Legal and Regulatory Pitfalls with Token Offerings

It isn’t hard to be excited about the many possibilities in the emerging crypto and blockchain space.

Stablecoins? ICOs? STOs? Decentralized exchanges? Programmable money? There seems to be no limit!

But at the same time – it is easy to jump in with both feet and …then end up in a legal dead-end.
As exciting as crypto can be, there are many legal and regulatory pitfalls and not everyone knows how to address them.

Our experience at LEXcellence has shown that it is well worthwhile to carefully consider all the implications of your crypto business BEFORE embarking on your entrepreneurial journey.

Let us shine some light on a few of the major pitfalls that you should watch out for.

The big three - KYC, taxation and regulation

Generally speaking, there are three main areas which prove the trickiest for crypto companies - and which many startups try to avoid dealing with:

- KYC
- Taxation
- Regulations (in various forms)

While it may seem to be tempting to avoid these issues in an initial phase, sooner or later, all businesses will find themselves in need of a clear position regarding the law in the country where they operate.

That’s why it is important to start early and consider all the options - and all of the various consequences of the approach you take.

We’ll go through each of these areas as they concern specific token types and business models - but first a quick recap of definitions:

KYC: know-your-customer - For financial transactions and operations, KYC requirements are an important part of the regulatory framework to prevent fraud, money-laundering and other financial crimes. While many in crypto, in particular the developers, consider them to be a nuisance and unneeded burden, implementing KYC is also a key part of mitigating your company’s risk and liability.

And this in turn, puts you in good standing with the people you want to do business with, in particular with banks. While opening a corporate bank account for companies dealing with crypto business is already difficult, to open a bank account without having a proper KYC process in place, proves to be virtually impossible.

Taxation – Not, that anyone needs a special introduction to the concept of taxes, but still… While many entrepreneurs actively ask about corporate income tax or personal income tax they often don’t take into account the fact that there is a wide range of other kind of taxes that may apply to the planned business blockchain based models - some of which are less obvious than others, like VAT or withholding tax.

Regulations - Broadly speaking, there is a myriad of regulations which may also apply to your blockchain startup. They might have to do with treatment of your business as a financial intermediary, licensing as a broker, dealer in assets or even as a bank. There is as well a possibility that your token may be classified as a financial derivative.

Now let’s take a look at some specific situations.

Utility tokens

A utility token is one of the main innovations brought into existence by blockchain technology. By the way, utility tokens are not “dead”. One still needs utility to build the scale of the intended business. What is dead, are the “ICOs of utility tokens” where no utility was involved.

Utility token introduce many new possibilities as well as various challenges, legal and otherwise.

According to the Swiss financial regulator (FINMA) token classification guidelines:

...utilitiy tokens [...] are intended to provide digital access to an application or service.

Another way to put it is that a utility token (from the point of view of the regulator) allows people to do things and access things (services, platforms and networks) that they wouldn’t be able to access without the token.

This has several implications:

1) Value Added Tax (VAT) - Because the key value transfer inherent in the use of a utility token is access to a service, the issuing company may be perceived as providing a service to its users/customers. Services in many countries, including Switzerland are usually subject to a VAT. If your business model and operations don’t take into account the need to collect and report this VAT - you may be in trouble down the line.

2) Change in characteristics - Over the last one and a half year the vast majority of crypto startups went to great length into structuring their token in such a way as to be classified as a utility token, avoiding the potential burden of securities laws - both in Switzerland and in other countries. However, there is a catch when it comes to using the utility token tag in Switzerland.

According to the mentioned FINMA guidelines, a utility token must be usable as such on the day of issuance. If a company issues a token before the platform or protocol is completed and ready for use, the token being purchased might fall under the security token classification resulting in a broker license requirement for an exchange platform to trade them.

Furthermore, an initial utility token might change its function into a payment – exchange token. In such a case the need for KYC requirements can be started to apply as well.

Payment tokens

Payment tokens (or exchange tokens as they are referred to in some jurisdictions such as the UK) are those which are used in a similar way like fiat currencies. They can also be simply referred to as cryptocurrencies.

Whereas a utility token may entitle a holder to receive something (i.e. access) in “exchange” for it, this utility is most often limited to specific action or function and does not foresee that the token should become a unit of exchange or settlement beyond its core functionality.

Payment tokens, however, are not limited in this way and thus are considered more like “money.”. They do, however, gain their classification as payment tokens by the fact that they are exchangeable at the moment of issuance.

For these reasons, payment tokens fall under the general regulatory framework currently in place for currencies and for businesses dealing in currencies - such as banks, brokers, asset managers etc.

Here are few challenges that you might be faced with:

1) KYC/AML – FINMA expects that payment tokens/cryptocurrencies will be treated with the same care as normal currencies. If your business is to be international, you need take into account different jurisdictions: there are some regulators which allow crypto-to crypto transactions to be taken out of the AML scope, but majority of the regulator require that FIAT to crypto transactions are subject to AML regulations.

The Swiss regulator FINMA expects that payment tokens/cryptocurrencies will be treated with the same care as normal currencies. This means first and foremost carrying out proper know-your-customer and anti-money laundering checks under various Anti-Money Laundering (AML) regulations.

2) Regulation concerning acting as a financial intermediary, asset manager, issuer of e-money or even as a bank.

