What an ICO investor should be aware of buying security tokens

July 9, 2017

by Arthur Minasian, LLM in US Legal Studies, Case Western Reserve University, School of Law (am@telecomlawyer.ru)

Most of ICOs are aimed to raise money by issuing digital tokens that can be spent within its ecosystem (so called “cryptofuel”). You do not need to be a sophisticated investor to buy tokens which are designed for marketplaces or businesses that have yet to be built. Investors who are buying them just take advantage of its consumptive use and are betting that the businesses will become successful so the tokens will become more valuable as more and more people flock to the platforms (product tokens, utility tokens). And in fact, such platforms get thousands of engaged supporters who are highly motivated to contribute in promotion of such platforms (let’s call them fans of innovations, blockchain evangelists or early bitcoin buyers).

There is, of course, the possibility that many of the tokens could become worthless but it seems that people fully understand this risk and just place their bets: those who have made money in bitcoin are trying to convert that into other kinds of cryptocurrencies (including cryptofunds that usually have arrangements to buy tokens on an ICO presale stage with a 30-50 % discount).

For now, most of the companies raising money are tech and blockchain focused but more and more venture companies are considering this method to be applied to their business. However, in order for it to work and get their projects funded these companies have to persuade a different type of potential investors: those who want to participate in a venture business through ICO as small venture capitalists and have to buy bitcoins or ether for fiat money at a current high rate in order to be involved in ICO process. In this case legal risks are of much greater importance since investors are not interested in the consumptive use of tokens or a would be increase in a market prices of ICO tokens and merely rely on dividends or repurchase of the tokens by the issuer in the future, i.e. we are speaking of so called “security tokens” (according to a well-known Howey test, a clear expectation of profits predominantly from the efforts of others is required to consider a token as a security/investment).

Most likely we will be seeing more and more venture projects seeking funding through ICO mechanism. Taking into account the above-said, the recent Strata ICO is of our interest. The scheme is very interesting and, in brief, can be described as follows:

The purpose of the tokens is to allow a Singapore based Cross Coin Pte. Ltd. (the “Company”) to purchase 33% stake in a NY limited liability company — Starta Accelerator 16/17 LLC which owns an average stake of 7 % of common stock in 21 early stage private technology companies and to invest any remaining funds in future Starta Accelerator portfolio companies. To the extent that the Company generates a profit from its operations, the Company anticipates using all net profit minus reasonable expenses and 2,5 % administrative fee, to buy-back the tokens.

It is obvious that such investments in venture capital type assets are speculative in nature and involve substantial risk of loss. But the thing is that investors should carefully read the terms of token sale since by purchasing tokens they expressly acknowledge and assume the risks mentioned there. Investors have to fully understand and detect some legal risks of losing their investments (totally or partly) or receiving less they expected even irrespective of the success of the enterprise.

Should we take a look at Starta ICO terms of token sale just as an example (Terms of token sale (TTS), not Whitepaper which is usually not a legal binding agreement unless it contains certain specific clauses) we will see, inter alia, the following:

1. The Company anticipates using all net profit minus reasonable expenses and 2,5 % administrative fee, to buy-back the tokens.

The Company just anticipates, i.e. it is not a legally binding obligation.

2.  The Company cannot guarantee that it will be able at any time to buy-back any tokens from the holders of such tokens; the buy-back price of the tokens may be lower than the original price; the buy-back price will be determined by the Company in its sole discretion.

There are no limitations on new loans (lack of relevant covenants) and sale of ownership stake in the Company’s capital (lack of change of control clause). Such actions will most likely diminish the buy-back price of the tokens (if any price will be paid at all);

3.  The exchanges used for secondary trading of tokens (including buy-back) are subject to little or no regulatory oversight, making them more susceptible to fraud or manipulation.

4.  Tokens are uninsured: in the event of loss, there is no insurance whatsoever arranged by the Company.

5.  Company may cease operations in a jurisdiction in the event that regulatory actions, or changes to law or regulation, make it illegal to operate in such jurisdiction, or even commercially undesirable to obtain the necessary regulatory approval to operate in such jurisdiction.

