I Am Not A Lawyer, but just in case I will borrow the disclaimer that lawyers use.
Disclaimer: The following analysis is for informational purposes only and does not constitute legal advice. You should contact an attorney for advice with respect to any particular issue or problem. Use of and access to this post does not create any attorney-client relationship between the author and the user or reader.
Read on, plenty of lawyers involved in making this happen.
This document outlines:
❏ Why ITOs are difficult to understand
❏ Why ITOs could be very valuable
❏ Why ITOs are dangerous
❏ Why the conventional regulatory approach won’t work
❏ One approach to the global jurisdictional problem
❏ The people behind this initiative
❏ The process from here
Why ITOs are difficult to understand
Is it a bird, is it a plane, is it a…
It is a new paradigm, yet all of us (entrepreneurs, investors and regulators) seek a simple analogy from traditional finance. Is it a:
● Currency (ICO) like another Altcoin?
● Equity (IEO) with a fixed supply (max = 100%)?
● Bond (IBO) with a fixed income?
● ANO Asset (IAO) (like property, art, wine)?
● Something entirely new where none of the old analogies quite work? This could be something technical like a database right or access right.
We use the term Initial Token Offering because “token” is neutral. A token represents value and that value could be a currency, equity shares, a fixed income bond or any other asset. However we also recognise that ICO is used by most people in the market.
These are new concepts and none of the old analogies fit. Different market participants see it in different ways and some promote that view out of self interest. These competing viewpoints from interested parties make understanding even harder.
Why ITOs could be very valuable
The old saw is “if it ain’t broke, don’t fix it”.
The corollary is “if it is broke, find a way to fix it”.
The innovation capital business is broken for both parties:
Entrepreneurs need an easier way to raise the capital that they need to get a product/service built and into the market. The end result is a product/service, capital is simply a tool to that end. The problem is that investors, even those who claim to be early stage, want evidence of traction to avoid the chasm that so many ventures fall into before achieving Product Market Fit (PMF). This pushes more risk to founders and their friends/families. The IPO window keeps getting harder to get through, leaving a dwindling number of acquirers, making investors even more risk averse.
Investors need a chance to get in early but also to get liquidity. By the time most investors get a chance at IPO (when they have liquidity), the best returns have often already been taken by private investors. Yet if they try to get into private rounds most investors are at a disadvantage to the top tier VC funds and they have to accept their capital being locked up with no control over liquidity. This is hard for even the HNWI and UHNWI investors, but it is doubly hard for smaller investors who are sometimes legally prohibited or have to pay a big % in legal expenses.
ITOs – done right – could help both parties because there is liquidity, which allows some investors/traders to take a short term view if they want to (and these speculators provide liquidity). ITOs also have some of the advantages of rewards based crowdfunding services like Kickstarter, because the investors in ITOs are often also the users. They use the tokens on the network/service. So they help get the venture to PMF. It is their passion and knowledge that drives the process.
Why ICO/ITO is dangerous
It is very simple to raise money via an ITO (ICO). This will bring out honest entrepreneurs who are fed up with the current way of raising capital. It will also bring out crooks. It already has. So far early investors have been people playing with “found money”. For example if you invested in Bitcoin in 2009-2011, putting some of those profits into Ether in 2014 seemed pretty easy, even if you follow it up by losing it on the DAO in 2016. It is quite different when Josephine Q Public is investing from earnings that took 40 years to accumulate and which she is banking on for a comfortable retirement. If ITO scales, more crooks and more Josephine Q Public actors get involved.
The words Initial and Offering make one think of IPO and that is beguiling for both entrepreneurs and investors and that can make them blind to the downside.
The Howey test (from an SEC legal case from 1946) is basically – if it looks and acts like an equity it probably is. Many ICOs fail this test, putting them in the regulatory cross hairs.
This is a problem for both parties:
Honest Entrepreneurs get “tarred with the same brush” from scams and lousy offerings and will face a heavy regulatory backlash.
Investors will face scammers who are very skillful both technically and in obfuscation and marketing.
Why the conventional regulatory approach won’t work
Two end results will be bad:
- Unregulated scamsters discredit the whole ITO concept, causing investors to shun them.
- A regulatory backlash kills the potential of ITOs for both entrepreneurs and investors by being too heavy handed.
Lots of vested interests in the capital markets (such as big VC funds and investment bankers) will be hurt if ITOs go mainstream. So we can expect many well reasoned calls for strict regulation.
One very powerful feature of ITOs is that they are totally global and permissionless - like bitcoin. Josephine Q. Public can invest in an ITO without permission from any commercial or government institution no matter where she is based and no matter where the entrepreneur is based and no matter how much money she has. Yet regulation works on a sovereign jurisdictional basis and in many jurisdictions there are competing agencies involved in any single transaction. If we let one big powerful jurisdiction define the rules (say USA or EU or China), there are too many complex conflicts of interests and many other jurisdictions will want to add their local nuance. Then we will have a complex overlapping set of regulations that will kill the agility/simplicity that entrepreneurs and investors like about ITOs.
Sovereign jurisdiction still does matter. Smart Contracts are great until there is a dispute and even in a well designed smart contract there are exceptions that the designers never anticipated. That is when old fashioned courts, judges, juries (in some countries) and lawyers are needed.
One approach to the global jurisdictional problem
Digital communication is permissionless. I don’t need permission to send an email/text to somebody in another country. Money is different - bits don’t stop at borders but money has to show its passport.
One approach is to keep it simple by defining three different sovereign jurisdiction locations:
❏ Where the entity is located. This will encourage jurisdictional competition. Jurisdictions will have to get the balance right between meeting the needs of both entrepreneurs and investors. Too far in one direction will not be sustainable. Examples of jurisdictions that may want to innovate like this are Switzerland, Malta, Iceland, Estonia, UK, Delaware, Hong Kong, Singapore.
❏ Where the token buyer is located. This is where the rules can vary from country to country. We may also eventually see the securitization of tokens, which would allow a token buyer to decide whether they want to go through an onshore or offshore vehicle. In this scenario, feeder funds will emerge and compete in major jurisdictions.
❏ Where the founding team, directors/officers are located. In todays world this can be multiple locations and separate from Entity location, but investors should be able to see in which jurisdiction they are in case it all goes wrong and the investors want to take them to court.
The objective of the ITO Self Regulatory Code of Conduct is simple. We want an Issuer to say “we abide by the ITO Self Regulatory Code of Conduct”. Our aim is to offer simple tools to compare any offer to this Self Regulatory Code of Conduct.
The people behind this initiative
The process from here
To start with we are inviting public comments on the mission. Then we will create a model code of conduct and invite comments on that.
If you would like to get more involved please tell us in comments. We want people who have the rare combination of expertise in a subject that few people understand without having too much conflict of interest.