Neither Utility nor Security: Defining a ‘Hybrid’ Asset Class for Cryptocurrency

Image by Marina Rudinsky

On August 31, 2017, in the midst of last year’s crypto market boom, the Israeli Securities Authority (ISA) announced the establishment of a special committee for the purpose of examining the regulation of public initial cryptographic coin offerings (ICOs). We at Orbs were very happy about the announcement. As a global business primarily located and operating from the State of Israel, we were paying (and continue to pay) close attention to emerging crypto regulation in other jurisdictions, but did not have any indication as to how this is activity is viewed by different regulatory authorities in our own country.

While it took them longer than expected, after conducting thorough research and holding meetings with different market participants, the ISA committee issued their interim report on regulation of public ICOs on March 19. They actually did an amazing job of researching, understanding, and summarizing both the crypto space and the approaches adopted in various jurisdictions around the world. The 188-page interim report is by far the most comprehensive study of token sale regulation ever put to writing in Hebrew. It is also very clear from that report and our own discussions with ISA committee members that they are not out to kill the market, but are looking to strike the right balance between allowing crypto business to flourish within Israel and protecting token/cryptocurrency holders’ rights.

That being said, it does seem that the committee is very focused on the distinction accepted in many other jurisdictions, under which cryptographic tokens are divided into three categories:

1. Tokens that are used as a means to transfer value and are not connected to any specific venture
2. Tokens that are intended to grant ownership, membership or participation rights in a specific project and have the characteristics of a security (commonly referred to as “security tokens”)
3. Tokens that are intended to grant access or usage rights in a service or product offered by a specific project (commonly referred to as “utility tokens”).

This distinction is useful insofar as it distinguishes between the possible uses of tokens across various projects. However, it is not clear that this distinction is useful as a tool for determining whether a particular token should be subject to the securities laws.

Distinctions without meaning

While the definition of “security” under the Israeli Securities Law is very different as compared to the criteria laid out by the famous/infamous Howey test for the definition of “investment contract” under the US Securities Act, both definitions are applied in a way that is broad enough to include a wide variety of utility tokens that give their holders use rights with respect to a certain product or project.

As a result, the interim report implies that there is no clear distinction between utility tokens and security tokens. And therefore there is a significant probability that a token meeting the definition of a utility token would also be considered a “security” under the application of the current legal tests as described in the paper.

The situation is similar in other jurisdictions, where the distinction between utility and security is not clear and grants no certainty regarding the application of securities laws to a token.

In certain jurisdictions, most prominently the U.S., the practice is to treat tokens that do not have a current use as “securities” under the relevant securities laws, while leaving open the possibility that with the passage of sufficient time and after the tokens have achieved sufficient practical use, the tokens may lose their status as “securities” and be considered utility tokens that are not subject to the securities laws.

However, under this approach it is not clear whether achieving the characteristics of a utility token would actually remove a token from the definition of a “security” and the resulting regulations, or even when this would happen.

Result: Land of Confusion

In my experience working with dozens of companies who are developing blockchain businesses while honestly trying to comply with the law, I have seen first-hand that this focus on a strict distinction between regulation applicable to utility tokens and one applied to security tokens has created confusion and deeper uncertainty.

I believe that drawing a line between security tokens on the one hand (whose offering is highly regulated under the existing regulatory regime applicable to issuance of stocks and bonds) and utility tokens on the other (whose offering is subject to very little regulation, mainly general contract laws and consumer protection legislation) does not address the key question: Which protections are appropriate and which should apply with respect to 1) the sale of cryptographic coins or tokens to the public and 2) secondary trade of such tokens?

Instead, projects are either being forced into a burdensome regulatory framework that doesn’t fit the reality of the assets, or are left without regulation, leaving the market exposed to bad actors.

A New Distinction between Security Tokens and Utility Tokens

I believe that a preferable approach to determining the regulatory framework in this context is to advance a new distinction that differentiates between two different types of tokens — one category of tokens that possess classic features of a security, and a second category with a residual definition, i.e., tokens that do not have the classic features of a security but may be purchased for both practical use on a platform/product as well as for investment purposes; i.e. “hybrid tokens.”

