Fintech Genome

A self-regulatory code of conduct for ITO (Initial Token Offering) and ICO


#21

ITO Should Do List
Updated based on feedback
Consider these pegs in the ground. Tell us if a) any pegs missing b) any of these pegs are broken (defined wrong) or in the wrong place. If the peg looks good, lets take it to the next level so that we can define it in both legal and technical terms.

  1. Cap the amount to be raised. That was the DAO problem. Let investors compete on time not amount. If the amount to be raised is open, scammers can create hype and raise a lot and disappear.

  2. Declare stage:

Stage 1: Technical risk. White paper, maybe some early code on Github.

Stage 2: Market risk. Prototype/MVP. Accessible via at least a public Beta.

Stage 3: Scale risk. Where big funds and ibankers like to play.

Let market challenge the Issuer. For example, if Issuer says we are Stage 2, potential users/investors should be able to say “we don’t see it” (which is different from an opinion on how good it is).

  1. Human ID. All the founding team, Officers, Directors should offer enough data to show:

• Where they live (ie in what jurisdiction you could sue them).
• What work they have done in the past and what entities they are affiliated with (ie are they a credible team to back). LinkedIn Bio.

The data should be enough for investors to do background checks if they want to.

  1. Declare Legal jurisdiction. In what country is the ITO Issuer based? This defines what laws the entity is subject to.

  2. Only accept payment in a cryptocurrency. This just adds a tiny hurdle to deter investors who should not be taking this risk if they don’t even have funds in Bitcoin or Altcoin.

  3. Declare Accredited Investor status. An Issuer may say "we are only open to Accredited Investors” (like Z Cash did) or leave it open as many others have done. Many people have lost respect for the Accredited Investor hurdle because it is a self-declared status. Yet it can be a hurdle that gives an investor pause to think and that is good. The requirement is simply that Issuer must define which approach they are taking.

  4. Define convertibility and liquidity. Define how you can convert to Bitcoin (assuming investors know how to convert from Bitcoin to Fiat). Defining Liquidity is key and before a Token is traded the answer has to be that there is zero liquidity in which case the Issuer may want to outline their path to liquidity for investors to scrutinize.

  5. Define Reporting. Will Issuer report on Use Of Funds, Cash Balance, Burn Rate? What else? On what frequency. The Code of Conduct does not define Reporting, just that the Issuer must define how Reporting will be done.

  6. Define use of funds. This relates to 1. A massive seed round should raise suspicions, but if the plan is good, investors can make their own decision.

  7. No social validation investing without total transparency. Saying “brilliant cyber investor Y (bought Bitcoin in 2010 and ETH in 2014) is an investor” is a good way to scam naïve investors (who should be doing their own diligence not blindly following a celebrity). If Issuers want to use social validation, they must define:

• How much the investor bought ($5k in a $5m round for somebody with a huge net worth is no more than a dabble)
• What terms they got. Any other relationships need to be declared.

Note: this transparency is only needed if social validation is part of the pitch.

  1. Issuer Entity Mandatory data
    Current ownership structure (cap table)
    Legal counsel
    Auditors

  2. What type of ITO is it? May define regulatory status and investor interest and what data should be mandatory;

  • Digital assets that are collateralized or backed by another existing asset: These are digital assets whose value is directly linked to an analog asset. This digital asset class is representing the tokenization of the conventional world. For example, The Royal Mint Gold (RMG) which is live-tested on the CME (read more The wave of Gold trading technology is a game changer coming from the West); or the SEC approved digital preferred equity shares of Overstock on the T0 platform (read more in T-Zero sings “Love me do” to the SEC with its Blockchain Series A Preferred Shares).

  • Protocol Tokens governed by a coded protocol on a blockchain: The value of such tokens can be linked to their scarcity, their adaptation and their anticipated network effects; and/or their potential as a store of value or as a currency. For example, MLN (Melonport), ETH (Ethereum), BTC (bitcoin). Protocol Tokens are digital assets that have not made their way yet into the traditional asset management world. We are seeing some very early ventures like Polychain Capital: A hedge fund investing at the Protocol layer of Web 3.0 .

  • Derivatives of digital assets: For example, the 1year forward Lykke forward issued earlier this year and trading on Lykke exchange.


#22

Bernard, I think this deserves a day-long meeting with a structured conversation. In the US, you can’t get around the 1934 act and the JOBS act, both of which severely restrict offerings and whom/how you can approach for private deals. The accredited investor is still the foundation there, which is why CoinList went that direction (they created the SAFT). If you don’t care about the US, then you have Canada and the UK, both of which have similar approaches. A universal code would have to distinguish the offering jurisdictions, as they have different rules, as you know. If we let the US determine our code of conduct, that ignores the progress being made in other places.

