Ether Review Legal Discussion #2 The Legality of Raising Money Using Tokens

In today’s discussion we look at the legality of raising money through token launches, the potential risks involved, and approaches to improving the safety of these new bearer assets. We also examine the term ICO in depth and find that terminology, while relevant is second to the nature of the offer and state of the project involved. Following the discussion is an interview With Peter Van Vaulkenburg recorded at Devcon 2, applying the Howy test to TheDAO.


Hannah — Securities law: different depending on jurisdiction and token. Must ask: what is being offered, who is it being offered by, who is it being offered to? (E.g. IPO for shares = interest in a company, issued by that company). ICOs are more vague: not always issued by a company, not always a ‘share’, offered to people all over the world. The law depends on the framework of the token itself.

Pip — Classifications: promise of why a person would take up an offer is central to why a person would participate in an ICO. When issuing, securities are done so that the investor expects to participate in a venture for which they will receive profit.

Hannah — Yes, and you also know what you are participating in; you know their existing activities and they are held accountable. This is very different from a traditional securities environment.

Pip — Invitation to treat/advertisement. The word invest is never used; rather, crowdfunding language is used. However, crowdfunding suggests the donation of money, for which the donor does not expect anything in return.

Alex — In NZ, crowdfunding is the process of investing into a company — companies can only raise up to $2m in a 12 month period, which differs from normal securities.

Hannah — Similar principles of general investing. If it’s crowdfunding, you get equity, whereas this is not always the case in ICOs. If the rights look and act like a share, it could possibly be a share.

Alex — Peter from Coin Center mentioned in the previous talk that ICOs are for financing open source movements and building infrastructure; this should not be treated the same as trying to raise funds for a company or private venture. This is a different beast from what we have had before. “ICO” language needs to be changed.

Pamela — People use the term ICO because they want the affiliation with an IPO; they are intentionally drawing those analogies to promote sales. E.g. Ethereum presale; talk of a crowdsale of a token, buying into the Ethereum system with an equity token. This changed very quickly, and the language was changed to a software presale rather than equity token. The marketing of the tokens (and how people view their use of the tokens) is very important for the legal perspective.

Arthur — MasterCoin, BitShares and CounterParty were initial examples of ICOs.

Hannah — It is difficult to figure out what is being offered.

Pamela — Favourite ICO is — a parody ICO which is actually raising a decent amount of money.

Hannah — If it looks too good to be true, it probably is.

Pamela — You don’t need to be an accredited investor for ICOs (although the barrier to entry is understanding of how to use crypto). Avoiding a regulatory barrier to entry makes them more convenient to buy into. Raises the question of why such regulatory barriers are there in the first place, and whether they should be revised given the latest technological architecture.

Hannah — Shows a lack of capital in the market. Barrier to entry is being eroded, as some ICOs are now accepting fiat.

Pip — In a normal online purchase, you don’t have an expectation of profit on top of the value of the asset. However, in the case of ICOs, people are attracted by the potential for profiting from the token, and this is their expectation.

Pamela — Secondary markets exist across the economy. E.g. Beanie babies — the secondary market was the catalyst for a lot of the purchases. The law is good when things are clear and consistent, but when people get involved, it starts to get messy.

Alex — The existing laws are for a different age. If existing laws had applied to the internet, we wouldn’t be having this conversation online right now. In Singapore and Switzerland, ICOs are being treated as assets. They are taking off in Europe, and the States might get left behind.

Arthur — Regulatory arbitrage. Because this is an international market, creators and users are forced to use the jurisdiction that suits them the best, even when they are not geographically close.

Pamela — Many companies are unable to set up in the States; from a business risk perspective, it makes more sense for them to incorporate outside the US, and stay away from US customers. Opportunity for other jurisdictions to create frameworks which work well.

Hannah — Everyone can see the ICO, so the token is being offered to anyone/everyone. Therefore the jurisdiction of incorporation is not the only consideration; the jurisdiction of the purchasers will also be concerned.

Pamela — Also, how do we deal with purchasers who buy a token in one country when they are a citizen of another? Can they take their tokens back to their home country if they are banned there?

Pip — Completely novel question. Estonia allows registry as an e-citizen for anyone, and allows them to set up a business in Estonia; this could buy tokens. Could override geo-location by claiming that the jurisdiction of the purchaser (i.e. the business) is not the one where the person is.

Pip — It is expensive for governments to investigate how we should create laws. Need the crowdfunding smart contract to include clauses on arbitration, remedies etc.

Pamela — Has been advocating for the inclusion of robust arbitration clauses in ICOs. Even if they are not ready to include a smart contract element, they should do this to prevent some legal issues.

Pip — Has been approached about a PhD exploring arbitration on the blockchain. Only heard of this being done in theory though. If entities are not ready to articulate smart-contract arbitration, they should not be setting up in the first place.

Pamela — Interested in lawyers who are looking into arbitration in this industry. Another valuable resource is the American Arbitration Association’s clause-builder; people could use this as a basic outline.

Pip — Entities should work out the top 5 scenarios if disputes arise, and automate these. When it is automated, people could ratify the smart contract arbitration clause.

Liesl — We have to consider that the code might not reflect the plain English clauses, so people will not necessarily get what they are expecting even when there is a clearly outlined, theoretically binding framework.

Hannah — Code is black and white, but disputes have other circumstances. You can only code for the known unknowns, but there will be unforeseeable situations. We need to be careful that the code won’t have unintended consequences.

Pamela — There is no such thing as bug-free code, so there will always be some unintended outcome. Every time dispute resolution is encoded into a contract, this opens up more vulnerabilities, so we will need to find a balance. Some contracts might benefit from avoiding dispute resolution.

Arthur — To assume that code can’t be watertight is to relegate us to a prior time. In the future, we will possibly be able to get that right every time.

Pamela — The whole point of this is that it’s not a static system; it’s fluid. Even the cryptography we have now will not last for long. So it’s not about having bug-free code in a static environment, but about moving forward with the technical and software changes.

Pip — Concern in insolvency scenario; there is powerful jurisdiction preventing insolvent trading, and with the automation of crowdfunding projects this cannot be applied as in existing markets. Third parties; who is the agent? Questions of fiduciary obligations and trusts. Can people be held liable for breach of fiduciary duties?

Hannah — Comes back to relationship and promise; there is only a fiduciary relationship in certain circumstances. We need to look at who is involved, what their role is, and what is being promised.

Pip — Many ICO entities hold the tokens on trust for the purchasers (e.g. on an exchange).

Pamela — This is not an industry best-practice; the technology provides alternatives to that, and it is a huge red flag. The entire purpose of these platforms is that we don’t need to trust third parties, so if they are holding others’ assets, this becomes suspicious.

Pip — We should direct listeners to the Howey test (to explain the conditions for securities).

Alex — No one seems to be prosecuting yet. Better to beg for forgiveness than seek permission (i.e. start innovating now despite the unclear legal position).

Liesl — It will be hard to ensure enforcement of existing or new laws relating to token launches, given the architecture of these technologies. Launches often have very different characteristics depending on the intent. There are also enforceability issues due to anonymity and dubious agency.

Pip — Need information on the victims, and need to identify the perpetrators. We need confidence to develop to move into the next stage of these technologies.

Next time: Review of Howey test. Why aren’t regulators involved, and how should they do so? Terminology. Post-conference-season developments.

arthur fallsLegal