In my view, the classic features of a security that would place a token within the first category should include:

1. The right to participate in revenue or profit generated from a project
2. The right to receive various forms of dividends or distributions
3. Rights of ownership or membership in a common enterprise whose purpose is to derive economic benefit, etc.

In contrast, a hybrid token would be defined as a token that:

1. Grants access or use rights in a service or product that is offered by a specific project (in addition to tokens that have a range of other possible uses that are enabled by blockchain technology, including uses that have not been invented yet), but in parallel…
2. Could also be purchased by some purchasers for investment purposes, so long as it does not have the classic elements of a security.

My thinking is that the principles of traditional securities law should be applied only on tokens in the first category that have the classic features of a security.

With respect to hybrid tokens, while I do not argue that there should not be regulations governing the purchase and sale of such tokens, I do believe that the application of the current framework of securities legislation to this type of asset is not the right approach and is liable to lead to both regulatory overreach and inhibiting the development of new technology, products and services with substantial positive disruptive potential.

For example, limiting the transfer of a hybrid token to a closed group of trading platforms could inhibit the effective use of such token on the platform for which it was initially designed.

Not on a Case-by-Case Basis

In the interim report, the ISA committee suggests that without a relevant definition in the Israeli securities law regarding the classification of a utility token as a security, the application of the securities legislation to a token should be approached on a case-by-case basis, according to the facts and circumstances and in light of the purposes of the securities law.

The ISA committee further indicates that, insofar as the totality of facts shows that the tokens were acquired for purposes of use and not for financial reasons, such tokens would not be considered “securities” under the securities law.

In my view, this narrow case-by-case approach to the application of the securities law on the issuing of tokens is likely to create a chilling effect on the development of token-based technologies, products and services. An individual examination according to the circumstances of each case makes it difficult for developers to achieve legal certainty regarding whether the securities law will apply to the offer and sale of their tokens, since the regulator could potentially take an unexpected approach to this case.

In addition, if the classification of a token as a “security” is partially based on what the token purchasers and holders had in mind when they bought the token, the result in many cases will be that the classification of the tokens is not under the control of the developer. Instead, the classification of the token will depend on market dynamics, which may not always be foreseeable. Under this approach, developers of token-based projects will lack certainty regarding which actions they should take in order to comply with the law.

As a result, I think that that uncertainty will prompt developers to prefer to operate out of countries that take initiative and establish a clear legal framework regarding the issuance of cryptographic tokens.

While I do not believe that it is appropriate (or feasible) to leave the sale and trade of such hybrid tokens unregulated, I do think that the best approach is to develop new regulatory principles to govern the sale, trading and use of hybrid tokens. Those regulations should take into account the unique features that hybrid tokens possess as a new separate asset class (a “hybrid regulatory model”), rather than relying on existing securities regulation.

Hybrid Regulatory Model: A New Asset Class

For example, the value of a hybrid token that is designed to grant the right to use a product or service, in contrast to a stock, does not depend on the value of the issuing company but is rather determined by the current or future value of the relevant product or service, or by the usefulness of the token within the framework of the product or service.

Unlike a stock, a hybrid token is the key that allows the use of the product or service and does not represent a right in or to the legal entity launching the product or service.

In another context, a hybrid token could be used merely as a means of payment for a certain product or service or over a specific platform. In light of the differing nature and use of these tokens, I imagine that a fully formulated hybrid-token-specific regulatory framework would include protections similar to the protections afforded under current securities laws for trading in the financial markets. Simultaneously, it would allow the practical use of hybrid tokens for the purposes for which they were designed.

It is important to note that my approach does acknowledge that the reality acquisition of hybrid tokens is likely to have aspects of an investment in securities, as some market participants will purchase hybrid tokens with expectation of profit and speculative trading. At the same time, as noted above, attempting to apply the current regulatory framework under securities legislation to an asset that does not have the classic elements of a security is likely to inhibit the development of new technologies, products and services that might rely on use of such tokens.

