HKEx as a Leading International Stock Exchange
Hong Kong’s stock exchange (HKEx) is, of course, one of the world’s premier international stock exchanges. HKEx was the world’s top IPO fundraising exchange in six of the past ten years and has raised over HK$2 trillion in IPO funds in that time. It is the international listing venue of choice for Mainland Chinese companies and has hosted some of the world’s largest IPOs, including those of AIA Group which raised HK$159 billion, and Industrial and Commercial Bank of China Ltd which raised HK$125 billion. HKEx has implemented reforms to attract the listings of the new generation of tech and biotech companies, aiming to rival Nasdaq as the preferred venue for Chinese tech listings. Listing Rule changes made in April 2018 to allow tech companies with weighted voting rights structures and pre-revenue biotech companies to list on HKEx led to the listing of seven such companies in 2018 which together raised HK$94 billion.
Stringent Regulation Leaves no Room for SMEs
Yet key to Hong Kong’s success as an IPO market is a comprehensive regulatory regime aimed at ensuring market confidence and preventing corporate misconduct by HKEx-listed entities. Hong Kong’s listing application process is rigorous requiring compliance with some of the world’s most stringent due diligence requirements by the listing sponsor. With a huge number of Chinese companies listed on HKEx with offshore directors typically beyond the reach of the Hong Kong courts, applicants seeking listing on HKEx are subjected to intense scrutiny by the HKEx and SFC.
However, a consequence of the regulators’ efforts to ensure a “quality market”, is that it has become increasingly difficult and expensive for SMEs to list in Hong Kong. HKEx’s second board, GEM, was launched in November 1999 as a capital raising platform for start-up and growth companies. It thus had less stringent admission requirements than the Main Board and operated on an “enhanced disclosure based” regime with “buyer beware” risk warnings in company listing documents. Over the years, higher listing criteria were introduced for GEM listing applicants – today applicants must have minimum cash flow of HK$30 million for the 2 financial years before listing, market capitalisation of HK$150 million at listing, a 25% free public float, a minimum of 100 shareholders, 2 years’ management continuity and 1 year of ownership continuity. Moreover, the company must be one which the HKEx and SFC regard as “suitable for listing”: a test which is opaque at best. Factors affecting a company’s “suitability” include the sustainability of its business and whether it is overly reliant on its group companies.
The regulators have cracked down on so-called “shell listings” – listings they claim are intended to secure a profit from the company’s subsequent sale as a vehicle for a backdoor listing or reverse takeover, rather than to develop the company’s existing business. The line between an SME seeking to list for genuine reasons and one which aims to sell its listing status to the highest bidder, is a fine one, and convincing the regulators that a company is in the former not the latter camp is far from easy. Hence a company which meets all the black and white criteria for listing may still be denied listing if the regulators suspect it of being a prospective shell or doubt the sustainability of its business. This is particularly harsh given that Hong Kong’s listing application process is expensive and time consuming. HKEx’s Listing Rules require a sponsor to be appointed to conduct extensive due diligence on the listing applicant’s group before the application to list can be submitted. The process can take many months, the listing applicant incurs sponsors’ fees and legal and accounting fees while its management are heavily involved in the listing application process, all of which may be for nothing if the application proves unsuccessful. Even if the company lists successfully, the ongoing obligations of GEM listed companies are more onerous than those of much larger companies listed on the Main Board since on top of the obligations of Main Board-listed companies, GEM-listed companies must also produce quarterly financial reports. The regulatory compliance costs can thus be disproportionately burdensome for SMEs.
Unregulated ICOs: the other extreme
Initial coin offerings, on the other hand, are quick, inexpensive and largely unregulated. Instead of listing documents or prospectuses running to hundreds of pages, ICOs are marketed by white papers – skeleton documents giving brief details of the problem the ICO will address, the project, the tokens and their planned allocation. There is no financial information about the issuer, let alone audited accounts. Most ICO white papers do not even state the issuer’s registered address. While stringent IPO regulation produces tome-like documents which investors rarely read, with the possible exceptions of the “Summary” and “Risk Factors” sections, the lack of disclosure requirements for ICOs has been criticized by the OECD for exacerbating “information asymmetries already present in early stage SME financing”.
While companies listing on a stock exchange must have a specified track record (2 years on HKEx’s GEM), ICO issuers are often start-ups. Post-ICO, issuers have no ongoing obligations other than to develop the project outlined in their white paper. There are no requirements for ICO issuers to publish their financial information, inform holders of material developments or seek their approval. Crucially, the founders of the ICO issuer keep full control of the company: ICO tokens do not grant ownership rights or a right to share of the profits. The high failure rate for start-ups make ICOs risky investments since token holders do not have the benefit of insolvency laws or investor and consumer protection laws.
