Token Issuer General Counsels' Guide to Mitigating Risks in Token Offerings

As the world of cryptocurrencies continues to rapidly evolve, token offerings, particularly Initial Coin Offerings (ICOs), have emerged as a popular means for blockchain-based startups to raise funds for their projects.

Similar to Initial Public Offerings (IPOs), which are a way for companies to raise equity, ICOs allow entrepreneurs to offer their own digital tokens or coins to investors in exchange for funding. However, while ICOs can bring about high rewards, they also entail significant risks.

This article aims to provide a guide for token issuer general counsels on what they need to know about token offerings and how they can mitigate the associated risks.

Understanding the ICO Landscape

ICOs provide a unique opportunity for blockchain-based startups to raise capital. As you oversee the ICO, you retain equity and ownership in the project. A key benefit of ICOs is to provide token liquidity, of course. This facilitates investors to trade tokens quickly, which not only reduces their risk but is also conducive to encouraging investment in the token."

The blockchain-based nature of ICOs ensures transparency. It empowers investors to monitor activities and report any suspicious behaviour. Moreover, cryptocurrencies provide fast and fluid transactions, maintaining market value during exchanges.

However, creating an ICO is a detailed and complicated process. It requires a thorough understanding of the local jurisdiction's securities laws (and the customer's domestic laws who you’re targeting), the preparation and review of legal documents, and ensuring compliance with regulations and securities requirements.

Risk Factors Associated with ICOs

In order to know how to mitigate risks, it's important to know what the risks are. And, no amount of belief in blockchain or your own technology should ever leave a blind spot that could potentially be exploited. So, it’s wise to look at other ICOs failures, along with general crypto scandals.

Firstly, an ICO could attract a lot of eyes and money. Beyond becoming subject to other people’s hype (and the subsequent risks of that), a major risk factor that becomes inevitable is that individual crypto assets are heavily correlated to the crypto market as a whole. So, after an ICO, you become subject to market-wide risks, frenzies, and general sentiment towards crypto as a whole can impact your investors.

This is not something you can do much about, besides thoroughly explain the unique and independent benefits of your token/technology. Market manipulation and fraud is also another risk though, meaning cybersecurity becomes paramount. Compliance can help you stay on top of risks of fraud, but non-compliance is a huge risk factor as well. Non-compliance can lead to penalties, fines, and poor public relations.

Mitigating Risks in Token Offerings

As a general counsel, your role is crucial in mitigating the risks associated with token offerings. Below are some steps to take and risks to consider.

Conduct extensive analysis of your project and tokenomics

This should be done in accordance with your local jurisdiction’s securities laws. Understanding the legal landscape is crucial to ensuring that your ICO is compliant with all relevant regulations.

Whilst the FCA, Bank of England, and Treasury have stepped up efforts to regulate cryptoassets, token offerings are not always directly regulated - though, this is partly because so many fall outside of the jurisdiction. Whether an ICO is regulated by the FCA (or the degree to which it is) is determined on a case-by-case basis, and this needs to be investigated.

It’s also how you go about marketing your token offering that is in question, too. Recent changes coming into effect in October 2023 by the FCA have meant a clamping down on how cryptoassets are marketed to UK customers, even if the ICO is overseas. The risks need to be displayed and bonuses are restricted, which could impact an ICO’s marketing efforts.

The structure of the ICO needs to be determined (crowdfunding etc), the nature of the token needs to be clearly defined (utility, payment, security etc), and the business model of the ICO laid bare. An ICO strategy also needs to be developed. This involves planning the ICO's roadmap, setting clear objectives, and establishing a strong management team to oversee the ICO process.

Prepare and review the legal documents necessary for an ICO

These include Terms and Conditions, Privacy Policies, and White Papers, among others. These documents should be carefully prepared and thoroughly reviewed to ensure they are legally sound and protect the interests of both the token issuers and the investors.

The FCA claims that the white paper - which is a key document of an ICO - needs to avoid being unbalanced, misleading, or technically convoluted. It needs to be clear, comprehensive, and fully assess the tokens’ risks and characteristics.

It’s important to ensure compliance with relevant laws, regulations, and securities requirements.

This is crucial throughout the process of token development, ICO fundraising, and distribution. Ultimately, non-compliance can lead to severe penalties and damage to the ICO's reputation.

DAR and FSM - What Is a Security Token? What is an Asset?

The Designated Activities Regime (DAR), which is set to be a new addition to the Financial Services and Markets Act, is being introduced by the FSM Bill. Its purpose is to establish a regulatory framework for certain financial activities.

The government is contemplating the use of this regime to limit public offerings of cryptoassets that do not qualify as security tokens and to control the admission of a cryptoasset to a trading venue.

The FSM Bill characterises a 'cryptoasset' as “any cryptographically secured digital

representation of value or contractual rights that:

• (a) can be transferred, stored or traded electronically
• (b) that uses technology supporting the recording or storage of data (which may include distributed ledger technology).”

This definition is not exclusively linked to distributed ledger technology (DLT), unlike in some other scenarios — notably, under the UK’s Money Laundering Regulations 2017 (MLRs) and the recommendations of the Financial Action Task Force. A DLT-specific definition is also used in the EU Markets in Crypto-Assets (MiCA) Regulation.

Considering the wide scope of the definition, aside from certain Non-Fungible Tokens (NFTs) and utility tokens, it's unlikely that your cryptoasset wouldn't fit within it, as most will represent some form of value.

Conclusion

In conclusion, as a general counsel, your role in issuing token offerings is challenging, to say the least. You are tasked with understanding the complex legal landscape of ICOs, preparing and reviewing legal documents, ensuring compliance with laws and regulations, and mitigating risks.

By following the steps outlined in this guide, you can help your organisation navigate the ICO process successfully and mitigate the associated risks. However, feel free to get in touch with the Englebert team for ongoing compliance monitoring and developing a strategy to better manage risk. At Englebert, we understand the importance of an ICO in a project’s success, and how important a tailored approach is to achieve your project’s vision.

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