What are the Risks and Legal Issues of ICO?

What are the risks and legal issues of Initial Coin Offerings? It is paramount that you first consider the risks and legal issues surrounding an ICO or Initial Coin Offering and then go ahead with it if you find it to be feasible and productive for your tech startup.

Also referred to as Digital Token Sale, an ICO is one of the best ways to raise funds for your business.

The good thing about it is that if you take this route you will not have to incur debt, or issue equity, or even need to enter into a Convertible Loan Agreement or CLA.

However, everything in an ICO may not be good for you if you do not know how to go about it and the challenges that you may face down the road.

It is true that ICOs are making headlines but not everyone can make them work in their favor and meet all their expectations.

As an ICO issuer you will need to keep in mind and consider a lot of things such as:

  • The sentiments of the investors or the purchasers
  • The marketing strategies and how productive they are
  • The viability of your business model
  • The credibility and efficiency of the team that you have and, most importantly
  • The risks and challenges that you need to overcome.

It is only when all these things work together in perfect harmony you will be able to build a credible and successful ICO.

Here is an article that will tell you all about the ways to be successful in your ICO endeavor from the regulatory and legal perspective whether it is for launching a new crypto token or investing in one.

This article will also be of great help for those people who want to participate in an ICO as well.

What are the Risks and Legal Issues of Initial Coin Offerings?

What are the Risks and Legal Issues of Initial Coin Offerings

An ICO is perhaps the only aspect of the blockchain and crypto space that is the murkiest from the legal and regulatory perspective in the United States.

Initial Coin Offerings has been popularized and gained a lot of traction over the couple of years and several companies, especially the tech startups, offer ICOs to crowdsource funds for their business.

However, not all of them have been successful and there are several instances that show simply being ostensive in launching a new crypto coin or token is not enough.

You will need to know the complicated legalities and the risks involved in the process and overcome them.

Historically, the ICOs in the past have been weighed down due to several legal issues right from the time this concept came into existence.

The main reason behind this is that the companies typically did not follow or keep their promises that they made to the investors.

Also, there is a high risk of frauds, scams, and hacks.

As a result, the ICOs also gained a lot of attention from the federal regulators and prosecutors such as the SEC or The US Securities and Exchange Commission.

However, this does not mean you can go ahead and issue an ICO and expect it to be successful simply because the SEC is concerned about it.

Ideally, a lot of personal legal connotations are needed to consider while making an Initial Coin Offering, which is much similar to an Initial Public Offering or IPO that is a commonplace in the stock exchanges.

However, the most significant difference between an ICO and an IPO is that ICOs are made to create a new crypto coin or a token, an app or a service.

Ideally, the coins that are issued in an ICO may also have utility for a software product or service.

The interested investors receive a new crypto token when they buy into an ICO issued by a company.

Some of these ICOs have produced huge returns for the investors but a lot of them have performed poorly.

If you want to participate in an ICO and be successful, here are the few factors that you should consider.

First of all, you will need to know the fundamentals of crypto exchanges and wallets.

You should also keep in mind that the ICOs, for the most part, are entirely unregulated.

Therefore, whether you are issuing a coin through an ICO or investing in one such ICO, you will need to research a lot, do your due diligence and exercise extreme caution to make sure that you do not lose in either way.

Factors to Consider

Start with the different factors that you will need to consider before you jump into issuing a new token for the general public.

Just for you, here are the most significant factors to consider.

One of the most significant things to consider if you wish to issue an ICO to raise funds from people for your business is the model of your business and the technology.

Both, the business model and technology should be such that it will attract the crypto investors towards it.

Well, this is not a legal factor but is still a good human factor to consider.

Therefore, before you consider the legalities of an ICO, consider its feasibility for your business and the chances of success.

ICOs seem to be most successful for businesses that are based on blockchain technology, mostly Ethereum.

Your business model and technology should also have some novel applications.

For example, if you are a startup, the rate of success will be higher if you allow the users to use crypto in their digital wallets through a debit card that they can use as a credit card.

It is also important to consider the credibility of your business because the investors are adept in sniffing out the ICO issuers that are credible and those that are not.

In this regard, the best thing to do is focus on building a digital token that will have some very clear use cases on the blockchain app.

