Welcome to the Carnival — A Primer on Token Classifications in the Current Global Regulatory Environment

Author: Eli M Blatt, PhD. Founder and CEO of BitFinance, PBC and Whitepaper Consultant at Blockchainpr.io

Coin Confusion

There is widespread misconception that regulations for the offer and sale of cryptocurrencies are as yet either non-existent or else ill-defined. In fact, while the regulatory landscape regarding cryptocurrencies and token sales specifically is beginning to shift globally and new regulations are being formulated and codified, the most relevant regulations in the U.S. and abroad affecting cryptocurrencies and tokens are securities and tax laws, which have existed for nearly 100 years. For those who understand developing international standards around the legal treatment of tokens and are positioned to capitalize thereon, the regulatory landscape is quickly becoming less of a hazard and more of an opportunity. That said, perhaps the single biggest area of Fear Uncertainty and Doubt (“FUD”) in the international ICO landscape is a general misunderstanding of the difference between token types within and between international jurisdictions.

Utility, Payment, and Security Tokens

There is a trend across exchanges for investors and traders to treat all coins as equities, even though many are patently not equities, as they do not render the holder a shareholder of the issuing entity, and even though in many cases the coins are explicitly positioned as not being securities by virtue of having a utility. But having a utility, at least in the United States, is not relevant to whether a token is considered a security; and internationally, whether or not a utility token is, in fact, a security depends on when that utility is available relative to when the token is issued. Utility aside, being a security does not make a token an equity — though being an equity does make a token a security. Simple, right? Taking a step back from tokens and differences in classification across international jurisdictions, let’s look at what securities and equities are in principle and how they relate to tokens that have a putative utility which ostensibly renders them neither a security or equity.

Broadly speaking, the term “security” refers to any investment product that 1) can be exchanged for value and 2) involves exposure to risk in the form of loss of value. Additionally, securities must be readily transferable between two parties, and the owner must be subject to the loss of some or all of the invested principal. Key attributes of a security are thus transferability, the expectation of gain, and the potential for loss.

An equity is generally any security representing an ownership interest, a right to distribution, and/or a right to liquidation in the issuing entity, whether private or publicly traded. Thus, all equities are by definition securities, but not all securities are equities. These two financial instruments, securities and equities, are well established and there exists little confusion or discrepancy across international jurisdictions on their classification, whether in tokenized or paper incarnations.

But what about a utility token? This is a somewhat new classification and it’s where things begin to get nuanced. This is because it’s increasingly clear not only in the United States (where the expectation of gain alone on the part of the purchaser is enough to render a utility token a security — more on that below) but also abroad that simply having an ostensible utility does not mean a token will not be deemed a security. If a token is sold as a utility token without complying with securities regulations but is subsequently construed by a regulatory body to be a security, the issuer may be subjected to civil liability, rescission, fines and criminal prosecution. And the token will likely also be delisted from current exchanges, which are not registered to exchange securities.

To help delineate the classifications, consider by analogy a scenario where the tokens will not be used for a digital product, but rather for going to a Carnival — an experience most of us can relate to.

Utility tokens are your ticket to the Carnival, meaning they get you access to the Carnival grounds. Inside the Carnival, some rides and attractions may be included as part of admission, and of course while inside the park you get to explore and have fun with your friends. But these tokens don’t enable you to play all the games or go on all the rides, and you don’t get free food either — or a chance to win a giant teddy bear — you just get to enter the Carnival. Your entrance ticket is not exchangeable for goods or services, just access to the Carnival, and although it is transferable, it does not have the potential for principal loss. Through this analogy, it is clear how a properly structured utility token that provides access to a platform or network will not be considered a security (at least in jurisdictions outside the United States, more on this below).

Payment tokens allow you to buy goods and services inside the carnival for effective cash value; they are the Carnival’s transactional currency. If you want to take full advantage of all the attractions inside the Carnival — play the games, take the rides, eat the food, win a teddy bear — you need these separate payment tokens that can be effectively redeemed for cash value. It’s the effective cash value of the tokens and the fact that more tokens are redeemable for goods and services that renders them payment tokens. Since the value of the tokens doesn’t change — the same number of tokens is always required to take a ride or buy food — there is no expectation of gain and no potential for principal loss, and so payment tokens do not qualify as securities.