Having spent my entire life in startups and studied venture capital extensively, I would say that the planning fallacy and several other cognitive biases are at work most of the time (see www.globalbetaventures.com for a list of biases that affect early-stage investors). You simply cannot lay out your plan and your budget and have it work more than maybe 2% of the time. Almost every successful company you can name 1) had a night when the founders went to sleep not knowing whether they would have a company the next morning and 2) pivoted hard away from their original plan.

A few things wrong with current ICOs:

  1. They must issue a token. If you can’t issue an equity token, then you need a utility token, and as soon as you pivot you also have to pivot the use of your token. I’m afraid this will result in thousands and thousands of useless tokens. There are probably plenty of good business ideas and teams that don’t have much use for a token but still have a good concept.

  2. Equity is out. That sucks. It’s more aligned with reality and skin in the game. Is there some kind of shadow equity (SAFT) token that could be created without running afoul of the SEC regs? I don’t know.

  3. They typically raise in one go, selling 80% and retaining a small amount for founders. This leaves no room for pivoting or growth financing later. More ICOs are just selling 50% or so and declaring future growth raises later. This should become the norm. It also more limits the amount raised, which is good.

  4. Keep in mind that 6 months ago we had 90% BTC and 10% ALT. Look now - it’s 50% BTC and 50% ALT. Why? Think about it. It’s not an accident. Bitcoin whales are diversifying into tokens. Most of the token market is now BTC whales parking money, manipulating markets, pumping and doubling and getting out. Most of the investors in any ICO are flippers - there are very few natural buyers. I would argue this is not as bad as it seems. But any code of conduct needs to take this into account. We should discuss this - it’s probably the overriding factor in what’s happening today.


#23

By the way, my solution to this problem isn’t a code of conduct. It’s a token. Seriously.


#24

@davids I think I understand what you are working on and like it but won’t mention it in case it is confidential. Do open another thread to discuss that, it deserves its own thread. I don’t think a code of conduct and a token (for whatever purpose) can be in conflict - apples and oranges.


#25

We can add the following as well:

Provide current ownership structure
Legal counsel
Auditors
LinkedIn profile links
Social media links

Provide reports on site of company seeking capital
Company
-Officers (bios, link to LinkedIn
-Directors (bios, link to LinkedIn

Post transaction Governance
How are the funds being used by quarter according to the use of funds


#26

Lykke is the one that comes close to showcasing most of the information you mention @oscar. Only the information is included in their monthly newsletter which means that one has to be registered on the Lykke App.
I know they will eventually, have all this info open on their web site. Right @tempus?
@tempus can you share here a sample please?

Lykke from the start was open. @davids wrote about them last Fall (October was their first Lykke ICO sale - they offered shares in the company and their “trick” is that they run an exchange) and publicized ownership information ect.
Good read. This should become pretty standard


#27

Thanks @Efi and I agree that Lykke is an example of doing it right. The other one, an eon ago (3 years in cyberland is an eon) was the Ethereum ITO in summer 2014. It was controversial on a regulatory/legal front of course but a) new technology was funded that VCs would not have touched b) the coin has done well for those who got in early.


#28

Yes. And these two are examples of the two main categories:

  1. Tokenized equity

  2. Utility token

The second one is the one that is “booming” and needs a new framework.

I think there is still alot of confusion around the term “Digital Assets”. It merits repetition to make sure that everybody understands what it means.
Melonport does a good job on this topic and I have built on their distinctions to clarify that there are Three categories of Digital Assets (see more in https://dailyfintech.com/2017/05/23/the-infrastructure-for-asset-management-of-digital-assets-melonport/)

Digital assets that are collateralized or backed by another existing asset: These are digital assets whose value is directly linked to an analog asset. This digital asset class is representing the tokenization of the conventional world. For example, The Royal Mint Gold (RMG) which is live-tested on the CME (read more The wave of Gold trading technology is a game changer coming from the West); or the SEC approved digital preferred equity shares of Overstock on the T0 platform (read more in T-Zero sings “Love me do” to the SEC with its Blockchain Series A Preferred Shares).

Protocol Tokens governed by a coded protocol on a blockchain: The value of such tokens can be linked to their scarcity, their adaptation and their anticipated network effects; and/or their potential as a store of value or as a currency. For example, MLN (Melonport), ETH (Ethereum), BTC (bitcoin). Protocol Tokens are digital assets that have not made their way yet into the traditional asset management world. We are seeing some very early ventures like Polychain Capital: A hedge fund investing at the Protocol layer of Web 3.0 .

Derivatives of digital assets: For example, the 1year forward Lykke forward issued earlier this year and trading on Lykke exchange.


#29

Thanks @Efi those definitions are helpful, will add them to the pegs in the ground post.