The demand of your token will then be high when the app succeeds because it will boost the utility of the token due to its strong potential and solid concept.

Another useful way to ensure success of your ICO issuance is to issue tokens that have a very strong connection and are compatible with the underlying technology of your business.

It is only then your new coin will be able to attract the investors.

However, if the whole intention of creating a new coin is to give the holders and investors the right to get some dividends, returns or profits, it is highly likely that you and your coin will run into some kind of legal or regulatory issues. Sometimes, these issues can be really thorny (more on it later).

Then, it is also very important to structure your ICO in the best and most productive way possible to make sure that it is efficient and useful to the investors.

There are lots of different ways in which you can do that but the whole thing depends on your main objective of designing the coin.

Remember, the success of an ICO mainly depends on what you want to achieve and how the potential investors view your crypto ICO.

Here are some of the most significant considerations to make:

  • How you want to cap the amount of tokens you want to put on sale
  • Do you want to set aside a specific percentage of total supply of the tokens for the insiders such as the founders, advisors, development team, the startup, and others
  • Do you want to let the buyers of the tokens decide the price of token based on the market value of it or want to issue them at a fixed price and
  • Do you want to sell the tokens on a first come, first served basis or in some other way of your choice.
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Typically, when it comes to determining the structure of an ICO, the most commonly followed one is a capped and first come-first served structure.

This is a specific structure in which a fixed number of tokens are sold at a fixed price for a definite period of sale on a first come, first served basis.

Also, in this method the issuers usually keep aside a certain percentage of the coins for the insiders.

Another popular structure is the capped auction structure. In this process, the total number of coins to be sold through an ICO is capped.

The investors here have to bid for buying a coin at a desired price which is usually at a particular budget.

The number of coins sold in this process usually varies based on the bids made for them.

You can also follow the uncapped version of it when you want to use this structure. In this process you will however gain a much wider variety of token holders.

However, if there is an oversubscription, you can offer a fraction of the tokens the buyers with a higher total budget wish to purchase.

You can also ensure a wider range of token purchasers by limiting each investor to only one transaction as well as the number of tokens they can buy.

Ideally, structuring your ICO will largely depend on the outlook of the potential investors on you and your ICO.

Jurisdictional Regulatory and Legal Concerns

The legal and regulatory concerns can be varied based on different jurisdictions and therefore you should take every step most cautiously.

The first thing that you need to consider is whether or not your ICO can be distinguished as a security token or any other kind of project.

Depending on this, it will further help you to decide:

  • What type of regulatory approvals is required for it
  • Is it feasible for you to go ahead with it or not
  • Which legal entity issuing your coins you would like to register with
  • Where do you want to conduct the ICO and
  • Who do you want to take part in it and who do you want to prohibit?

The next thing you need to consider is the compliance with Anti-Money Laundering or AML as well as Counter-Terrorism Financing or CTF protocols.

For this, you will need to do some thorough research and due diligence irrespective of the legal characterization of the ICO or the token.

And now, it is time to consider the terms and conditions to include with your ICO so that you abide by the rules and regulations and the token does not face any legal or regulatory issues down the lane.

These legal and regulatory issues may vary according to the jurisdictions, which once again calls for in-depth research.

However, to simplify the process for you, here is a brief overview of the regulations regarding ICO in some of the major countries of this world.

Singapore:

MAS or the Monetary Authority of Singapore issued a press release on August 1, 2017 stating that all issuance of digital token in the country will be regulated by them especially if the tokens represent those products that are regulated under the SFA or the Securities and Futures Act.

The press release also stated that the issuers of the coins, depending on the type of it, will be needed to record a prospectus with MAS prior to offering their tokens if these are not exempted.

In addition to that, there are also some other specific licensing requirements imposed.

This means that the MAS made it very clear that it will oversee the core of the arrangements regarding the ICO.

It also means that it has the right to determine whether or not a specific token amounts to securities or any other form of collective investment scheme that may be regulated by the MAS currently.

Further, on November 14, 2017, the MAS issued a guideline to Digital Token Offerings.

In this guide it is stated that the MAS will have the right to scrutinize the structure of the digital token as well as its characteristics in order to determine whether the particular token represents a capital market product in any of its types that are regulated currently under the SFA.