Security tokens are a way to actually invest in the Carnival and become a beneficial owner.If, after a day of paying admission to the park with a utility token and paying for games and rides with payment tokens, you decide you like the Carnival so much you want to actually own an interest in the park itself and potentially receive dividends if it’s profitable, you can find the owner and buy an ownership stake in the Carnival in the form of either a security token or any other traditional equity interest. Because this token is transferable and investors have the potential to either gain or lose money holding it, it is a security. And because the token represents interests in an enterprise, giving the issuer a claim against the principal and profit of the Carnival, it’s not just a security but an equity token.

Simple, right? Not quite, as Carnivals in different states are subject to different requirements. Because officials don’t want charlatans stealing people’s money and having the games rigged so people can never get their prizes, there are laws in every state around gaming and gaming commissions that regulate whether and how one can run these Carnivals. If you want to open your Carnival in Los Angeles, there are all kinds of permits, security, bonds, insurance, regulatory hurdles and approvals that are required and it could take a year to clear the regulatory hurdles (e.g., Public Health Department, Franchise Tax Board, California Gambling Control Commission and local permits), but if you want to open the Carnival in Cody, Wyoming, you might simply have to pull a permit from the Department of Agriculture, choose a location and be able to get your Carnival up and running in a month.

To bring the analogy back full circle to ICOs, consider BitFinance, which is launching an online investment platform at bitfinance.com where retail investors will be able to purchase institutional-grade alternative investments. BitFinance will issue BFA, a utility access token that unlocks access on the investment platform to BitFinance’s funds by asset class. But to actually make an investment in the funds, users need to purchase their interests in the funds using BFI, a payment token used to purchase BitFinance investment products; the fact that the token is exchangeable and that the holder can gain or lose money in the process renders it a security. And then, finally, in order to enable its users to become shareholders, BitFinance will issue BFE, a corporate equity token, which likewise is considered a security.

But this platform will be available to ICO investors worldwide. This creates a wrinkle because just as Wyoming and California have different regulatory standards around Carnivals, so do different international jurisdictions have differing regulations around securities and tokens. The main issue that arises in evaluating token sales across international jurisdictions is whether a token marketed as a “utility token” will in fact not ultimately be deemed a security in some or all international jurisdictions. And given exchanges’ recent positions to defer to classification as a security if a token is offered in any jurisdiction as a security, this issue becomes all the more critical.

This brings us to an important distinction that must be considered when evaluating the international regulatory landscape: namely that, compared to many other international jurisdictions, the United States follows a different standard for determining whether something is a security or not.

International Regulatory Landscape

The United States, by virtue of a nearly Century old law, evaluates tokens using a different standard than most of the international community. Outside the United States, there are increasingly clear signs that the international community will adopt Swiss law around token classification. That being said, the U.S. is still perceived to be one of the most advanced and secure financial markets in the world.

The legal test in the United States for determining whether a transaction is a “security” is the “Howey Test,” which resulted from the 1946 Supreme Court decision in SEC v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946). Under Howey, an “investment contract” is deemed a “security” as used in the provisions of § 2(1) of the Securities Act of 1933 (“the Act”) and registration or an applicable exemption is required under the Act, when a “contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profit solely from the efforts of the promoter or a third party.”

Since the Howey ruling, courts have broken the Howey test into four prongs to determine whether a transaction is a security, as follows:

1. Does there exist an investment of money?

2. Does there exist a common enterprise?

3. Does there exist an expectation of profit?

4. Is the expectation of profit solely from the efforts of others?

While many issuers of utility tokens have argued that the tokens represent the sale of goods or services, the expectation of gain among buyers, most of whom are purchasing the tokens at a discount, means that those tokens would be deemed to be securities. As a consequence, the Securities and Exchange Commission (SEC) has provided a strong indication via recent subpoenas that any Simple Agreements for Future Tokens (SAFTs), ICOs or token issuances, whether labeled a utility, currency or equity, will be deemed by the SEC to be “securities”. As SEC chairman Jay Clayton stated plainly: “every ICO I’ve seen is a security”.

The basis for classifying utility tokens, as well as the SAFTs and more recently RATEs (Real Agreements for Tokens and Equity) by which most have been sold to investors to date, as non-equity securities in the U.S. is that under the Howey test (1) the tokens do not yet exist and therefore the SAFT is being construed as a “futures contract”, and (2) there is an expectation of profit from speculation that the tokens will go up in value and betradable. It is this second criteria where the United States appears to diverge from the rest of the international community.

