2017 saw the explosive growth of Initial Coin Offerings (ICOs), a new method of fund raising which is shaking traditional models of financing.
According to data aggregated by the American website CoinSchedule, in 2017, the equivalent of more than 3.7 billions of dollars was raised via 235 ICOs, against only 96 million dollars for around 50 ICOs in 2016.
As an example, on May 31, 2017, Brendan Eich, one of the founders of Mozilla, raised the equivalent of 35 millions of dollars for its web browser “Brave” in the context of an ICO… and this in 30 seconds only!
Another record ICO, the one performed in August 2017 by the company Filecoin, a kind of decentralized Dropbox, where each user provides to the network a stocking capacity and can, in return, host his/her content in a secured space, which succeeded to raise the equivalent of 257 millions of dollars within only a few days.
Thus, ICOs have followed one another reaching more and more dizzying amount, awakening the interest of entrepreneurs, investors, but also more recently the authorities since these transactions (or most of them) intervene today outside of the scope of any regulation.
But practically, what is an ICO?
Derived from the term Initial Public Offering (IPO), which designates a fund raising when listing a company on the stock exchange, an ICO corresponds to a fund raising executed in cyber currencies.
If in the traditional scheme of an IPO, a company issues securities in exchange for fiat currencies like the euro or the dollar, in the context of an ICO, the company raising funds will issue digital assets called tokens in exchange for cyber currencies most of the time, like Bitcoins or Ethers.
Tokens acquired by the investors do not have any legal status: they rather constitute the digital representation of a set of rights of which the nature change in function of the finality defined by the issuer.
These rights and prerogatives attached to the tokens can cover very different realities depending on the intended operation or on the degree of maturity of the project. Following are few concrete examples:
The application token, which can represent a right of use of a product or of a service that the project carriers are developing (ex: for the decentralized Dropbox project carried by Filecoin: the user must buy its tokens in order to have a stocking space. If on the contrary, he/she puts his/her own stocking space to disposal, he/she will receive tokens in return);
The fidelity or award token, assigned as soon as one use a product or a service (ex: when a traveler has finished his/her stay in a hotel, he/she receives a token as a reward that he/she can spend in other hotels or exchange against money or some other cyber currency);
These tokens constitute liquid exchange money (cyber currency) which transfer is secured by cryptographic keys and is executed on specialized platforms. Their assessment being random, up to impossible, to determine, they are quite often assimilated to a speculative instrument.
The mere qualification of some tokens can demonstrate to be sensitive when, for instance, they give the right to some incomes or dividends (ex: “the DAO”, first investment fund entirely autonomous and decentralized, which token allows to have a right of vote on the proposals of projects to finance and to receive the relative earnings, as the case may be).
In view of the peculiar nature of the ICOs and of the hybrid character of the tokens, the regulating authorities in France (1) as well as on the European level (2), try their best to apprehend this phenomenon.
1. In France, the Financial Markets Authority (FMA) started a public consultation and a support and research program on ICOs
On October 26, 2017, the FMA announced that in the absence of specific regulation applicable to ICOs, it started a consultation paper (which closed on December 22, 2017) in order to gather the view of the involved parties on different types of potential regulations.
In parallel, the regulator has also put into place a support and research program for digital asset fund raises called UNICORN (“Universal Node to ICO’s Research & Network”) in order to brainstorm about the tokens’ market in direct coordination with the project carriers.
1.1 Warning on the risks of these operations
The start of this consultation was first of all the opportunity for the FMA to bring the attention of potential investors on the numerous risks that ICOs present, starting of course with the absence in France - and often abroad- of a specific regulation.
Indeed, the FMA warned that during an ICO, investors, and now mere individuals, do not benefit of any of the protection measures associated with the floating of a company (prospectus, FMA visa, etc.).
The investment intervene on the base of commercial brochures or a mere document of information, called “White Paper”, which can describe the project in an incorrect manner, omit to explain the underlying technology or present the forecast in a biased manner or excessively optimistically.
