In a research paper on initial coin offerings (“ICOs”) published in December 2017 , it was noted that fewer projects had reached their financing goals in November 2017 than in the previous months. It was also noted that most ICOs lacked a clear reason for using tokens and blockchain technology. Statistics published in the same research paper illustrated the fact that ICOs related to blockchain technology were among the most successful, together with projects targeting data storage, finance and online gaming. At the end of 2017, it was clear from the same statistics that most projects still remained in the “idea stage”, with very few prototypes and even fewer running platforms. Yet the appetite for ICOs has seemingly not diminished, as illustrated by the high number of events, publications and initiatives.
What this first wave of ICOs brought, however, is awareness of the issues to be addressed by regulators, lawyers and other advisors and service providers working with blockchain start-ups. It became clear that the blockchain entrepreneurs could not continue to rely on purely technological solutions ignoring existing legal and regulatory problems. As part of our series on FinTech, after discussing some of the risk factors related to cryptocurrencies (see Top Ten Risks for the Crypto-Currency Investor: A View from the Cayman Islands) and Cayman Islands laws which may be triggered in connection with ICOs (see Cayman Islands Legal Perspective on the Regulation of Initial Coin Offerings (ICOs)), this issue will focus on some best practices for blockchain start-ups in the Cayman Islands in preparation of an ICO.
Do Categories of Tokens Matter?
The term ICO refers to an “initial coin offering”, i.e. a public sale of digital tokens or coins, to which various rights may be attached. Although there is no generally recognized classification, industry experts and some regulators have started referring to several categories of tokens based on the underlying economics, as determined on a case-by-case basis after review of the white paper published by the founder team.
Payment Tokens or Cryptocurrencies: Modeled after Bitcoin (BTC), some tokens (or coins) have no rights attached giving the holders a claim against the issuer, but they are designed to be limited in quantity, similar to precious metals, so that their value may increase based on their adoption by various users. Their value is also tied to the benefits provided by the blockchain platform they are built on (e.g., security, decentralization, disintermediation, anonymity or pseudo-anonymity). Although Mastercoin is generally regarded as the first ICO, Ethereum (ETH) was more successful in 2014, raising 25,000 BTC from investors in the first two weeks of the public sale and later on developing Ethereum as the largest platform for ICOs.
Utility Tokens: Most ICOs sell tokens which are designed to provide access to an application or service on a blockchain-based platform. Such tokens may be “burned” upon use, but new tokens can generally be purchased on the same platform. Such tokens are the blockchain version of digital coupons, but with the additional benefit of being tradeable securely and pseudo-anonymously (and benefiting from a potential increase in value if the number of users of the platform increases ).
Asset Tokens: Tokens which give the holder a portion of the profits of the business or other economic rights are considered to be securities in several jurisdictions, i.e. a blockchain version of equity interests, debt instruments, etc.
- Hybrid or Other Tokens: Any combination of the above can generally be considered a hybrid token; this may trigger an overlap of applicable regulations.
In some cases, the same blockchain project generates two or more categories of tokens with different rights attached, which are issued in the different stages of the project. In other cases, investment contracts for future tokens (SAFT, SAFTE, and several other variations) are signed before an issuance, enabling the founder team to develop a working model of the blockchain project before any “public” sale. Finally, some blockchain start-ups do not offer any type of coins or tokens.
The assumption would therefore be that issuing tokens in a certain “category” would trigger regulation, while another “category” may not. Such assumption, however, if not confirmed by review by specialist legal counsel, exposes the issuer to substantial legal and regulatory risks, especially since the regulators’ position, as expressed through “Guidance Notes” or unofficial statements, may change over time . Also, ICO founder teams are generally based in multiple jurisdictions, and promotion efforts may target investors from various countries. Without realizing it, ICO founder teams may in fact be required to comply with several very different regulatory environments.
What Guidance for Cayman Companies Undertaking an ICO?
As at the date of this publication, there is still no specific regulation in the Cayman Islands addressing ICOs and blockchain technology. However, several of the existing laws and regulations are applicable to blockchain start-up companies and their pre-ICO and ICO operations. Also, a recent series of statements have been made by the Cayman regulatory authority, which generally encourage the blockchain ecosystem development. The Cayman Islands Monetary Authority (“CIMA”) itself has unofficially commented that cryptocurrencies, ICOs and FinTech generally are here to stay and that although the Cayman Islands Securities Investment Business Law (2015 Revision) (SIBL) does not include cryptocurrencies or tokens in its list of securities , CIMA may be issuing further guidance to issuers and promoters as they increasingly look to access “real money” through the offshore funds industry.
