Blockchain token sales create new issues for the market

Author: | Published: 28 Jun 2017
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They are entering the mainstream and getting investors excited, but are deal makers and their lawyers ready?

1 minute read
Even if many in the market have a basic understanding of what blockchain tokens and how they work in practice, few have thought about how they fit in the areas of contract law, commercial law and corporate law, and more generally in the whole transaction process.

Key questions to bear in mind during the deal-making include: are app-tokens considered securities? What terms and conditions need to be used for the sale, purchase or use of tokens? Who can be held responsible in the event of a contract breach? And crucially, will lawyers be required by clients to interpret smart contract code in the same way as traditional contracts currently?

Readers who have even casually followed the widespread media coverage of the rising market prices of Bitcoin and other so-called cryptocurrencies such as Ether, Zcash and Monero in recent months will have become at least passingly familiar with some of the new lingo in the blockchain space: initial coin offerings (ICOs), token sales and appcoin offerings. Some readers may even be able to rattle off the names of some of the most buzzworthy token sales completed in recent months, such as the initial offering of Bancor's Ethereum-based Bancor Network Token (BNT) in June 2017, which reportedly raised the equivalent of over $150 million in just three hours.

Along with such hype, though, has come increasing focus on the legal uncertainties and risks surrounding token sales, with some blockchain commentators drawing analogies between token sales and pump-and-dump or Ponzi schemes, calling for regulators to step in and cool the market. Meanwhile, more innovation-oriented partisans insist that regulators should give token sales a chance to breathe, and that they will be as constructively disruptive to venture capital financing as Uber and Airbnb were to livery and hospitality. This latter camp has also pushed back on the seductions of overly facile linguistic analogies between token sales and equity financings – such as the parallelism between the terms initial public offering (IPO) and ICO, and the tendency to reference token-developers as issuers and token-buyers as investors. The reality is much more complex.

While many legal and investment experts may now have a basic grasp of what blockchain tokens are and their most immediate implications, very few have thought ahead about the farther-reaching ramifications of blockchain token technology on wide varieties of deal-making and transactional activity. For example, few commentators have given serious thought to the challenges and opportunities token sales pose to traditional notions of contract law, commercial law, corporate law and transactional lawyering. To advance the dialogue among blockchain developers, investors, lawyers and regulators on these topics, it is worth exploring the phenomenon of token sales in light of some of these lesser-mentioned legal implications.

Token basics

In the broadest sense, a blockchain token is any digital representation of value that may be utilised on a decentralised, peer-to-peer network secured by a cryptographically authenticated ledger. Under that broad definition, all of the well-known, cryptocurrencies including Bitcoin and Ether, are tokens. Indeed, Ether – the foundational token of the Ethereum blockchain – was itself first issued to the public pursuant to an $18.5 million token sale in September 2014. By contrast, however, Bitcoin was not issued pursuant to a token sale, and instead, its supply simply began at zero and built up gradually over time through issuances of additional Bitcoin to network participants as rewards for verifying transactions by mining.

Tokens like Bitcoin and Ether, which are the fundamental store of value and medium of exchange on a particular blockchain, may be referred to as protocol-tokens. As important as they are, these are not the kinds of tokens that are generally at issue in most token sales or ICOs being discussed today. Rather, the next wave of blockchain tokens are second-order tokens that are built on top of existing blockchains like Bitcoin or Ethereum. Rather than functioning as general purpose tokens that are distributed across an entire blockchain ecosystem, these second-order tokens generally have more specific and narrower objectives, utilise smart contract functionality, and are generally intended to provide users with certain rights, privileges or rewards within the context of a particular protocol or application. Such second-order, functionalistic tokens may be referred to as app-tokens.

Because Ethereum is a Turing complete computational protocol, app tokens may be built on Ethereum using its native functionality. By contrast, building app tokens on Bitcoin requires utilising a bolt on protocol such as Counterparty, which leverages Bitcoin's OP_CODE script to generate dummy transactions filled with smart contract metadata.

