The ICO Phenomenon: Legal Perspectives on Crypto Crowdfunding

Crowdfunding 101

Entrepreneurs often require additional funding to bring their creative ideas to life. However, due to lack of sufficient capital, they turn towards crowdfunding. This is particularly common among individuals who are passionate about entrepreneurship but don’t have enough financial resources. To cater to such needs, lawmakers have legally recognized and regulated crowdfunding. Crowdfunding is a way to keep up with the rapidly developing technology and financial advancements by funding deserving ideas.

The main idea is that while entities or people with great or even small capital become a part of a very profitable project, entrepreneurs acquire the financial resources they desperately need. Furthermore, crowdfunding is a process where many people with low capital get together to raise great capital. Therefore, crowdfunding is a quite effective way to increase people’s participation in the financial system, even with an insignificant amount of capital.

Initial Coin Offering(s) (“ICO”) is the term used for the process of introducing crypto assets to the public or participants. These assets can be offered in different stages, including during the project phase, development, or after completion. Once launched, these assets can be bought, sold, and stored on crypto asset transaction platforms.

ICOs represent a significant evolution in crowdfunding, marrying technology with finance and offering an alternative to traditional financial systems.

The popularity of ICOs can be attributed to several factors. These include the convenience, reliability, and cost-effectiveness of using technology to generate, store, transfer, or invest in digital currencies or assets. Additionally, the economic crises and lack of trust in institutions have driven people to seek solutions through technology. ICOs are evolving into a more convenient, faster, and cost-effective crowdfunding tool than traditional financial services.

Crowdfunding activities can be classified under four main categories: based on rewards, donations, equity, and debt. In each crowdfunding activity, the relationship and structure between the parties change.

Types of Crowdfunding

Crowdfunding can be conducted through various procedures and methods, and it is divided into different classes based on what they promise in return for the funds provided by investors. It can be examined under four classes: donation, reward, lending, and equity models. In the first two types of crowdfunding, there is no partnership or debt relationship between the people providing the funds and those being funded. In crowdfunding activities, providing shares or debt instruments to the funders is not mandatory, and sometimes, these crowdfunding activities may also be related to social responsibility projects.

Donation and Reward-Based Crowdfunding

In donation-based crowdfunding, the fund providers receive nothing in return and donate to the project. In reward-based crowdfunding, investors are given a reward in return, which may have financial value or not and can be material or sentimental. In both types of crowdfunding, there is no establishment of a partnership or creditor relationship between the parties.

Debt and Equity-Based Crowdfunding

Fund providers act as investors in debt or equity-based crowdfunding and are generally interested in financial gain. They become either partners in or creditors to, the venture companies or funded projects in exchange for the capital they provide.

In debt-based crowdfunding, the funds collected from investors are considered a debt. This debt is repaid by the funded entrepreneurs to the investors, along with predetermined interest, upon maturity. Investors in this type of crowdfunding act somewhat like creditors, aiming to make a profit by getting back the funds they provided along with interest. It is quite similar to government bonds.

Considering the debt relationship between the investor and the funded company/project, and that the fundamental aspect of this relationship is the investor’s aim to make a profit, it can be said that the bond between the investors and the funded company/project is weaker compared to equity-based crowdfunding.

In equity-based crowdfunding, instead of seeking debt capital for the funded company/project, partners are sought for the company. In this type of crowdfunding, the capital provider becomes a partner of the company. Investors who provide funds and become partners of the company through equity-based crowdfunding can earn a share of the profits from the partnership according to the terms of the agreement between the parties.

Parties Involved in Crowdfunding Activities

Crowdfunding activities, regardless of their type, almost always exhibit a three-pronged structure. Firstly, entrepreneurs who lack sufficient capital for their ideas enter a search for funding to realize these ideas and projects. These entrepreneurs in need of funds form the first leg of the crowdfunding activity.

These entrepreneurs, seeking funds for their ideas and projects, generally apply to a crowdfunding platform instead of raising the funds themselves. Through these crowdfunding platforms, investors who want to use their capital to finance ideas and projects lacking sufficient financial resources become aware of these ideas and projects, providing financial support through the platforms. Crowdfunding platforms emerge as a kind of intermediary agency in this activity.

The final and arguably most important leg of crowdfunding is formed by investors who want to finance the entrepreneurs’ ideas and projects. These investors, who bring the crucial element of funding, may become partners in the funded company, creditors to the company, or sometimes act merely as donors and supporters without any financial motive. The position of the investors varies depending on the type of crowdfunding activity, as detailed above. In equity-based crowdfunding, investors become partners in the funded company, while in debt-based crowdfunding, they become creditors to the company. Additionally, in cases often involving social responsibility projects, investors may finance projects without seeking any financial gain.

To summarize the parties involved in crowdfunding activities, there is an idea or project in need of funding, platforms that facilitate the funding of these projects by investors or supporters/donors, and through these platforms, investors or supporters/donors who want to provide funds to these financially needy projects for financial motives and/or other reasons. The legal relationships between the crowdfunding platforms facilitating the funding, the individuals seeking funds for their projects through these platforms, and the fund providers should be carefully noted as they are subject to general legal provisions.

Crowdfunding in Türkiye

In Türkiye, crowdfunding is mainly governed by the strict rules set forth by capital markets law provisions. Crowdfunding can only be done through intermediaries who are duly licensed by the Capital Markets Board of Türkiye. Licensing procedures regarding these intermediaries, also known as crowdfunding platforms, are quite challenging and demanding. Crowdfunding platforms must register with the Capital Markets Board and subsequently form investment boards.

Furthermore, strict capital markets law provisions necessitate additional requirements for the establishment of such crowdfunding platforms, such as minimum capital, who can be a shareholder, qualifications of shareholders, minimum educational or professional experience for members of the board of managers and investment, etc.

It is strictly forbidden and subject to serious legal and criminal penalties to conduct unauthorized crowdfunding. The act of conducting crowdfunding without necessary authorisation from Capital Markets Board in fact regarded as unauthorized/licensed capital markets activities. The penalty for such action ranges from 2 to 5 years in prison in addition to serious monetary fines.

