By Jeremy S Goldstein – IBC Group & Blockchain Legal Strategies, LLC
The US State of Wyoming and the European Nation of Switzerland have more in common than sparse populations and majestic landscapes… both seem to love utility tokens.
On February 16, the Swiss Financial Market Supervisory Authority (FINMA) published updated guidelines on how it intends handle ICO enquiries, clearing the way for some public token sales to proceed without regulatory scrutiny. The FINMA guidelines expressly exempt nearly all traditional cryptocurrencies and most utility tokens from securities regulations.
On February 27, five separate bills addressing blockchain and cryptocurrency were passing through the Wyoming State legislature in various stages. One of the five, HB 70, the Open Blockchain Tokens – Exemptions Bill, better known as the “Utility Token Bill”, expressly states that functional utility tokens which meet certain enumerated requirements are not securities, and will not face application of the Wyoming Uniform Securities Act (WSA). HB 70 passed the Wyoming House unanimously, and is set for a first reading in the Senate on February 28, with the expectation of passing.
Interestingly, both the FINMA guidelines and HB 70 are essentially asking the same three questions:
1) Is the token is a “Functional Utility Token” used for acquiring goods or services on a blockchain;
2) Is the token is marketed or is acting as an investment; and
3) Is the token sale is fair to investors.
The FINMA Guidelines differentiate these tokens from “Payment Tokens” or pure-crypto like Bitcoin, Litecoin, and Dash, by categorizing them as “Utility Tokens”. HB 70 lists them as “Open Blockchain Tokens”. Here, we will refer to both as “Functional Utility Tokens”, assuming they pass the first test.
Let’s break down the legal elements presented in each the FIMNA guidelines and HB 70, respectively, in these categories.
- Whether the token is a Functional Utility Token
Both the FINMA Guidelines and HB 70 require a Functional Utility Token to be exchangeable on a blockchain platform for good or services.
FINMA defines utility tokens as “tokens which are intended to provide access digitally to an application or service by means of a blockchain-based infrastructure.” In order to be considered a Functional Utility Token exempt from filing, the “sole purpose [must be to] confer digital access rights to an application or service” and the token must be able to be actually used this way at the point of sale. The reason FINMA created these clear-cut exemptions is because “in these cases, the underlying function is to grant the access rights.” The grey area in the FINMA Guidelines is what level of purpose additional to its platform utility will trigger “Asset Token” classification, and mandatory securities filings.
HB. 70 similarly defines a utility token as a “digital unit” “exchangeable or provided for the purposes of receiving goods or services[,]” which is created “in response to the verification or 3 collection of a specified number of transactions relating to a digital ledger or database[,]” based on “random selection or the possession or age of existing units[,]” or a combination of the two. HB. 70 therefore, recognizes both proof of work and proof of stake as applicable protocols on which to operate a Functional Utility Token, given that the token is exchangeable for goods or services on the platform.
2. Whether the token is marketed or is acting as an investment
Even if a token meets the requirements of a Functional Utility Token, it may still not be permitted to access the exemptions in the FINMA Guidelines or HB 70. Both prohibit public sales without registration for tokens found to be marketed or acting as an investment.
The FINMA Guidelines do not exempt tokens which have either a whole or partial “investment purpose at the point of issue[,]” and FINMA will treat such tokens as securities. The FINMA Guidelines expressly state that one of the factors that allows Functional Utility Tokens exemption from securities regulations is that there is no direct “connection with capital markets.”
This is a typical feature of securities, and if it exists, the token is not a functional utility token.
FINMA has not provided any guidance on what level of investment purpose is required to transform a Utility Token into an Asset.
FINMA considers tokens to be acting as investments, and as such subject to securities regulations, if they are suitable for mass standardized trading and represent either an uncertified security or derivative, or if the developer does a pre-financing or pre-sale phase. This eliminates from exemption most ICOs which have, prior to filing, released a pre-sale or crowdfund round.
HB 70 also addresses this issue directly, mandating that a token may only pass muster as a Functional Utility Token if it “has not been marketed by the developer or seller as an investment[.]” HB. 70 is also likely to bar pre-sales and crowdfunding; it expressly states that tokens acting as investment contracts, where the investment is in “a common enterprise with the expectation of profits to be derived primarily from the efforts of a person other than the investor[,]” are investments not exempt from the WSA.
3. Whether the token sale is fair to investors
Sale of a Functional Utility Token which is not marketed as, or acting as, an investment, must also present a fair sale to the public to be exempt under FINMA and HB 70. FINMA requires that all “trading should be fair, reliable, and offer efficient price formation.”
HB 70 goes further, expressly mandating as a core element that the developer not “enter resale agreements or manipulate the price” before, during, or after the token sale. This can likely be cured through adequate due diligence, transparency, and token freezing mechanisms.
In addition, the FINMA Guidelines and HB 70 require all three elements to be satisfied for exemption from the WSA. HB 70 also requires a good faith belief on behalf of the seller or developer that the token meets the three requirements, and that they take action to stop the trading of a token if it fails to continue to meet those standards.
The FINMA guidelines and HB 70 are pushing the envelope in regulating ICOs. Both are favorable to Functional Utility Tokens, whose developers act in good faith and conduct adequate due diligence. They are not, however, a free-pass to any partial-utility token, nor to investments masking as utility token sales. Beyond the excitement for ICO developers, it is important to note the similarities between the FINMA Guidelines and HB 70, because herein lies the key… the similarities are no accident. If the past is any indicator, it is likely that future ICO regulations in other jurisdictions will look to the FINMA Guidelines and HB 70 as a baseline. If so, these future regulatory frameworks will likely include an analysis revolving around the three legal considerations posed, herein, namely: 1) whether the token is a Functional Utility, 2) whether the token is, or is marketed as, an Investment, and 3) whether the token sale is fair to investors. Yet, as always, it is up to the lawyers, legislators, and courts to determine what that really means for developers and investors.
Jeremy S Goldstein is an Attorney in Colorado, USA, a Legal Advisor for IBC Group, and the Founder of Blockchain Legal Strategies, LLC, a firm providing legal and sustainability consulting services to blockchain projects with a positive social or environmental impact. He holds a Juris Doctorate and Graduate Certificate in International Law from the University of Denver Sturm College of Law, a B.B.A in Economics from Baruch College, and a Certificate in Public International Law from the Hague Academy of International Law. If you wish to contact Jeremy, you may reach him here: [email protected]
*This article is made available by the author, lawyer, or law firm publisher for educational purposes only and is not intended to be, nor should it be considered or construed as legal advice, and does not create an attorney client relationship between the reader(s) and author(s). For full disclosure, the author owns some cryptocurrency, which has no impact on the authors decision to expressly name, or omit, any specific token or coin from this article.