As things currently stand, ICO founder teams and promoters looking at the Cayman Islands for incorporation of their company or companies should be aware of the following best practices:
1. Have a Real Project. Setting up a Cayman Islands exempt company for your ICO (the “Company”) is not complicated and it usually only takes a few business days. However, a successful project requires more than a legal entity. Based on your business model and strategy, the legal vehicle which may be best suited for your purposes may also be different: for example, a foundation company instead of a regular exempt company may work best if your purpose is to create a stand-alone blockchain ecosystem, not “owned” by a particular person or group of persons. For more details regarding Cayman Islands foundation companies, see our alert Foundation Companies can now be incorporated in the Cayman Islands. Generally, the founder team should be prepared to answer the following questions:
What are the key features of the service/platform to be developed?Which market participants (investors) will the ICO target? Are there any restrictions regarding investors? Are the founders planning to bring in pre-ICO investors on a private placement basis (through SAFT agreements or otherwise)?
What is the project timeline (ICO phases, milestones, etc.)?
What technologies will be used (new or existing, open source project vs. blockchain patent envisaged, etc.)
Which cryptocurrencies will be accepted? Will the ICO have a floor or a cap?
Have the funds already been allocated to a specific project? How will surplus funds be handled?
Will a token be created in the course of the ICO?
Which functionalities are planned for the token? What rights will be attached?
At which point, by whom and in which manner will the token be transferred to the investors?
How can the token be transferred (compatible wallets, technical standards)?
Is the token already functional at the time of transfer? If yes, to what extent?
How and where can the token be acquired or sold after the ICO (secondary market platforms)?
Will it be possible to use the tokens to buy goods or services or make payments to third parties?
Are there plans for the Company to buy back tokens?
Which service providers will be involved with the ICO?
2. Have a Real Lawyer. A lot of the information generally available on the web about setting up a company or opening up a bank account in the Cayman Islands is inaccurate. Even going to a real CIMA-regulated corporate service provider may not be sufficient in itself, as they will only be able to help with setting up the company and certain basic compliance issues. It is imperative that founder teams use legal counsels who regularly operate within the ICO space and have detailed, specialist knowledge of the regulatory landscape. As shown by the recent wave of enforcement actions and subpoenas in the United States , regulators will not hesitate to go after ICOs if not properly carried out, and the founder team may be forced to return funds, raise compliance standards or face sanctions.
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iEY research: initial coin offerings (ICOs), December 2017, in which Ernst & Young studied 372 ICOs having raised US$3.7b in funds.
iiSuch as FINMA, the Swiss regulator – see https://www.finma.ch/en/news/2018/02/20180216-mm-ico-wegleitung/
iiiFrom the Ethereum self-published statistics - see https://blog.ethereum.org/2014/08/08/ether-sale-a-statistical-overview/
ivIt has been pointed out by many that although blockchain gives the impression of anonymity, in reality most wallets can be linked to a physical identity and in reality only offer a sort of pseudo-anonymity. For example, KYC/AML obligations apply to all cryptocurrency exchange platforms and buying cryptocurrencies on such exchanges is subject to the user providing government-issued identification.
vFor this reason, it may be considered that all tokens are in reality bought for speculative purposes and therefore all tokens (even utility tokens) should be treated as securities in the US (among other jurisdictions).
viFor example, China and South Korea have banned all ICOs. Other regulators have issued warnings to investors and guidance notes, but reserve the possibility to adopt a specific ICO-related regulation or take action at a later stage.
viiQuote from Ms. Heather Smith, Head of Investments & Securities Division of the Cayman Islands Monetary Authority (CIMA), during the Opalesque 2018 Cayman Roundtable.
viiiSchedule 1 of Cayman Islands Securities Investment Business Law (2015 Revision) (SIBL) exclusively refers to shares (including stock of any kind in the share capital of a company, interests in a limited partnership, or units of participation in a unit trust), instruments creating or acknowledging indebtedness such as debentures, debenture stock, loan stock, bonds, certificates of deposit and any other instruments creating or acknowledging indebtedness, instruments giving entitlements to securities, certificates representing certain securities, options, futures and contracts for differences.
ixQuote from Ms. Smith during the Opalesque 2018 Cayman Roundtable, see FN vii above.
xOn 24 August 2017, following a request for information from the Securities and Exchange Commission (SEC), Protostarr cancelled its ICO and refunded its investors. On 4 December 2017, the SEC obtained an emergency asset freeze to halt the ICO of Quebec-based PlexCorps. On 11 December 2017, the SEC ordered Munchee Inc. to cease and desist its ongoing token sale. On 17 January 2018, the Enforcement Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth brought an enforcement action against Caviar, a Cayman Islands company, and its founder. On 30 January 2018, the SEC obtained a court order to halt the ICO of Dallas-based AriseBank for allegedly conducting a fraudulent ICO