What are you buying when investing in ICOs? Lawyer's perspective on EOS token offering.

I am a corporate and securities lawyer by training and have been helping companies go public and raise capital in the financial markets for the past ten years. This was always a painful and time consuming exercise that involved various advisors verifying each and every statement in offering documents. Crowdfunding of startups has never been part of this big play but ICOs carried it to an apogee. The amount of capital raised through recent ICOs is remarkable, with transaction values reaching levels typical to venture capital and securities markets. At the same time, issuers give very few undertakings in exchange of funds raised.

If you go to a venture capitalist, you would have a hard time defending the potential and budget for your project. If successful, funding will most likely come in tranches tied to your project milestones. In the ICO world, you raise your capital up-front by giving few to no explanations as to why you need a particular amount and how you are going to spend it.

Much has been said on whether ICOs fall under securities law disclosure regimes, so I would not be discussing this in this post. Most people now seem to have agreed that you should assume they do, particularly if you wish to sell in the US.

This article examines how ICOs are structured from a legal undertakings perspective. I decided to start the analysis with EOS.

EOS is an interesting example due to its unique offering structure. EOS ICO is a protracted process strained for almost a year with "transaction closings" occurring every day. This is something you would never see in a conventional venture capital and securities transaction. What makes things even more tempting is a moving legal environment around ICOs. With legal positions being formulated and argued by lawyers and regulators by the time block.one completes its EOS offering they may find themselves in a different regulatory world than the one they have been in when the deal was launched. Nonetheless, they do not seem to be afraid.

There are obviously other ICOs where issuers take different approaches on how they structure their offerings. Hopefully, I will cover those in my next posts.

As a lawyer, I should make some disclaimers. I have no intention to cast a shadow on block.one team and EOS offering. In fact, I believe they have made all the risks associated with investing into EOS clear to potential purchasers. Also, this is not legal advice, but my personal opinion of the EOS offer structure.

Key features

The EOS project was launched by block.one's team of developers.
block.one's corporate structure is not disclosed and is unclear. Places of incorporation and the names of block.one's operational legal entity and token issuing entity are not disclosed. According to the press and EOS FAQ, the team is primarily located in Hong Kong, while token issuer entity is incorporated in the Cayman Islands.
ICO was launched on the Ethereum blockchain under the EOS Distribution Smart Contract and ERC-20 EOS Token Smart Contract.
The token sale price is not fixed. It is determined for each distribution round separately and depends on the amount of ETH contributed to block.one during such round.
ETH is the only currency accepted in the offering.
Tokens offered at ICO are EOS Tokens, which are not EOS Platform tokens. EOS Platform tokens do not exist and are expected to be issued at the EOS Platform launch.
ICO launched on 26 June 2017 and is still ongoing, with the end date set as 1 June 2018.
As of November 2017, EOS raised circa USD 300 mln (with circa USD 185 mln raised during the initial five-day sale round at the end of June 2017).
There is no cap on the amount of money to be raised in the ICO. The market expects block.one to accumulate around USD 1 bln by the end of the offering.
Token supply, in the ICO, co-exists with token supply on the secondary market at exchanges. Speculative arbitrage on a difference between ICO daily round price and price on exchanges is possible.
EOS Tokens offered at ICO provide no rights to use the EOS Platform, block.one provides no assurance that the EOS Platform will ever be developed, or if EOS Tokens will ever be converted into EOS Platform Tokens. block.one indicates that it will not be developing an EOS Platform. If such platform is ever developed, it would be developed by third parties utilising the EOS Software developed by block.one.
EOS Tokens are only liquid during the ICO period, following which, they will be locked on the holders wallets until the EOS Platform is developed and launched.

Issuer corporate structure

Undisclosed and unclear.
Token issuer entity and operational / project entity are not disclosed in the offer documents.
Press relates block.one team to Cayman Islands and Hong Kong.