In addition to Bancor's BNT, some other current and pending examples of app-tokens include:

  • the BAT token issued by Brave, which advertisers will use to buy the right to display in-browser ads to users of the Brave web-browser;
  • the Kin token proposed to be issued by Kik, which Kik users would use to pay for access to unique in-app features like chat stickers, VIP groups and bot services; and
  • the Reputation token issued by the Augur prediction market, which enables Reputation token holders to report the outcomes of events that are the subject of prediction bets on the market and, so long as the holders' reports are accurate, to receive a pro rata share of Augur's market fees as an economic reward; and
  • the Storjcoin X token issued by Stork on both Bitcoin (via Counterparty) and Ethereum, which enables users to pay for data storage on a decentralised cloud storage platform.

A typical app-token sale works like this: a group of developers, which may be as loose and informal as a circle of like-minded individuals who have never met in person and know each other through blockchain-themed internet discussion groups, or as formal and traditional as the founders and employees of an incorporated startup company which may already have raised one or more rounds of traditional venture capital, develops an idea for an internet-based business, often in the form of a decentralised application (DAPP). Whether the business is or is not decentralised, and thus controlled by a smart contract, is not important. What is important is that the app used in the business makes some functional use of a blockchain token. Users might be required to hold the token in order to make any use of the app at all, or the app may be usable without the token but afford additional functionality or privileges to users who do hold the token. The token might also be issued to users of the app as a reward for taking revenue-generating actions, such as watching ads, spending money on products or recruiting additional users.

What is important is that the app used in the business makes some functional use of a blockchain token

Having identified an idea, the development team will typically publish a whitepaper which will set forth – with varying levels of professional polish and clarity – the proposed functioning of the token and the basic terms of a proposed sale of the app-token. The whitepaper will often provide projections of when the development team plans to meet certain development milestones, depending on how much funding is raised through the app-token sale. Importantly, however, the whitepaper will generally not contain financial information, projections, or risk factors of the type typically found in an offering of securities. The development team will then market the app-token by building community support in blockchain-oriented web forums and, often but not always, arranging for online exchanges to list the app-token for trading.

To actually launch the token for sale, the development team will either appoint a third-party escrow agent to hold the tokens and release them to the right addresses at the conclusion of the sale or (in what may be considered a more decentralised and blockchain-specific method of conducting the sale) establish a token sale smart contract/DAPP on a blockchain such as Ethereum. Such a smart contract will function much like an autonomous transfer agent, holding the app-tokens within a virtual wallet represented by a specific blockchain address. A person who wishes to buy the relevant app-token can send another token – typically, a protocol-token like Ether – to the smart contract address with a purchase command, and will automatically be issued the app-tokens in accordance with a prearranged exchange rate. The buyer's deposit of protocol-tokens will either continue to be held in the smart contract, or may be forwarded to a wallet controlled by the development team. The app-tokens may or may not be subject to certain transfer- or use-restrictions for a period of time, and may or may not be accompanied by withdrawal rights enabling the app-token holder to effectively sell the app-token back to the smart contract in exchange for protocol-tokens.

Once the token sale ends, the development team may use the protocol-tokens now held in the smart contract – which are often more liquid than app-tokens and can be immediately sold for fiat currency (dollars, sterling) on any number of exchanges – to fund the costs of developing the app advertised in the whitepaper. Unlike the shares of a corporation, app-tokens typically will not entitle the holder to an equity interest in the development team's business, nor to influence or control (via stock voting) the management and operation of the development team's business. However, the app-tokens will often start to trade on an exchange very quickly after completion of the initial app-token sale, and may rise in value due to speculation. In the longer term, if the app ultimately is completed by the development team and adopted by a wide user base, the app-token might become very valuable through the familiar macroeconomic dynamics of supply and demand.

From an entrepreneur's perspective, the token sale channel presents a highly appealing alternative to traditional venture capital fundraising. As much as venture capitalists may like to tout the business expertise they will contribute to a start-up alongside their monetary investment, some entrepreneurs see these claims as exaggerated. By contrast, the token sale avenue is (at least in theory) a startup entrepreneur's dream come true – allowing capital to be raised quickly, easily and in quantities of tens of millions of dollars with no angel investors or venture capitalists pushing for a fast exit or premature jump in scale.

