In 2017, digital token sales (also known as ICOs or token generating events) eclipsed early stage venture capital funding, at least for technology companies.
Briefly, in an ICO, a company typically sells blockchain-based digital tokens, generally utilising the Ethereum platform, in exchange for a pre-existing cryptocurrency (or possibly in exchange for cash). Often the tokens are structured as digital pre-paid vouchers for software products that have not yet come into existence; many are unregulated by existing financial services laws. Given the early stage of many of these projects, the conceptual “Whitepapers” (which explain the project to be funded) and Terms and Conditions of sale do not provide concrete commitments on the part of the issuer – that is, many simply promise that if the project comes to fruition, a token holder may access the platform using tokens and/or use tokens as a medium of exchange within a particular ecosystem. Certainly, most terms steer clear of promising dividends, investment returns and so forth to the participants. So, without external regulation, and with little in the way of contractual promises, it might seem that ICOs would receive a lukewarm reception. However, a report by venture capital firm Mangrove Capital Partners claims that a blind investment in every ICO to October 2017, including those that have failed, would have generated an average return of 1,320% for investors. These figures, and the smiles on the faces of the participants, will have been assisted by the material rise in the value of Bitcoin which, alongside Ether, the cryptocurrency associated with the Ethereum blockchain, is most usually the required currency for ICO settlement.
With all this mushrooming value, what could possibly go wrong?
Well, even though much money has been made, there will be those who feel that more of it should have come in their direction, or they have missed out on some of it, or that those entrusted with spending the ICO proceeds have not played by the rules. Although there are a multitude of potential claims scenarios arising out of ICO, (including perhaps the most obvious, which would be the result of a regulator taking enforcement proceedings against an issuer as having wrongfully offered unlicensed securities), we concentrate on three.
Failure to execute on pre-ICO promises
Participants in an ICO will have accepted Terms and Conditions linked to one or more Whitepapers, which spell out the business model behind the project. The Whitepaper may state that an existing business will be transferred across to the operating company, in exchange for some or most of the value raised.
Alternatively, the Whitepaper may describe the germ of an idea, and how the token sale proceeds will be used to develop and commercialise that idea. There are many points in between, of course. This entails a contract being made between the purchasers of tokens and the issuers – hopefully encapsulated in the Terms and Conditions.
There are many things that may go wrong in this journey. Even assuming the tokens are in fact issued to purchasers (but see below for problems there), the timetable for launching the touted platform may not be adhered to, or the pre-existing business or underlying intellectual property rights may not be injected into the token issuing vehicle. The founders and backers may take such a large percentage of the proceeds of the ICO that there is little left to finance the development of the objects of the sale. Alternatively, those same founders, having had their pay day, may not be incentivised to work hard to proceed with the development of the project, without adequate lock-ups. Even if they are still incentivised, the business model may be flawed, such that the balance of the sale proceeds is quickly depleted. The founders may have second thoughts about the business model, and use the ICO proceeds for other purposes or investments, not mentioned in the pre-ICO Whitepaper, which come to naught. Some might rely on fine print to change tack altogether.
In these circumstances one or more investors (who may include a subset of the founders) may seek recompense for breach of contract (i.e. breach of the Terms and Conditions of the ICO) or for misrepresentation (fraudulent or otherwise). The ICO Terms and Conditions should contain a dispute resolution provision (often arbitration), or at least will state a governing law. The founders and advisors are characteristically immodest about their participation, (their names and photographs are usually (and properly) fully represented on the company website). The elements of legal proceedings (forum; legal basis of claim; causation, loss, and identity of parties) are all made out. Although the value of the issued tokens may be seriously impacted by either or both the poor performance of the business or the emergence of the claim, those behind the ICO will as night follows day have secured as much conventional crypto-currency as possible (Bitcoin or Ethereum), and may have converted much of it to fiat currency. So, any judgment of arbitral award may not be fully enforceable in the final analysis.
Technical problems leading to loss of funds or tokens
While blockchain technology is (at least until the rise of quantum computing) extremely secure, there is a lot of software and process between the blockchain and the investors which can fail to deliver as intended or required. ICOs generally operate using smart contracts. These are self executing contracts designed using software. Like all software they are susceptible to defects (bugs), and like all software, if they have not been used in a live environment with significant use to expose defects, they are apt to failure. The smart contracts for the receipt of ICO funds and deployment of tokens, and the “instructions for use” will be used in anger for the first time for the duration of the ICO. They may fail to operate as planned, and this may lead to intending investors being unable to participate in the ICO (either because they are locked out, or their instructions misinterpreted in some way). In circumstances where considerable immediate profits can be made by early acquirers of tokens (even if the value subsequently reduces), those investors who lost out may well wish to take legal action against the proprietors of the offering, for breach of contract in failing to accept the investor’s stake, or for negligence in using inadequately robust systems. Depending on the metrics, this can lead to class actions (in some jurisdictions) and representative actions (in others) to recover the lost profit from the investor(s)’ attempted participation.
Given the vast amounts of currency (crypto- and fiat) being transferred over the course of an ICO, a live token sale is a prime target for hacking activity. This can take the form of malicious denial of service attacks to disrupt the sale, or exploiting weakness in the smart contracts and surrounding protocols to exfiltrate money, cryptocurrency or tokens. Losses in such circumstances may be felt directly by investors, or indirectly by all participants, whether by way of dilution of the value of the tokens being issued, or via losses to the issuer (in terms of financial stability or reputation).
As with other technical problems, angry investors may seek recompense from the proprietors of the offering, either for breach of contract, or for negligence in failing to provide a secure system to operate the ICO.
In most of the above scenarios, the proprietors of the issuing company or foundation are not perpetrating a scam, but lose their way, either let down by the immaturity of either their technology or their business plans (or sometimes both). The knives are being sharpened. All ICO issuers can do is stick to their business plans and deliver quality at every stage. They should also keep abreast of best practices as they emerge – one key example being those issued by the Fintech Association of Hong Kong in December 2017. From a purchaser’s perspective, ICO reviews and discussion threads are becoming more sophisticated, but nothing supplants reading documentation and obtaining professional advice when needed.
Note: King & Wood Mallesons advises on token sales and other digital asset projects. KWM staff were also heavily involved in the Fintech Association of Hong Kong’s “Best Practices for Token Sales”. Certain staff own tokens and other digital assets in their own right. However, KWM makes no endorsements and this should not be treated as advice. Please contact us if you would like to discuss your needs.