Remember, CIS or Collective Investment Schemes in Singapore are also regulated.

This means that, if the MAS consider a particular token to be a unit of CIS or a security, the company needs to register the whole arrangement of the issuance of this token with the MAS or else it will or else it will be considered as violation of the law.

In the Digital Token Offering guide the MAS has also mentioned that the digital tokens that do not fall under the purview of it, may then come under other legislations.

These rules are designed especially to deal with money laundering, terrorism financing, and other issues.

Therefore, it is clear that in Singapore, the companies who want to issue a token other than utility tokens will need to be very cautious and knowledgeable about the MAS and SFA rules and regulations that may be applicable.

This needs the issuers to do some due diligence to verify the identity of the buyers of the tokens even before a sale of the token is executed.

United States:

In the United States, the Securities and Exchange Commission or the SEC issued a report regarding ICOs made by any Decentralized Autonomous Organization or Decentralized Autonomous Corporation (DAO/DAC).

According to the report, all these will be subject to rules and regulations regarding federal securities.

This means that the digital tokens sold by these companies in an ICO will be considered as securities.

This is quite an interesting aspect considering the fact that the DAOs are actually virtual corporate units and not registered and official entities.

According to the US Exchanges Act and the US Securities Act, any investment contract is considered to be a security.

The primary criterion for considering them as an investment contract is that the money is invested in an ordinary project with a realistic expectation of income consequential from the managerial or entrepreneurial efforts put in by others.

This means that in the US the SEC emphasizes more on the economic realism underlying the transaction and not on the labels or brand name involved in it.

However, this does not mean that the SEC considers any and every ICO in the US to be illegal.

However, the point to consider or be worried about is the ‘reasonable expectation of profits’ part.

This is a very broad and often confusing concept and can be interpreted in different ways by different token issuing companies.

The above mentioned Securities and Exchange Acts also considers it to be illegal for a broker, dealer, or exchange to be involved in a transaction both directly or indirectly of a security or to report it unless it is registered as a nationalized securities exchange under the Exchange Act or is excused from such listing.

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And, as a result, from the perspective of the US citizens, several ICOs may prohibit them from participating in their token sales, which is also applicable to the people residing in the United States.

China:

As for China, though the country has banned use of crypto since September 2021, the Chinese government was always apprehensive about crypto.

Way back in September 2017, the central bank or the Peoples’ Bank of China released a statement banning ICOs as well as digital token trading in the country. This forced all crypto exchanges to close.

According to the statement, banks and other financial institutions were also prohibited from doing any type of business with companies that conducted Initial Coin Offerings.

The statement also required the companies who have already completed making their ICOs to protect the interests and rights of the investors or face legal consequences.

Other jurisdictions:

As for the other jurisdictions, their legal standpoint regarding ICOs and Digital Token Offerings are not very clear as of now.

However, here is the apparent understanding of their viewpoints summarized for you:

  • The FCA or the Financial Conduct Authority of the United Kingdom has issued a consumer warning regarding ICOs. In this the FCA states that whether or not an ICO will fall under the purview and regulatory boundaries of the FCA will be decided on a case to case basis.
  • The SFC or the Securities and Futures Commission in Hong Kong have also issued a statement regarding ICOs. According to the statement, the digital tokens offered to the public may be considered as securities and therefore be subjective to the laws of Hong Kong but it will primarily depend on the circumstances of the ICO.
  • The ASIC or the Australian Securities and Investments Commission have issued a statement in their website where it has mentioned that it is the type of the ICO and the right associated with it will determine whether or not the Corporations Act is applicable to it.
  • And the Securities and Exchange Commission in Thailand has released a general statement on ICOs that tells about their tentative and non-definitive position. This lack of clarity encourages the stakeholders to be involved with them.

Therefore, you can see that the laws related to ICO all over the world are still not very clear but still there are a few legal issues that may arise due to violation of the local laws, knowingly or unknowingly.

That is why proper consultations, research, and due diligence are required before getting on with an ICO.

Possibilities of Individual Lawsuit

If you are wondering whether or not there is any possibility of individual lawsuits in issuing a digital token through an ICO, there are several instances and reports where the buyers have sued the coin issuers privately according to the federal securities laws.

