Legal Structuring for the Paid Distribution of Utility Tokens

August 18, 2022
TABLE OF CONTENTS

Legal Structuring for the Paid Distribution of Utility Tokens

August 18, 2022

Previously, we’ve explored the differences between the legal qualifications of different token types, and the specifics of token issuances in the Cayman Islands. Today, we look at how to organize a paid distribution of utility tokens in a legally compliant way.

What is a paid token distribution?

There are different ways a Web3 project can distribute tokens, the defining criteria being whether a recipient provides the project with consideration in return. This consideration is normally fiat money (USD, EUR, etc.) or another virtual asset (usually BTC, ETH, or USDT). If they do, the distribution of tokens is paid. These can range from the use of launchpads, IDO and Public Token Sales executed via smart contracts to Private Token Sales via special legal instruments such as Token Sale Agreements or Simple Agreements for Future Tokens / Simple Agreements for Future Tokens and Equity (SAFT / SAFTE) with Private Placement Memorandums.

An article previously published on Legal Nodes’s Resouce Center covers token warrants, SAFTs and Token Sale Agreements but does not address another type of document: the Private Placement Memorandum (PPM). A PPM is a legal document sometimes provided by the token company to prospective tokenholders (investors). Its purpose is to provide future purchasers with important information needed to make an investment decision, such as information about the token company, the ecosystem as a whole, the tokenomics, the team behind the token company, and any legal risks associated with the token sale. A PPM is required when a token is a security token sold under one of the available exemptions in security regulation, not via a public sale. Therefore, a paid issue of utility tokens will not require a PPM.

It’s important to note that there can also be unpaid token distributions for founder, team, advisor, and community token pools.

What is a utility token?

A utility token is a virtual asset with value inside its native ecosystem. The source of this value is not the ability of the token to act as a medium of exchange or a store of value, or the rights to profits or governance participation, which would otherwise make it a payment, security, or a governance token, respectively. It is also not tied to any unique digital asset, which differentiates it from NFTs.

Instead, a utility token allows a person to access a specific service or feature, perform an action in the ecosystem, receive benefits such as reduced transaction fees, or it can be used to compensate gas fees for launching smart contracts and blockchain protocols. They can be compared to access keys, vouchers, or codes in the Web2 era. Despite that, its value is found in the ecosystem does not mean it cannot be traded on secondary markets such as cryptocurrency exchanges. Moreover, there are more crypto exchanges available for listing utility tokens, than exchanges available for listing security tokens.

📚 Read more: What is tokenomics and how it impacts a legal structure of a Web3 startup.

How to determine if a token is a utility token

Several legal mechanisms help test whether a certain token is a utility token. Essentially, they ask a series of questions. The most commonly used test is the product of the U.S. judicial lawmaking (SEC v. W. J. Howey Co. [1946]) known as the Howey test, which has been actively applied to digital assets since the boom of ICOs in 2017. Another famous test is the Maltese Financial Instrument Test which is part of Malta’s comprehensive Virtual Financial Assets framework.

Other states' guidelines also often contain similar provisions, albeit in less detail. For example, Lithuania has a legislation applicability test to determine which laws apply to the issuance of tokens.

To have a firm view on whether a token can be considered a utility token, founders need to get a Token Legal Opinion from qualified lawyers in the country where founders plan to issue their specific token. For example, if founders plan to issue tokens in Switzerland, they must obtain a Token Legal Opinion from a qualified Swiss lawyer. That being said, it is not uncommon for a lawyer preparing a Token Legal Opinion to the U.S. test, even if the tokens are not issued in the U.S. This is because the US test provides a good indicator as to the legal nature of the token. But, in the end, the laws of the country where the token issuance is planned will be the primary factor for whether a token qualifies as a utility token. 

What does “substance over form” mean concerning token distribution?

The popularity of ICOs at the end of the last decade, indicated most notably by the U.S. SEC Report on The DAO, and numerous regulatory guidelines on token distribution have established the “substance over form” principle for token distributions. Essentially, this means that to determine the type of the token, the actual scope of legal rights it grants to its tokenholders holds more relevance than its title or description on a website or in a Whitepaper.