#30

@davids I am confused. If you are issuing a Token then it is either unregulated, government regulated or self regulated. Those are the only 3 options AFAIK. Our thesis is that unregulated alone will lead to the whole business getting killed from scams leading to distrust and government regulated alone takes two long.

We believe that government regulated and self regulated can coexist. Investors and issuers may be subject to different jurisdictions and in a multipolar world there is no one uber-jurisdiction. For example, if a Swiss Issuer wants investment from a US investor, then SEC is involved. But not if is a a Swiss Issuer and a Singapore investor. Obviously a US Issuer will need to be regulated by SEC if anything like a security is involved. Every Issuer will make their own ROI decisions on which markets/jurisdictions they want to be regulated in.


#31

I think self-regulated guidelines should follow what makes sense in the public markets, not what regulators currently do in the public markets. I don’t think most regulations help save investors from losing money, as we continue to see time and time again. I think self regulation should be around transparency, because that is something you can audit. I don’t think it should be around some kind of “legitimacy” test, because things that look very legitimate often turn out to be bad investments and things that look shady or sketchy can grow up to be quite good companies. So in the startup world, I would say less is more. In the case of loans, credit, other types of tokens, then I think again transparency is what counts. If people like your deal, they’ll go for it. If they don’t, they won’t.

The second part after transparency is accountability. Not what happens if it doesn’t work out as planned (it almost never does), but what happens if they are lying?

I would strongly recommend self regulation on transparency and accountability. The rest is too complex to tell the good from the bad, in my opinion.

I’ll write about my token solution when I have time.


#32

Hi Efi! Yes, Lykke provides all or at least most of those infos. A good example is maybe the site of their last Crowdfunding: https://forward.lykke.com

There are 3 documents and 1 link to the asset on the blockchain:

  • Fact-Seeht shows basic infos about the company and details about the offer.
  • Offering Memorandum is in fact something like a financial report and includes nearly everything
  • Investor Deck: That are slides, more “advertising-direction”, but also infos including of course, shows the founders and the team, a roadmap, some charts of usergrowth etc.
  • Asset-Metadate shows the Asset on the Blockchain

They’ll publish a new financial report soon. I haven’t seen it yet but that might be an even better example because as far as I know it’s planned to include pretty much everything.


#33

Hello all,

I am excited to join this group. I am the author of the two EthNews pieces that @davids shared a couple days ago, and am looking forward to looking through this thread to see how you all have dissected the relevant issues. If you would like, I am happy to provide input on your work as it manifests.

I am doing a longer blog-piece right now examining each of the various methods that have been employed so far in ITOs in their efforts for compliance. I am gathering a list of compliance techniques ITOs have used to minimize the risks @BernardLunn identified (eg token caps, reverse dutch auctions, accredited investor approval to meet JOBS Act and Reg D exemptions, Coinbase’s proposed holistic framework, SAFT, etc) and analyzing their effectiveness, ideally creating one shareable document of various techniques and of their success as a single resource. There will also be an analysis of how these techniques comply with the US SEC record and mission, but I hope that the piece will be useful in other countries as well. The purpose of the piece isn’t to suggest a model code of conduct as I understand you all are, as much as to aid in efforts like yours to create one or to help other attorneys and advisers in making their own decisions on how to counsel clients. I will be scrolling through to catch up with the discussion so far, but I appreciate any other thoughts or input you all might have for this document.

In the meantime, please feel free to add me on LinkedIn and/or follow me on Twitter for new blockchain law articles I post in EthNews or elsewhere, and to generally to establish a line of communication if you would either like my input on something or if you know of an issue or event that I or one of my publications might be interested in reporting.

FYI, I also have published articles regarding the upcoming change to Deleware law enabling DLT-enabled share/stock issuance and management (http://bit.ly/2oJX3si), and a piece summarizing the American Bar Association’s day-long event on the current status of blockchain law in the US, covering issues like tax, securities, intellectual property, and other emerging legal areas as they relate to DLTs (http://bit.ly/2oA4xgg).

Good to meet you all and I am glad to see this kind of discussion occurring online.


#34

I would be careful in advocating this point too hard. The SEC regularly files actions against foreigners who have never even been to the US. They tend to file an action for anything that affects a US-based investor(s) in any way. This doesn’t mean that the SEC will be successful in its litigation, only that an action was filed. But failure to fight the litigation can result in a default judgment, and just fighting it (even if you win) can bankrupt or severely injure a company financially. Some ICOs have opted to block their advertising materials from US-based IP addresses specifically for this reason.