A new legal frontier

The legal issues surrounding token sales are myriad and go well beyond what can be summarised here. Below are a few key issues that are most important in corporate and commercial law.

Securities law issues

One of the most fundamental questions that should be asked by both issuers and buyers prior to participating in any app-token sale is whether the app-tokens constitute securities. Offers and sales of securities are subject to complex regulatory requirements that do not apply, for example, to sales of ordinary software. The case law determining the existence of a security is complex, was developed long before the invention of blockchain technology, and is not easily summarised. But, generally speaking, in the US, an app-token will be a security if it represents an investment of money or monetary equivalents in a common enterprise with an expectation of profits solely from the efforts of others. In this article, we refer to tokens that are securities as token-securities.

While the issuers of certain app-tokens (for example, Blockchain Capital) have voluntarily classified their app-tokens as token-securities, the majority of issuers have taken the position that app-token buyers are purchasing the app-tokens not as an investment, but so as to be able to use them in the to-be-developed app. Other than in the case of some obvious Bitcoin derivative securities that lacked even the appearance of a non-investment use case, we have yet to see these developers' positions challenged in enforcement actions by securities regulators. Accordingly, the application of securities law to app-tokens remains both untested and unclear.

What is clear, though, is that sales of token-securities (if there are such things) should be conducted dramatically differently from sales of app-tokens that are not securities. For example, in the US, an issuer must either register its securities with the Securities and Exchange Commission – a complicated and expensive process only undertaken by very highly valued and relatively mature companies – or limit the sales of its securities to narrowly targeted and modestly sized private placements to high-net-worth individuals and qualified institutional investors (or the general public, but only for crowdsales raising $50 million or less and satisfying various other criteria). But even a private placement of securities may be subject to antifraud rules which impose greater disclosure obligations on the issuer, and provide the prospect of greater remedies to the buyer, in stark contrast with the liabilities applicable to the sale of ordinary software.

Moreover, privately placed securities are often restricted from being transferred except pursuant to special exceptions, and, while blockchain functionality is, in many ways, ideally suited to monitoring and enforcing such restrictions, the resulting illiquidity of tokens would surely dampen buyer interest on the front end.

The above notwithstanding, the appropriate classification of app-tokens remains a grey area and because tokens are not necessarily securities, the rule of caveat emptor should continue to apply, and prospective token buyers should not assume they will have the same rights (such as the right to receive scrupulously accurate and detailed disclosure) and remedies (such as rescission) when buying tokens as when buying, say, the stock of a publicly traded company. Moreover, investors will need to develop new toolkits to conduct due diligence on token-securities. For example, if the token-security is tethered to a smart contract, investors will need to retain attorneys who not only have a deep understanding of securities law, corporate governance and how to negotiate and document equity financings, but also have the ability to read and comprehend the smart contract code that is supposed to implement such arrangements on a blockchain.

Traditional Start-up Investment v. App-Token Sale
  • Purchase of shares of a company
  • The shares generally are securities, entitle the holder to voting rights, and give the holder a residual right to distribution of the company's assets.
  • Due diligence consists of reviewing the books and records of a company.
  • Sale proceeds fund development
  • Formal deal documents which contain traditional representations and warranties, with clear avenues for recovery (such as indemnification, fraud etc).
  • Clearly stated governing law for all transaction documents
  • Fiduciary duties for company board members, officers etc
  • The shares may be subject to transfer restrictions, enforced by regulators and courts.
  • Purchase of digital blockchain tokens
  • App-tokens are not necessarily securities, do not necessarily entitle the holder to voting rights, typically do not give the holder a claim to the enterprise's assets, and often have a mere 'utility function.
  • Due diligence consists of technical analysis of the software code of apps, smart contracts, tokens and their blockchain deployment.
  • Sale proceeds fund development
  • Some sales are governed by end use licence agreement-style purchase agreements, but most are based on technical white papers and implied terms.
  • Generally, no reference to a chosen governing law and, typically, no clearly identifiable primary jurisdiction of most relevance
  • Unclear duties and standards of care for developers
  • The tokens may be subject to transfer restrictions, enforced automatically through smart contract code.