For instance, some new KYC and AML regulation may come into effect making problematic for the Company to pay any buy-back price to the holders of the tokens without time and money consuming efforts.

6.  The Company and/or Starta Accelerator 16/17 LLC may dissolve due to an unfavorable fluctuation in the value of bitcoin or ether or fiat currencies, decrease in the tokens’ utility, the failure of commercial relationships, or intellectual property ownership challenges.

Due to an extreme volatility of cryptocurrencies this is not a remote risk at all and it can have a negative impact on the investors in both ways: the Company may become short of funds if the value of bitcoin and ether substantially decreases until bitcoin and ether were converted by the Company to fiat money or the Company will not be able to repurchase its tokens if the value of bitcoin and ether substantially increases. And this risk refers even to fiat currencies as well.

7.   All decisions involving the network and Company will be made by Company at its sole discretion, including sale or liquidation of the Company (tokens confer no governance rights of any kind with respect to the network or Company, including, but not limited to, any voting, distribution, redemption, liquidation, proprietary, or other financial or legal rights).

8.  Ownership of tokens carries no rights, express or implied, other than the right to use tokens as a means to enable usage of and interaction with the network; tokens do not represent or confer any ownership right or stake, share or security or equivalent rights, or any right to receive future revenue shares, intellectual property rights or any other form of participation; the tokens are not intended to be a digital currency, security, commodity or any other kind of financial instrument.

This is a very interesting part of TTS: the legal wording per se provides for no legal obligation to share any future revenue or rights in order to avoid “expectation of profits predominantly from the efforts of others” part of the Howey test. However, the US regulator may conclude that investors were, nevertheless, convinced by general wording to buy the tokens because of the expectation of profits (as a result of successful sale of assets as anticipated). That’s why these TTS contain a necessary disclaimer regarding US citizens (along with a general representation on behalf of the investors that purchase of the tokens complies with applicable laws and regulation in investors’ jurisdiction);

9.  The bitcoin and ether proceeds from Company’s sale of tokens will be used to compensate staff, cover marketing costs and operating expenses, develop technical infrastructure, exercise the option, and invest into future portfolio companies of Starta Accelerator.

This is a good explanation how the proceeds will be used but investors shall keep in mind that promoters of the token sales probably have no legal fiduciary duties to use the proceeds of an ICO for the benefit of token holders;

10.  No class actions or representative actions: investors are not allowed to gather in group of individuals to file lawsuit in Singapore meaning that each investor has to bear its own costs associated with arbitration proceedings in Singapore (it is obviously very burdensome and in fact preclude an average investor from filing a law suit in a foreign jurisdiction).

11.  Last but not least: In no event will the aggregate liability of company and the company parties (jointly) exceed the amount investor pay to the Company for the tokens (i.e. nominal value).

Generally, it should be noted that investors in such venture ICOs shall keep in mind the following:

— the “Howey Test” interpretation (see “Appcoin Law: ICOs the right way” at www.coindesk.com by Marco Santori of Cooley LLP, Oct 15, 2016; the Howey test legal analysis at www.coinbaise.com/legal/securities-law-framework.pdf);

— a recent case in Utah, SEC vs Traffic Monson (this case – which does not involve an ICO, but involves what is arguably an analogous offering – is instructive for how the SEC may approach ICO enforcement according to Benjamin Sauter and David McGill of Kobre & Kim LLP and Brian Klein of Baker Marquart LLP, see “Initial Coin Offerings: Where the SEC might stand” of June 16, 2017 at www.coindesk.com);

— lack of covenants prohibiting to take loans that confer new obligations on the company — issuer of tokens);

— lack of change of control clause (prohibits to sell stakes in the company-issuer of the tokens);

— lack of legal opinion regarding the company-issuer of the tokens;

— lack of legal opinion regarding the jurisdiction of ICO.

Therefore, if you are not an early bitcoin buyer, а cryptofund or a hotshot chineese investor, you better wait until new regulation regarding ICO will come into force or some investor protective standards will be applied by ICO organizers to their offerings. Unless you want to feel yourself like a venture capitalist whatever it costs.

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