The relevant jurisdictional rule is that a foreign person is subject to US jurisdiction if they have made “sufficient minimum contacts” to indicate the person reasonably believes they are subject to US law/court jurisdiction. This is not a clearly defined standard, and may be as little as anticipating an asset is traded on a US exchange (possibly Polo or Coinbase?). More info at https://www.crowell.com/documents/SEC-Actions-against-a-Foreign-National-Living-Outside-the-United-States.pdf

I am not sure about other countries, but I wouldn’t be surprised if some have similar rules. I don’t think it is accurate to say simply whichever country an ICO issuer is based is the laws which they are subject; given the global nature of ICOs, it may be more reasonable to advise issuers to seek guidance from an adviser with a global compliance strategy than with experience only in their home country.


#35

Hi @Jason welcome to this discussion and to Fintech Genome. Your expertise is invaluable.

I urge everybody to check out Jason’s writing at Hacker Noon:

https://hackernoon.com/@My2Wei

In case it is not obvious, I Am Not A Lawyer, but just in case I will borrow the disclaimer that Jason uses.

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.

In particular I urge people to check out Jason’s post about what Delaware is doing:

https://hackernoon.com/how-proposed-changes-to-delaware-corporate-law-enables-blockchain-corporations-and-stock-ce3b24bf5b57

The key bit is here:

“Keeping with its commitment as a leader of business-related law, the State of Delaware has joined this recent stream of blockchain-related legal innovation by announcing proposed amendments to its Delaware General Corporate Law (the “DGCL”) that would recognize “Distributed Ledger Shares” as a legitimate method to track and account for corporate stock. If passed by the Delaware’s General Assembly, corporations in the famously business-friendly state can look forward to legally issuing shares via distributed ledgers as of August 1st, 2017.”

This illustrates the general theme of jurisdictional competition to get the balance right between the wealth creation of permissionless innovation and protection of investors.

The “wealth creation of permissionless innovation” is well illustrated by Jason’s story:

“His first exposure to blockchain was his investment in Bitcoin in 2011, the proceeds from which he used to finance his first year of law school.”


#36

Thanks @Jason , very helpful.

We may lament such heavy handed action, but it is reality.

To summarise;

  • Go out of your way to avoid US investors (public statements and blocking IP) until you have a legal way to do this. In practice this means that sophisticated US investors will invest via offshore vehicles they control.
  • If you want to go seriously after US investors, consider Delaware as your jurisdiction (see earlier post for link to Jason’s post about this).

#37

We are in the middle of an ITO that will launch in July. We would be happy to be guinnea pigs for this project. @bernard if you have any kind of format or guidelines for us, or if anyone wants to work on this with us, we are a volunteer community and want to show the way forward. We hope to raise quite a bit and put it to good use. Please contact me if anyone wants to help us put together a standard scorecard or some kind of transparency document and let’s learn as we do it. I’m david@2030.io and will happily cooperate with anyone who wants to help us in this.


#38

Hi @Consultant thanks that is very helpful. Smith & Crown seem to be in a similar space to ICO Rating and that is very valuable. Looking at the ICOs they list, a lot don’t raise any or very little. Which is a good thing. Quality will pay off. Would be interesting to look at best practices of the successful ones (say raised over $1m).

BTW, your contributions would be given more weight if you can show your identity. Its up to you and I understand if you want to remain anonymous, but if you make great contributions (you do) why not get some recognition for that?

I do think that Govt Regs (what we normally call Regulation) can coexist with Self Regulatory Code of Conduct. Some Issuers will choose which to go for and Investors will make decisions based on what they trust. I can totally understand if some investors say “has to be SEC approved or I won’t touch it” but other investors want to look a fundamentals and adhering to a Code of Conduct will be one of those fundamentals and they may decide that they don’t care about Govt Regulatory stamp of approval


#39

Hi @davids Yes, we will want early adopters and our timeframes may be compatible.


#40

I think this is the best way to go. However, regulation of such (at least in the US) would require a new administration, which would require an act of congress and approval by the president. A lot of people are concerned about the probability of successfully creating a new bureaucracy in the modern American political climate, but until that happens, we will have conflicting rules coming from FinCEN, SEC, FTC, CFTC, and OCC. Ironically, the answer to too much bureaucracy in this case may be more bureaucracy.

I would imagine that a digital token or access right is the best new classification. Tokens that act as securities (enabling shareholder voting, ownership rights, distribution rights, etc) probably can rightfully be monitored by securities regulators. What we are hoping for is to avoid securities oversight on AppTokens, since an ITO will never be able to provide the quarterly and annual reporting figures required by the SEC (or others) when a product hasn’t even always been built yet.

As far as self-regulation goes, it seems to me unlikely that the regulators will never regulate. That’s what their job is and they are eager to make sure they do it. The goal of self-regulation (in my mind) is to find a model that works for the industry while protecting investors that regulators can eventually adopt, rather than having the regulators create rules on their own that may be subject to either political biases/pressures or be formed with less than perfect experience/information. Declaring equity tokens (for example, those offered by Overstock or the DAO) as securities and focusing our attention on tokens with little or no functional overlap to those tokens will help in this approach.