The issue of legal qualification of solutions based on blockchain technology still provides many new challenges. This is especially the case with the issue of cryptographic tokens, which may incorporate various rights and obligations, including those similar to those of ownership of shares or other securities.
Why is token classification important?
Deciding whether a given token is a security is key to answering the question whether it will be subject to financial market regulations, and in particular those specifying requirements for conducting public issue. Three types of tokens are usually distinguished due to their functions in trading, which also translates into their legal classification:
- Utility tokens;
- Payment tokens (e.g. bitcoin);
- Security tokens (investment).
Only investment tokens under EU law and then Polish will be qualified as securities. The EU MIFID II directive defines securities by listing them. It is worth quoting here their definition contained in art. 4 clause 1 point 44 of that directive:
“Transferable securities” means those types of securities which are negotiable on the capital market – excluding payment instruments – such as:
(a) shares in companies and other securities equivalent to shares in companies, partnerships or other entities, as well as depositary receipts relating to shares;
(b) bonds and other forms of securitized claims, including depositary receipts for such securities;
(c) any other securities giving the right to buy or sell any transferable securities or giving rise to cash settlements in relation to transferable securities, currencies, interest or return rates, commodities and other indicators or measures.
Clarification of the directive
It is worth paying attention to the term “such” in the above definition, which means that the definition does not limit the catalog of securities to those listed therein. The frequent situation where tokens have a hybrid form incorporating usability and investment rights and issuing them by the issuer with names that may not correspond to their real nature, means that when assessing whether a given token is a security, a substance-based approach should be used over form approach, which focuses on analyzing the functions assigned to a given token. Hence, the Community judiciary and regulatory authorities have developed a group of functional criteria to demonstrate when we will be dealing with a security within the meaning of the MIFID II Directive:
- negotiability on capital market;
- similarity to already existing securities (comparability).
Transferability is a feature that accompanies many tokens of different categories. We are talking about a situation when there are no contractual or technical obstacles to transfer a given token from one person to another.
If it is possible to sell tokens on capital markets, it is important to define what the capital market is. It is worth using the broad definition of this concept provided by the European Commission, according to which the capital market is any place where buyers and sellers of securities meet to carry out transactions.
With such a broad definition of this concept, there is no doubt that the capital market will be the so-called “Cryptocurrency exchanges” and similar activities related to the investment tokens sold there. Often, such platforms enable the trading of various types of tokens, including utility and payment ones, which, however, does not make them securities, most often due to the lack of features similar to those already in use in trading.
Standardization comes down to recognizing tokens generated in one issue as co-creating one class. In order for tokens to be considered belonging to one class, they cannot incorporate rights or obligations that make them different from each other.
The last of these criteria raises some controversy, which is the functional similarity to already existing securities. It is impossible to agree with the opinion of some authors that meeting the first three criteria is sufficient to recognize a given token as a security. This would result in the need to apply legal requirements specific to securities also for many utility tokens, which act as a voucher or access code to certain functions of the platform as well as for payment tokens similar to traditional money.
Some important differences
The EU legislator does not seem to want the voucher to buy specific products in the store (only in the form of a token created using blockchain technology) to be considered a security. This is unlikely, for example, due to the fact that an attempt to classify a token should assess whether the investment risk generated by such a token is large enough to be considered a security. This risk does not exist or is very limited in the case of a “clean” utility token (pure utility token).
Most often, when comparing a given token to securities, it is analyzed whether it guarantees the possibility of future cash flows, if such a payment resembles a dividend-style payment or if it gives a voting right similar to that of a shareholder in a joint-stock company (voting rights).
The dividend is related to the share function of securities, which “allows to reap the benefits of managing a given property in proportion to the size of the share held in that property.” Undoubtedly, not every payment associated with having a token will be similar to a dividend. If the payment is not proportional to the size of the share held in tokens, and, e.g., is the remuneration calculated on the basis of the profit generated by the actions taken by such holder, this reduces the likelihood of recognizing the given token as a security.
Also, the voting rights incorporated in the token will not always be similar to the rights granted even to the shareholder in the company. This is due to the fact that the voting right in a joint-stock company is to enable shareholders to take actions resulting in a profit for the company, while in the case of utility tokens, it allows investors to shape the functions of a given product, platform.
The border between the utility token and the investment token is very fluid. Therefore, each case should be analyzed separately. Sometimes, only a slight change, e.g. in the requirements that must be met to get the payment associated with the token, may cause that two similar tokens will be classified differently.
Kijewski Graś Law Firm