Moreover, it is worthwhile to note that the fact that the crowdfunding activity takes place outside of Türkiye does not necessarily mean that provision of Türkiye is not applicable. According to the Article 13 of Crowdfunding Communique issued by Capital Markets Board, if a crowdfunding activity is promoted, advertised or enabled for Turkish citizens or legal entities, then, the crowdfunding itself and persons who manage such crowdfunding in fact may be held responsible to comply with Turkish law in this matter. Therefore, it is crucial for managers of a crowdfunding company to be very careful about how to advertise and promote their activities.

Introduction to ICOs

For the sake of fluidity in the narrative of this paper, tokens and coins are commonly used interchangeably, rendering almost no substantial effect to the meaning of the text, unless it is explicitly stated.

New ways of raising funds have emerged recently with the use of blockchain technology. One such method is an ICO, where blockchain-based tokens or coins are sold in exchange for crypto assets or traditional money. These tokens can serve different purposes, such as accessing a product or service, representing assets, or representing ownership in a project. Additionally, many buyers of these tokens are interested in profiting from selling them on a secondary market.

The first token sale took place in July 2013 by Mastercoin, marking the beginning of what would become a multi-billion dollar phenomenon.

The first token sale took place in July 2013 by Mastercoin, followed by Ethereum and a few others in 2014. The popularity of ICOs grew with TheDAO’s token sale in May 2016, which raised around $150 million. However, it was in 2017 that significant amounts of money were raised through ICOs. By the end of 2018, ICOs had collectively raised approximately $24 billion through over 5,000 token sales. Despite regulatory challenges, the number and size of these offerings continued to increase until March 2018, when around $1.8 billion was raised in that month alone.

In the face of economic crises, ICOs have evolved into a more convenient, faster, and cost-effective crowdfunding tool compared to traditional financial services.

Definition of ICOs, Benefits and Risks

ICOs are a way for businesses to raise capital by exchanging fiat or virtual currency for digital assets called tokens or coins. These tokens allow investors to access the business, participate in its returns, and potentially sell the tokens for a profit on the secondary market. For example, an amusement park may sell tokens to investors in order to fund its construction, and those tokens can then be used to access the park or traded for profit.

Businesses create tokens and sell them to investors after registering them on the blockchain. Unlike traditional banking systems, where money is sent to a central server, the blockchain is a decentralized ledger that records transactions across a network of computers. This allows for the transfer of crypto assets between digital wallets, providing a new method for issuing and trading these assets.

The record, known as the blockchain, enables anyone on the network to confirm and monitor the movement of assets across different networks. When a computer joins the network, it receives a copy of the blockchain, which includes records of all past transactions. Each connected computer is referred to as a node. Once a transaction is made public, it cannot be altered.

The popularity of ICOs grew with TheDAO’s token sale in May 2016, which raised around $150 million, showcasing the massive potential of this new form of crowdfunding.

Benefits

The significant increase in ICOs can be attributed to the advantages they offer to both investors and issuers. One major appeal for investors is the potential for significant returns. ICOs allow for investment in the early stages of a project without a minimum investment requirement, making it possible for everyday investors to invest small amounts and earn large profits.

Unlike traditional investment avenues that are only available to a select few, ICOs are accessible to the average person. Typically, an average investor would have to pay a premium at an initial public offering (“IPO”) , after the venture capitalists have already absorbed most of the company’s/project’s true value. However, with ICOs, all information about the company is generally available to the general public, giving every investor, regardless of their size, equal access to investment opportunities from the very beginning.

ICOs offer various advantages for companies, including the ability for founders to keep all the money raised, unlike venture capitalism. Additionally, ICO issuers are not burdened with expensive paperwork, allowing a wider range of companies to participate. ICOs are generally not subject to government control, commissions, or taxes. Moreover, ICOs provide opportunities for funding projects that may not appeal to venture capitalists.

Moreover, due to the global and border denying nature of the blockchain, investors from all around the world may in fact join these crowdfunding activities through blockchain and crypto assets. Furthermore, the secure record keeping nature of blockchain provides a more trustworthy environment for the investors in terms of auditing and following the transactions regarding the funded project.

Last but not least, ICOs provide comparably more easy infrastructure when it comes to crowdfunding. In many jurisdictions, crowdfunding is strictly regulated. In order to crowdfund a project, authorisation of many governmental bodies is required. Furthermore, many jurisdictions foresee an intermediary which collects the funds and then transfers it to funded projects. Blockchain technology and crypto assets make intermediaries unnecessary and make global crowdfunding easy, accessible and safe. Any individual across the world with an internet connection may smoothly access crowdfunding through crypto assets.

Risks

Although this technology has the potential to revolutionize fundraising, it currently has many significant flaws. There are numerous stories of people gaining unexpected wealth through crypto asset investments, which scammers and promoters of risky investments take advantage of. These predators attract investors by offering high returns and the chance to be part of this innovative field.

Market manipulation, specifically through a ‘pump and dump’ scheme, is a frequently employed tactic by fraudsters. They deceive investors by spreading false information through different channels to artificially increase the value of an investment. Once the value rises, the fraudsters sell their portion of the investment, making a profit. They then cease promoting the investment, causing its value to decline and resulting in financial losses for investors.

In addition, if someone who invests in tokens is scammed or has their funds stolen, it is challenging to recover the money. The decentralized nature of ICOs makes it hard for law enforcement to pursue the perpetrators and track the movement of funds.

When exchanges happen overseas or are operated unlawfully without the investors’ knowledge, the risk becomes even greater. For example, foreign issuers can sell tokens in the United States, allowing them to receive funds outside the control of US regulators. This makes it difficult for the SEC to address any misconduct by the issuer. Even if the asset is found, law enforcement may struggle to freeze or secure the virtual asset due to encryption of virtual wallets. Due to many unfortunate events arising out or in connection to ICO, many jurisdictions started to closely examine and even try to regulate these ICOs.

