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State of the ICO Market - A GC’s View

Contributed by Emma Channing, CEO & GC of the Satis Group

At the time of writing, the author was GC of Argon Group


State of the ICO Market

2017 was the year that Initial Coin Offerings (“ICOs”) broke onto the wider public consciousness (not to-date, assisted by the fact that ICO is a misnomer for digital token offerings in every single way conceivable).  To put 2017 in context we should look back to 2016, where a total of USD256 million was raised (compared to 500 million raised in traditional Venture Capital funding) with a total of 43 ICOs and average size of 6 million. Notable raises were Waves, Iconomi, Golem and SingularDTV, all in the 7.5-16.5 million range.  While there was definitely a height of activity in November 2016, with a total raised of just over 20 million that month, that was little to prepare anyone for the oncoming storm, that is at least unless you’d grasped the possibilities. We were at that time furiously developing the concept for Blockchain Capital’s BCAP offering. 

2017, however, has seen a dramatic increase. There’s nothing quite like looking at the trackers, for example Coindesk’s or Smith & Crown’s to see quite how significantly 2017 blew 2016 out of the water.  There have been 228 ICOs in 2017 to date and venture capital funding was surpassed in June, which along with July were record breaking months that saw 1.5 billion raised in the space of two months alone.  Average size is only 12 million, but the high raises have been extraordinary; Filecoin raised 257 million, Tezos 232 million (now sadly beset with undeserved class actions and controversy), EOS Stage 1 alone raised 185 million and continues to raise, while Bancor raised 153 million. 

The market slowed in October and November, as demonstrated in Argon's most recent market report.  Many factors have impacted the market, including increasing caution among purchasers and investors regarding the quality and liquidity of ICO offerings, the ETH and BTC rapid rise in value and forks, and a certain amount of deal fatigue amongst the cryptocurrency whales, venture capitalists and family offices that invest in ICOs currently.  In particular, with regard to security tokens, the world awaits with bated breath the first US compliant securities exchange capable of trading securities, which requires an ATS licence.  Security tokens are legally by far the simplest and least risky path for issuers from a legal point of view, and are also the only form of digital token permitted at-law to promise a return, and thus we are very long and bullish that security tokens will lead the way in 2018. The key will be liquidity (currently, few exchanges can trade security tokens). We, of course, hope and expect our joint venture with tZERO will be the first to market, but there are many alternatives we know are moving into position, targeting 2018Q1-2.  We also expect the market to pick up pace again in 2018Q2, although we expect the demand for quality and real businesses rather than vague white papers to continue.

State of ICO Regulation

2017 has, of course, also seen some extraordinary developments in terms of regulatory oversight of ICOs.  I have often been the “odd one out” on panels during the first half of the year, indeed even now, when fellow panellists will insist that the ICO market is not regulated.  Of course it’s regulated; there are several rules that apply when you cross the road in most jurisdictions and there are rules that apply whether it’s an “app/platform access/utility” token or security token.  The key question is whether there has yet been enforcement of that regulation, and increasingly the answer is yes.

Current regulations are actually well-suited to ICOs. Indeed, if it is a security token, at least your regulatory regime is relatively simple because US federal pre-emption means that US federal securities laws overrule all other federal agencies and state bodies and laws.  This is one of many reasons why we think security tokens are the future of the market. Furthermore, the JOBS Act liberalisations, particularly Section 506(c) of Regulation D and Regulation A+ seem perfectly suited for ICOs.  Sadly, 26 US Code § 1031 and 1032 (which limit tax-free capital raises to those granting stock and make the tax treatment of contributed property complicated) could do with some significant revisions if the ICO market is to thrive in the US. Most other major jurisdictions take a very similar approach to securities law. On the other hand, if you are issuing an app token, then you face a complex hodge-podge of contract, fraud, tax and state law just to name but a few, and it makes the analysis particularly complex, contrary to popular opinion.

