Examining the legal implications of a token requires analysis of two criteria:
- The token’s use case that drives the value of the token
- The method of token allocation (token minting method) and token distribution (token launch strategy)
In a previous guide, we focused on the first criterion, and examined how different token use cases for utility tokens, security tokens and real-world assets all carry different legal implications for a Web3 project. If you have not yet read that resource, we encourage you to check it out here.
This guide examines the second criterion and explores the legal implications of different token allocation and distribution methods on a token’s legal status.
It is important to note that both criteria must be taken into account so that an effective legal analysis can be performed. Before we begin with the analysis of the second criterion, it is important to understand why and how this criterion affects the legal status of a token.
3 ways token launch strategies affect a token’s legal status
Last year, the US regulator, the Securities and Exchange Commission (SEC) issued separate lawsuits against two giants: crypto exchanges Coinbase and Binance. The SEC alleged that 19 tokens listed across the two exchanges, including utility tokens like ATOM, NEAR, SOL and ADA, were in fact unregistered securities. The SEC alleged that, by listing these tokens, Coinbase and Binance were acting as unregistered brokers. Each of the 19 tokens had been used for initial token sales, fundraising events (ICOs), or in some form of developmental pledges. The SEC also noted how, in some cases, social media had been used to share features and advantages about the protocols. The SEC’s position is quite clear, as set out in this FinHUB SEC document: issuing a token for fundraising makes the token a financial instrument.
In July 2023, a court ruled that the sale of Ripple’s XRP tokens on exchanges and via algorithms did not qualify as investment contracts. However Ripple did violate federal securities laws through the institutional sale of XRP tokens (worth about $782.9 million) to hedge funds, institutional buyers and other parties. The court found that investors would have purchased XRP tokens with an expectation that they would profit from Ripple’s work. In contrast, “programmatic sales” of XRP didn’t amount to a sale of securities because the SEC could not definitively assert that speculative investors had a reasonable expectation of profits derived from the managerial or entrepreneurial efforts of Ripple. Therefore the second way that a token strategy can affect a token’s legal status hinges on who these tokens were sold to and whether the buyers held any reasonable expectations of profits as a result of the sales.
The third case that played a significant role in shaping law last year is the SEC’s case against Tron, whereby the regulator alleged the defendants of fraud and market manipulation, selling and airdropping unregistered securities and coordinating wash trading on an unregistered trading platform. The case focused on how the initial issuance of tokens took place, who controls the majority of tokens after their issuance and how long they control them for. Should the project team be in majority control of the tokens, then they effectively have significant control over their tokens, and could use them in a non-competitive manner, for example, by manipulating the token price or executing a ‘pump and dump’, etc. Therefore, the third way that a token strategy can affect a token’s legal status relates to if the token issuance permits the project team to hold significant control over the tokens.
Identifying a token’s use cases is pivotal for determining the token’s legal status. Token distribution and allocation can further illuminate how tokens are used, so the legal analysis should always consider:
- What is the purpose for which a token is issued?
- Who are the recipients (buyers) of the tokens and how are they targeted by the token distribution campaign?
- What is the method of allocation (minting) and distribution of tokens?
- Who is the administrator (controller) of the issued (minted) tokens?
Taking this into account, we can now perform an extended legal analysis of token types via an examination of the token launch strategy.
Types of tokens based on their launch strategy
Two approaches or strategies for token allocation and distribution have been recognised in case law:
- a decentralized token launch strategy
- a centralized token launch strategy
The choice of token launch strategy directly affects the token’s legal status. A token launch could reinforce the legal status of a token as a utility token, and allow the token to remain part of the unregulated open-source protocol. Conversely, the token launch could increase the risk that the token will be recognized and requalified as a security token (as the above-mentioned case law indicates).
We can analyze token launch strategies by looking at a few key factors: the objectives of token issuance, the token recipients, the methods of allocation and distribution, and the control structure over any pre-minted tokens. The table below sets the analysis out in more detail.
Decentralized token launch strategy
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Legal considerations for a decentralized token launch strategy
Web3 teams choosing to launch a token via a decentralized strategy will have to grapple with one small challenge: launching a token that is sufficiently decentralized from day one is almost impossible. To overcome this, teams may find it useful to use the Progressive Decentralization framework. This framework enables teams to build a sufficiently decentralized protocol ecosystem with native tokens and facilitates partial decentralization as a temporary and necessary (forced) stage of development of the Web3 project.
From a legal perspective, using the Progressive Decentralization framework in the context of token launches will:
- ‘Decentralize’ ownership of the tokens by distributing the token capitalization among various stakeholders of the Web3 project ecosystem, including builders, contributors, validators, DAOs, ecosystem foundations, and liquidity providers. This will enable the establishment of a sufficiently decentralized system of governance of the Web3 protocol ecosystem.