Moreover, ICOs themselves may in fact pose various legal risks. Many jurisdictions tend to regulate some of the ICOs in terms of capital markets law. For instance, the Securities and Exchange Commission of the United States closely examines ICOs and generally applies the Howey Test to determine whether the offered crypto asset is a security or not. If the offered crypto asset is deemed to be a security, then, the ICO itself is subject to capital markets law of the United States which requires prior strict approval and authorisation processes. Conducting an ICO without prior approval and authorisation of SEC may in fact be considered as unauthorized securities offering which raise the risk of both criminal and legal liability.

Legal Status of ICOs

In terms of regulation, traditional crowdfunding is subject to various regulations that depend on the platform and jurisdiction, while ICOs are seeing an emergence of regulatory frameworks

The analysis of the legal status of ICOs can differ based on the specific type, characteristics, and purpose of the crypto asset being examined. When evaluating the purpose of an ICO, the initial factor to consider is the type of crypto asset being provided. The main emphasis should be on legal qualification of the offered crypto asset. Additionally, the significance of the White Paper, which outlines the ICO’s purpose, along with the characteristics and potential applications of the crypto asset being offered, cannot be underestimated.

Another important feature of an ICO is its online nature, where crypto assets are transferred to virtual wallets without any physical ties to a specific location or country. This quality underscores the global reach of ICOs, allowing it to take place anywhere in the world. As a result, individuals from any part of the globe can partake in any ICO. This introduces an element of unfamiliarity to legal relationships, which may lead to conflicts of laws and significant difficulties in resolving disputes in ICOs involving parties from diverse jurisdictions.

The characteristics of the crypto asset provided, along with the statements and explanations found in the White Paper regarding its integration, functions, and use cases, can sometimes result in the ICO being classified as Initial Coin Offering (ICO), Initial Exchange Offering (IEO), Security Token Offering (STO), Equity Token Offering (ETO), or occasionally as Fan Token Offering. As a result, it is important to internally analyze and classify the features of the relevant crypto asset, particularly in regards to its initial offering, before assigning a legal characterization.

The tokens provided to participants in each ICO can possess various characteristics. The legal regime and principles governing the ICO may differ based on the type and extent of rights and powers granted by the token. Matters such as whether participants are categorized as consumers or investors, the application order and extent of legal rules, and the authority of institutions in terms of regulation and enforcement may become topics of discussion.

Comparison with Traditional Crowdfunding Methods

Unlike traditional investment avenues that are only available to a select few, ICOs are accessible to the average person, democratizing investment opportunities

Traditional crowdfunding has distinctive characteristics when compared to ICOs or crowdfunding activities performed by crypto asset service providers. However, both are usually commenced for similar reasons. Crowdfunding is used by entrepreneurs that may lack sufficient funds and capital for their projects.

As aforementioned, there are four main forms or types of crowdfunding that can be utilized; reward-based crowdfunding, equity-based crowdfunding, debt-based crowdfunding and donation-based crowdfunding. ICOs mainly occur as a combination of crowdfunding or equity-based crowdfunding with digital/crypto assets.

In traditional forms of crowdfunding, funders contribute their funds in exchange for products, services or rewards, typically without receiving equity or ownership within the project or company in return for the funding. In comparison, an ICO will usually have funders receive crypto assets, representing a stake or gain access to more services or potential profits, in exchange for their contribution. In terms of regulation, traditional crowdfunding is subject to various regulations that depend on the platform and jurisdiction the crowdfunding project is subject to. On the other hand, ICOs are seeing an emergence of regulatory frameworks. However, in both traditional and new forms of crowdfunding, there is a focus on protecting backers and an insurance of transparency in activity.

Traditional crowdfunding appeals to a much broader audience of consumers and individuals, while ICO crowdfunding attracts a more specialized audience, usually with an interest in blockchain technology. Another difference is that often, traditional crowdfunding is utilized for creative projects or inventions and small businesses. ICOs however have been primarily associated with blockchain-based projects and crypto asset service providers’ projects.

Typically, funds can be accessed directly in the form of currency or fiat money and are managed by the platform conducting the crowdfunding. For ICOs, the funds are raised in the form of crypto assets. This distinction is where ICOs or non-traditional forms of crowdfunding brought by the utilization of crypto assets grants funders to participate globally, without being bound to currency conversion.

Yet, a factor that shall be considered is that crypto assets have a volatility that fiat currencies do not. The value of the crypto assets issued in an ICO can be extremely volatile. In contrast to traditional crowdfunding, the value of these assets is frequently determined by speculative market feelings surrounding the blockchain project rather than by real assets or a tested business plan.

ICOs frequently function in a murky regulatory environment. Significant risk is increased by unclear regulations or the possibility of future regulatory crackdowns. Investors can encounter legal issues or the chance of the ICO being closed down by regulators. On the other hand, since traditional crowdfunding is generally strictly regulated by governmental authorities, legal risks are comparably more foreseeable.

Last but not least with comparison to traditional crowdfunding, ICOs present some serious technical risks. Participants of an ICO must be aware of technical requirements such as wallets, smart contracts and blockchain technology.

Furthermore, ICO itself may in fact constitute serious technical liabilities. For example, a technical error in the smart contract of a very famous ICO also known as the DAO resulted in unlawful gain for some ill-intended persons.

The DAO’s smart contract code had a weakness that the hacker(s) took advantage of. More specifically, the reentrancy attack was made possible by a recursive call fault in the code. Because of the attack’s recursive nature, the hacker was able to continuously withdraw Ether from the DAO and deposit it into a duplicate DAO with the identical structure — before the original DAO’s balance was updated. This procedure was carried out repeatedly in order to deplete the DAO’s Ether reserves. The hacker was able to divert over 3.6 million Ether, which was valued at around $50 million at the time.

Legal Frameworks Governing Crowdfunding and ICOs

The decentralized nature of ICOs makes it hard for law enforcement to pursue the perpetrators and track the movement of funds.

