Article

IFCs step in to support Asia-Pacific’s ICO boom


Added on 13/08/2018

(Asian Legal Business) -- A few years ago, the focus was on the latest and largest investments in technology firms in the United States. But a glance at any newspaper or business website will show you that this trend is now shifting, in favour of increased focus on investing in tech companies in Asia. Companies in the region are mushrooming, driven by young, hungry entrepreneurs who are rejecting conventional roles in more traditional companies to branch out on their own. The technology itself is at the forefront of the world, with Asia the leading region in areas like artificial intelligence, innovative payments and blockchain.

Startups in the Asia-Pacific region attracted $72 billion in just the first half of 2018, according to business data platform Crunchbase. These new types of technology companies are also seeking out innovative structures when it comes to funding and investment for growth, and offshore law firms, which have a history of enabling novel vehicles for transactions are extremely well-placed to assist them.

A key trend noticed by a lot of the offshore lawyers Asian Legal Business spoke to is the increasing popularity of initial coin offerings (ICOs) in raising capital.

“Traditionally, we would see entrepreneurs raising funds for their new business venture through debt or equity financing with banks or venture capital firms as counterparties. Over the last 12-18 months, we have been approached by quite a number of tech entrepreneurs wanting to do ICOs,” says Christopher Page, a Hong Kong-based counsel with Conyers Dill & Pearman.

He is far from the only one to notice this.

“The buzzing tech scene is certainly a significant driver behind the types of transactions we have been seeing in Asia over the last couple of years. Asia is a hive of activity when it comes to blockchain and cryptocurrency. In particular, Hong Kong and Singapore seem to be developing into hubs for blockchain technology companies and there has been a lot of ICO activity in these regions, particularly following China’s retreat from ICOs,” says Kate Hodson, a partner in Ogier’s Hong Kong office.

“There is hardly a week that goes by that we don’t receive an enquiry for a transaction that is ICO, crypto or blockchain related,” she adds.

“As our clients bring innovative products to market, so we must keep pace. We have been doing initial public offerings (IPOs) for years; it is only since the advent of bitcoin that we have had to contemplate the ICO,” says Ellie Crespi, a partner in Harneys’ Hong Kong office.

Another firm experiencing this is Collas Crill. “We’re seeing that ICOs and token generation events (TGEs) are proving to be powerful and more popular as fundraising tools with our clients and, as a result, offshore activity from Asia has grown substantially,” the firm says.

“Our Asia-based clients will typically form a Cayman Islands foundation company to act as token-issuer, and a Cayman Islands-exempted company to act as the management entity holding intellectual property rights and managing the related platform,” it adds.

“The altruistic and transparent aspects surrounding distributed-ledger technology have also given rise to the use of Cayman foundation companies as corporate governance vehicles within the blockchain community, and to their use as grant-making funds formed by successful founders in the space,” notes Collas Crill.

“Asia certainly looks set to continue to be at the forefront of activity, with ICOs and the like becoming an increasingly attractive and interesting way to raise funds,” it says.

“Consequently, the interaction and alignment between our Asian and Caribbean offices play an important role in facilitating activity in this space,” the firm adds.

GOLD RUSH

The rise of blockchain and its nature of operation has created a movement akin to a gold rush.

“We are experiencing a global demand for ‘tokenised’ transactions. These types of transactions involve an offshore issuer of a cryptographically secured token or cryptocurrency recorded on a distributed ledger. The traditional rules and methods of incentivisation and capital raising have been flipped upside down with a lot of the tech projects we work on,” says Cory Macculloch, a Cayman Islands-based associate with Ogier who works within the firm’s Investment Funds and Digital, Blockchain & Fintech groups.

“Many of these projects involve the use of open source technology – technology which by nature is to be used without commercial exploit. The use of token generation events to fund these projects has seen developers and market participants contributing to these projects with the hope that their tokens may appreciate in value or that they will be awarded additional tokens,” he adds.

Provided the issuer follows best practices and is transparent, these transactions may continue to benefit investors in traditional ways by providing opportunities for capital appreciation and profit participation.

“These projects may also benefit other stakeholders such as third-party developers and consumers who have often not been given a meaningful stake in these projects. One exciting trend we are seeing is the use of tokens to monetize and provide value to consumers who are providing third parties with access to their personal information,” Macculloch says.

Even though the motivations to provide and receive value are varied, Macculloch believes the transactions of distributed ledger (or blockchain) networks can be broadly divided into two categories.

“These transactions fit into two baskets: (1) transactions where tokens represent traditional securities or commodities (as USDT Tether is to USD) and (2) transactions or ‘token generation events’ where tokens represent a right to access or use a decentralised software platform or network (as Ether is to Ethereum),” Macculloch explains.