Inappropriateness of ICOs for retail investors
The OECD considers ICOs to be inappropriate investments for retail investors given the risks associated with them. Risks include:
- Fraud – estimates that some 90% of Chinese ICOs were scams was a major factor behind China’s September 2017 ban on ICOs.
- Financial crime – the risk of cryptocurrencies being used for money-laundering and terrorist financing.
- Security – crypto theft via cyber-attacks on crypto exchanges have been common. Japan’s Coincheck was hacked in January 2018 resulting in the theft of some US$530 million worth of NEM tokens.
- Market-abuse activities such as ‘pump-and-dump’ schemes which are outside the scope of traditional price manipulation and other market misconduct laws.
ICOs – the Benefits
Yet, according to the OECD, blockchain-enabled ICOs “have the potential to offer a new way to raise capital for projects, benefitting from efficiencies, cost savings and speed of execution, if appropriately regulated and supervised”.
Source: OECD (2019), Initial Coin Offerings (ICOs) for SME Financing.
The benefits the OECD identifies include:
- Efficiency gains and cost savings from the use of distributed ledger technology such as block chain and disintermediation where value is exchanged without a bank intermediary;
- Access to an unlimited investor pool – with no restrictions on geographic location or investor type;
- Inclusive fundraising method also creates a network of future users of the issuer’s product or service whose active participation impacts the issuer’s viability;
- SME founders can raise early stage funding without relinquishing ownership, a key disadvantage of IPOs;
- Speed – ICOs can be completed in a fraction of the time required for an IPO. BAT raised US$34 million in less than a minute. But the lack of regulatory standards means that speed is achieved because of the lack of information disclosure and due diligence requirements;
- Liquidity provided by token listings on crypto-exchanges;
- Cryptographically secured tokens benefit from the features of distributed ledger technology – immutability, permanence and security; and
- The use of smart contracts can reduce counterparty risk as transactions are executed automatically on the occurrence of pre-defined conditions.
Costs – ICOs vs IPOs
In the early days, the costs of an ICO issue were limited to the cost of the infrastructure establishment and protocol development and the fees payable to crypto exchanges for listing the tokens. The lack of regulation meant that professional advisers were not normally engaged. ICO costs have increased: statements by regulators as to the potential application of securities and other laws have led ICO issuers to obtain legal advice in the key jurisdictions in which they will market the tokens. Marketing costs, exchange listing fees and the costs of post-ICO community management have also bumped up the costs of ICOs. Yet although more expensive than they were in the early days, ICOs are still considerably cheaper than IPOs, particularly due to the absence of underwriters fees.
ICOs – the Limitations
A key reason why ICOs are unlikely to become a mainstream financing tool is that ICOs are not for everyone. The SMEs that stand to benefit most from an ICO are those whose business model uses distributed ledger technology to meet a real consumer need. For these companies, the token issue creates a customer base before the project is launched providing for faster adoption of the product or service. This is a major advantage of an ICO over other forms of financing.
In addition, ICOs mainly address SMEs’ seed and early stage funding needs and are less suited to funding the later growth stages in an SME’s life cycle.
And since this is an accounting event, the lack of accounting standards for ICO tokens must also be mentioned. There are currently no accepted financial reporting practices for ICO tokens which arguably renders ICO investment decisions more difficult.
The case for regulation
Another major impediment to ICOs developing as a mainstream funding method is regulatory uncertainty and the potential for regulatory arbitrage. The OECD makes a case for regulatory clarity to allow SMEs to enjoy the benefits of ICOs while protecting both SMEs and investors from the potential risks. It highlights standardised disclosure requirements as the way to eliminate information asymmetries which already characterise SME funding and points to enhanced retail investor protection measures and improved retail investor education on the risks of ICO investment. The Financial Action Task Force (FATF) has revised its recommendations to require “virtual asset service providers”, including crypto exchanges, to be licensed and supervised in their implementation of anti-money laundering and counter-terrorist financing procedures. The OECD further recommends the mandatory application of anti-money laundering and counter-terrorist financing procedures to ICO issues.