There are numerous of jurisdictions (e.g., Japan, Estonia, Singapore, and Switzerland) where a true utility token would not be deemed a security simply because of a purchaser’s expectation of gain. By analogy, if one were to buy a car, an art piece, a bottle of wine, or a concert ticket with the expectation of selling said property at a profit, it would generally not be considered a security. However, if the property did not yet exist and the good itself had not yet been delivered, but rather there was a token representing the good or a promise of future utility not currently available, then there would be a high probability that the token would be deemed a security in most jurisdictions. In the United States, however, the mere fact that almost all tokens are sold at a discount creates a prima facie case that the investor expects a gain and therefore assumes that the token will be deemed a security under United States Law.

The distinction of whether the token exists when it is sold, whether the goods or services exist at the time it is issued, and whether the purchase of the token is primarily driven by access to the service or the purchase of the good vs. as an investment is becoming determinative of its classification in foreign jurisdictions. The relevant laws that may be applied are the banking legislation for any deposit-taking activity; the securities legislation for tokens classified as securities; the anti-money laundering legislation for any activity of a financial intermediary for AML purposes; and the collective investment schemes legislation for any fund management or related activity. The issue of whether or not a token will be deemed a security is delineated in the most recent regulatory guidance from the Swiss Financial Market Supervisory Authority (FINMA). FINMA’s guidance assists in determining how to structure the sale of tokens and coins in Switzerland and is indicative of the regulatory trend in many other jurisdictions.

FINMA classified tokens in 3 classes:

1. Payment tokens or cryptocurrencies are intended only as means of payment for acquiring goods or services and that do not give rise to any claims against the issuer. To the extent that a token does not constitute a digital representation of any rights of token holders that are exercisable against the issuer but instead are designed to be used as a means of transacting payment, it would not qualify as securities under FINMA guidelines.
2. Utility tokens provide access rights to a digital application or service. An important caveat to this definition provided by FINMA is that the utility provided by the token must be available at the time the token is issued; if the token promises a future utility that does not exist at the time of issuance, the token would be considered to have an investment purpose and thus would be deemed a security under FINMA guidelines. Less clear under FINMA guidelines is the extent of the utility promised by a token that has to be available at the time of issuance in order to not be deemed a security. For example, a token that provides access to a Beta platform that does not afford the full future utility promised by the token could potentially be deemed a security. Whether or not the utility afforded by a token at the time of issuance is sufficient for the token to not be deemed to have an investment purpose and thus be deemed a security can be discussed with FINMA.
3. Asset tokens represent an asset, a debt or equity claim against the issuer or a third party. This includes tokens that represent pro-rata rights to an underlying commodity, equity, or revenue. All asset tokens will be deemed securities under FINMA guidelines by virtue of their digital representation of equity interests in an underlying asset.
4. Tokens may also take a hybrid form by including elements of more than one category, for example an asset token that can be used as a transactional currency would be deemed a security by virtue of being an asset token, regardless of its use as a payment token.

The Rise of Security Tokens

While much talk is made in the United States and abroad regarding ‘security tokens’ and so called STO (Security Token Offerings), the Swiss guidelines lay out a very different schema, effectively classifying asset tokens as equity tokens and treating the matter of whether a token is a security as a function of whether it represents effectively a futures contract or not. There is arguably a prevalent misnomer in discussions of STOs whereby tokens being called security tokens should arguably be called equity tokens or asset tokens; the terms are often inappropriately used interchangeably. This is because a utility token can be a security — as arguably could be a payment token if it were solely used to purchase securities. In fact, the term ‘security token’ relates less to the payment, utility, or asset-backed nature of a token than it does to how the token will be classified and regulated by international agencies; namely whether it will be deemed to be a security or not, regardless of the token’s ostensible use or value, and whether or not as a result that token can be traded on existing exchanges.

The exchanges now operating worldwide are utility token exchanges; they are not regulated in a manner that permits them to exchange securities. This is one big reason for recent investor trepidation around investing in utility tokens that could ultimately be deemed to be securities based on their having been sold prior to issuance or issued prior to having an active network to which they offer access; besides potentially running the issuers afoul of international regulations, the tokens could find themselves delisted from utility token exchanges likewise worried about running afoul of international securities laws. The oncoming wave of security token exchanges such as t0 are regulated to exchange securities, just as traditional stock exchanges are. And since a token that is issued explicitly as a security has no less international legal ambiguity than any other type of security, this means that so-called security tokens (whether the token has a utility or is used as a means of payment or to represent a digital claim to an underlying asset) can be sold and exchanged on those exchanges without any of the FUD that currently plagues utility tokens. This is the reason for the incredible amount of excitement and anticipation surrounding security tokens.