BIGGER THAN VC

In June last year, ICOs overtook angel and venture capital seed funding for the first time. It brought in more than $550 million for coin issuers compared to the $300 million raised from VC investors that month.

Last year, Quoine’s QASH cryptocurrency was Asia’s largest ICO, bringing in $112 million for the Japanese- Singaporean startup. Though it looks promising for the companies, reactions from regulators have been more mixed throughout the region.

Both China and South Korea have banned fundraising activities involving cryptocurrencies, whereas countries like Singapore and Taiwan have tried to develop legal frameworks surrounding it.

“After China’s crackdown, many entrepreneurs have looked to Singapore and Hong Kong as more ‘crypto friendly’ jurisdictions. Japan has also embraced the technology with the Japanese government being the first to amend their banking laws to recognise cryptocurrencies as a method of payment,” Hodson points out.

“With the explosion of the new ICO market, we’re seeing an increasing number of strategic M&A partnerships with financial institutions and asset managers engaging with technology companies to gain a competitive edge, as well as developing accelerator programmes to support early-stage businesses,” she adds. “Drivers of this trend include maximising cost efficiencies, enhanced data analytics, attraction of new customers, breaking into new markets and R&D.”

Because of this, Hodson sees a high demand for “cryptocurrency fund formation advice, investments into blockchain technology companies, project fund investments into pre-IPO and pre-ICO fintech companies.”

Page thinks the ICO boom is “more of an evolution than a need.”

“The genesis of these offerings was as a form of crowdfunding amongst tech-savvy participants, well able to evaluate the technology of the underlying start-up. Tech professionals found a way to effectively raise funds to assist with their blockchain start-ups in a way that was quick, inexpensive and didn’t give up control of their fledgling businesses,” he says.

“Tech entrepreneurs approach fund-raising in a completely different way than someone from a more traditional business or finance background. They found a fund-raising solution that worked for them and is, in some ways, more attractive than traditional ways of fund-raising,” he adds.

The application of blockchain is transformative and wide-ranging with potential for all sorts of industries and technologies, including, but not limited to, finance, energy and government. And it seems ICOs are simply an offshoot of using this technology as a new method of fundraising for start-ups.

There have been around 600 ICOs so far this year raising $12.5 billion, compared to 43 in 2016.

However, as participation has gained popularity and broadened then naturally global regulators have begun to take more interest to ensure that these offerings aren’t simply circumventing securities regulations that are in place to protect investors.

“Given the potential of blockchain technology and the opportunities that this offers for entrepreneurs then I don’t see ICOs as being a phase. However, even over the last 18 months they have become more mainstream as regulators get to grips with this area and so the days of seeing an ICO as a way of raising quick, easy money are over as offerors become more aware of the potential consequences of falling foul of the securities regimes in various jurisdictions,” Page says.

Though token offerings are considered a fairly new thing, the considerations of companies are still traditional. No matter how cutting-edge they are, they still need liquid assets.

“High tech companies may need liquidity that is hard to obtain from banks, because of the risk profile of the company or because the loans would be smaller ticket sizes than the banks are accustomed to writing,” says David Meredith, a partner with Harneys’ Shanghai office.

However, the very nature of ICOs place the liquidity of such offerings in a grey area.

“Whilst the offering entities are most often corporate vehicles, arguably a coin offering doesn’t comfortably fit the debt or equity analysis as these ‘coins’ do not offer share rights providing a return on the business, nor are they loans that would be subject to repayment,” Page says.

“After issue, the coins are often traded on digital exchanges. Often the proceeds of the offering are used to fund the development of a platform related to a start-up blockchain venture and the coin is used to participate in the underlying product or service offered on the platform,” Page adds.

“Purchasers of the coins on the secondary market established on the digital exchange are betting on the popularity of the platform,” he says.

REGULATORY HEADACHES

That has given regulators something new to think about.

“The developments have been explosive, and it will take time for regulators (and financial institutions) to get to grips with the legal and practical ramifications and for markets to sort out the ‘good from the bad’ and find acceptable standards of practice. When it comes to asset management of cryptocurrencies, for example, there are still hurdles around custody, OTC markets and KYC and source of funds checks. It will take time to work out these issues, but I expect solutions to develop as well as the regulatory framework to develop around them,” Hodson says.

“However, I certainly see this as an ongoing trend. There are clear benefits of blockchain technology when it comes to maximising efficiency, cost reduction and reliability of transactions,” she adds.

And now that the dust is settling, regulators are also placing ICOs into existing categories of consideration.