Contract and commercial issues

Just as important as the question of whether a token constitutes a security are the basic questions contract and commercial law, such as: what terms and conditions govern the sale, purchase and use of this token? Which jurisdictions and/or jurisdictions' laws are applicable to the token sale and its terms? Are those terms written or unwritten? Express or implied? If there is a contract, who are the parties to the contract, and what are their respective rights and obligations? Does the token purchaser own the token, or has the token purchaser merely acquired a licence to the token? If a licence, what kind of licence?

While certain issuers (such as and Lunyr) have sold their app-tokens pursuant to an express presale purchase agreement or similar written contract, they are the exceptions. More often, the only document circulated in advance of an app-token sale is a technical whitepaper. Such whitepapers rarely appear to have benefitted from the review of legal counsel or even peers, often neglect to disclose the risk factors associated with purchase of the tokens, and are usually lacking in the standard commercial terms – such as representations and warranties, indemnification provisions, limitations of liability, mandatory arbitration provisions, choice of law provisions and class-action waivers – that would ordinarily be found in, for example, a run-of-the-mill software licence. More concerning still, token sale whitepapers often contain forward-looking statements, promises or undertakings by the development team, such as that 65% of the funding raised pursuant to the token sale will be utilised to pay employees, 12.5% will be utilised for marketing, and so on.

The token sale channel presents a highly appealing alternative to traditional venture capital fundraising

What happens, though, when these often very firmly worded whitepaper commitments are not honoured? While developers promoting their next big idea for an app-token may assume they can sell the app-tokens on one basis, raise the funds, and then later pivot toward other use cases without refunding the buyers, the law may have something else to say – even if there is no contract between the issuer and the buyers. For example, under the doctrine of promissory estoppel, a whitepaper's claim that 'the proceeds from our token sale will be used to fund development of a chat app where the token may be used to send promotional ads to users,' if relied upon by the token buyers, may create a binding obligation on the part of the development team. If, in the final product, the token can only be used to buy discounted pizza, the token buyers may be entitled to sue the development team for damages under a quasi-contract theory. On the other hand, because such claims are difficult to prove and often require a showing that the buyer's reliance on a statement was reasonable, app-token buyers should not assume that, in the absence of a written contract with the development team, any statements made in a whitepaper regarding the planned future development of an app-token are reliable or enforceable as a matter of law.

As complex and unclear as such threshold questions are, they pale in comparison to the contract law issues raised by the emerging generation of blockchain technologies. To take just one example, consider the Ethereum Foundation's pending proposal to hard-fork the Ethereum blockchain to switch from proof-of-work mining to proof-of-stake mining. Under the new proof-of-stake model, miners who engage in 'selfish mining attacks' at the expense of the network can have their Ether holdings burned ie annihilated (or, what amounts to the same thing, restricted for purposes of the protocol so that they can never be spent) which would be impossible under the former proof-of-work model.

There are many unanswered questions regarding such protocol upgrades. If a participant in the Ether initial token sale bought Ether on the basis that Ethereum used proof-of-work mining, and is damaged by the change to proof-of-stake, for example, by having his Ether burned, can that participant sue the Ethereum Foundation for breach of contract or for committing a tort like conversion of personal property? Does the answer change depending on whether the relevant protocol revision is implemented via a soft-fork – in which case, the user has no viable alternative to using the newly revised protocol – or a hard fork – in which case, the user (and other like-minded users) may be able to remain with the old proof-of-work blockchain, but the network effects of such blockchain may be greatly reduced by virtue of many users migrating onto the new chain?

