Uncertainties related to ICOs and ITOs
Initial coin and token offerings (“ICO/ITO”) are innovative ways to finance startups similar to shares IPOs or crowdfunding. Startups may use these processes to raise funds with the aim of avoiding the rigorous regulation of the traditional capital-raising process.
Gergely Szalóki, Partner, Schönherr Hetényi Attorneys at Law and Virág Palguta, Associate, Schönherr Hetényi Attorneys at Law
What is an initial coin/token offering?
In ICO/ITO, tokens (i.e. tools allowing for different benefits) are issued and sold to investors in exchange for legal tenders or other cryptocurrencies. The first generation of these virtual assets were crypto-coins like Bitcoin, while the next generation are tokens which cover a broader utility than crypto-coins and therefore, they may be more attractive for investors.
In the ICO/ITO processes, the startup issuing the token creates a whitepaper. This document describes the background of the project, the features of the product, the terms and conditions of the token, timeframe and the team behind the project. ICO/ITO campaigns are conducted online, meaning anyone with access to the internet may participate in an ICO/ITO. After the marketing stage and when the whitepaper has been circulated, the startup will have a sense of whether investors have an interest in the project. Considering the amount of interest shown, the startup may sign the offer and announce the start date of the ICO/ITO. The tokens may have several features; for example tokens may provide access or purchase rights to the product developed by the issuer using the proceeds gained from the ICO/ITO, or a share in future revenues/voting rights etc. Other tokens may be exchanged for traditional or virtual currencies at specialized coin exchanges after issuance. The ICO/ITO will be unsuccessful if the money raised by investors does not meet the minimum amount required by the startup. If the raised money meets with the required funds within the specified timeframe, the scheme will be completed.
What is attractive for startups, might be a gamble for investors
ICO/ITO requires less effort, and fewer resources and obligations to fulfill. Startups may bypass the regulatory requirements as the tokens do not qualify as financial instruments (except when the token’s benefits are related to participation rights, such as voting or some form of profit sharing, in which case there is a risk that the tokens qualify as securities). Therefore, the ICO/ITO will not constitute a regulated activity and thus, will not be bound by legal requirements. Also, there is no legal standard for the whitepaper. Whereas, in the case of an IPO, the issuer must comply with a broad range of regulatory obligations.
From the investors’ side, however, an ICO/ITO is considered much riskier than other types of investments. At the end of 2017, the European Securities and Markets Authority issued two statements addressed to investors and firms involved in ICO/ITO schemes, identifying the main risks emerging in relation to them. In particular, investors are not protected by law, investors may lose the invested money due to the risk of failure of the funded project, an ICO/ITO may be used for fraudulent activities, whitepapers may contain incomplete or inadequate information, or coins/tokens may be stolen.
Similarities with crowdfunding – Hungarian aspects
The Hungarian regulatory environment for ICO/ITOs is very underdeveloped. Due to the similarities between crowdfunding and ICO/ITO, though, there is a chance that ICO/ITOs might be treated similarly to investment-based crowdfunding. Regarding crowdfunding, the National Bank of Hungary (MNB) concluded that investors may be deemed as providing lending activity which may be subject to licensing requirements, if repayment of the invested money is set forth (e.g. in case tokens will be exchanged for (crypto)money).
The MNB also noted that startups looking for funding (via crowdfunding) might be deemed as collecting money from the public if repayment of the invested money is required. In Hungary, such activity is strictly reserved for banks. Such a conclusion might also be reached regarding an ICO/ITO in the case that the terms of the tokens are not carefully worded.
Considering the above uncertainties, we can conclude that the Hungarian regulatory environment is not (yet) adept at ICO/ITO, but there are signs that both the legislator and the regulator have started to consider the new world of cryptos.
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