“A lot of consideration has been given to whether these ICOs amount to securities offerings and they have received a lot of publicity recently with regulators now crystallising their attitudes accordingly,” Page says.

“For the client, offering ICOs has been quicker and more attractive in that they retain greater control of their businesses. Thus far, investors have been subject to less regulatory restrictions. However, as ICOs have become subject to greater scrutiny by regulators, arguably these perceived advantages begin to lessen,” he adds.

Page believes this is now leading to a maturing of this market in the sense that issuers are now becoming aware that there are consequences to falling foul, even inadvertently, of the securities regulations as they apply to the purchasers of the coins.

That has also created an opening for legal professionals to offer their compliance services.

HELP FROM OFFSHORE

Because ICOs have outpaced the legal framework surrounding it, the capabilities of many “traditional” law firms may not be as nimble as offshore firms.

“Tech is changing the way businesses are operating at an incredible pace. There are many challenges and opportunities that face investors, financial institutions, businesses and tech start-ups,” says Anthony McKenzie, managing partner of Carey Olsen’s Singapore office.

“As with much new technology, the speed of change frequently outstrips the legal and regulatory landscape and innovative approaches are often required in order to adapt. With this ever-changing tech landscape, offshore jurisdictions have continued to be popular

and recently introduced several innovative structures, demonstrating their ability to respond to the needs of tech clients,” he notes.

As regulators in different countries figure out their stances on ICOs, tech companies offering such token sales are increasingly turning to offshore jurisdictions.

“Offshore jurisdictions quite often provide founders with flexible and balanced ‘home country’ option from a regulatory perspective. Generally speaking, offshore jurisdictions may offer founders certain benefits when it comes to taxation, local securities law compliance and intellectual property protection,” Macculloch says.

The general benefits for going offshore may be obvious for some, but it is a particularly good fit for structuring ICO, investment fund or M&A transactions.

“Whereas onshore jurisdictions like Singapore and Hong Kong have become a ‘hub’ for founders of such businesses and a destination for companies wanting to fundraise, when it comes to structuring their ICO, investment fund or M&A transaction, offshore jurisdictions such as British Virgin Islands (BVI) and Cayman have proved popular domiciles for the vehicles used in such structures,” Hodson says.

“This is not surprising as they have been a popular choice of vehicle in the traditional space and the regulators have not jumped to block these types of businesses, rather they are allowed to operate within the existing legal framework,” she adds.

“The offshore jurisdictions of Bermuda, the Cayman Islands and the BVI offer well developed flexible legal systems where complex vehicles can be set up which allow parties from different jurisdictions to structure their affairs in an efficient and neutral manner. As such they have always been a good place to create holding companies where cross-border activity takes place. This makes them a natural choice for persons wishing to set up a vehicle to undertake an ICO,” Page says.

“Until recently, none of these jurisdictions has had any specific legislation that addresses the issue of coins by entities established there. Provided no offer is made to the public in the applicable jurisdiction, then incorporating the issuer in any of these jurisdictions is generally straightforward and inexpensive. I said, ‘until recently’ as Bermuda has just introduced a regulatory framework that is intended to promote blockchain ventures in a business-friendly, but what it considers to be, appropriately regulated environment,” he adds.

The Cayman Islands and the BVI have not introduced any equivalent legislation at this time. Persons wishing to undertake an ICO now have a choice and whether they choose Bermuda, the Cayman Islands or the BVI will likely depend on several factors including their tolerance for regulation and familiarity with each of these jurisdictions.

INNOVATIVE STRUCTURES

Tech companies are also seeking out offshore firms, in particular, to help them with structures and framework in the early stages.

“For the client, offering ICOs has been quicker and more attractive in that they retain greater control of their businesses. Thus far, investors have been subject to less regulatory restrictions.

 “In our experience, many tech companies look to establish themselves using offshore company structures that enables them to attract investor capital (predominantly from private equity and venture capital investors) at an early stage whilst at the same time providing them with the right corporate and governance framework to: (1) grow and to potentially evolve into a structure that is of a size that enables them to achieve their business and commercial objectives; and (2) which may be suitable for a potential merger, takeover or an initial public offering,” says Matt Roberts, a corporate partner with Maples and Calder’s corporate team in Hong Kong.

“Typically, these tech companies attract investor capital by issuing different classes of preferred shares that provide different dividend/distribution, liquidation preference and certain veto/control rights as well as certain enhanced rights to participate in any takeover offer, merger or initial public offering,” Roberts adds.

He believes the Cayman Islands exempted company is by far the preferred form of offshore company structure for this purpose.