Token features

EOS Tokens offered at ICO have no value, utility, or use. There is no representation given as to whether an operator of the EOS Platform (which may be different than block.one) will allow conversion of EOS Tokens into EOS Platform tokens.
Tokens become liquid following the end of each allocation period provided the purchaser claims them from EOS Distribution Smart Contract and transfers them into its wallet.
The liquidity period is, however, limited to the period of the ICO. Once ICO completes (starting with 2 June 2018), all tokens will be locked in token holders' wallets until the EOS Platform is launched. The EOS Tokens might then be converted into EOS Platform tokens (provided EOS Platform is adopted as envisaged by EOS Software). Article 2.6 of the Token Sale Agreement states: "Within 23 hours after the end of the final period on June 1, 2018, at 22:59:59 UTC, all EOS Tokens will become fixed (ie. frozen) and will become non-transferrable on the Ethereum blockchain. At this point the EOS Token distribution will be complete and any person who wishes to launch a public blockchain platform adopting the open source EOS.IO Software (an 'EOS Platform') will be able to generate a file or 'snapshot' showing the fixed balances of the EOS Tokens from the state of the Ethereum blockchain (the 'Snapshot'). As block.one will not configure and/or launch any EOS Platform, block.one will have no control over when, how or whether the EOS.IO Software is adopted or implemented, or how, when or whether a Snapshot will be created or used or whether an EOS Platform is launched. In order for the balance of your EOS Tokens to be included in the Snapshot if a Snapshot is created, you must register your Ethereum address with an EOS public key."
EOS Tokens are now traded on Livecoin, BTER, Tidex, Kraken, Yobit, Binance, HitBTC, Liqui, and Bitfinex. EOS Tokens were first listed by Bitfinex on 26 June, the first day of the ICO. The next exchange to list them on 1 July was Kraken. Kraken lately delisted EOS/USD and EOS/EUR pairs for the reasons that these pairs were not liquid enough to maintain them, thus keeping only EOS/BTC and EOS/ETH pairs. The EOS/USD pair is now traded on Bitfinex, HitBTC, Yobit, and Livecoin.

The token distribution model

Allows for a year-long primary token supply:

10% allocated to block.one under lockup (not being traded or transferred, vesting starts following the launch of the EOS Platform and continues annually in equal portions during a 10-year period starting from the launch of the Platform).
20% allocated during Period I (26 June 2017 - 1 July 2017)
70% to be allocated by 1 June 2018, and it is distributed each day over a 341-day period. Each day (namely, a 23-hour period) is a separate distribution period during which two mln tokens are distributed pro rata amongst all purchasers based on the total ETH contributed during a respective day period (i.e., the fewer participants who take part in the round, the more EOS Tokens are received by those who took part in the day round).The purchasers are also allowed to participate in any future round, depositing ETH in advance.

Management of funds accumulated during ICO and use of proceeds

There is no corporate governance procedure with respect to the management of funds accumulated during ICO implemented by block.one.
The token sale agreement and FAQ published on the EOS website expressly provide that "...proceeds from the sale of the EOS Tokens will be utilized by the Company in its sole discretion" and will be "...the revenue of block.one."
FAQ further provides that "block.one intends to use certain of the proceeds for general administration and operating expenses, as well as to build a blockchain consulting business focusing on helping businesses re-imagine or build their businesses on the blockchain, developing more open source software that may be helpful to the community and building decentralized applications using EOS.IO Software" and that block.one does not believe that proceeds from the ICO should be donated into any foundation or non-profit organisation as "...any blockchain that adopts the EOS.IO Software will generate natural inflation in such blockchain tokens at a rate of five percent per year to be distributed to the platform's block producers in connection with their confirmation of transactions on the platform and to the top three smart contracts or proposals that receive the most amount of votes from holders of such tokens. In this case, such a blockchain will not be reliant on any one foundation, organization, or individual for its growth, development, or maintenance."

KYC

The token sale agreement requires all purchasers be compliant with AML regulations in their home jurisdiction. The agreement also mentions that block.one may, at any time, request any documents it believes are necessary for KYC and AML checks.
As a matter of fact, no KYC on purchasers is performed by block.one. No identification documents are required to participate in the offering.

Documentation

WhitePaper is very technical and does not contain any information on token offering structure. Published on Github.
Software Roadmap. Technical document. Published on Github.
Terms of use. Relate to the use of EOS website and provide for general disclaimers and release of EOS from any liability resulting from the use of EOS website. Published on website.
Privacy policy. Standard privacy policy document. Published on website.
Token Sale Agreement. Two versions available on EOS website (dated 22 June 2017 and 4 September 2017):

Agreement does not clearly define block.one as a party;
Governed by Cayman Law;
Provides for arbitration in the London Court of International Arbitration (LCIA);
Provides no undertakings whatsoever from block.one and seeks to release block.one from any liability;
provides for purchasers to waive their rights for class arbitration, class action, or any other type of similar representative proceedings.

Guides on how to purchase, register, and claim tokens (published on website).
Sales restrictions and disclaimers (published on website).
The FAQ provides for further explanations on the use of proceeds and reasons for exclusion of U.S. persons from participating in the ICO. Contains a representation that block.one will hire an independent auditor to confirm that ICO has not been inflated by the block.one team using the proceeds of the ICO's previous rounds to buy further rounds into ICO (published on website).

