Blockchain IPOs: capital raising in a crypto-world February 2019

By KATHRYN MITCHELL, Published in Financial Law

Disclaimer: the footnotes are there for cryptosuper-nerds and those especially interested in crypto-culture and history.

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An initial public offering (IPO) is a company's offer to the public of any securities that have not been offered to the public previously. IPOs are regulated in terms of Chapter 4 of the Companies Act, 2008. "Securities" are defined widely in the Act as "any shares, debentures or other instruments, irrespective of their form or title, issued or authorised to be issued by a profit company". The rules relating to IPOs are clear; if the criteria in the definition of an IPO are met, a prospectus must be produced. Any failure to comply with the IPO provisions in the Act may result in civil and/or criminal liability.

Against this regulatory background enters the initial coin offering (ICO), a crypto answer to finance-raising in a digital world. ICOs are similar to IPOs in that a company issues crypto-tokens, in whatever form, to the public for the first time in order to raise finance for that company. Clearly, there are differences between ICOs and IPOs, the critical ones are:

  • the object being offered to the public is a digital token instead of a share or a bond1;
  • ICOs do not appear to be subject to the same regulations as IPOs.

A brief history of the development of ICOs

One of the first ICOs took place way back in 2015. On 17 August 2015, as the Chinese stock market crashed and the S&P 500 had its worst day in four years, a company called Augur launched one of the most successful internet-based capital raising campaigns in history. Augur, a decentralised market prediction protocol, raised more than US$4 million in a week by selling its REP coin. One REP coin was offered at US$0.6 and it now trades at US$9.48. This is a 300% return on investment over approximately three years. From there, the practice of ICOs took off.

Interestingly enough, a market standard for ICOs has developed (one which is not mandated by any legislation or regulatory authority) by which coin-offerors typically:

  • announce the ICO in various crypto publications (for example, Cointelegraph or Reddit);
  • publish a so-called white paper (which performs a similar function to a prospectus in IPOs) which sets out an overview of the company's business as well as the mechanism behind the token's operation2;
  • the white paper is sometimes followed by a yellow paper which describes in detail the programming behind the business and the token.

Notwithstanding this market practice, ICOs have proved susceptible to hacks and scams that leave innocent investors exposed with little legal recourse in the seemingly unregulated crypto-landscape.

The hacks typically take the form of bugs in the digital wallet established by an entity to receive the proceeds of the ICO. Funds are diverted anonymously from the wallet into the hacker's wallet. Scams also happen where nefarious parties stage an ICO for either a false or existing organisation – easy to do in an environment where no checks and balances exist and ICOs are not underwritten by anybody.

A particularly high profile hack catapulted ICOs into the regulatory spotlight and resulted in an important directive from the Securities and Exchange Commission (SEC) in the United States of America. In 2016, the Decentralised Autonomous Organisation (DAO), an entity 3 which is essentially a very complex smart contract that provides a secure digital ledger to track financial transactions and is built on the Ethereum network, launched a US$150 million ICO. The ICO was immediately hacked and DAO and investors lost US$50 million.4 This triggered an investigation by the SEC into the DAO ICO and resulted in a finding that certain digital tokens constituted "securities" for the purpose of federal law. In the SEC press release on the issue, offerors are cautioned that:

"…the innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designated to protect investors and the integrity of the market."

But this is caveated – the SEC also said:

"Whether a particular investment transaction involves the offer or sale of security – regardless of the terminology or technology used – will depend on the facts and circumstances, including the economic realities of the transaction."

The effect of this is that the SEC will be able to investigate the true nature of a coin and then either classify it as a security or not. This will determine whether or not it is a regulated instrument. 5

ICOs in South Africa

ICOs in South Africa have been less prevalent than those in developed markets (it is hardly surprising that San Francisco and Silicon Valley have led the charge in this respect) but there are local start-ups which have been drawn to ICOs as a cheaper, more start-up friendly alternative to a public share sale. This is especially because coin-sales have the advantage that shareholders are not required to dilute their control in the company as they are with a sale of shares.

But start-ups, beware! The SEC directive may well be persuasive in the South African context, particularly in light of the wide definition of securities in the Act. It is advisable that companies considering an ICO comply with all regulations applicable to an IPO or, alternatively, ensure that the structure of the ICO does not constitute an IPO. For example, not offering the coins to the public but rather raising finance through a limited private sale may be one differentiating factor.

Unfortunately (or fortunately) for tech-entrepreneurs, ICOs are not the regulatory haven they were once thought to be. The result of this has been that the number of ICOs has fallen by 94% since 2017. But it is important to realise that in the vast majority of ICOs, coins rapidly lost their value or the issuing entity failed completely. Perhaps, with a little more regulatory oversight, quality will prevail over quantity.

As ever with burgeoning technology, regulators have to strike a balance between innovation and regulation; progress and protection. This is incredibly difficult to do and we must anticipate the pendulum swinging from one extreme to the other, before it comes to settle.

Mitchell is an Associate, Corporate and Commercial, with Fasken (South Africa).

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1 Some writers have argued that the difference between a share and a digital coin is that a share is simply a collection of rights (i.e. a right to a thing) whereas a coin is an entirely separate thing. This distinction, however, will depend on the nature of the coin and the rights attached to the particular coin.

2 The white paper follows in the tradition of the white paper published by Satoshi Nakamoto, the mysterious programmer behind Bitcoin, which set out the foundations of Bitcoin and, thus, Blockchain.

3 The nature of DAO's juristic personality is unclear.

4 The hack was ultimately rectified through a controversial hard fork in the Ethereum blockchain which has resulted in two competing ether currencies – ether and ethereum classic. All the money was recovered.

5 Interestingly, Singapore has ruled that digital tokens do not constitute securities and are therefore exempt from the regulatory framework for securities. It is anticipated that this will result in Singapore being a haven for ICOs.