With over $12 billion raised via token offerings (also commonly referred to as cryptocurrency crowdfunding, initial coin offerings or “ICOs”) since 2014, and over 1,200 blockchain tokens (also commonly referred to as “digital tokens,” “coins” or just “tokens”) in circulation with a combined market capitalization of over $300 billion, it should not be surprising that the level of attention paid to ICOs by regulators has dramatically increased.

Yet regulatory postures towards ICOs vary widely across the globe. In Asia, while countries such as China have banned all ICOs outright, and countries such as South Korea have stated that all forms of ICOs, regardless of whether they involve the sale of securities tokens, would be banned, Japan has taken a more neutral approach, recognizing the new fundraising technique’s potential while keeping in mind potential risks to investors. This stance is reflected in a new industry-backed report (the “Report”) by the Center for Rule-making Strategies at Tama University.[1] Released on April 5, 2018, the Report provides guidelines and principles for properly conducting ICOs so as to better protect investors and garner wider support among the general public.

The key features of the Report, which can be separated into three categories, are summarized below.

1. ISSUANCE PRINCIPLES. While the Report acknowledges that certain aspects of token trading may fall under Japan’s Payment Services Act, it also notes that there are no laws clearly governing the issuance of tokens. Without such laws to provide guidance, participants in ICOs—both investors and issuers alike—have great difficulty understanding their rights and obligations. To address this dilemma, the Report proffers two principles:

Principle #1
Issuers should clearly define and disclose what services will be available to investors post-issuance, as well as how any raised funds, profits or residual assets will be spent or disbursed.

This principle serves to enhance investor confidence and bolster issuer legitimacy.

Principle #2
Issuers should provide a means for tracking a project’s progress.

As noted in a previous client alert,[2] companies conducting ICOs often release white papers with timelines outlining development stages and planned deliverables. However, whether these timelines are met or changes to the white papers themselves are made is often left to founders’ discretion with few avenues for investor input. As such, this principle aims to at least provide investors a means of staying informed about a project, similar to the continuing disclosure requirements placed upon companies that conduct public, registered offerings in the United States.

2. GUIDELINES. The Report also offers two practical guidelines that build upon the principles above.

Guideline #1
ICOs should be designed to be acceptable to existing shareholders and debt holders.

Going forward, market practice may develop such that potential stakeholders explicitly address the issuance of tokens in their agreements. For example, banks providing mezzanine financing could employ restrictive covenants to limit a borrower’s ability to conduct ICOs. Indeed, the National Venture Capital Association (NVCA) recently updated its model certificate of incorporation, used as a guiding template by many market participants, to include a potential veto right for investors to disallow issuances of tokens.[3]

Guideline #2
ICOs should not be viewed as a means of escaping the usual responsibilities of equity financing.

While structures to safely conduct ICOs currently exist,[4] potential issuers may find some requirements overly burdensome. Nonetheless, to avoid unfavorable scrutiny from regulators, regardless of the jurisdiction in which an ICO is launched, issuers should consider them valid alternatives to extant fundraising models rather than a means of skirting regulatory regimes and structure their ICOs accordingly.

3. OTHER PRINCIPLES. Lastly, the Report offers an additional set of five principles to enhance protection for both investors and issuers.

1. 1. Issuers should confirm the identity and suitability of potential investors via Know Your Customer (KYC) verifications, such as passport and bank statement submissions.
   2. Administrative entities, such as banks and legal counsel, that assist with the issuance of tokens should confirm the KYC of issuers themselves.
   3. Cryptocurrency exchanges should define and adopt an industry-wide minimum standard for token listings.
   4. After tokens are listed, unfair practices such as insider trading should be considered unlawful.
   5. Parties related to the trading of tokens such as issuers, administrative entities, and cryptocurrency exchanges should make efforts to ensure the cyber security of both tokens and users’ personal information.

