Marco Cillario sizes up the pros and cons for legal advisers of the current ICO boom
‘We are in an odd position: we feel we need to be closely involved in this, but there is a reputational risk because there is a lot of fraud.’ Understandably, the partner expressing this view does not want himself or his firm identified. But such words still sum up many securities lawyers’ feelings on the hottest topic in their field for years.
The issue? So-called initial coin offerings (ICOs), or the emerging notion of ditching the boring certainties of stocks and bonds to instead raise capital via blockchain. ICOs are broadly defined as the selling of cryptocurrency or ‘tokens’, giving investors a future entitlement. This being largely start-up funding, it is essentially a high-risk bet that the embryonic business will be a success. And it is currently growing very fast.
ICOs have raised more than $11bn since the beginning of 2017, according to the specialist news service CoinDesk. Though a few pioneering ICOs date as far back as 2013, the vast majority happened in the last 12 months, including the $6bn already raised this year.
Capital markets teams are fielding client requests on the matter on almost a daily basis. The appeal for young, usually digital, companies to raise funds through an ICO rather than going public is obvious: who would not want investors to put money into their business without having to share profits? Contrary to traditional initial public offerings (IPOs), there is no prospectus with the attached regulation involved. The information the issuer has to disclose in the so-called white paper is far more limited, saving time and money.
‘The common perception is that an ICO should be very quick and easy – off you go and you have got millions in your pocket.’
Philip Smith, Allen & Overy
Though such offerings are dubbed ICOs to echo the jargon of a public stock sale, the process is more accurately described as a ‘token sale’. The start-ups or young companies offer to sell tokens to investors for conventional currency or established cryptocurrencies like Bitcoin or Ether. The sale can be arranged to investors privately or publicly via an online platform, with Ethereum established as the dominant home.
It is the issuing of ‘utility tokens’ and ‘currency tokens’ that is often talked up. The model is new and largely unregulated: their main function is to be used as currency on a blockchain platform, often with the promise of a Bitcoin-like rise in value. Messaging app Telegram famously raised $1.7bn between February and March by selling its tokens to fewer than 200 private investors, although the company later scrapped the publicly-offered element of its planned ICO.
So far so good. Except it is a lot more complicated than that and regulators all over the world are racing to catch up. ‘What are these tokens considered as a matter of law? Everyone is trying to figure out where this fits,’ says Baker McKenzie partner Sue McLean. ‘The regulatory side is not clear yet. It very much depends on what the coin offers,’ agrees Bird & Bird international finance co-head Trystan Tether.
‘The common perception is that an ICO is the Wild West, that it should be very quick and easy to do this – off you go and you have got millions in your pocket,’ says Allen & Overy (A&O) debt capital markets partner Philip Smith. ‘But people very quickly realised that there are significant regulatory pitfalls to avoid and you have to be very mindful of complying with existing regulation, especially in the US.’
The US Securities and Exchange Commission (SEC) has taken a hard-line approach and started filing the first lawsuits against alleged frauds. ‘SEC chairman Jay Clayton made it clear in February that every ICO he had seen is a security and should be regulated,’ notes Hogan Lovells’ John Salmon. In the UK, the Financial Conduct Authority is taking more time to publish clear guidance. As are most European regulators, although Switzerland, Malta and Gibraltar are at pains to present themselves as crypto-friendly jurisdictions. In Asia, you go from mainland China’s outright ban to Hong Kong’s and Singapore’s booming activity.
A confusing regulatory backdrop is not the only reason many law firms are treading cautiously.
The chances that ICOs could be scams are high. Estimates put the amount of fraudulent coin offerings between 25% and a startling 80% of the total. With the source of money invested often hard to identify, arranging banks are reluctant to get involved. Failure rates are also sky-high, with some industry analysis concluding that more than 40% of 2017’s ICOs have already failed.
‘There are projects of which blockchain is part and makes sense,’ says Dentons Europe co-head of capital markets Robert Michels. ‘But in many it is clear that a company that was not able to find investors is going through an ICO.’
What makes the risk-reward equation even less appealing is that many of these companies are early-stage start-ups, which can hardly afford law fees and ask firms to be ‘creative’ when it comes to billing – payments in cryptocoins are regularly offered.
As a result, many leading securities teams are sceptical. ‘On the IPO side, companies would often go to a Magic Circle firm because they know those firms have done hundreds over the last ten years, whereas on the crypto side you don’t have that,’ points out RPC’s Jonathan Cary.