Since the world or ICOs and DTOs are ever-changing, there are a few laws that the buyers can resort to if they are treated unduly in the process.

Therefore, if you are looking to make sales through an ICO process, you are better aware of such risks.

Special Considerations

There are also a few special considerations that you need to make before launching an ICO.

If you want your ICO to be a success, then you should make sure that you set it up as real and accountable.

Be very clear about your aim and the things that you want to offer to the investors so that they do not think it as another scam, which is a commonplace in the world of ICO.

Also, make sure that your business will benefit substantially from the ICO or it is meaningless to go ahead with it.

If you are a buyer, you should do your homework and research a lot about the ICO.

If you can go through the history of the company or the project then it is nothing like it.

And, do not fall prey to any hype or tall promises that are too good to be true, because they are, and there is a high chance that it is a scam.

Gather a lot of info regarding the new opportunities and first get familiarized with the crypto space before participating in an ICO.

Since the Securities and Exchange Commission may intervene, as an issuer you should also make sure that you avoid the risks and legal issues with your ICO.

For this you will to make sure that:

  • The goals of the ICO are clearly defined by the project developers
  • The white paper is simple and understandable
  • There is 100% transparency in the process
  • The legal terms and conditions and reviewed and are apt and legit for your ICO
  • The funds are stored safely and properly in an escrow wallet
  • The wallet is secured with multiple access keys and other useful protective measures.

If you are a buyer, you will first need to own a particular crypto in a particular wallet to buy a new token issued through an ICO.

This is because in most cases new tokens can only be bought in exchange of an established crypto coin such as Bitcoin.

Therefore, as a buyer, you will need to have two separate crypto wallets.

One to store the coins you wish to use to buy the new coin and the other to hold the new coin that is being sold through the ICO.

Initiative of the Securities Exchange Commission           

In order to make people aware of the issues related to ICOs and warn them about the risks involved in it, the SEC introduced a fake coin in 2018 called the HoweyCoin.

This coin demonstrates the dangers of ICOs to the individual investors.

This coin is named after Howey Test conducted by the agency in order to figure out whether or not an investment meets the criteria as a security.

Ideally, the SEC used this test to charge a messaging service Kik that raised funds to the tune of $100 million by making illegal sales of a security through an unregistered ICO.

The agency also started cracking down on companies since 2017 that tried to make sales or offer securities illegally in this way.

The first attempt of the SEC was made on December 11, 2017.

They issued a cease-and-desist letter to halt the ICO of Munchee, a food review app company in California when they tried to raise funds to create a crypto token that can be used within the app to place an order for food.

Therefore, make sure that you stay away from such practices to avoid legal hassles and forced closure.

Issues Related to Accounting

ICOs are similar to any other crowd-funding campaigns but typically do not signify any ownership interest.

The tokens issued simply provide access to a developed platform and can also be traded on a crypto exchange.

The number of coins to be issued in an ICO is usually fixed and the offerings also come with bespoke terms and conditions.

Sometimes, the ICOs are also considered as securities by the regulators depending on the prevailing rules but it is important to know that there is no global rule for it and therefore there is no specific standard for accounting these tokens.

As a result, the issuers of a token should be abreast with the latest rules and regulations in order to avoid legal issues and risks during designing an ICO, issuing the token, maintaining records, and during accounting.

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Remember, any little changes in the rules and regulations can have a significant impact on financial reporting and accounting.

If there is a pre-sale agreement or a ‘Simple Agreement for Future Tokens’ called SAFT, then the number of the tokens will depend on the price of the ICO token during issuance.

The significant factors to consider for proper accounting for these types of coins include and are not limited to the features and characteristics of the tokens along with the rights that the future holders are entitled to have.

When it comes to accounting for the tokens issued by an entity that has been undertaken, the considerations are different and vary according to the asset.

It is also very important to understand the characteristics as well as the economics of the transaction.

If an ICO has a joint arrangement then, according to the IFRS 11, ‘Joint Arrangements’ must be considered.

It is possible that the subscribers who provide the major part of the funding may have a collaborative arrangement with the ICO entity.

But, these subscribers are usually passive. This means that they will not have joint control.

In some cases, the issuer may grant veto rights to the subscribers over the development and future course of the project.

Since these are quite protective in nature, it will typically not allow joint control as well.

