• Advokat Jeppe R. Stokholm

What is a crypto security - and when is a token subject to financial laws?

Updated: Feb 1, 2018

#Cryptolaw


When participating in an #ICO (Initial Coin Offering) and/or an #TGE (Token Generating Event) it is important to know the difference between a crypto security and a crypto token. Risk is, that the crowdfunding event trigger US and/or other countries laws on securities.


Only fools rush in where angels fear to tread.


No uniform approach


However, no uniform approach exists on how to define #tokens and #cryptosecurities, and international standards do not exist either. Guidance may be found in the CPMI-IOSCO “Principles for Financial Market Infrastructures” that is a global standard for payment systems, securities depositories, securities settlement systems, central counterparties and trade repositories (collectively: “Financial Market Infrastructures”).



Fact is, that tokens can be associated with one or more IT-systems (networks, platforms, applications, software, protocols etc.) and be found in multiple functions such as:

  1. A token representing a crypto currency,

  2. a token representing an ownership right,

  3. a token representing a creditor relationship, and/or

  4. a token representing a financial contract (derivatives)

Therefore, in the following, a crypto security is defined as:


a token subject to financial laws, that regulate the public offer, sale and/or trade of securities.

In this respect, a distinction between virtual currencies vs. virtual tokens or coins must be made.


The duck test


When determining, whether a token is a crypto security or not, a “substance over form” test must be applied. It is not the form (i.e. the label or masquerade of a token), but the actual facts and circumstances, including the economic realities of a transaction, that defines whether a token must be categorized as a crypto security or not. This can also be described more informal as the duck-test:


If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck[1].

Special attention must be raised, if a token is to be sold in the US and/or to US investors. The reason is, that US securities laws are very strict. If clarification is needed in order to qualify, whether the token in question is to be deemed as an “investment contract” for the purposes of the US Securities Act and the US Securities Exchange Act, the #Howeytest must be applied.


What is “the Howey-test”?


The Howey-test dates back to 1946 and the precedence from the US Supreme Court case of SEC v W. J. Howey Co (328 U.S. 293, 1946) regarding the question, whether a sale & lease-back arrangement was to be qualified as an investment contract subject to US federal securities laws (principally the Securities ACT of 1933 and the Securities Exchange Act of 1934).


Due to the Howey-test:


  • an investment contract (defined as an investment of money in a common enterprise with an expectation of profits predominantly from the efforts of others) is a security.


The Howey-test highlights some of the most important aspects of US securities laws into a relatively simple formula on how to determine, whether an instrument sold in the US or to US investors qualifies as an “investment contract” for the purposes of the US Securities Act and the US Securities Exchange Act. Due to the Howey-test a transaction is an investment contract, if the following four factors are met:


1) It is an investment of money,

2) There is an expectation of profits from the investment

3) The investment of money is in a common enterprise

4) Any profit comes from the efforts of a promotor or third party.


The four factors are cumulative, i.e. in order for a token to be considered a security, all four factors must be met. The Howey-test is only directly applicable and relevant, if:


A. a token is to be sold in the US or to US investors, and


B. clarification is needed in order to qualify whether the token in question is to be deemed as an “investment contract” for the purposes of the US Securities Act and the US Securities Exchange Act.


Different jurisdictions, different legislation on securities


When discussing the legal treatment of crypto securities, it depends on the jurisdiction involved.


A few jurisdictions have a very closed approach to the acceptance of crypto securities, such as China and South Korea, that have banned initial coin offerings (#ICO) labelling such token sales as “illegal and disruptive to economic and financial stability”.


Most jurisdictions have a more open approach and accepts the use of crypto securities, as long as they comply with local laws on securities.


It is out of the scope of this article to give a detailed and comparative list of countries and jurisdictions, that accepts or bans tokens subject to financial laws, that regulate the public offer, sale and/or trade of securities. However based on an analysis of the Howey-test and other analytical frameworks, including section 2(a)(1) of the US Securities Act and section 3(a)(10) of the US Securities Exchange Act, the conclusion seems to be, that if the purpose is to create a non-security token, it is very important, that the token in question only consists of limited rights and does not include any investments interests subject to financial regulation, that regulate the public offer, sale and trade of securities.

Conclusions


In general, passive tokens are more likely to be considered securities than active tokens, i.e. it is always important to investigate, if the generated tokens are:


a) Tokens representing a crypto currency?

Such tokens are most likely non-regulated tokens.


b) Tokens representing an ownership right?

Such tokens are most likely regulated tokens subject to financial laws.


c) Tokens representing a creditor relationship?

Such tokens are most likely regulated tokens subject to financial laws.


d) Tokens representing financial contracts (derivatives)?

Such tokens are most likely regulated tokens subject to financial laws.



Advokat Jeppe R. Stokholm is based in Zürich, Switzerland. The area of expertise is corporate affairs, including M&A, Venture Capital, Private Equity and Crypto Law. Advokat Jeppe R. Stokholm represents several international oriented Law Firms, Auditors and Family Offices on a case-by-case basis and provide discretionary counselling to global operating companies and private UHNW clients. 



NOTES:


[1] The ”duck test” may arise from the poet James Whitcomb Riley (1849-1916), when he wrote: ”When I see a bird that walks like a duck and swims like a duck and quacks like a duck, I call that bird a duck”.


​Zürich, Switzerland