Sales restrictions

EOS Tokens are not offered to U.S. or Chinese persons. This is achieved by the EOS website blocking U.S. and Chinese IP addresses from accessing the token-offering section of the website. Also, by accepting the terms of the token sale agreement, block.one requires each purchaser to represent that they are not a U.S. or a Chinese person, and indemnify the company for any losses that may result from such representations being untrue. The above is all that is done to ensure that U.S. or Chinese investors do not participate in the offering. No passport identification is required to participate in EOS Token offering and confirm the purchaser residency.
It is also unclear how the US and Chinese sales restrictions are enforced in secondary market and tradings at crypto exchanges.

Team behind EOS (information from public sources)

Brendan Blumer, CEO: Involved in the blockchain industry since 2014, serial entrepreneur who has built businesses including trading of virtual currencies in MMORPGs in the US, okay.com in Hong Kong, and 1Group in India.
Daniel Larimer, CTO: A serial entrepreneur focusing on innovative technologies ranging from virtual reality simulators to second-generation crypto currencies, most notably, BitShares. Dan is a specialist in software development and the inventor of the widely adopted "Proof of Stake" and "Decentralized Autonomous Corporations" concepts.
Brock Pierce, Partner: A venture capitalist and entrepreneur who pioneered the market for digital currency in games and has raised more than $200 million for the companies he founded. Brock is the Chairman of the Bitcoin Foundation and co-founder of Blockchain Capital, among others.
Ian Grigg, Partner: A financial cryptographer who has been building cryptographic ledger platforms for over 20 years, Ian is the inventor of the Ricardian Contract and the co-inventor of Triple-Entry Accounting.

EOS Software Development Roadmap

Phase 1 - Minimal Viable Testing Environment - Summer 2017.
Phase 2 - Minimal Viable Test Network - Fall 2017.
Phase 3 - Testing & Security Audits - Winter 2017, Spring 2018.
Phase 4 - Parallel Optimization Summer / Fall 2018.
Phase 5 - Cluster Implementation The Future.
There is no undertaking from block.one to stick to this timeline and report on deliverables. In fact, the opposite holds true, as block.one reserves the right to stop developing EOS software at any time.

Mechanics of EOS Tokens acquisition

A purchaser needs to register at https://eos.io/instructions, accept the terms and conditions of the sale of EOS Tokens, and transfer ETH (the min. contribution is 0.01 ETH) from any compatible wallet.
In order to receive the EOS Tokens, the purchaser needs to claim them from the EOS Distribution Smart Contract once the daily round in which the purchaser participated is over.

VC/PE Investors participating in the ICO

According to the press, the following institutional investors participated in the EOS Token distribution: Fenbushi Capital, Blockchain Capital, Li Xia Lai, Michael Cao, Bitfinex, Yunbi, Aurora Investment Advisors, and Hyperchain Capital.

Some conclusions

From the legal perspective, the EOS ICO structure is quite controversial.
The token sale contract does not contain any undertakings or obligations whatsoever from block.one. The only purpose of the sale contract seems to be to provide as many disclaimers as possible to put the token purchasers on notice that they are, in fact, simply donating money to block.one. Purchasers of EOS tokens have more obligations and much greater responsibility towards block.one than block.one itself.
No practical steps are taken with respect to purchasers' KYC to ensure that there are no ‘dirty money' in the ICO. Block.one simply relies on the purchasers' assurance that they are complying with their local AML regulations.
The block.one counterparty in the token sale agreement is not defined. No specific company or individual is mentioned, but rather a reference is made to a team of individuals acting under the block.one name. This makes it unclear who is responsible under the contract from the block.one side. This is perhaps less of an issue, given that the contract does not contain any undertaking from the block.one side.
Block.one structured the offering as donations with EOS tokens representing some sort of receipts confirming the fact of donations. This is uncommon for business entity to receive donations.
The use of proceeds specified by block.one in the token sale contract and in the FAQ clearly demonstrates that it has nothing to do with the development of EOS Project. There is no clear explanation why block.one needs such a significant amount of money.
Although block.one takes the view that EOS tokens are not an investment and speculative instruments because they have no value, EOS tokens are traded on a number of exchanges and a significant number of token purchasers participate in the ICO for speculative reasons and arbitrage possibilities.
There is an attempt to avoid US securities risk (as well as the Chinese ICO ban) by EOS tokens not being offered in these jurisdictions. This attempt is limited to a disclaimer on a website and IP blocking. The EOS tokens, however, become liquid immediately following the offering round and can be sold at exchanges where US and Chinese persons may participate.
The sale contract provides for LCIA arbitration, which is expensive for a customary retail purchaser. Also, the Cayman Islands are not party to the NY convention on enforcement of arbitral awards, so query as to how the LCIA award will be enforced by token purchasers.