The FMA indicates that they are quite often complex technological projects at an early stage of their developments, aimed first and foremost to an informed public, technophile, but which can also be addressed to the general public.
Yet, the risks reminded by the FMA are quite real:
Loss of the integrity of the capital invested as it is not guaranteed;
Money laundering practice;
Absence of market allowing to resell tokens;
Projects without concrete application;
Considerable volatility of the tokens: as an example, the startup “Tezos”, which raised the equivalent of 232 millions of dollars through an ICO in July 2017, saw its token lose nearly 40% of its value in 3 hours, following a conflict between its founders;
Risk of scam and of cyber criminality: the most resounding example concerns the cyber currency exchange platform “Bitfinex” which had 65 millions of dollars stolen in August 2016.
In front of the recent arrival of neophyte investors on the market, the challenge of the public consultation started by the FMA is thus to limit all these risks by creating a tailored legal framework.
1.2 Legal analysis of the ICOs in view of the rules the FMA ensures the enforcement:
In order to define the possible regulation applying to ICOs, the regulator reflex was to proceed by elimination, by comparing this new tool with the entire body of legislation available.
The exercise is delicate because the financial instruments issued are very diversified.
Tokens issued during the ICOs being able to be acquired and exchanged, they could present similarities with various financial titles defined by the Financial and Monetary Code:
Could it be a capital security? The FMA argues that it is difficult to consider that tokens could be qualified as capital, notably because their issuers, rarely having a legal personality, do not own a share capital strictly speaking.
Could it be a debt security? Traditionally, it is considered that a debt security represents a sum of money, yet, none of the ICO presented to the FMA to this day resulted in the issuing of tokens similar to a debt security.
Could it be units or shares of collective investment bodies? The regulator estimates unlikely that token subscribers could be the “community of investors” required to be qualified by the Undertakings for Collective Investment in Transferable Securities ("UCITS"). According to the FMA, some types of ICO might be qualified under the Alternative Investment Fund (AIF), but again under certain conditions.
The mechanism of crowdfunding can neither be accepted as in the framework of an ICO no investment advice is provided. Moreover, contrary to an operation of crowdfunding, ICOs are not realized through the intermediary of websites satisfying the regulatory conditions.
Finally, the FMA states that some ICOs which “put forward the possibility of a direct or indirect financial earning or having a seminal economical effect” could fall under the regime 1 or 2 of brokers in miscellaneous goods (the diverse goods being defined as atypical products of investment, like diamonds, precious metals, art pieces, ancient letters, etc.).
Thus, and even if to this day no specific legal regulation exists, it would be wrong to think that an ICO escapes any control as, if its structure were to correspond to one of the tool here-above, an established legal regime would apply.
1.3 FMA proposed three options of regulation:
As the involved amounts during ICOs are not anecdotic anymore, the FMA does not only state it does not have yet any satisfying legal framework but suggest few options of regulation:
Promote a guide of good practice with existing law: this hypothesis is without a doubt the most open but also the most risky as it consists in fact to regulate only the ICOs falling under the scope of existing legal provisions, meaning a very small minority. Other ICOs would only be submitted to rules of good practice, defined by the FMA, which would however have no legal binding force in the absence of any regulation.
Extend the scope of existing texts to apprehend ICOs as offers of securities to the public: the aim there would be to supervise all ICOs, whatever their forms and characteristics, as if they were traditional offers of securities to the public. The process of instruction and given of a visa by the FMA would hence be applied. This option would mean regulating in an identical manner startups and listed companies which are quite different. Furthermore, the ICOs requirements of flexibility and of rapidity would not necessarily be compatible with the “prospectus” regulation of the FMA.
The aim of a measured regulation would be to supervise ICOs and thus to offer warranties to investors, without however restraining the liberty and innovation which are still determining for the project carriers.
2. In Europe, warnings have been issued by the ESMA
Made official on January 1st, 2011, the European Securities and Markets Authority (ESMA) is one of the three regulation institutions created by the European Parliament and Council following the financial crisis of 2008.