By way of illustration, while the application of prospectus and disclosure requirements to developers of hybrid token projects is feasible in and of itself, forcing the secondary trade of those hybrid tokens into the current security-trading framework is not practical (i.e. the requirement that transfer or other disposition may only be done on a registered securities exchange and through a licensed broker/dealer).

In practice, it would result in the complete prevention of tokens providing any utility to their users.

Accordingly, the best way for regulators going forward is formalizing a hybrid regulatory model. This lets token developers issue hybrid tokens without concern for inadvertently violating current legislation. Simultaneously it would achieve the purposes of current legislation in the context of the unique features of these tokens (i.e., protecting investors and the integrity of the markets).

I believe that the hybrid model should be based on a dedicated disclosure regime that takes the special features of hybrid tokens into account. It will be designed to ensure that all material information is provided to token purchasers in a manner that lets them make an informed and rational decision regarding their purchase, holding and sale of tokens.

In the ISA report, the committee indicated that the disclosure applicable to issuance of a crypto token should include financial and business information in clear and accessible language. It should have an emphasis on crypto-specific issues, such as:

1. Cyber and security threats
2. Information on the development team
3. The project protocol
4. The rights and specifications attributed to the token
5. Future plans for the development of the platform
6. Other information that is necessary for making an educated decision regarding the purchase of tokens.

A fundamental purpose of modern securities legislation is full disclosure, meaning issuers provide full, correct, and complete information that is tailored to enable the public to make educated decisions.

I have seen projects specifically avoiding full disclosure due to the concern that disclosing information that is not inherent to the product would be considered a solicitation of a purchase or would serve as an indication that the tokens are being purchased for speculative purposes. The existence of a dedicated disclosure regime would clarify the information that needs to be disclosed in the context of a hybrid token issuance and would allow developers to provide full and appropriate disclosure, without worrying that disclosing information of a certain nature would force the offering into a regulatory framework that is not necessarily appropriate for the offering.

A hybrid regulatory framework would need to set out disclosure obligations that are tailored to the unique features of the token. For example, if a token permits use of a product, the issuing entity should be required to provide full disclosure of material information regarding the product. It would also be advisable for the issuer to be required to disclose the documents relevant to the token offering a specified amount of time prior to the sale in order for potential purchasers to have sufficient time to examine the documents and to ask questions of the issuer with respect to that token sale.

The disclosure requirements should begin to apply concurrently with the initial sale of the hybrid tokens. In instances when the hybrid tokens will be tradeable in the secondary market, the issuer would be subject to continuing disclosure requirements such that token purchasers have consistent access to updated information. As I see it, defining a dedicated disclosure regime would ensure that sufficient information is provided to permit token purchasers to make educated decisions regarding hybrid tokens while removing the concern that the purposes of securities legislation be violated.

Conclusions

I believe that in the framework of the hybrid model, it is crucial that the authorities understand that regulation of sales in the secondary market needs to be calibrated to the unique features of blockchain technology, especially with respect to those projects where trading on the secondary market represents an inherent part of the offering and the business model of the product.

Applying restrictions on transfers of tokens in the secondary market is liable in practice to prevent the use of tokens for the purposes for which they are designed, basically preventing such tokens from having any real-life utility.

Appropriate regulations should be designed to allow for the operation of exchanges that are designed for hybrid tokens, with the right types of protection for consumers and traders, while simultaneously allowing for the transfer of tokens between users and business who are not necessarily registered brokers, both peer-to-peer and on the platform for which the such tokens were designed.

To conclude, I think regulators should stop struggling with trying to categorize blockchain tokens as “utility” or “security” tokens but rather accept the fact that we seek to regulate a new asset class of “hybrid” tokens, which may offer utility with respect to certain products and services, while in parallel being purchased and traded for financial investment purposes.

Instead of trying to use “old world” tools to regulate this new asset class, I think regulators should go back to the drawing board and create a new regulatory regime, which would afford investor and consumer protections while encouraging the development of new technologies’ products and services.

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