The unique risks associated with crowdfunding and its role as an alternative to traditional banking and finance raise important considerations for lawmakers when creating regulations.

Several countries are exploring different ways to regulate crowdfunding. Two main approaches have emerged: regulating through laws or other normative acts, and regulating based on basic principles. There are also different approaches to regulating financial crowdfunding and social crowdfunding. Some countries advocate for special regulation for financial crowdfunding, while others prefer traditional regulation. Also some jurisdictions tend to include ICO into established capital markets laws and mainly crowdfunding provisions.

Investment restrictions on casual investors are widely used, such as setting limits on investment amounts for specific projects or periods. Some countries exclude crowdfunding platforms from the regulations that govern professional stock market participants and banks. There are also requirements for disclosing information about the risks of companies raising funds through crowdfunding platforms. Additionally, there is a licensing process for crowdfunding platforms that attract funds on a repayable basis.

Prominent Jurisdictions to Consider

United States

The US was the first country to establish regulations for crowdfunding with the adoption of the JOBS Act in 2012. This act aimed to make it easier and cheaper for new and small companies to attract capital. Title III of the act sets rules for stock issuance, investors, and platforms. In 2015, the US SEC implemented rules for Title III, including criteria for exemption from registration requirements and allowable investment amounts. Platforms were also given certain requirements, such as not providing investment advice to users.

The United States has taken a more regulated and scrutinized approach to initial coin offerings, or ICOs. Because initial coin offerings (ICOs) are frequently viewed by investors as unregulated transactions, the U.S. Securities and Exchange Commission (SEC) has become more involved in looking into and enforcing regulations surrounding them.

The SEC has made it clear that initial coin offerings (ICOs) may be deemed securities offerings and thus be subject to federal securities laws based on their particular characteristics. Thus, a large number of initial coin offerings (ICOs) will probably have to register with the SEC or be eligible for an exemption from registration. The SEC highlights that a token does not automatically become less of a security just because it is structured to have some utility or is branded as a “utility” token.

On the other hand, the Commodities Futures Trading Commission (CFTC) has expanded the scope of its regulatory authority to possibly encompass some Initial Coin Offerings (ICOs). ICOs are seen by the CFTC as falling under its purview, particularly when they involve utility tokens that are not securities. This position is a result of the CFTC’s extensive enforcement jurisdiction over commodity transactions, which encompasses “virtual currencies.”

When implementing federal commodities laws and regulations, the CFTC and the SEC take a similar approach to initial coin offerings (ICOs), concentrating on the intent and nature of the activity. Although ICOs that fall under the CFTC’s purview are closely monitored, the commission has not said that ICOs are inherently bad or that enforcement action will inevitably follow. ICOs that are legally compliant, have the right structure, and have made the necessary disclosures can move forward. The CFTC focuses on issues such as virtual currency fraud and manipulation, even in cash-market exchanges and transactions that don’t involve financing, margin, or leverage.

SEC’s Regulatory Approach

The SEC has pointed out the unique risks associated with investing in crypto assets. Unlike traditional securities and bank accounts, crypto asset investments are not insured, leaving investors vulnerable to potential losses from fraud, technical issues, or hacking. Additionally, the crypto asset market is relatively new and lacks a proven track record of credibility. The market also experiences extreme volatility, with investments able to rapidly increase or decrease in value. Overall, investing in crypto assets is considered to be a high-risk endeavor.

On the SECs official website a list of things to know about ICOs and information for investors is presented. ICOs can be securities offerings based on specific facts and may fall under the SEC’s jurisdiction of enforcing federal securities laws. Hence, they may need to be registered with the SEC. Also, tokens sold in ICOs can be called many things; the SEC here states that ICOs, or more specifically tokens can be called a variety of names, but merely calling a token a “utility” token or structuring it to provide some utility does not prevent the token from being a security. It is further stated that ICOs may pose substantial risks as many may be frauds.

The SEC v. Telegram Group Inc. and TON Issuer Inc.

On October 11th of 2019, the SEC announced its filing of an emergency action and its obtaining of a temporary restraining order against two offshore entities that were claimed to be conducting unregistered, ongoing digital token offering in the U.S. and overseas. These offerings had raised more than 1.7 billion dollars in investor funds. The SEC filed, stating that Telegram Group Inc. and its wholly owned subsidiary TON Issuer Inc. started raising capital in January of 2018 to finance company business as well as develop their own blockchain called the “Telegram Open Network” or “TON Blockchain”.

Important accusations and revelations from the SEC’s Telegram case consist of:

Unregistered Offering and Sale of Securities: According to the SEC, Telegram violated federal securities laws by selling Grams through an unregistered offering of securities. They contend that because investors purchased Grams expecting to profit from Telegram’s efforts to develop the TON Blockchain and raise Gram’s value, Grams are securities.

Absence of Required Disclosures: Telegram failed to give investors the information that is normally required in securities offerings, which left them without the knowledge they needed to make wise investment choices.

Telegram’s Marketing Initiatives: The Securities and Exchange Commission (SEC) notes that Telegram actively marketed Grams as an investment, highlighting the anticipated rise in their value and the possibility of financial gain.

Integration of Grams with Telegram’s User Base: As part of its strategy, Telegram positioned its messaging platform as the main factor driving Grams’ uptake and value, taking advantage of its sizable user base to boost demand for Grams.

Expectation of Profits from Telegram’s Efforts: Telegram’s development efforts, as well as the company’s successful launch and integration of the TON Blockchain, were key factors influencing investors’ expectations of profits.

Absence of a Functional Ecosystem for Grams: At the time of the offering, Grams could not be used for any goods or services, meaning that their value was speculative and contingent on Telegram’s future developments.

Plans for Quick Distribution and Market Development: In order to establish a liquid market for the tokens, Telegram intended to quickly distribute Grams to a large user base.

The SEC pleaded for the following relief:

• Telegram faces long-term injunctions for breaking securities regulations.

• orders to repay all unjustified profits, including interest earned prior to judgment.

• Penalties for civil money.

• prohibitions against taking part in offerings of digital asset securities in the future.