Responsible regulation and reasonable enforcement is generally a good thing in our book and the SEC has made it pretty clear that its initiatives this year are cyber-related issues and protecting retail investors — two issues that always turn up in poorly designed ICOs. We have watched the SEC’s enforcement activities to date on ICOs with interest and great respect — which have predominantly been the:

•  The SEC’s 21A Report on the DAO (the “SEC DAO Report”)
•  The SEC enforcement against Protostar
•  The SEC enforcement against two scam coins

These have been careful, well thought-out and discrete enforcement actions that, particularly in the case of the SEC DAO Report, have greatly increased the understanding of practitioners as to where the SEC will be focusing its efforts and how it will be interpreting the Howey Test, which will always be a facts and circumstances analysis. The SEC has upped its activities in recent months with a blizzard of subpoenas issued to ICOs whose white papers are close to the line and we expect that activity to continue both in the US and globally. 

Other global regulators are taking steps to come up with guidance, in particular the Singapore Monetary Authority which issued “A Guide To Digital Token Offerings” on 14 November, 2017, although it will be much more difficult for the US to do such a thing given the complex history of the Howey Test.

Alternative Views on the Howey Test

Section 2(a) of the Security Act of 1933 (the “Act”), as amended defines the term “security” for the purposes of the Act as some 30 or so items, one of which is an
“investment contract”.  The key test for an investment contract was introduced under the case SEC v Howey Co, 328 US 293 (1946) and the wide body of case law that followed and is now known as the Howey Test.  In essence, the Howey Test is this:


1.  An investment of value (which the SEC in the SEC DAO Report stated includes BTC and ETH);
2. In a common enterprise;
3. Derived from the managerial efforts of others;
4. With a reasonable expectation of profits.

I use this slightly idiosyncratic order of the limbs of the test for the reason that the vast majority of ICOs trip limbs 1-3 of the Howey Test, and that brings you down to the last limb, which is the expectation of profits.  This is where we think many poorly designed ICOs, particularly those designed from a single jurisdiction’s point of view such as Switzerland, often trip up.  Indeed, in the long and complex case history of SEC v Howey, the courts have been quite content barely to focus on the first three limbs when extravagant profits are being promised.  For example, see the SEC v Koscot Interplanetary and SEC v International Loan Network line of cases which found an investment contract where extravagant profits were promised.  We think this is particularly problematic in the case of those ICOs that carelessly promise a return and/or talk up secondary exchanges and likely market price or market appreciation. 

This particular topic was dealt with in detail by the Cooley team in a very thoughtful white paper published in October.  While it focused on the concept of Simple Agreement for Future Tokens (SAFT), there was a powerful contribution to the research in the space, in particular on the market appreciation aspects of these tokens when trading on the exchanges, which is where we suspect we will see a concentration of enforcement efforts from authorities in the next few months. We have always been hugely impressed by Marco Santori and his continued commitment to making the ICO world a safer and more accessible market for founders of emerging growth companies.  However, where we would question Cooley’s white paper is on the topic of functionality and any absolutes with regard to the use of SAFTs. We would tend towards the view that a presale does not change the character of a utility token, for the purposes of the Howey Test, merely because it is sold before the full functionality is established (as long as purchasers will ultimately be able to use the platform). We also think the SAFT presents an elegant solution for those who want offer profits in conjunction with discounted utility tokens.  However, the key to its success will be in ensuring that the SAFT includes a reasonably detailed description of the token to ensure certainty at the time of signing of the SAFT, not a crystallisation at the time of issue of the utility token (which could raise all sorts of complicated issues relating to concurrent offerings, a topic which stops every securities law attorney’s heart cold).

The highly talented Joshua Klayman from MoFo was quick to point out in an early post on October 2nd “Some Early Impressions re: the SAFT White Paper” that securities law analysis of digital tokens did not lend itself to simple answers but detailed analysis and judgment, adding a timely reminder that advising on digital tokens requires a global perspective.

Lee Schneider’s team’s followed up on that vein in a more detailed client update on October 17th entitled “Bright Lines Don’t Work for Blockchain Tokens” emphasising the point that there is no bright line test for Howey, and that applying the Howey Test will remain a facts and circumstances analysis closely focused on the characteristics of the digital token in question (as emphasised by the SEC in the SEC DAO Report ).  We are very much of this view (and huge fans of Lee, his team and their work) and while everyone in the ICO space would clearly like our clients and the thriving emerging growth company community in the US in particular to have bright lines, we are going to have to follow best practice cautiously and prudently and apply the case law.  The SEC DAO Report gives us a great starting point and, while it is sure to be unpleasant for the recipients, we hope to see new enforcements and cases brought by the SEC which will fill in some of the gaps left in the SEC DAO Report, particularly the impact of secondary markets.