Token Sales and ICOs: why and when you need legal advice

Digital token sales are creating a gold rush on the web, with a token sale advertised every day in digital circles and social media and the movement – in some cases – of huge sums of money.

Token sales still move in international waters from a legal and regulatory point of view, however international regulators are increasingly paying attention to the issue and considering how to regulate certain specific risks associated with digital tokens, such as money laundering risks.

What is a token sale?

A digital token (“token”) is an intangible asset, cryptographically -secured (typically based on blockchain technology). It usually has a monetary value (based on a virtual currency exchange or cryptocurrency) and may entitle the token holder to certain rights (and potentially obligations and liabilities). Such rights and obligations may be set out in “normal” paper documents (such as an offering document or whitepaper) or may be included in a smart contract.

Tokens may be offered to raise funds for a project, in which case the token sale is labelled as “crowdfunding“, or may give access to permanent rights and obligations, or even shares (or less regulated “units”) of a company, in which case the offering may be labelled  “ICO (Initial Coin Offering)“.

Once purchased, the token may or may not be able to be traded or – sometimes with limitations – exchanged back for money.

As token sales gain momentum, aside from obvious financial considerations (extreme volatility) and common sense assessment (whoever trades on the web needs to be able to recognize bogus offers such as Ponzi schemes), participants also need to be aware of a number of legal issues that need to be considered when participating in a sale – including when they need to seek legal advice.

I set out below a few important points to be considered, keeping in mind that the legal and regulatory landscape regarding cryptocurrencies and token sales is rapidly evolving, and the practice is evolving as well.  Recent token sales for examples have restricted participation from certain jurisdictions which raise legal/regulatory issues, eg the US and Singapore.

Do your due diligence

What is the underlying project for which the token is sold? What value does it propose to bring, who are or would be its customers? Is it technically sound, has it been economically analysed, does it have a specific timeline and how is the issuer accountable for the timeline?

Is there an actual organisation behind the project? What kind of organisation is it – a company, fund, trust, a DAO? Who is the team behind  the project? Do the individuals have a track record of successful projects? Is it a dedicated team or a “borrowed” team? Is the project seeking its first funds or does it have some institutional “real-life” investors?

Is the project legal?  Is it based in a specific country (and is it legal in that country) or is it completely virtual? Even in case it is completely virtual, where do the key participants to the project reside?

Is the project legal in your country? Is your participation in the project subject to approval, registration or a license?

And finally, what does the token do? What kind of rights does the token gives access to? What kind of activities does it enable? Is it genuinely attached to a project or does it look like a Ponzi scheme?

Assess the documentation

The token sale will be described and offered through a document (whether an offer document, a white paper, or a descriptive section of the website). Representations and warranties will be asked of the buyer eg as to his/her capacity to participate to the sale.

Some information included in the documents needs to be assessed carefully, in particular:

• Whether and how you will be able to sell back the tokens
• The existence of a lock-up period and what parameters it is tied to
• Whether and how you will be able to trade the tokens to another investor (“secondary market”), always keeping in mind that this may attract other regulatory and legal issues
• The issuer’s policies about data protection
• The issuer’s cybersecurity policy
• Termination events, or what happens if the project is interrupted.

Note that the more reputable issuers conduct anti-money laundering (AML) and know your customer (KYC) checks. It is always a good sign when AML/KYC procedures are set out as it means that the issuer is concerned about regulation.

Be aware of applicable (and evolving) regulations

The legal and regulatory landscape regarding token sales is uncertain and currently evolving. A key concern up to now has been money laundering and terrorist financing risks when transactions are anonymous (less so when the issuer carries out know your client procedures, see above) and the large quantity of funds raised and moved internationally and in a short time.

Other regulations also apply. A number of regulations will apply to the issuer based on where the issuer’s organization is incorporated and certain regulations will apply in jurisdictions where the project is based or where the buyer is based, such as consumer protection and data protection laws.

Most jurisdictions do not (at this stage) regulate virtual currencies per se however a number of international securities authorities are studying how to regulate activities involving digital tokens which do not function exclusively as virtual currencies, such as when they represent ownership or a security interest in an issuer’s assets or property, or represent a debt owed by an issuer so that they may be considered a debenture under certain jurisdictions’ laws.

The Monetary Authority of Singapore (MAS) for example clarified just on 1 August that the offer or issue of digital tokens in Singapore will be regulated by MAS if the digital tokens constitute products regulated under the Securities and Futures Act (SFA).

A lack of compliance by the issuer with applicable regulations may be unsafe for the buyer as well as while liability for compliance may fall on the issuer, lack of compliance may have consequences at best on the value of the token and at worse on the legality of the project.

Token sale may be suspended if the sale should have been approved or registered, any token you have bought may become worthless. If the issuer is investigated, the project may be interrupted. The buyer may be subject to additional obligations that were not set out in the initial documents.

A final note about tax, as tax advice should be obtained when trading tokens as some jurisdictions have stringent capital controls that may apply to cryptocurrencies and tax may be attracted in respect of any capital gains arising from the tokens.

© Stefania Lucchetti 2017. For further information Contact the Author

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