7 Things Every ICO Issuer Needs to Know About Compliance
Contrary to what someone may sell you on, launching an ICO is not easy. Nor should the decision to do so be taken lightly. There are a number of critical decisions that need to be made around legal, tax planning, business planning, marketing, tokenomics, network and community development, investor relations, and more. The devil is in the details, it is what sets apart the successful ICOs from the rest.
While this article should not be considered legal advice there are a number of critical factors any ICO entrepreneur, manager, or advisor should be aware of:
1. It’s not about you
Securities legislation doesn’t exist to make the life of an issuer difficult. Regulators have a duty to ensure market stability and, more importantly, investor protection.
What this means for ICO issuers, ICO advisors, and fintech entrepreneurs is that it does not matter if you launch your offering or product outside of the USA — what matters is whether a US citizen is able to own the asset. For an ICO, the responsibility is on the issuer, and their advisors, to ensure they do not open their token to US investors.
2. Compliance doesn’t stop at the initial crowdsale
Unfortunately, this is where most ICOs from 2017 will find themselves in trouble. While many offerings chose to either exclude US investors entirely or limit their offering to accredited investors in the US, they neglected to ensure the token would not be purchased by ineligible investors during secondary trading, whether peer-to-peer or through an exchange.
Once a single individual who is not eligible accesses the token, the validity of the entire offering is put at risk. While solving this problem for blockchain transactions is not easy, it is still entirely possible. The important part is to ensure it is done in a decentralized manner. One solution, the Prefacto compliance protocol from iComplyICO, injects governance and compliance logic directly into the token. This enables the token itself to monitor AML, KYC, and a myriad of other compliance with jurisdictionally specific considerations on every transaction. This unlocks a critical piece of the puzzle for decentralized financial systems to be implemented into global capital markets.
3. The reach of the SEC extends well beyond US borders
Issuing from Gibraltar, Grand Cayman, Singapore, Japan, etc. doesn’t matter when it comes to investor and consumer protection laws. What does matter is where the investor or consumer is. Certain members of the blockchain community, such as Munchee in Canada, learned this the hard way when the SEC sanctioned them during their offering for accepting US investors.
4. Utility or Security and the expectation of profit
Calling a token a utility isn’t only up to the issuer. Certain metrics of the Howey Test such as ‘the expectation of profit” are centered around the expectations of investor, not issuers. Some of the critical factors that could create an expectation of profit are: selling the token at a discount (i.e. in the presale), using a fungible token such as an ERC20 vs the non-fungible ERC721, and listing the token on an exchange for secondary trading.
5. The technology is evolving faster than the regulations
Recently, Tokenfundr received approval from their securities regulator to launch their ICO using the Securities Act exemption, Section 2.9 of National Instrument 45–106. This exemption is more commonly known as the Offering Memorandum. The regulator gave Tokenfundr the green light with a major limitation: no secondary trading.
To understand why this is the case, we need to consider the archaic and painstaking process that’s required for any trade to be executed on the stock market today: a whole series of checks and balances, from KYC and AML to shareholders’ agreements and corporate compliance procedures, must be completed before any trade can settle. The reason Tokenfundr was given the exemption with a restriction against secondary trading was because they need to figure out how to implement these checks and balances for secondary trades, either by centralizing their network or by implementing a secondary trading compliance protocol.
Many ICO projects have taken time and incurred considerable expense to complete ID verification, document authentication, AML, KYC, and the rest of logo soup to screen their investors during the token sale. They often don’t realize that once the token trades peer-to-peer or on an exchange, they must ensure that the new owner also meets their investor eligibility criteria. The onus is on the issuer, not the exchange or peer-to-peer protocol.
Previously, compliance for secondary trading of tokens was thought to be impossible with blockchain. New solutions are now enabling this to happen — some more effectively than others. Some frameworks, such as those proposed by Gibralter, Templum, or Polymath hope to accomplish this by centralizing certain critical aspects of the market. Others, such as T0, AMLT, and iComplyICO are tackling the problem within the ethos of decentralization. At iComplyICO, we offer a solution to decentralized secondary trading with a Prefacto compliance protocol that is currently available as a private whitelabel solution to token issuers on the Ethereum blockchain. You can sign up for a demo here: https://www.icomplyico.com/register/
6. Beware the ‘experts’
If you find yourself talking to an ICO advisor, lawyer, accountant, consultant, etc. who makes it sound like they know all the answers — run, do not pass go, do not collect $200.
This market is new: regulators are uncertain of what actions to take next, top securities lawyers are struggling with nuances of structuring a sound offering, and experienced accountants are just beginning to get clarification on FIFO vs LIFO (First In First Out vs Last In First Out).
Recently, I attended a presentation by a lawyer who self proclaimed themselves to be an ICO expert. Only days previous, I learnt this lawyer was actually wrapping up only their first ICO — a platform we work closely with. Two days prior to his presentation this lawyer downloaded our research whitepaper, Regulated Digital Assets — A Compliance Landscape, Solutions, and Opportunities. Imagine my surprise when his presentation included our case studies, tables, and even content structure without crediting his sources.
They say imitation is greatest form of flattery, so I suppose I owe him a thank you but two things really concerned me about the whole situation. First, that he used the content to pretend he had expertise he did not. Second, that the presentation ignored the risks to the issuer. In the words of one attendee, who has spent significant dollars on qualified legal advice, “This presentation is basically how to go to jail for violating securities law.” It was true.
The SEC has not only issued statements targeting ICO issuers and investors, they have been tremendously clear with lawyers, consultants, accountants and advisors as well. Many agents are taking funds from clients not because they have the expertise but because the market is hot and the money is good. This doesn’t protect you as the issuer — you are still liable. For the advisor however — especially in the case of some legal advisors — there is a significant upside if your broke client raises $50 Million and then needs a team of legal defence work. Think about it.
I’m not saying that all, or most, advisors are bad or have ill will. I am saying that you should do your homework, know what you are paying for, and don’t disregard someone who says, “I’m not sure but I can look into that for you.”
7. Mo money, mo problems
ICO litigation — namely, class action lawsuits, often appear to be all but forgotten in ICO discussions.. If you thought launching an ICO was worth good money, imagine what litigation fees would be in a class action suit.
In the USA, multiple law firms have filed class action lawsuits on behalf of investors for violations of the Securities Act including selling unregistered securities, fraud, false advertising, and more. One law firm has already filed against Tezos and is ‘investigating’ — which means they are looking to see if the case will generate enough revenue — several other ICOs including Kin, Bancor, Stox, Paragon, Cobinhood, and Centra.
While this list is far from exhaustive — and again, should not be construed as legal opinion or advice — it details some of the major hurdles facing ICOs today. While companies who issued ICOs in 2017 did not have decentralized compliance solutions available to them at the time, issuers in 2018 do.
Despite this, existing ICOs are still able to implement decentralized compliance protocols providing they can get their network on board — forking a network is no small feat. For new issuers, the future is getting brighter as the advent of ICOs issued in compliance with current securities regulations unlocks the door to institutional investment, larger raises, and mitigation of many of the risks facing their non-compliant counterparts.
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Matthew Unger is CEO of iComplyICO, an automated compliance protocol that enables issuers and their investors to both launch and trade tokens in compliance with securities, identity, and privacy regulations. ‘Prefacto’, ‘iComply’, and ‘iComplyICO’ are copyright and trademark of iComply Investor Services Inc.