The ESMA mission is to reinforce the protection of investors and to promote stable and performing financial markets in the European Union (EU).
It is in the framework of its missions and in front of the craze for this new funding model that the ESMA has published two communications on November 13, 2017, alerting on the dangers concerning ICOs.
2.1 First communication destined to investors
The ESMA warns investors tempted to subscribe to an ICO by listing some of the risks generated by this kind of funding operation:
Absence of regulation favoring the development of illicit or fraudulent activities;
High risks to lose the integrality of the capital invested in a project generally at a very early stage;
Lack of liquidity and tokens extreme volatility;
Insufficient information of the investors;
Flaws in the technology on which the ICO is resting because it has not yet been proven.
2.2 Second communication addressed to enterprises contemplating to realize an ICO
Similarly to the FMA, the ESMA reminds that if issued tokens were to be considered as financial instruments, the ICO initiators would have to conform with the rules applicable in the EU, and on a non-exhaustive manner.
The « Prospectus Directive » concerning the prospectus to publish in case of an offer to the public of a transferable security or in the view of the admission of a transferable security to the negotiation;
The MIFID Directive concerning the markets of financial instruments;
The AIFM Directive on the managers of alternative investments fund;
The 4th Anti-Money Laundering Directive prohibiting money laundering and terrorist financing.
These texts naturally impose numerous obligations, notably in terms of controls, professional ethic or even transparency.
3. Meanwhile, priority to fighting money laundering
The Order n°2016-1635 of December 1st, 2016 reinforcing the French rules on the fight against money laundering and terrorist financing created a new category of entity falling within the scope: “Any person who, as their usual profession ; either present themselves as the counterparty, either act as an intermediary, in view of the acquisition or sale of any instrument containing on a digital form value units non-monetary that can be kept or transferred with the aim to acquire a good or a service, but not representing a debt on the issuer.”
This new provision targets crypto currency exchange platforms.
The forth anti-money laundering directive is under revision in order to, notably, include exchange platforms (but also electronic wallets stocking private keys of cyber currencies holders) in the scope of the fight against money laundering and terrorist financing.
The project of reform anticipates that the European Commission will have to present within the two years of entry into force of the future directive a report on, in particular, the possible implementation of a central data base where the identity of cyber currency holders would be registered.
Thus, in the case of an ICO, the issuer as such would not be submitted to the obligations of combating money laundering, except if he/she manage him/herself the private keys of the tokens he/she issues (and if these tokens are of a cyber currency nature, which could be the case for a number of currency tokens).
Yet, everyone agrees to say that the AML obligations apply even to ICO issuers. On which legal basis then? We go back to the guide of good practice or the legal modification invoked by the FMA in its consultation.
In this framework, it would be good to also foresee a regime where investors in crypto currency could be “checked” by a trusted third party (a bank, a notary, a lawyer) confirming their identity, and even attesting in some cases that they are qualified investors if the ICO is opened only to them. This check could be done via a smart contract. Thus, investors could stay anonym in the framework of the ICO, while reporting to the KYC obligation on a trusted third party.
On the notion of qualified investors, some have suggested to create a new category of investors qualified “technologically”, which would correspond better to the sociology of the crypto sphere.
Indeed, investors qualified “technologically”, even though not qualified as profession investors, are capable to identify the technologic risks of the operation and often have an important capital in cyber currency.
To date, the approach of the FMA has been resolutely flexible and prospective, contrary to some other regulators which have decided to simply and purely prohibit ICOs.
The French approach should be acknowledged.
The ICOs indeed offer an original financing method to innovative startups, allowing them to raise funds through a large community of investors in a simple and rapid manner.
This driver of growth still unexplored will lead to the rise of new practices; it also presents important risks for investors.
It is hence more than ever essential to thoughtfully consider what measured set of rules could attract the most serious projects, which always need the control of a regulator.
In reality, even more than a regulatory challenge, it is a real challenge of attractiveness in Europe and France in particular.
 with the collaboration of Ghislain Grotti, lawyer.