Most currencies in the fiat world are issued by central banks. Those who handle them - accepting deposits, facilitating payments, borrowing or lending - are regulated at least as financial intermediaries and in many situations, they must be licensed as financial institutions.

This may apply to your blockchain company as well.

Here’s what to look out for:

- Do you hold tokens or equivalent amounts of another cryptocurrency on behalf of others?
- Are the tokens held in separate private wallets, or are they mixed in one to which you have access and have them at your disposal?
- Is your payment token pegged in value to another cryptocurrency, fiat currency or another financial instruments?
- Do you carry out any other payment-related actions using your own token or other cryptocurrencies on behalf of others?
- Are you planning to operate a blockchain based on an open payment network in which merchants and consumers can participate and the token:

• Is it stored electronically?
• Does it have monetary value?
• Does it represent a claim on the issuer?
• Is it issued on receipt of funds?
• Is it issued for the purpose of making payment transactions?
• Is it accepted by persons other than the issuer?

If you answer yes to one or more of these questions, you have to check carefully as it is very probable that regulations related to financial institutions (including bank laws) or financial intermediaries could apply. In particular, bear in mind that if your token is classified as a e-money and you operate the business in an EU countries, an e-money license might be required. If this is the case, there are also requirements related to the amount of minimum capital (EUR 350.000) in order to receive the license at all.

Security tokens

The latest big hype in the blockchain and crypto space is the so-called “STO” – Security-Token Offering. A large number of blockchain projects are now turning to so-called “security token offerings” and do so because the STO seems to be the most clear-cut and legally-sound way to raise capital.

Indeed, this has always been (and still is) true, but offering and trading security tokens also presents the biggest legal challenge. This is why most startups attempted to avoid being classified as issuers of security tokens, trying to fit in the utility tokens model by all means, even if there was no utility at all.

So, if you want to offer security tokens, make sure that you know what you are talking about. The term “security token” belies a wide range of financial constructs which a company may choose to use. Each of these will have corresponding legislation which much be followed, in order to find out which legislation must be followed, analyze the token economics from the point of view of their functionality:

1) STO – IPO - if the tokens are actually crypto-assets resembling in their function shares in a company, then the planned STO will most probably be classified similarly to an IPO. In such a case, check the rules about IPOs applying in your jurisdiction. Bear in mind that in that very moment many countries consider changing or adapting their laws in this regard. This is also the case in Switzerland where the current rules will not be replaced but adapted to current the requirements of the technology i.e. concerning written form and registering of the assets.

2) Financial Instruments – if the tokens are factually financial instruments such as tradeable derivatives or bonds check the regulations about issuing and trading financial instruments, in many cases a license from a regulator will be needed.

3) Taxation - in all cases check the rules regarding taxation: the gain distributed to the token holders will most probably be subject to a taxation. If the gain is in fact a dividend, check the rules about withholding tax and applicable taxation treaty. Just as example, paying out dividend from Swiss companies (even to private persons located outside of Switzerland) might be subject to 35 per cent of withholding tax.

Stablecoins & conditional tokens

Two new kinds of tokens are becoming increasingly popular and they present their own unique legal challenges.

1) Stablecoins - as the name suggests, a stablecoin is a cryptocurrency which is meant to have a relative value (based on another currency or asset) which is not volatile at all.

Some examples of stablecoins include DAI (by Maker DAO), Tether (tied to the US dollar) and Swiss Crypto Tokens (tied to the Swiss franc). In each case, the stability is achieved through a different financial construction. In the case of Tether, the issuer guarantees to hold the equivalent amount of USD in reserve. In the case of DAI, the stability is achieved through so-called Collateralized Debt Positions (CDP). The Cryptofranc by Swiss Crypto Tokens is backed by a bond construction.

It’s important to be aware that if you wish to establish a stable coin, your claim of stability must be backed by a clear mechanism to ensure it. The token will not stay stable only by saying a magic formula: “stay stable”. Not holding adequate reserves or failing to ensure the correct price at all times, will open you up to immediate legal action.

It goes without saying that your construct must also fit within regulatory guidelines - holding an amount in excess of CHF 100 Mio. as surety for the coin, could subject you to bank law in Switzerland. If you choose a bond set-up, you might need to issue a prospectus. If you issue stable coins in one of the EU countries, you need to consider obtaining of an e-money license.

2) Conditional tokens - conditional tokens are built on the idea of stable coins in that they are linked to another coin or to another asset, although not necessarily to the actual value of that coin or asset. One of the pioneers in this space is Gnosis with its use of conditional tokens in the prediction market space.

The main thing to watch out for is whether this will be defined as financial derivatives. If this is a case a licence from financial regulator (FINMA in Switzerland) might be required.
Conclusion

Token economics and blockchain technology provide many exciting possibilities - but they remain young and, in many ways, unproven. It is essential to proceed with caution even while taking full advantage of the many new opportunities they afford.

Our team at LEXcellence is happy to have already accompanied many teams on this journey and we are glad to be able to use our experience to help you safely navigate the complex and ever-changing world of tokens and crypto here in Switzerland and beyond.

And last, but not least: the publication above cannot be considered legal advice of any kind.

For detailed legal advice please contact us at info@lexcellence.swiss

 

Consensus NY 2019

We also will be happy to answer questions in New York at Consensus in the CVA booth 338/340 in Americas Hall!