. Although the SEC did not outright opine that all ICOs would be securities under federal law, subsequent ICOs have taken different forms of responsive actions, such as excluding US investors from participating in their ICO, registering the ICO in foreign jurisdictions, or enhancing the non-financial aspects of the tokens to make them more strongly resemble an asset.
ICOs (initial coin offerings) are digital token sales that have been embraced by both companies and investors as a blend between crowdfunding and an IPO. Companies conducting ICOs offer virtual tokens (virtual coins that are normally recorded on the Ethereum blockchain) for cash or another form of virtual currency. ICOs are in the midst of a banner year in 2017 and have already raised over $2.16 billion. A large factor in their popularity is that start-up companies view them as a cost-efficient method to raise funds in a very quick timeline because an ICO avoids both the investment bank fees and regulatory compliance requirements imposed by governments when raising capital via traditional means.
Notably, the investors/buyers in an ICO only receive the tokens and, although tokens have a limited purpose for use on the platforms created to support the token’s use (for example, an online gaming platform), a primary goal of investors is to gain from the anticipated increased value in the tokens as the newly created platform increased in utility and value. Tellingly, the fact that investors often purchase a significant number of tokens (which is in excess of what they purchase for use on other online platforms) and they also purchase them well in advance of the launch of any actual platform (as opposed to simply going to a different currently active platform) speaks to speculation as a strong component of the investors’ motivation. In contrast, people do not purchase tokens for use in arcades or buy smartphones months in advance of having the option to actually use their purchased tokens to play the arcade or receive a smartphone for immediate use.
Obviously, the SEC’s approach is far more cautious than that taken by the Chinese regulators. That is partially due to legal restrictions in the US because the SEC cannot (or practically will not) simply prohibit a current business practice and order all completed transactions to be unwound immediately. Thus, it is unlikely that the US will follow the Chinese government’s model of banning ICOs. However, all companies contemplating ICOs should reevaluate the potential market in light of the shutdown of the Chinese market and also carefully consider the possibility and implications of being a security under US securities laws.