The Legal Reality for ICO’s

Lessons learnt from Initial Coin Offerings

This article was originally published in the print editon of Fractal’s ‘Around the Block’ magazine in 2018. The free digital edition of the magazine is available here

Legal compliance with regulations has been a challenge from the outset of the cryptoeconomy. It took some hard lessons for the industry, in particular ICO contributions sealed in bank accounts because zero information on investors could be provided to the bank, until the community was prepared to accept that it could not develop sustainable business models without a basic understanding of regulations — and that it would hit a wall when money laundering is dealt with carelessly.

This was the birth of compliance in the token economy. Since then, ICO structures have changed considerably, and compliance has become a vital factor for a successful ICO. In many respects ICO are now taking the same route as conventional public offerings.

Here are the legal lessons learned from various ICOs:

1. Tax is more important than you think

Blockchain is about transferring values and tokens are about storing values (an obvious simplification). It was therefore only a matter of time before the tax authorities came up with the idea of demanding their share of the added value. For reasons of equal tax treatment, the token economy could not be a tax-exempt area. This concerns both turnover tax and income tax issues. With regard to the ICO incentives, which are typically granted to the participants including the ICO company itself in the form of tokens, each ICO must first be audited for tax purposes: When do which values emerge, and how is the added value to be assessed for tax purposes?

A missing or wrong assessment can cost the parties involved dearly. Especially if liquid funds are not available to pay any tax debts and the tokens themselves are also not yet liquid (because they are locked, not listed or cannot be sold for various reasons).

Many questions still can not be clarified quickly because the financial administration lacks the know-how or — in the case of fundamental questions — only lengthy coordination is necessary. Nevertheless, the analysis of tax risks is necessary.

2. Check on popular myths in choosing your forum

Cryptocurrencies are often regarded as ‘wildly speculative’. Regulators, however, have a differentiated view on the token economy. While warnings of the risks of ICO’s dominate the headlines, most regulators (and governments) are shy to take a too restrictive view on token regulations. The token economy challenges them to weigh the risks of strict regulation against the risks of poorly regulated crypto currencies. In fact, most countries want to be the place of business for blockchain companies.

However, while some countries are quicker and more aggressive to create favourable legal and, in particular, regulatory conditions for blockchain companies and ICOs, in many cases the supposed advantages turn out to be myths. At least in EU and European Economic Area countries, governments are bound by the EU legal framework which leaves little room for solo runs by individual countries. Advantages are mostly limited to tax, administrative procedures and, in some instances, a safe(r) regulatory environment. These have to be weighed against a number of disadvantages in small countries with, occasionally, a reputation for tax evasion and/or money laundering: Long journeys, high costs of professional advisors and the ongoing tax risk if it turns out that the main place of business is still in fact in another country.

So, before setting up shop in ‘allegedly favourable’ jurisdictions, ask if there is any real advantage.

3. Regulatory loopholes may prove to be temporary

The German financial supervisory authority regards tokens as a financial instrument. Whether this also applies to pure utility tokens is controversial. Payment and security tokens, however, will be regarded and treated as unit of accounts or securities. As financial instruments, tokens are included in the scope of the German Banking Act. In addition, numerous other laws regulating financial instruments, securities, investment funds and money laundering must also be examined.

The multiplicity and complexity of financial market regulation is tempting many ICO companies to look for loopholes, especially in countries where financial market regulation is not fully geared for token issues. Such perceived benefits are often only temporary. All governments we know are working to fill gaps in existing regulations. Any remaining benefits must therefore be exploited quickly and run the risk of being reversed. In the worst case, regulation “overtakes” an ICO and thwarts it.

Ultimately Token regulation will most likely be harmonized across Europe. The EU is competent in financial market regulation and is already either exploring or taking regulatory actions.

All major countries agree that blockchain regulation (at least in Europe) shall be harmonized. It is likely the views of the major countries will prevail. Not only, because regulation is also a power game, but because the larger EU members have bigger resources to deal with the complexities of blockchain.

So, be aware that any regulatory loophole may be temporary at best.

4. Local regulations only cover your business, but not your offering

A widespread misunderstanding amongst ICO companies is that rules of conduct are governed by the jurisdiction at the place of incorporation only. In fact, local laws can only regulate local matters, e.g. license requirements for ICO companies. An ICO is no local matter. Tokens are distributed across various jurisdictions. Each jurisdiction, even in Europe, applies its own rules. In one country, your token may be classified as security, while in another regarded as a utility or payment token. Targeting the right countries for your offering is paramount. Selling tokens to retail investors in the United States without SEC registration may land you in jail next time you’re there.

5. What to know about KYC/AML

KYC is a tricky issue for ICO companies. Firstly, identifying your investors is contrary to the conviction of blockchain evangelists that transparency is great but for the acting individuals. Secondly, KYC is key if your ICO wants to do a simple thing like opening a bank account. If banks are prepared to do that at all (which in a number of countries is difficult), they will ask you to provide information on your ICO investors. Are they allowed to do so? Even this is not entirely clear. Banks need to identify their customers and their beneficial owners. Token investors are not beneficial owners. However, there are many reasons why banks are not only entitled but obliged to identify Token investors. Discussions are futile anyway: If you don’t cooperate, you will not get an account or your token revenues transferred to your account.

KYC is also tricky because most ICO companies often don’t know what they are supposed to do.

As a matter of law, only ICO companies pursuing business listed in the AML regulations are “obliged entities” under KYC/AML laws. As a matter of fact, most ICO companies are not “obliged entities”. That means they don’t need to do KYC themselves. But they have to assist their bank (that is the “obliged entity”) to meet its KYC obligations. This means they have to provide all the information the bank needs to identify the ICO investors. They do not have to identify ICO investors themselves.

Collecting information from potentially hundreds or even thousands of investors is a challenge. Most ICO companies do not have and do not want to build the know-how and the infrastructure for such an enterprise. This is where specialized KYC service providers may help to know what information will be requested and what to do with it.

6. Retail investors are hard to catch

A disappointing truth has to be acknowledged in the ICO market: Although blockchain is such a great technology for serving retail investors, from a legal point of view they are hard to target. Financial regulations and general customer protection laws in Europe provide safeguards for retail investors that are difficult to overcome. Most prominent are prospectus obligations in the retail offerings of security tokens. ICO that still address retail investors and take their money run considerable risks. More often than not, retail investors are excluded from ICOs, not just US retail investors. It is an open secret that in spite of such exclusions many retail investors buy and receive tokens in ICOs. This is a grey area regulators have not been dealing with properly (so far). As they can only enforce laws in their own jurisdictions it’s harder to catch offerings from abroad. Yet, it’s only a question of time until regulators get organized and more efficient in dealing with ICOs only pretending to exclude retail investors.

7. Liability is not only for the CEO

Marketing is critical for the success of a ICO. Social media and your website play a big role. Preparing an ICO presents another considerable challenge to the communication skills of anICO company. Every piece of false information on an ICO generate a potential liability claim. Whitepapers must be precise, websites need to meet not only legal standards but must not contain misleading content about your ICO. Presentations need to be double checked. Make sure that your marketing team is fully prepped and informed about the ICO.

ICOs walk on uncharted grounds in many respects. The fog is slowly lifting and rules are getting ever clearer.

The biggest mistake is to close your eyes to legal and regulatory questions. Involve your tax consultants and lawyers early before it’s too late.