Digital token issuers advised to undertake due diligence to avoid violating securities laws

Singapore

17 August 2017. By Tsering Namgyal.

Blockchain-based platforms that are planning to issue digital tokens to raise capital in Asian jurisdictions are advised to conduct thorough due diligence and, if necessary, seek necessary legal advice so that they do not run the risk of violating securities laws.

In the wake of recent announcements by various authorities, startups that are planning to offer digital tokens in Asia are seeking more clarity about the regulatory landscape governing initial coin offerings, or ICOs.

Broadly speaking, ICOs of digital tokens, which have raised more than $2 billion so far this year, are currently divided into two categories depending upon their individual properties.

So-called "utility tokens," which give buyers the right to use certain software, are generally exempt from securities laws, but digital tokens that involve investment schemes or share ownership are likely to be regulated just like other equity or debt securities.

Robson Lee, a securities market lawyer at Gibson Dunn, said: "An offering of digital tokens giving a subscriber only the right to participate in a given blockchain activity, such as joining an automated investment project or getting access to cloud computing services, is not likely to be regulated by the MAS [Monetary Authority of Singapore]."

But, according to an announcement by the MAS on Aug. 1, digital tokens offered in an ICO "representing ownership or a security interest over the issuer's assets or property, or a debt owed by an issuer, may be considered a public offering of securities or units in a collective investment scheme" and will be regulated under the Securities and Futures Act, or SFA.

If they are deemed as securities, the law requires the issuers to publish a prospectus, unless specifically exempted, like any other traditional public offering of securities.

Issuers or intermediaries of such tokens might also need to apply for a license in accordance with the SFA and the Financial Advisers Act, unless exempted. In addition, any platforms where such tokens are traded after they are issued in the secondary market would also have to be an "approved exchange or a recognized market operator," respectively, under the SFA, Lee said.

While virtual currencies per se are not regulated, money laundering and terrorist financing risks apply to all of them equally.

The MAS is at present assessing how to regulate money laundering and terrorist financing risks associated with activities involving digital tokens that do not function solely as virtual currencies. Such guidelines could come sooner than expected, MLex was told.

Some ICOs have been seeking the help of novel compliance solutions to mitigate money laundering risks and ensure they are compliant with relevant laws, as MLex has reported.

In addition, the MAS and Singapore's Commercial Affairs Department on Aug. 10 issued a consumer advisory highlighting potential risks of digital tokens and virtual currency-related investment schemes.

The announcements by the MAS come on the heels of a similar statement by the US Securities and Exchange Commission, or SEC, which said that digital tokens involving investment schemes — as exemplified by the case of a digital token known as the Decentralized Autonomous Organization, or DAO — would be subject to securities laws.

Most ICOs in Asia are selling virtual products and the right to use certain software protocols, which should generally make them exempt from securities laws.

For instance, Hubii, a Norway-based news aggregator, is planning to conduct an ICO in Singapore soon to finance the development of a new blockchain technology for a decentralized content platform.

Since Hubii's digital tokens do not represent any share ownership, it passes the so-called Howey Test, said the company's founder, Jacobo Toll-Mesia, referring to a test that was created by the US Supreme Court to judge whether transactions are investment contracts. It was the basis of the SEC's DAO ruling.

But Toll-Mesia said he still wants to make sure that "everything is transparent," and that local regulators are informed about the exact goal of the issuance of digital tokens.

In the meantime, lawyers in Singapore are busy advising issuers of digital tokens, MLex has learned. The key is to spell out the commercial objectives clearly in their "white papers" and to ensure that what they are communicating is not misleading, legal experts said.

Consumers, however, are advised to exercise caution, because the structure of many ICOs is vague and their goals are often not immediately apparent to amateur investors.

"Such investment schemes are usually vague or inchoate and not transparent in their business and management disclosures," said Lee of Gibson Dunn.

Determining on which side of the law digital tokens would fall, however, is not as simple and straightforward as it seems.

"At a basic level, most ICOs offer token holders some right to use software, but the key question is whether there is anything on top of that," said a Singapore-based regulatory lawyer at an international law firm.

In addition, such ICO operators could be based outside Singapore, which makes it difficult to ensure if they are legitimate, or to trace the operators in the event of failure. If the businesses collapse, the recovery of money would be difficult because they would be regulated under foreign laws or regulations that may or may not be comparable with Singapore's laws and regulations.

Furthermore, it is hard to assess the value of digital tokens, which makes them highly speculative and their price volatile.

"There is a high-risk that a consumer could lose his entire investment amount. In the worst-case scenario, the digital tokens could be rendered worthless," said Lee, who is advising clients who are exploring ICOs in Singapore.