“A number of significant tech companies which started off as private tech companies and then evolved to public companies have used, and continue to use, Cayman Islands companies for this purpose. The BVI business company is also a popular choice for offshore company structuring purposes,” he says.

In essence, both the Cayman Islands and the BVI are globally accepted and understood as providing clear, efficient, flexible and pro-business corporate law regimes which accommodate all major securities exchanges requirements, particularly in Asia, as they are very familiar to investors and financial institutions.

“In fact, the basic corporate framework largely remains the same and this is a good thing – with Cayman and BVI there are no surprises. However, this outline structure allows for great flexibility within it. It does this in terms of how the corporate cake is sliced and diced between all the different participants through weighted voting at director and shareholder level, the circumstances in which shareholder rights such as conversion rights, rights of first refusal and drag and tag rights may operate. In that respect, each deal is unique while remaining within a comfortingly familiar outline given by the Cayman and BVI corporate structure,” Roberts explains.

According to Maples and Calder’s, the basic structure works as follows: a new offshore company is generally established (typically a Cayman Islands exempted company or BVI business company) to act as the holding vehicle for the other companies within the group (such as Hong Kong companies which in turn will hold the equity interests in the relevant PRC companies that hold/control the underlying PRC assets).

The Cayman Islands exempted company or BVI business company is the holding vehicle that will attract investor capital by issuing shares (usually preferred shares) because of its flexibility, neutrality (including tax neutrality) and being acceptable to prospective investors. The offshore company’s constitutional documents (memorandum and articles of association) are developed to facilitate this structure and drafted to be consistent with the commercial terms of the deal.

“In this respect, the offshore firms work with the onshore PRC, HK and international law firms who will advise, prepare and negotiate the commercial deal documentation (such as share purchase agreements, shareholders agreements and other related documents). Both onshore and offshore firms work in partnership with our clients to ensure that the onshore and offshore issues are appropriately dealt with and our clients’ commercial objectives are met,” Roberts says.

“When the company is looking to list, it will generally utilise an offshore structure such as a Cayman Islands company as the listing vehicle. Although BVI companies are also permitted to list on the Hong Kong Stock Exchange (HKSE), it is worth noting the dominance of the Cayman Islands as the jurisdiction of choice for listing offshore vehicles on the HKSE.”

According to the HKEX Fact Book 2017, the number of Cayman companies listed on the HKSE represented approximately 47 percent.

Roberts points out that a recent development has been the HKSE’s acceptance of weighted voting right share structures for certain company listings, including technology companies, and which has generated enormous global interest.

“The exact structure will depend on where and to whom the offer is being made and the regulatory and tax advice the tech entrepreneur has received. Because of the global nature of the offering, more often than not an offshore company will be chosen as it provides jurisdictional and tax neutrality,” Page says.

A foundation company in an offshore jurisdiction also allows for more structural freedom. Foundations are structures to which legal ownership of property (money, shares, gift, land or encumbrance) is transferred. They are hybrid in nature, containing vital features of the corporation and the trust. As such, foundations are particularly useful as asset management and tax planning tools but in fact are multi-purpose.

“We have acted for a number of token generation events where a Cayman foundation company was used as part of a structure. A foundation company is a novel structure that allows for the creation of a corporate entity with no shareholders,” Macculloch says.

“Following the lead taken by other offshore jurisdictions, the Cayman Islands enacted the Foundations Companies Law in October 2017. The key difference between a Cayman foundation company and a trust is that a foundation company has a separate legal personality and so can undertake transactions on its own behalf (rather than via a trustee),” says McKenzie.

McKenzie adds that he has already seen significant interest in foundation companies in cryptocurrency and fintech industries, particularly if an orphan vehicle or ownerless structure is desired.

This structure is often used where founders envision the creation of a global, perpetual and “decentralised” entity. These entities will operate to further a particular object, often the development of a blockchain network or software platform that utilises smart contracts.

“Foundation companies are also being used as holding vehicles for shares in investment funds and private trust companies (PTCs) and as special purpose vehicles (SPVs) in structured finance transactions,” McKenzie adds.

“These structures provide tech companies with the right governance framework to grow and to develop their business. They allow tech companies to attract investor capital, including international investor capital when it is critically required at early stages of their life cycle and then for those companies who are looking to go public or to effect a strategic M&A deal or takeover, to provide the right framework for those companies to be in a position to take the next step to do so,” Roberts says.

Besides that, offshore firms are also going out of their way to discuss token transactions with clients.

“Harneys co-founded the CoinAlts conference, a leading conference in the digital assets space, which launched in San Francisco in September 2017 and continued in New York in April 2018,” says Philip Graham, the head of Harney’s BVI Investment Funds and Regulatory team.