Regarding their unregistered offering of “Grams” digital tokens, Telegram Group Inc. and TON Issuer Inc. reached a settlement with the SEC in June 2020. Telegram consented to pay a $18.5 million civil fine in addition to returning more than $1.2 billion to investors. Prior to this, the court had granted Telegram a preliminary injunction, reiterating the SEC’s argument that the Grams offering was not registered in accordance with federal securities laws. In addition to requiring Telegram to notify the SEC prior to any future digital asset offerings, the settlement also includes an injunction.

The DAO Incident and SEC’s Report

The DAO case involved an unincorporated organization that used blockchain technology to operate as a “decentralized autonomous organization.” It raised funds through an Initial Coin Offering (ICO) by issuing DAO Tokens in exchange for Ethereum. However, The DAO was hacked, leading to a significant loss of Ethereum. The SEC investigated and concluded that DAO Tokens were securities, thus subject to federal securities laws. This case set a precedent for the application of securities laws to ICOs and similar digital asset transactions.

The SEC report provides a detailed analysis of The DAO’s Initial Coin Offering (ICO). It underscores that ICOs, where digital tokens are offered in exchange for assets like crypto assets, are often subject to federal securities laws. This classification depends on the economic realities underlying the transaction, including factors like the expectation of profits and the role of a third party in driving those profits. The report is critical for understanding the regulatory landscape for ICOs, highlighting the importance of compliance with securities laws to ensure investor protection and fair market practices.

SEC v. Kik Interactive Inc.

In the lawsuit against Kik Interactive Inc., the SEC claims that Kik violated Sections 5(a) and © of the Securities Act in 2017 by selling Kin tokens through an unregistered offering of securities. From mid-July to September 2017, Kik sold Kin tokens to both wealthy investors and the general public, raising about $100 million.

The SEC’s main accusations are as follows:

• Federal securities laws required Kik to register the offering and give investors the required disclosures before selling Kin tokens.

• Kik was able to raise roughly $50.5 million from the general public in addition to $49.5 million from sales to wealthy investors.

• Kik made no distinction between money received from different investors or via different channels.

• Kik emphasized its own role in guaranteeing the success and raising the value of Kin when presenting the Kin tokens as an investment opportunity.

• Kik didn’t take any action to find out if investors were purchasing Kin to invest in them or to resell and distribute them right away.

The following final ruling is sought by the SEC:

• an injunction prohibiting Kik Interactive Inc. from breaking securities laws for all time.

• All profits or unjust enrichment obtained from the activities must be disgorged, along with any prejudiced interest.

• payment of civil fines in accordance with Securities Act Section 20(d).

This case underscores the significance of disclosures and registration in initial coin offerings (ICOs) and underscores the SEC’s focus on ensuring compliance with securities laws in digital asset offerings.

The SEC obtained a final judgment against the company in October 2020. The court determined that Kik had failed to register its token sales, which were considered sales of securities. As a result, Kik was ordered to notify the SEC prior to any future transactions involving digital assets and was permanently barred from breaking the Securities Act’s registration requirements. Kik was also mandated to pay a $5 million fine.

European Union and MiCA

The European Union (EU) began to regulate crowdfunding around 2015–2016. By May 2016, seven out of 28 EU Member states had implemented national laws regarding equity-based crowdfunding. However, charity crowdfunding remained under existing legislation, with some specific provisions. G. Gabison analyzed the regulations introduced by European states and identified various requirements such as platform licensing, limitations on funds raised, investment restrictions for non-qualified investors, and requirements for attracting funds from professional investors. Most EU Member states did not require registration for crowdfunding platforms that solely operated for charitable or repayment purposes, as long as they did not provide payment services.

The European Commission and European Parliament are consistently interested in crowdfunding and believe it is important to have ongoing communication with member states, regulatory authorities, and individuals involved in the crowdfunding industry. In March 2018, the European Commission proposed regulations for crowdfunding service providers as part of their FinTech Action Plan. These regulations would allow platforms to apply for an EU passport based on a standardized set of rules, making it easier for them to offer services throughout the European Union. The Commission’s regulations only apply to crowdfunding services that involve financial repayment to investors.

The EU Council has released a compromise proposal for the regulation of crowdfunding platforms in the EU. This follows the European Parliament’s position on the project, which aimed to increase investor protection. The proposal focuses on assisting cross-border crowdfunding platforms, implementing adaptive rules for different types of financing, and establishing uniform authorization and supervision rules for national authorities.

ESMA released a report on July 12, 2019 regarding the licensing regulations for FinTech companies in the EU. The report identified that issues arise when the activities of FinTech companies fall outside of current rules, such as those involving crypto asset, blockchain, and ICOs. ESMA stated that certain tokens are considered financial instruments and should be regulated. It is important to note that crowdfunding instruments are not classified as ‘financial instruments’ according to the MiFID II.

Some countries have implemented laws to define and regulate different types of crowdfunding. For example, Finland has the Crowdfunding Act, which defines loan crowdfunding and investment crowdfunding. In Lithuania, the Law of Crowdfunding regulates the terms and requirements for crowdfunding platforms. Australia has introduced a special regulation for public capital funding called Crowd-Sourced Funding (CSF). These laws do not apply to charity or donations, as they are covered by separate legislation.

In the EU, there is no unified regulatory framework for ICOs yet. Instead, each member state applied existing financial regulations to ICOs on a case-by-case basis.

The European Securities and Markets Authority (ESMA) has issued warnings to investors and companies about the potential risks involved in Initial Coin Offerings (ICOs). They stressed the importance of adhering to the current securities laws in the European Union.

Several EU member states have implemented regulations and guidelines for ICOs. Malta and Switzerland have positioned themselves as blockchain-friendly countries and have established regulatory frameworks for digital assets, including ICOs.

AML and CFT regulations were enforced on ICOs to prevent illegal activities, often necessitating the implementation of KYC procedures by issuers. In certain situations, Initial Coin Offerings (ICOs) may be required to comply with the prospectus regulation, which mandates issuers to release a prospectus unless they qualify for an exemption.