Now, when an ICO is made in the form of a cryptographic asset and not in the form of cash, it may result in an exchange of similar products or services. In this case no accounting will be needed.

But the problem is that it is not quite likely that an ICO will be exchanged as a ‘similar goods or services.’

This is because no two crypto assets are usually the same.

With all these aspects given and assuming that the arrangement does not provide a joint control and there is an exchange transaction made, the consideration received by the issuer of the ICO is recorded on the debit side of the journal entry.

Here, the primary challenge in accounting for the issuing entity is to determine the credit side of the journal entry.

This entry will mainly depend on the type and nature of the issued token along with the guidance of the accounting standard that is applicable.

In this matter, the issuer of the coins needs to understand the different obligations apart from understanding the terms of the contract.

A few of the major considerations are as follows.

The financial liability:

It is very important for the ICO issuer to make sure that the token satisfies the classification of a financial liability in IAS 32. According to it a financial liability is:

  • A contractual obligation to offer cash or any other financial asset to or to exchange financial assets or liabilities with to a different entity on conditions that are not favorable to that entity or
  • A particular contract that can be settled in the own equity instruments of the entity.

If the ICO meets any of the above two definitions of financial liability, the IFRS 9 guidance should be followed for accounting.

Equity instrument:

This is a contract that involves a residual interest after deducting the liabilities in an asset of the entity according to IAS 32, paragraph 11, which ideally should not be the case,

But if it is then it is needed to carefully consider whether or not the rights to the cash flows are related to the specific project only or does it provide the ICO entity with the rights to residual cash flows.

Revenue transaction:

Finally, it is important to consider revenue transactions or forestallment for future goods and services.

Sometimes, the tokens issued in an ICO are simply a contract with the customers.

In such situations, the guidance of IFRS 15 should be followed for accounting purposes.

This particular accounting standard is applicable when three different conditions are fulfilled such as:

  • When the ICO token receiver is a customer
  • When there is a specific contract existing for accounting purposes and
  • When the performance obligations related to that specific ICO token are not in accordance with other standards.

If none of the above considerations are applicable or are irrelevant, the issuer of the tokens should consider other pertinent guidance such as the hierarchy in IAS 8.

This will help in determining the most suitable accounting treatment.

It is highly unlikely for an issuer to have no obligation to the customers.

It may not be an arrangement that results in a financial instrument or a guarantee to deliver goods or services, but there will always be a constructive and legal obligation of the issuer to the subscriber.

In such a situation, the issuer is required to be aware of the provisions in accordance with IAS 37.

Finally, when goods and services are purchased by the ICO entity in exchange of the ICO tokens, there are some general as well as above-general considerations to make by the issuer for accounting purposes.

One, in such situations the production of ICO tokens should not generate any proceeds for the ICO entity.

If it does, it will be considered as an exchange transaction and be included in accounting.

Two, if the ICO tokens are used for developing a platform and pay for the third parties services, it is important to know the economic essence of the exchange.

Typically, the accounting treatment to follow will depend on conditions like:

  • The substance received b the ICO entity in return for the crypto assets and
  • The characteristics of ICO token produced and offered by the entity.

It is also required by the issuer to consider the debit and credit side of the journal entry.

As for the debit side, the cost is to be considered whether or not it can be capitalized as an asset according to IFRS guidance or recognized as liability under IAS 38.

As for the credit side, the obligations of the entity are to be considered as a consequence of the issuance of the tokens.

It will be based on the promises associated with the tokens. It will help in determining the accounting standard to follow.

And, when the ICO tokens are used to pay or reward the employees, the issuer will need to consider the IAS 19 or IFRS 2, ‘Share-based Payment’ aspect for determining the accounting treatment.

Once again it is the characteristics of the ICO tokens that are considered provided it does not automatically meet the definition of equity instrument or the ‘Share-based Payment’ definition under IFRS 2.

It should typically fall under the ‘Non-cash Employee Benefit’ according to IAS 19 and determine the recognition and measurement of the benefit.

Conclusion

If you are a startup in blockchain technology and need funds for your business you can make Initial Coin Offerings.

But as pointed out in this article, it is elementary that you navigate the legal and regulatory minefields to create a credible ICO and make it a success.