Overall, the Japanese government has remained relatively progressive in its stance toward cryptocurrencies. For instance, on April 1, 2017, the Japanese Parliament passed the Virtual Currency Act (the “Act”), which requires cryptocurrency exchanges to register with the Financial Services Agency (FSA) and meet requirements such as maintaining a certain amount of capital.[5] The Act also officially recognized bitcoin as a legal means of payment. Further, two prominent cryptocurrency industry groups, the Japan Cryptocurrency Business Association and the Japan Blockchain Association, are scheduled to combine this month into a new group that will work with the FSA to develop industry standards for cryptocurrency investing and fundraising.[6] Meanwhile, a working group of the FSA’s Financial System Council is also reviewing ICOs in the context of FinTech legislation.[7]

However, Japan has also taken steps to raise awareness of the early-stage nature of the ICO fundraising model.[8] In response to the theft of over $530 million in NEM tokens from the Japanese cryptocurrency exchange Coincheck on January 26, 2018,[9] the FSA investigated the exchange’s offices and ordered a revision of its management structure before its acquisition by Japanese online brokerage Monex Group was announced on March 30, 2018.[10] In addition, the FSA also ordered two cryptocurrency exchanges to suspend operations for two months.[11]

More recently, the FSA issued a set of five new requirements for cryptocurrency exchanges wishing to register in Japan, including on-site investigations to review each registrant’s operations.[12] These new requirements include specific restrictions, such as not storing user tokens on computers connected to the Internet and having separate roles for employees responsible for system maintenance and asset management. It is expected that further legislation will be introduced by the FSA in the near future, but that its position will continue to be neutral, not hostile.

As the market for cryptocurrencies develops and improves their utility as fundraising and payment vehicles, Morrison & Foerster will continue to monitor developments out of Japan regarding new regulations of, and best practices for, its participants.

[1] See “Call for Rule-making on ICO” (April 5, 2018), available at https://www.tama.ac.jp/crs/2018_ico_en.pdf.

[2] See “8 Key Items You Need to Consider Before Staging Your ICO” (March 19, 2018), available at https://mofotech.mofo.com/topics/8-key-items-before-staging-ico.html. 

[3] See “NVCA Model Certificate of Incorporation” (last updated January 2018), available at https://nvca.org/resources/model-legal-documents/.

[4] See “Do You Want to Launch an ICO? Please, Listen to the SEC.” (February 8, 2018), available at https://www.mofo.com/resources/publications/180131-ico-sec.html.

[5] See “Details of Screening for New Registration Application as Virtual Currency Exchange Service Provider” (September 30, 2017), available at https://www.fsa.go.jp/en/news/2017/20170930-1/02.pdf.

[6] See “Japan’s cryptocurrency markets start policing themselves in April” (March 3, 2018), available at https://asia.nikkei.com/Spotlight/Bitcoin-evolution/Japan-s-cryptocurrency-markets-start-policing-themselves-in-April.

[7] See “Study group on virtual currency exchange industry etc.” (April 10, 2018), available at https://www.fsa.go.jp/news/30/singi/20180410.html.

[8] See “Initial Coin Offerings (ICOs): User and business operator warning about the risks of ICOs” (October 27, 2017), available at https://www.fsa.go.jp/policy/virtual_currency/07.pdf.

[9] See “Japan's Coincheck suffers record $530m virtual currency theft” (January 27, 2018), available at https://asia.nikkei.com/Spotlight/Bitcoin-evolution/Japan-s-Coincheck-suffers-record-530m-virtual-currency-theft.

[10] See “Japan's FSA orders 2 cryptocurrency exchanges to halt business” (April 6, 2018), available at https://asia.nikkei.com/Spotlight/Bitcoin-evolution/Japan-s-FSA-orders-2-cryptocurrency-exchanges-to-halt-business.

[11] Ibid.

[12] See “Japan fleshes out crypto market rules to prevent Coincheck 2.0” (May 6, 2018), available at https://asia.nikkei.com/Spotlight/Bitcoin-evolution/Japan-fleshes-out-crypto-market-rules-to-prevent-Coincheck-2.0.