Understanding Legal and Regulatory Factors of ICOs

Legal Considerations We’ve Encountered Building Quidli

Law and regulation is a commonly overlooked topic for ICOs. Understandably, people are more focused on the technical and financial elements — How many total coins in supply? Who gets what and how much? When should the tokens be released? But equally important is another question — What exactly is being bought in a sale, and in what manner can it be bought? Not all ICOs are the same, and tiny differences in what a coin does can drastically impact a project’s legal situation. To help bring clarity to an otherwise dry topic, we’ve decided to start blogging on the legal and regulatory world of ICOs, and how we at Quidli are approaching it (this is mainly for people who aren’t legal experts).

So let’s start with: How is a coin regulated?

The world of cryptocurrency can be divided into three categories: Currency, Security Tokens, and Utility Tokens.

Many of the main Quidli team members are based in France today, so let’s use a French example. Let’s imagine that along with developing Quidli, the team starts a new winery, Maison Crypto. Maison Crypto wines are some of the best wines in the world. However, running a winery is expensive. Maison Crypto has to buy supplies, pay its workers, and distribute bottles of wine all around the world. So, Maison Crypto starts thinking about cryptocurrencies.

Most people think of one thing when they think about cryptocurrency: Bitcoin. Bitcoin fits all the characteristics of a Currency Token, and the fact that it has no physical presence is typically not a problem in understanding how it works. Today, the creation and distribution of a new cryptocurrency is largely unregulated. So for example, Maison Crypto could mine a whole new cryptocurrency that it calls Wine Tokens. It would then convince others to start mining it as well, and maybe one day it will see Wine Tokens used widely enough that it might be able to buy and sell things. This is no different from Maison Crypto printing paper money with grapes on it and trying to convince others that Grape Cash is the cash of the future. The value of the Wine Token is simply a measure of whether people want to use it, and generally governments aren’t too bothered by this. Indeed, this was an early critique of Bitcoin — it’s not backed by anything, so its value is undefinable.

However, most ICOs are not purely currencies. Most ICOs are selling you something more complex than a currency token. They’re selling you something that has a value backed by something. And it’s precisely what the underlying value is that impacts how it’s regulated. While there’s no universal standard for how such tokens are regulated, the most useful standard here is the one in the United States, which asks the question: Is the value of this coin as a result of the work of someone else, or is it as a result of some intrinsic value in the coin itself?

Maison Crypto wants to make a coin that’s a bit more connected to the sale of its wine. Historically, the way it might have done this is through selling equity. People purchase a right to own part of the company and part of the profits of the company. This brings us to Security Tokens. This type of token gives its owner a right to share in the proceeds of the work done at Maison Crypto. The coins are valuable because Maison Crypto has people maintaining a vineyard, picking grapes, and bottling wine, i.e. producing a product. Security Tokens are the most regulated form of cryptocurrency. Governments are concerned with protecting people from such assets because of the ease with which sellers can commit fraud. For instance, Maison Crypto could convince people who know nothing about wine and nothing about France to invest everything in trying to grow wine in parts of the country where grapes could never grow.

Because the value of the coin is entirely subject to the efforts of the company, the company could simply raise the money, and stop making wine. It is the fact that the value relies on the efforts of others that makes it so important. Governments thus put strict requirements on anyone offering equity: If they wish to sell to the public, they must disclose everything, follow strict procedures for what they say and how they say it, issue formal reports on a regular basis, and so on. Complying with these restrictions has created a multi-billion dollar industry of bankers, lawyers, and accountants. Alternatively, companies can limit sales to only the richest people, people who governments assume will be savvy enough to avoid dubious investments, or wealthy enough to stay financially solvent despite losing significant money. Any coin that offers you a right to the ownership or profits of the company is a Security Token, and if it isn’t regulated like equity, it will be soon.

Continuing our example, Maison Crypto has decided to offer Bottle Coin, a token that offers no ownership or profits, but instead, a right to purchase the wine it makes. The underlying value of the token is in its utility in buying valuable wine. As the wine wins awards for its great taste, the token’s value goes up. As the public’s desire to buy the wine fluctuates, so too does the value of the token. Nobody’s efforts drive the value; the value is based on an intrinsic sense of what the user can buy with it. When you buy into an ICO that offers you use of a product, you’re buying a Utility Token.

These are not clean lines. While blockchains are digital, regulations are analog. The more a token is like a utility token, the less-regulated it is. But in most countries there is no clear guarantee that a specific token will be treated as a Utility Token. One of the largest pitfalls here is an ICO of a product that does not yet exist.

If Maison Crypto starts selling its Bottle Coin before it’s even started planting vines, then the value of the Bottle Coin is not about the value of the wine, but about the presumed capabilities of the company to make good wine in the future. That is, the value is once again based on the efforts of others. Many countries have made clear that a Utility Token becomes a Security Token if the utility of the token doesn’t actually exist when sold.

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