Token classification varies depending on the jurisdiction, with some tokens being classified as securities and others as utility tokens. The EBA and ECB have both stated the importance of having a unified regulatory approach for crypto assets due to their international nature.

Markets in Crypto-Assets Regulation

A thorough regulatory framework for crypto assets, including those sold through initial coin offerings (ICOs), is known as “Markets in Crypto-Assets Regulation” (MiCA). It attempts to provide investors and issuers with clarity and legal certainty by standardizing the regulation of crypto assets throughout the European Union.

MiCA outlines the rules for the issuance and trading of different kinds of crypto-assets. This covers tokens with particular regulatory requirements, such as utility tokens, asset-referenced tokens, and e-money tokens.

The framework sets tight guidelines for organizations that use initial coin offerings (ICOs) to issue crypto assets. This includes having to release a white paper that outlines the project’s objectives, finances, risks, and token holders’ rights and responsibilities. The white paper must contain accurate, lucid, and non-misleading information and be approved by the appropriate authorities.

MiCA prioritizes investor protection by putting a strong emphasis on issuers’ integrity, equity, and professionalism. It requires the creation of complaint handling protocols, the management of conflicts of interest, and clear communication.

The main goals of the regulation are to protect ICOs’ transparency and integrity of the market. Issuers are required to give comprehensive details about their financial status, governance, and token technical specifications. To keep the confidence of the market, regular reporting and auditing are also necessary.

Issuers must uphold strong governance, risk control, and sufficient capital to cover any losses in order to maintain operational resilience. This guarantees their operations’ dependability and continuity.

MiCA requires issuers and service providers to perform due diligence on their customers and report suspicious activities in line with current AML and CTF regulations. Furthermore, the rule gives issuers and service providers passporting rights, facilitating cross-border operations within the EU. This unites the markets in all EU member states for crypto-assets.

MiCA makes sure that issuers follow the rules by outlining the consequences for non-compliance. Administrative sanctions and fines are included in this. In addition to market regulation, MiCA seeks to foster competition and innovation in the EU’s crypto asset market. It offers both new and established businesses a controlled and secure environment in which to develop new financial services and products.

In conclusion, MiCA is a big step toward the European Union’s standardization of regulation for initial coin offerings (ICOs) and digital assets. It creates a thorough legal framework for the issuance and administration of crypto-assets while striking a balance between the demands of investor protection, market integrity, and innovation support.

China

In September 2017, the People’s Bank of China (PBOC) and several other Chinese regulatory bodies issued an outright ban on Initial Coin Offerings (ICOs). Given China’s role as a major market for digital assets, this ban was a significant development in the global crypto asset landscape. The following are the key aspects of this ban:

Comprehensive Prohibition of Initial Coin Offerings (ICOs): The esteemed People’s Bank of China has pronounced the categorical illegality of all forms of ICOs. It has unequivocally asserted that ICOs function as unsanctioned means of soliciting funds, posing threats of financial deceit, unlawful issuance of securities, illicit fundraising practices, financial dupery, or even schemes of an exploitative nature.

Ceasing of ICO Platforms: Moreover, in compliance with the prohibition, it became imperative to terminate any and all platforms associated with ICO fundraising. This encompassed platforms facilitating seamless exchanges between conventional currencies and digital assets.

Refund Obligations: In order to safeguard the financial well-being of investors and effectively address potential risks, it was imperative for organizations and individuals who had previously undertaken Initial Coin Offerings (ICOs) to honor their commitment of refunding investors.

Reasoning for the Prohibition: The PBOC has invoked the imperative of safeguarding the equilibrium of the financial market and the well-being of investors. Furthermore, apprehensions have been expressed regarding the possibility of ICOs being exploited for illicit purposes, such as the facilitation of money laundering and perpetration of fraudulent activities.

The prohibition swiftly and considerably influenced the worldwide crypto asset markets, resulting in a substantial decline in the values of prominent digital currencies.

The ban on ICOs in China aligns with a wider framework of robust regulation surrounding cryptocurrencies and their associated activities. The Chinese government has adopted a prudent approach towards digital currencies, prioritizing financial stability and acknowledging the impact they may have on conventional financial regulatory systems.

Singapore

In Singapore, business owners who cannot secure funding from traditional sources like banks may turn to crowdfunding platforms. This involves issuing shares or debt instruments to potential funders in exchange for their investments. This can also include peer-to-peer lending.

Equity-based and debt-based arrangements can be considered securities-based arrangements because they involve the issuance of securities to funders. The definition of securities includes shares, units in a business trust, debentures, and other prescribed products. However, it does not include collective investment scheme units, bills of exchange, certificates of deposit, or other prescribed products. Equity-based arrangements typically fall under the definition of securities in limb (1), while debt-based arrangements typically fall under limb (2). Previously, promissory notes were excluded from the definition of securities, but this led to issuers classifying their debt as promissory notes to avoid securities laws issues. The Monetary Authority of Singapore (MAS) has stated that promissory notes should be subject to regulation to provide investors with the same protections as other debentures. As a result, MAS has amended the Securities and Futures Act (SFA) to remove the exclusion for promissory notes.

Despite some challenges with certain exemptions that platform operators may rely on, the growth of the alternative finance market is largely due to increased regulatory certainty and confidence. Unlike traditional debt and equity markets, crowdfunding investors have not had clear regulations and enforceable accountability until recently. The MAS has also shown a willingness to ease certain requirements for securities-based arrangements. If crowdfunding platform operators adhere to the regulatory parameters set by the MAS, there is potential for further growth and development of the alternative finance market in Singapore.

For instance, MAS stated on June 28, 2019, that it plans to grant up to two licenses for digital full banks and three licenses for digital wholesale banks. These new digital banks would be separate from any digital banks already established by Singapore banking groups under MAS’ current internet banking framework.

