Although the case-law is sparse owing to the nascency and emerging nature of blockchain and the lack of widespread digital currency adoption, the use of digital currency to raise capital is expanding to various sectors, not just limited to technology companies.
- Smart contracts are unstable: The law on the enforceability of smart contracts is still uncertain due to the nascency of the blockchain and lack of regulatory structures and formal enforcement mechanisms to accommodate programmable smart contracts. It will need to be determined whether legal contracts that are implemented in whole or in part on a blockchain, renders them enforceable under existing law. For example, the Uniform Electronic Signatures Act (“UETA”) and Electronic Signatures in Global and National Commerce Act (“ESIGN”) already recognize, enable, and validate the use of electronic signatures and electronic records when using a blockchain. We will need more such statutes to provide additional recognition and validation.
- STOs are unregulated and lack liquidity: The market for STOs is mainly unregulated, other than two national and regulated digital asset exchanges such as the JSE and BSE that are onboarding STO issuers. The technological capability and regulatory approvals required for licensed securities dealers to list and integrate blockchain-native tokens into their offerings are non-existent. This demonstrates there is a limited active secondary market for trading, and thereby a lack of liquidity. Although the JSE and BSE have migrated from a traditional stock exchange to a digital asset exchange (retaining all traditional stock exchange capabilities), boards will need to carefully evaluate their secondary market needs and determine which jurisdiction(s) and the extent of regulation are required to best list their STO. Boards need to consider the absence of investor protections or insurance to mitigate against potential frauds, scams, or other malfeasance concerns.
- Director liability revisited: If issuers decide to raise capital via an STO, ICO, or IEO, and list on decentralised and mainly unregulated exchanges, such exchanges do not provide investor protections nor deposit insurance for neither issuers nor investors. If issuers are sued for any type of fraud, scam, misrepresentation, or other malfeasance, existing D&O (Directors & Officers) liability insurance may be insufficient or void altogether. SEC enforcement actions listed above with various ICO issuers is evidence that the SEC enforcement climate is alive and well and directors need the required protections.
- Higher leakage costs: Blockchain powers digital currency. Issuers that raise capital via an STO, ICO, or IEO must realize that shareholder dissemination of information is now instantaneous, giving rise to the efficacy of the efficient market hypothesis. Any internal leakage of material, non-public information of corporate events or transactions are likely to significantly increase the speed and ferocity of leakage or slippage costs. This carries reputational, business, and director liability risks if certain shareholder groups are advantaged at the expense of others.
- Adoption rates are slower than expected: Although the market for ICOs peaked in late 2017 and early 2018, the market for STOs hasn’t been as torrid as adoption has been much slower than expected. Adoption has been mainly dependent on the state of SEC regulation to ensure investor protection and market integrity, which has delayed legislation or formal regulation of STOs. Not only has the SEC been slow to enact rules for digital currency issuers, it has denied various applications to secure regulatory approval for ATS (Alternative Trading Systems), BTC Exchange Traded Funds (ETFs), and other registered entities with a digital currency component. The pace of STO financings will depend on the wider adoption of digital currency, such as BTC, while adoption has been slow and concentrated. For example, BTC currently represents nearly 70% of the total global market cap of digital currency. This poses concentration risk among the core five functional digital currencies.
With the gradual and tactical evolution of STOs becoming actively listed and traded, the need for voting and programmable corporate governance dynamics will likely increase in prominence. Voting rights allow token holders to participate in important decisions related to the underlying asset of a digital currency- whether it is considered a utility or security token. Security tokens bring a unique flavor to voting rights as governance decisions are not only relevant to the lifecycle of the underlying asset, but also to the digital asset itself.