The Path Forward

Using the Swiss guidelines as a harbinger, recent developments in the regulatory environment entail that for a utility token to not be deemed a security — at least outside of the United States — the utility afforded by the token must be available at the time the token is issued. This also means that the legal trend worldwide is to deem SAFTs as securities. If the network to which the token provides access is not yet active at the time of its sale, or if in any other salient way the token represents a promise of a future utility as opposed to a presently available one, the token or SAFT promising a future token will likely be deemed a security in every jurisdiction worldwide.

Given this regulatory landscape, it seems that the best strategy for an ICO today where the ICO is funding the development of a product, service, or platform to which the token will provide access (as opposed to an existing product or service that offers an ICO to access it) is to conduct a traditional equity round of financing separate and apart from any token sale, and then use the proceeds of the equity round to build the network, product or service.

The next step would be to mint the tokens offshore as a utility token sale with real and existing tokens that have immediate access to a real platform with tangible value. This, under Swiss law, would be a utility token and not be deemed a security. After proving the model offshore, the issuer of the token can seek a no action letter from the SEC and, if obtained, bring the network and token sale onshore as a utility rather than as a security. Alternatively, United States investors can be excluded in the ICO, or else the token can be issued as an exempt Security under SEC Reg.D 505(c), limiting the U.S. raise to 99 accredited investors and up to $150M.

If a company issues a token that will potentially be deemed a security under Swiss guidelines, exchanges that operate outside of the U.S. jurisdictions won’t allow the tokens on their exchanges, because they want to be able to openly sell the token without violating securities law. And investors that want to purchase tokens tradable on an exchange outside of the U.S. within the next 6 months likely won’t invest for that same reason. Since at present there are no security token exchanges operating, let alone any trading velocity for security tokens, it is not an ideal time to launch a security token.

So, if a company wants to issue a token that can be listed on exchanges and have trading velocity, value and volume in the next 6 months, they pretty much need to issue a token that is unambiguously not a security under FINMA guidelines and to sell the tokens in jurisdictions with clear guidance deeming that the token is not a security.

All of these distinctions demonstrate how important it is for issuers of tokens to carefully consider how their token will be classified with regards to securities law, and which jurisdictions will provide the most favorable tax, securities and consumer protection treatment for their offerings.

To summarize:

1. In the United States, the SEC has provided guidance that the expectation of gain upon exchange of the token by an investor renders both tokens and their purchase contract (especially a futures contract such as a SAFT), a security, regardless of any putative utility.
2. In foreign jurisdictions, Swiss Law appears to be setting the standard for distinguishing between three token types:
3. Payment tokens are tokens used purely for transactional purposes and do not represent any rights by the holder against the issuer.
4. Utility tokens must be deliverable at the time of sale and have a utility at the time of the token launch — not be a promise of future utility — in order to not be deemed securities despite their putative utility.
5. Asset tokens represent an ownership interest or right in or against the issuer resulting in a potential for gain or loss and will as a result be prima facie deemed securities.
6. Both Payment and Utility tokens could be deemed to be securities regardless of their transactional nature or utility value if they are effectively deemed to represent a futures contract.
7. When planning a token offering for a:
8. Utility token: Make sure the utility granted by the token is available at the time the token is issued.
9. Realize that if you are selling the promise of a token (e.g. a SAFT) or of a future utility not active at the time the token is issued, it will be deemed a security regardless of the token’s putative utility.
10. If launching a token for an as-yet-to-be-developed network, consider raising an equity round to fund development of the platform prior to issuing the token.
11. Security token: Beware of more strenuous international regulation around compliance for securities, as well as the fact that there is at present no significant or secondary market for security tokens given the lack of security token exchanges.
12. Recognize that there is at present no significant secondary market for security tokens given the lack of security token exchanges.
13. Note SEC Rule 144 and Section 4(a)(7) which require a 12-month lockup prior to public sales with the potential for resale to other accredited investors after three months.
14. Take into account the ability of US token holders to resell to foreign investors or potentially soon to US investors on ATS exchanges without a lockup period.