To put it in simpler terms, the rights associated with the token can be compared to a piece of candy, and the token itself can be viewed as the candy wrapper. To determine the token type and, in turn, which laws apply to it, the substance (the candy) is relevant, not what it is wrapped in. So, even if a Web3 project is marketing a token that is in principle a security token as a utility token, it will not make it a utility token.

Countries for paid utility token distributions with no permits

Once the preliminary legal design of the token has been finalized, Web3 entrepreneurs should start considering where to incorporate their token issuing company.

Should founders be interested in issuing utility tokens for consideration with the lowest possible administrative barriers, they might turn their attention to countries with a “wait-and-see” approach toward virtual assets. For example, no governmental permit would be required to issue utility tokens in the Marshall Islands, Panama, or the British Virgin Islands, as they have not enacted any laws applicable to utility tokens yet. An obvious downside is that this exposes the project to a regulatory risk if a regime is developed in the future. Either way, it is important to not forget about AML/KYC requirements and implement appropriate compliance procedures even if there are no specific VASP regulations.

Paid issue of utility tokens is also possible in Switzerland, which did not take the “wait-and-see” approach. On the contrary, they have issued several comprehensive guidelines on the applicability of Swiss laws to tokens. As long as the tokens issued are not securities, they can be considered utility tokens and be subject to Swiss civil law. That being said, as their related rights are fungible, they are legally considered uncertificated securities, meaning that a record of the number of tokens issued and the first buyers must be kept. 

Web3 entrepreneurs looking for a jurisdiction to organize a paid token distribution of utility tokens with higher legal certainty in the process may want to consider the state of Wyoming in the US. In 2019, Wyoming adopted a specialized Wyoming Utility Token Act, which specifically applies to utility tokens. What makes it an appealing jurisdiction is that it is also one of the best places to register a DAO, ideal for Web3 founders who are planning to move their project into a DAO stage and who expect their main token buyers and DAO members to be from the U.S.

While no authorization is required in Wyoming, an issuer must file a notice of intent and pay a filing fee. The main requirement for an issue is that the token is sold mostly for a consumptive purpose, and it is not marketed as a financial instrument.

Paid utility token distributions in countries with VASP regimes

To further increase legal certainty of the paid distribution of utility tokens, Web3 entrepreneurs can choose to incorporate an issuer company in a jurisdiction with a special Virtual Asset Service Provide regime, such as the one on the Cayman Islands. Their newly-enacted Virtual Asset (Service Providers) Act, 2022 specifically excludes utility tokens (referred to as ‘virtual service tokens’) from the need to receive a VASP authorization in cases where founders plan to do a private token sale. If it’s a public token sale, VASP authorization will be mandatory.

A similar approach was also taken by Singapore, where the Financial Services and Markets Act 2022 has also established that issuing utility tokens (referred to as ‘limited purpose digital payment tokens’) is not a digital token service and therefore does not require a license.

Web3 entrepreneurs looking for a jurisdiction to issue utility tokens for consideration with an actual permit may wish to consider Malta and Liechtenstein, as both countries have developed comprehensive authorization frameworks which cover token issuer companies. However, choosing this route would require paying a license fee and satisfying authorized capital, corporate governance, and other requirements as licensing pre-conditions.

Kickstarting paid distribution of your utility token 

To build a good legal foundation for the paid distribution of your utility token, it is important to:

  1. Make sure that no rights normally associated with securities or payment instruments are attached to your token;
  2. Choose appropriate token distribution method and prepare public documents for Public Token Sale or private legal agreement for Private Token Sales; and
  3. Choose a jurisdiction to incorporate a token issuing company that can accommodate the chosen distribution method.

If you decide to proceed with countries that exclude utility tokens from specifically-established VASP regimes (the Cayman Islands or Singapore), it is of utmost importance that the rights your token grants do not go beyond the licensing exception provided in law, which is found in the definition of the utility token. This is equally applicable to Wyoming, which has a legal regime covering utility tokens specifically, which have legally-defined characteristics.

To learn more about countries for paid utility token issuance, book a Legal Discovery Session with an expert at Legal Nodes. During the session, you will get:

  1. An intro to crypto-friendly countries, specifically the ones that will best accommodate the paid distribution of your utility token;
  2. An intro to token legal design to better understand all the implications of issuing a utility token for money; and 
  3. A checklist of actions to help you successfully perform a paid utility token issuance for your Web3 project.

Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.

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