Importance of Qualification of Offered Crypto Asset

For more detailed information, please see our paper on Crypto Conundrum: Navigating the Maze of Assets & Regulations Across Borders

There are three primary digital tokens in the crypto asset family:

• Currency tokens, such as Bitcoin, are digital forms of money that can be used to make purchases similar to how physical money is used. These tokens are created by blockchain platforms, like Bitcoin, and are meant to represent money for commercial transactions between the purchaser and any party willing to accept the platform’s currency. Unlike security tokens, currency tokens do not have a value tied to physical assets, but rather their value is determined by the platform that issued them. Crypto assets that may be regarded as currencies generally tend to fall into the scope of banking law. Therefore, it is important to closely examine and comply with strict regulations of banking law.

• Utility tokens, such as Ethereum’s ERC20, are created by the issuer to function like coupons that can be used in the future to purchase goods or services at a reduced price. These tokens are often sold by the issuer to raise funds for their business. Utility tokens are generally accepted as the safest option with regards to legal uncertainty. As long as issuers of the utility token are careful to not provide utilities that may make the token subject to securities law, it is right now the safest option for crypto assets.

• Security tokens are tokens that are created by the issuer to represent the funder’s investment. They can be equivalent to a certain percentage of ownership in an asset, such as a house. These tokens are backed by assets, similar to how gold backs a fiat currency. They offer liquidity and can be easily bought or sold in the market. Due to their stability and attractiveness as an investment, they are regulated as securities and provide a larger pool of investors for filmmakers. If the token is considered a security or an investment contract, then, securities law will most probably be applicable which is in fact not preferable. Also, if the token is accepted as security, then, offering of such a token is required to be authorized by relevant governmental authority.

Associated Rights to an Offered Crypto Asset

In general, ICO tokens can be categorized into four main types of rights: usage rights, participation rights, profit rights, and ownership rights. These rights are not mutually exclusive, meaning that a token can provide the holder with the ability to use a specific blockchain system, participate in its governance, and potentially receive future dividends.

We offer one example for each of the four categories listed below.

1. The right of usage refers to the ability of token holders to use various decentralized networks for different purposes. Examples of this include Filecoin for decentralized cloud storage, Golem Network for accessing a decentralized supercomputer, Ether for deploying computer code on the Ethereum blockchain, and bitcoins for using the Bitcoin network as a decentralized payment system.

2. The right of participation is given to token holders in DAOstack and MakerDAO. In DAOstack, token holders can vote on content and governance proposals, with voting power based on the number of tokens they have. In MakerDAO, token holders can vote on risk management and business logic decisions for the MakerDAO system.

3. Polybius digital bank created a token called Polybius Dividend Tokens (PLBT) to reward its investors. Each year, 20% of the bank’s profit is distributed to PLBT holders based on certain conditions. Similarly, TheDAO tokens allowed holders to collect a portion of profits from a decentralized investment fund. It is important to mention that TheDAO tokens also provided other rights, including participation and usage rights.

4. The right of ownership is demonstrated through various tokens. For example, DGX tokens from Digix can be redeemed for gold, stable tokens like Tether, USD Coin, and Paxos are supposedly backed by an equivalent amount of dollars, and Cryptokitties are non-fungible tokens associated with digital kittens that are owned by the token holders.

If the Offered Crypto Asset is a Security Token

A Security Token is a structure that can be created during an ICO, and it does not have to be in the form of a company. However, there is nothing stopping the establishment of a company at the start of the ICO to manage it. Additionally, it is also feasible to create tools or assets, like platforms, websites, or service providers, for trading the developed crypto asset without the requirement of establishing a company before or after the ICO phases.

If the token defined in an ICO gives participants ownership rights in the current or future company, offers or directly provides ownership in the ecosystem components where the crypto asset will be incorporated, or incorporates an instrument that can be exchanged optionally, such as a convertible bond, then in those instances, the token in question may be regarded as a security token. The issuance of this token could be categorized as an equity token offering or a security token offering.

Determining and accepting Tokens and their ICOs as securities, particularly in the United States, involves meeting the requirements of the Howey Test set by the U.S. Securities and Exchange Commission (SEC). The Howey Test states that if a Token possesses certain elements, it is considered a security and falls under the category of a capital market instrument. These elements include the expectation of profit from an investment made in an ICO, the investment being held within a common enterprise managed by others, and the profits being derived from the efforts of those individuals. If these criteria are met, the Tokens can be classified as Security Tokens. In this case, the team conducting the ICO must register with the SEC, regardless of whether it is done on the blockchain or with a crypto asset. Additionally, individuals who facilitate the buying and selling of such Tokens are also required to hold an SEC license.

European Union’s Approach: The Case of Estonia’s Proposed ‘Estcoin’

In 2017, Estonia was in the process of creating their own digital asset called Estcoin. The idea was introduced by Kaspar Korjus, who runs Estonia’s e-Residency program. The e-Residency program lets people from other countries start and run businesses in Estonia online, and according to initial plans, having a national Estcoin would make the program even better.

Key points of Estocoin’s proposal were that it introduced a token for e-Residency program. The main idea being the use of Estcoin as a token within the e-Residency program and here, digital currencies are used to facilitate transactions and provide additional services to e-residents. Secondly, there was a highlight to community involvement with a proposition to involve the global community in the development of Estocoin. One of the proposals was the creation of a community-driven venture fund where Estcoin holders could vote on projects and receive funding.

There was also consideration of an ICO where, initially, discussions were had on the possibility of conducting an ICO to fund the development of Estcoin and related projects. However, this aspect of the proposal faced criticism and regulatory challenges. Ultimately, there were concerns from the European Central Bank. The proposal faced skepticism from the European Central Bank (ECB), which expressed concerns about the potential impact a national digital currency would have on the eurozone. The ECB made it clear that no member state of the euro area can introduce its own currency. Despite talks and proposals, Estonia has yet to go ahead with its Estcoin plans, however, blockchain technology and digital initiatives are still at the forefront within the country.