Freshfields Bruckhaus Deringer says it is not currently handling ICOs, while Linklaters responds that the market remains too small and fragmented to spark its interest. Slaughter and May’s co-head of fintech Ben Kingsley gives the ICO market in its current form another 12-18 months of life: ‘There will be some regulatory action and possibly some spectacular failures, and ultimately that’s what will cause investors to turn their backs on hollow utility token offerings. We will then have a more restricted but more measured ICO market used as a means of raising tokenised debt or equity capital. I would expect then to see more familiar companies raising genuine capital in a blockchain environment and, in that sense, it will not look all that different to companies raising money through traditional securities issuances.’
‘In many cases it is clear that a company that was not able to find investors is going through an ICO.’
Robert Michels, Dentons
End of the story? While there are few law firms that have gone public advising on ICOs, A&O acted on SPiCE VC’s coin offering, with Cooley on the US side. A&O says that it currently has more than 50 lawyers globally advising on 17 ongoing ICOs, reflecting perhaps the firm’s muscular fintech business.
‘Some of our current clients could raise finance in a traditional way but look at going down the ICO route as a way to diversify,’ says Smith. His colleague Ben Regnard-Weinrabe is likewise bullish: ‘ICOs will accelerate quickly and become part of the normal funding landscape. The prior negative connotation will disappear once people understand this better. Twelve months from now we will be having a different conversation in terms of the type of players in this market.’
ICO cheerleaders are also among a group of firms that point to their global coverage as an edge in a field that is cross-border by its nature. CMS Cameron McKenna Nabarro Olswang is advising on the ICO of blockchain-based business London Football Exchange. Norton Rose Fulbright’s Victoria Birch says her firm has around 170 lawyers globally equipped to advise on the matter from its regulatory, fintech and commercial teams. According to Michels, Dentons has worked on around 50 ICOs, most of them through its Singapore arm.
Hogan Lovells’ US arm was known for fielding one of the top names in the blockchain field, finance partner Lewis Cohen, before he left to establish blockchain-focused boutique DLx Law in May. ‘We have got a lot of different ICOs going on all over the world,’ says Salmon. ‘We see it as a perfectly legitimate way to raise funds, but it is very difficult to navigate a plethora of regulatory regimes.’
As such, most law firms are treading carefully while keeping a wary eye on how this shakes out. Where many see a bubble, another touted scenario sees the more respectable end of the market ushered into a clearer regulatory framework – probably driven by the US – which suggests the sector could evolve into a genuine product line for corporate law firms. If the latter scenario occurs, you can expect an immediate stampede of lawyers to place their digital bets, while the early entrants will have a substantive market edge. Still, who can blame the cynic for noting that the legal industry’s record in spotting the next big thing is nothing to Snapchat home about.
marco.cillario@legalease.co.uk
The ICOs – the legal bluffer’s guide
What are ICOs?
An initial coin offering (ICO) is a means of raising capital from investors by selling tokens and using distributed ledgers rather than a conventional stock offering. As with placing securities, tokens can be sold privately or via an established online platform, like Ethereum. ICOs use blockchain, a distributed database that allows assets to be moved and securely recorded through the use of cryptography.
Why have they emerged?
Proponents of ICOs see them as a cheap and quick means for start-ups and young digital businesses to raise capital from like-minded investors. The flexibility of the model allows them to be easily customised, in effect offering investors different things in return for their capital. Critics cite their use by fraudsters and sky-high failure rates.
How much is being raised?
The overwhelming majority of capital has been raised through 2017 and 2018, with industry estimates putting the sums at over $11bn, including $6.3bn in 2018 alone as Legal Business went to press. A handful of large offerings have raised tens or even hundreds of millions of dollars, though most are for relatively small amounts.
What’s all this about tokens?
In ICOs, issuers are typically offering what are described as ‘tokens’, themselves a form of crypto-security or currency that investors buy with conventional currency or established cryptocurrencies like Bitcoin in return for future rights. Broadly the three forms are:
- Currency tokens, to be used as a means of payment to acquire goods or services.
- Utility tokens, which provide access to a service or application.
- Asset-backed tokens, which give owners some rights over the issuer, such as a share of earnings.
Asset-backed tokens are the closest equivalent to a conventional deal security like equities or convertible bonds.
And white papers?
A white paper is a document published ahead of an ICO in which a company describes its operations and the characteristics of the token it is issuing. It is the closest thing to a conventional prospectus.
What are regulators doing?
ICOs are controversial and banned entirely in some jurisdictions, notably China. US market agencies are currently moving to bring ICOs within the regulatory regime for securities. Regulatory response will largely determine the shape – or even existence – of the emerging field.