Unlike IPOs, ICOs are offered internationally rather than within a specific jurisdiction and cross-border trading occurs easily on online exchanges. The OECD argues for a more “coordinated global approach” to reduce regulatory arbitrage and to allow ICOs to reach their full potential as funding tools for blockchain-based SMEs. It is hard to argue against this. Yet, the reality is that widely different regulatory frameworks and economic and political objectives in different jurisdictions make regulatory cooperation extremely difficult.
Beyond FATF’s proposals for the application of anti-money laundering and counter-terrorist financing measures by virtual asset service providers, an internationally coordinated approach to crypto regulation has yet to emerge. Instead, different regulatory approaches have been adopted in response to local conditions. China banned ICOs in 2017 due to widespread fraud while a number of smaller jurisdictions including Bermuda and Malta have adopted crypto-friendly regulatory frameworks to promote themselves as crypto hubs. Many developed jurisdictions, including the United States, the United Kingdom and Hong Kong, are adopting a wait-and-see approach, regulating ICOs under existing securities laws where tokens have the characteristics of traditional securities such as shares, debentures or interests in a collective investment scheme or fund, but not introducing specific regulation to cover ICO tokens outside the existing regulatory perimeter. This approach should be welcomed since it allows ICOs to proceed without overly onerous regulation which could discourage companies from conducting ICOs and stifle the innovative projects they finance.
There is undoubtedly a second-mover advantage for regulators. FATF-member countries will be obliged to comply with its recommendations for virtual asset service providers. Otherwise, regulators can consider making use of regulatory sandboxes to allow issuers to experiment with ICOs.
A step towards this would be consistency of terminology. The regulatory grey area has largely related to so-called “utility tokens” which typically give holders access to current or future products or services and do not have features of traditional securities (e.g. a right to share in the issuer’s profits or to repayment of the purchase price). In the United States, uncertainty surrounding how these tokens are regulated has been exacerbated by statements from SEC officials, such as Jay Clayton’s statement, “Every ICO I’ve seen is a security”. This led to ICOs shunning the US, or only being offered there as “security tokens” or STOs under narrow exemptions from US securities laws, e.g. in private placements only to “accredited investors” and recently in Regulation A+ securities token offerings. On 10 September 2019, Blockstack PBC announced the conclusion of the first Regulation A+ token offering.
Yet the status of ICO tokens as securities under US law is not beyond doubt. The US adopts a functional approach to regulation which led the SEC to bring proceedings against certain ICO issuers for allegedly breaching US securities laws on the basis that they had primed purchasers’ reasonable expectations of profits. This was found to render the tokens “securities” under the 1946 Howey Test. The contesting of similar SEC allegations by Toronto-based Kik Interactive Inc. will hopefully clarify the application of US securities laws to utility tokens.
The approach adopted by the US regulators is also at odds with the position set out in the UK’s final 2019 Guidance on Cryptoassets which provides that utility tokens which give holders access to products or services, currently or prospectively, are not regulated provided they do not have the features of traditional securities. In particular, the guidance states explicitly that the tradability of ICO tokens on secondary markets and their potential use for speculative investment purposes will not of itself bring the tokens within the scope of FCA regulation. Assuming that Hong Kong would follow the UK approach, which is likely given that the statutory definition of “collective investment scheme” is virtually identical in the two jurisdictions, it is likely that an ICO of utility tokens would not be regulated in Hong Kong as a securities offering.
In conclusion, the position of ICOs as fundraising tools for SMEs would be much improved the introduction of low-key regulatory measures particularly the application of anti-money laundering and counter-terrorist financing procedures to virtual asset service providers (including crypto exchanges) and ICO issuers. Hong Kong is currently lagging in introducing a licensing regime for virtual asset service providers, primarily because the SFC’s regulatory remit is restricted to “securities” and “futures contracts”. The SFC has however invited crypto exchanges wishing to be licensed to enter its regulatory sandbox. The other key areas relate to setting standards of information disclosure in ICO white papers to ensure that investors are given all the information they require to make an informed investment decision and the education of investors as to the potential risks involved in ICO investment. Finally, the accountancy profession has a key role to play in developing specific accounting standards for ICO tokens.
 OECD (2019), Initial Coin Offerings (ICOs) for SME Financing, www.oecd.org/finance/initial-coin-offerings-for-sme-financing.htm
 Munchee Inc., CarrierEQ, Inc. and Paragon Coin, Inc.
 See Kik’s “Answer to Compliant” filed in Civil Action No. 19-cv-5244 (AKH).
 FCA. “Guidance on Cryptoassets: Feedback and Final Guidance to CP19/3”. July 2019.