These are questions that not only are currently unanswered, but may be unanswerable in the absence of serious new law-making, whether at the statutory level or through judicial adaptation of hoary common law contracting doctrines to novel blockchain technologies. Attorneys specialising in transactional law – who, until now, have taken a backseat in the blockchain cruiser to regulatory, securities and white-collar-defense attorneys – will play a key role in deciding these questions and establishing best practices for contracting in the context of token sales.

Corporate law issues

Tokens pose fascinating and important challenges to traditional corporate law, corporate governance and strategic corporate deal-making.

Decentralised autonomous organisations (DAOs) are autonomous smart contracts or smart agents existing as code on a blockchain, which issue tokens that function much like capital stock in exchange for deposits of protocol-tokens that function much like invested capital. A DAO may then function as a well-capitalised, semi-autonomous contracting agent on the blockchain, with token holders having varying degrees of voting control over how the DAO behaves.

Attorneys specialising in transactional law have until now have taken a backseat in the blockchain cruiser to regulatory, securities and white-collar-defense attorneys

It is tempting to liken DAOs to business entities like corporations and limited liability companies. But such entities – and the limited liability protections afforded to their equity holders under law – are traditionally viewed as the purview of governmental authorities and their sovereign power to bestow corporate personhood on otherwise inert contractual arrangements. Can a DAO – which does not depend for its existence on the filing of a certificate of incorporation or other state-approved action, is decentralised and, for all practical purposes, may be unstoppable in its operations (so long as the underlying blockchain network continues to exist) – reasonably be afforded any of the privileges of corporate personhood? And, if not, does that mean that every DAO token holder is jointly and severally liable with the other DAO token holders for anything and everything the DAO (or any of its other token holders) might do? On the other hand, if DAOs can be viewed as more like traditional business entities, should the software developers responsible for setting the DAO in motion have fiduciary duties to the token holders, as if the developers were the directors, and the token holders were the shareholders, of a corporation? What if the tokens for a particular DAO are so widely distributed that, as a practical matter, neither the development team nor any other person or unified group controls it – who can then be held legally responsible for a DAO's contract breaches, torts or crimes? Adding to the complexity, if the computer code governing the DAO does not expressly elect a jurisdiction whose laws apply, what law would be applicable?

Other questions will arise when traditional corporate deal-makers begin leveraging blockchain technologies in the context of major strategic transactions, whether to create new, trustless solutions to traditional zero-sum dilemmas or simply to facilitate back-end due diligence or payment processing workflows. For example, in private M&A transactions, rather than trusting (and paying) a third-party bank to hold indemnification funds in escrow, parties could deposit digital currency into a smart contract escrow deployed on a decentralised blockchain. Each interested party could hold an app-token marking the party's pro rata interest in the escrow, and the smart contract could be programmed to automatically pay out the funds at times and in amounts keyed off of determinable extrinsic events – such as the issuance of a judgment (itself recorded on the blockchain through an independent oracle function) awarding the purchaser of the acquired business damages against the sellers based on a false representation made at the time of sale?


All of the problems and themes of securities law, contract law, commercial law and corporate law will be very familiar to specialists who practice in those areas. What is less familiar- and is largely unknown as of the writing of this article – is how those problems and themes will and should play out in the context of blockchain token technologies, their sales to the public, and their management and governance once they are launched. Despite the fact that, unlike money transmitter laws and other traditional bastions of fintech law, these areas of legal expertise have not historically been a prerequisite to practicing as a blockchain attorney, as DAOs and similar token technologies burgeon, these traditional issues will be transposed into blockchain, and expertise in them will become a sine qua non of understanding legal issues in the blockchain space.

Likewise, as blockchain technologies evolve to a point where they can solve traditional investment, governance and deal-structuring problems better than old-school paper methods, specialists such as M&A advisors will one day be expected by their clients to evaluate smart contract code in such contexts as closely as they now pore over the intricacies of a traditional prospectus, a corporate charter, an investor rights agreement, a merger agreement or other legal document.

Lewis Cohen
Hogan Lovells (New York)
  Gabriel Shapiro
Senior associate
Hogan Lovells (Silicon Valley)