“We would love to roll this out in Asia as well. It’s proving incredibly popular within the blossoming sector,” adds Graham.

Also, offshore law firms who have the experience and market leading track record in advising these sorts of tech companies throughout their life cycle such as our firm have the expertise and experience to assist to guide these companies by advising on Cayman Islands and BVI law issues, which are critical to tech companies as they grow from today’s minnows to tomorrow’s tech titans.

Andy Randall, managing partner of Walkers’ Hong Kong office, believes offshore firms like his are in a good position to advise businesses specializing in blockchain technology, digital assets, alternative finance models and a range of related activities and services.

“We offer lawyers with specialist knowledge of licensing, marketing, data protection, tax transparency, outsourcing, international anti-money laundering regulation and other aspects which need to be understood by successful fintech businesses,” says Randall.

He adds that those areas have also been helpful in providing legal services to core fintech sectors, such as asset management, investment, banking, finance and insurance.

A wide network helps as well.

“With experts in international financial centres in Asia, the Americas, Europe and the Middle East, we understand that innovative businesses think beyond borders,” says Randall.

THE PLACE FOR FUNDS

Another reason that makes offshore jurisdictions is that they are an important place for investment funds.

“The Cayman Islands continue to be the primary offshore jurisdiction for investment funds. The Cayman Islands’ tax neutral status ensures the fund vehicle itself does not create an additional layer of tax, creating efficiencies in raising funds from a potentially global investor base,” McKenzie says.

The key Cayman vehicles for structuring funds continue to be the exempted company (for open-ended hedge funds), the exempted limited partnership (for closed-ended funds) and the exempted unit trust (for certain Asian investors).

“However, the Cayman limited liability company (LLC), introduced in 2016, has quickly become a recognized and established vehicle utilized by fund managers not only as investment fund entities themselves but for more general corporate and commercial applications such as joint venture companies, management holding vehicles, carried interest distribution vehicles or as general partner entities. The LLC is essentially a hybrid structure that combines certain characteristics of an exempted company with those of an exempted limited partnership,” McKenzie says.

“As global markets continue developments in fintech and artificial intelligence, we expect to see growing interest by founders with cryptocurrency and tech funds. In particular, there has been increased popularity with Cayman segregated portfolio companies (SPCs), which offer speed to market, flexibility and cost efficiencies for start-up founders/managers with multiple portfolios,” he adds.

The tech scene is a relatively new global industry involving young entrepreneurs who are generally not confined to the historical or conventional manner of structuring commercial deals. Deals are structured in a manner that best suits the underlying nature of the product and provides maximum benefit to all stakeholders involved. “A willingness to innovate is in part what has made offshore jurisdictions such as Cayman and BVI so appealing and successful for many years. This openness to innovation makes those jurisdictions the ideal place to set up new structures for clients and investors in those structures. As the tech market develops and pushes into new areas, the flexibility offered by an offshore structure can respond quickly to the demand,” McKenzie says.

ALWAYS EVOLVING

And many are certain new tech-driven requirements are here to stay, which can only be good news for offshore jurisdictions and the firms servicing those areas.

“The growth of technology companies is a global phenomenon, but Asia is one of the global hotspots and certainly the major Chinese tech companies have been vying with the U.S. tech companies for global dominance.

Both the Cayman Islands and the BVI have benefited from the growth in the tech sector as demand for Cayman Islands and BVI offshore structures continue,” Roberts says.

“Offshore jurisdictions will continue to adjust their business, legal and regulatory practices to match the changes the tech industry will ultimately produce,” McKenzie concurs.

The changes brought about by blockchain technology isn’t just affecting client needs. The new developments around the tokenisation of debt and equity, along with the trend of digitalisation, is also starting to have an impact on the way that offshore firms work.

Hodson thinks blockchain has eased and transformed certain areas. “KYC (Know your Customer) is a time-consuming, often document-heavy and as a result potentially costly exercise. It carries a lot of risks if not carried out properly and is a vital component of most businesses we are engaging with. There have been a number of companies which have developed tools leveraging technology to increase the efficiency in KYC and AML processes as well as to strengthen compliance,” she observes.

She also says company formation and document management are now faster, cheaper and easier. “We have worked with entrepreneurs who have started to digitalise the company formation process to reduce the set-up time and costs. Also, innovators are increasingly looking at how document management tools/systems can be deployed and utilised in digitalising the production of contractual agreements,” she says.

Whether change is on the client or the firm’s end, the ends remain similar. “The overall theme is, of course, one of innovation, how we can take existing processes and do things differently,” Hodson adds.