Conclusion

In conclusion, crowdfunding emerges as a pivotal and dynamic instrument in the financial landscape, catering to the needs of modern entrepreneurs and investors alike. This essay has delved into the various facets of crowdfunding, from its fundamental necessity for entrepreneurs lacking capital to its intricate legal and structural frameworks. The advent of Initial Coin Offerings (ICOs) represents a significant evolution in crowdfunding, marrying technology with finance and offering an alternative to traditional financial systems.

Crowdfunding is not a monolith; it is a spectrum comprising donation-based, reward-based, equity-based, and debt-based models. Each model presents unique dynamics and legal considerations, highlighting the importance of understanding these differences for both entrepreneurs and investors. The essay underscores the transformative role of crowdfunding in empowering individuals with limited capital to participate in financial ventures, thus democratizing access to capital.

However, this landscape is not without challenges. The legal and relational intricacies of crowdfunding necessitate careful navigation to ensure mutual benefits for all parties involved. Crowdfunding platforms play a critical role as intermediaries, connecting ideas needing funding with potential investors. This relationship, while beneficial, requires a keen awareness of legal and ethical considerations to maintain trust and efficacy.

Looking forward, crowdfunding stands as a testament to the innovative spirit of financial markets, adapting to technological advancements and evolving investor needs. As this landscape continues to evolve, it will be essential to monitor and adapt to the changing legal and technological frameworks. Crowdfunding not only fuels entrepreneurial endeavors but also reflects a broader shift towards more inclusive and accessible financial systems. The future of crowdfunding, particularly in the realm of digital assets and technologies, holds promising potential for further democratizing finance and empowering a new generation of entrepreneurs and investors.

Furthermore, this essay has explored the intricate world of Initial Coin Offerings (ICOs), a modern and increasingly popular method of crowdfunding using blockchain technology. ICOs represent a significant shift from traditional fundraising methods, offering unique benefits and challenges to both investors and entrepreneurs.

ICOs provide an accessible platform for diverse investors to participate in early-stage projects, potentially yielding significant returns. This democratization of investment opportunities is a stark contrast to traditional avenues like IPOs, which often favor larger, institutional investors. Furthermore, the global reach and decentralized nature of blockchain technology enable widespread participation, transcending geographical boundaries.

However, this innovation is not without its risks. The volatile nature of crypto assets, coupled with regulatory uncertainties and potential technical vulnerabilities, presents significant challenges. Investors must navigate a landscape rife with potential for market manipulation, fraud, and technical failures, as exemplified by incidents like the DAO attack.

As the legal and regulatory frameworks around ICOs continue to evolve, it is crucial for all stakeholders to remain vigilant and informed. The intersection of technology and finance through ICOs is reshaping the landscape of crowdfunding, offering new possibilities while also demanding a careful assessment of risks and rewards.

In sum, ICOs stand as a testament to the innovative potential of combining finance with blockchain technology. They offer a glimpse into a future where investment is more inclusive and global, yet also remind us of the need for robust legal and technical safeguards to protect all parties involved.

The exploration of the legal frameworks governing crowdfunding and Initial Coin Offerings (ICOs) reveals a complex and evolving landscape. Countries worldwide are grappling with the challenges of regulating these innovative financial mechanisms, balancing the need for investor protection with the promotion of technological advancement and market growth.

In the United States, the JOBS Act and subsequent SEC regulations reflect a cautious yet enabling approach, emphasizing investor protection while recognizing the potential of crowdfunding and ICOs. The SEC’s stringent stance on ICOs, particularly concerning registration and disclosure requirements, underscores the need for compliance with federal securities laws. This regulatory rigor aims to mitigate risks associated with crypto asset investments, such as fraud and market volatility, as illustrated by cases like SEC v. Telegram Group Inc. and SEC v. Kik Interactive Inc.

In the European Union, efforts to standardize regulations are evident in initiatives like the Markets in Crypto-Assets Regulation (MiCA). MiCA seeks to harmonize the legal framework across member states, focusing on transparency, investor protection, and market integrity. It establishes clear guidelines for crypto asset issuers and service providers, promoting a secure and competitive market.

Contrastingly, China’s outright ban on ICOs reflects a more conservative approach, prioritizing financial stability and protection against potential misuse of digital currencies. Singapore’s regulatory framework, on the other hand, illustrates a nuanced approach, accommodating the growth of alternative finance while ensuring investor protection through amendments to the Securities and Futures Act.

These diverse regulatory approaches underscore the complexities inherent in governing emerging financial technologies like crowdfunding and ICOs. As the global financial landscape continues to evolve, it becomes increasingly important for regulators to adapt and respond to these changes, ensuring a balance between innovation, market integrity, and investor protection.

Moreover, this essay has examined the complexities surrounding the classification and qualification of crypto assets, underscoring the varied nature of digital tokens and their implications in the realm of Initial Coin Offerings (ICOs). The distinction between currency tokens, utility tokens, and security tokens is crucial in understanding the legal and regulatory frameworks that apply to each. Currency tokens like Bitcoin represent digital forms of money and tend to fall under banking law, while utility tokens such as Ethereum’s ERC20 offer a safer legal ground by avoiding securities law as long as they are structured appropriately. Security tokens, representing investment in an asset, are subject to securities law and require careful handling to ensure compliance.

The rights associated with these crypto assets — usage, participation, profit, and ownership — further complicate their classification and regulatory implications. From Filecoin’s decentralized cloud storage to Polybius’s dividend tokens, each token category exemplifies the diverse functionalities and legal considerations within the ICO landscape.

A critical aspect of this discussion is the legal status of these tokens, especially in jurisdictions like the United States, where the Howey Test plays a pivotal role in determining whether a token is classified as a security. Compliance with SEC regulations is imperative for security tokens, involving registration and adherence to strict securities laws.

In conclusion, the qualification of crypto assets and the legal implications of ICOs represent a dynamic and evolving field. Navigating this landscape requires a nuanced understanding of the different types of tokens, their associated rights, and the regulatory environments in which they operate. As the digital asset space continues to grow, regulatory clarity and compliance will be key to fostering innovation while ensuring investor protection and market integrity.

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