- Build a ‘healthy’ system of checks and balances between different categories of token holders. This will prevent the concentration of a majority of tokens ending up in the hands of a centralized entity or group of people, and helps to minimize the risk of the Web3 project appearing to have a ‘project insider group’ with significant control.
- Build a transparent process of initial minting and allocation of tokens, which prevents a group or entity from gaining control over the mechanism / onchain vehicle for token minting. This also helps to minimize the risks of manipulations with distribution, additional issuance, burnings, and other actions that can affect the overall allocation of tokens and harm their holders.
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Centralized token launch strategy
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Legal considerations for a centralized token launch strategy
By comparing the two tables above, we can immediately identify some important differences between the centralized token launch strategy and the decentralized strategy. Most notably for the centralized strategy:
- ownership of tokens is centralized in the hands of the team
- fundraising is a priority goal and a purpose of the token
- there are no goals to implement decentralized governance for the Web3 ecosystem being built by the team, including decentralized governance regarding the process of managing and disposing of the treasury with tokens
In the eyes of a regulator, this token strategy requires more regulatory compliance measures to be met by the project team as a result of an increase in the following risks:
- risks of violating the rights of investors who consider buying a token as an investment, and as a result, who expect the price of the token to grow as a result of managerial efforts of the team or the entity that issued the tokens
- risks of recognizing the token as a security
- risks of manipulation with the token price (e.g., pump and dump, insider trading) by the team or company that issued the token
Therefore, if a Web3 project team wishes to execute a centralized token launch strategy, they will need to be ready to pursue the necessary regulatory authorizations and licenses.
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Legal qualification of a token
As mentioned earlier, both the use case criterion and token issuance method criterion are integral for analyzing the legal status of a token and determining its type. One way of examining this is via a graph.
Starting from the use case criterion of a token, set along the horizontal scale of the diagram (X axis), the token itself can be analyzed across a spectrum. A token use case could sit anywhere between the right end of the axis, where it would be identified as ‘a token with native software-infrastructure’ use case, or all the way to the left end of the axis, where it would be identified as a ‘dividend-share or tokenization-investment’ use case.
At the same time, we can also plot our token along the ‘vertical’ scale (Y axis), which reflects the level of ‘decentralization’ of the allocation (minting) and distribution process of tokens. The spectrum here stretches from ‘centralized token launch’ at the bottom to ‘decentralized issuance’ at the top.
Applying this graph during token analysis enables Web3 teams to conduct a preliminary legal qualification of their own token. Should their token be identified as having a native software-infrastructure use case and a decentralized launch strategy, then the team has a higher chance of their token being legally classified as a utility token.
Should the token’s use cases lean more towards dividends or investments, and the launch strategy lean more towards centralized, then the team faces a higher risk of their token being recognized as a security.
It is also important to note that a decentralized token issuance method is more characteristic of tokens that have utilities within a Web3 project's network and/or protocol layers. Conversely, centralized issuance is more typical for tokens that have use cases at the dApp layer.
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Token legal opinion and token regulatory approval
In conclusion, tokens at the network / protocol layer level are usually more characteristic of a decentralized issuance strategy, as these tokens are typically minted in an autonomous and permissionless way. Consequently, a Token Legal Opinion is often obtained, usually, in the jurisdiction where the protoDAO has been registered, or in the jurisdiction(s) of platform(s) through which the tokens are distributed. The purpose of a token legal opinion is to confirm the ‘decentralized’ nature of the tokens, which in turn will confirm the tokens’ legal status as ‘utility tokens’. Examples of projects that fall into this scope include Ether, Arbitrum, Solana, and Near.
As for tokens at the dApp level, these more typically follow a centralized issuance strategy. If this is indeed the case, then an important step for a Web3 team is to analyze how the tokens are regulated in the jurisdiction where the Token SPV is registered. The Token SPV is the company that will perform the centralized token issuance. It’s also important to understand if it will be possible to obtain Token Regulatory Approval and / or any other authorisations for the token issuance. Examples of jurisdictions that require crypto forms to obtain regulatory approval for token issuance include the United Arab Emirates and Singapore. Additionally, Switzerland and Liechtenstein also require token authorizations for token issuance.
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Identifying your token legal strategy: centralized or decentralized?
Depending on the type of token being issued and also the method of token issuance being used, we can distinguish two strategies for the legal structuring of a token:
- Centralized, which is more suitable for centralized issuance of utility tokens, and for RWA / Securities tokens. This route requires Web3 teams to follow strict regulations, such as obtaining authorizations for tokens, obtaining VASP / CASP authorizations, and implementing KYC and AML checks.
- Decentralized, which is more suitable for decentralized issuance of utility tokens, and which carries with it the increased possibility that the issuance will fall beyond the scope of any crypto and financial regulation.
We will consider each of these strategies, as well as the types of legal entities that should be registered, and the most favorable jurisdictions that are best suited for token issuance, in future articles. To get notifications about our new content updates, follow us on X or Linkedin and subscribe to our newsletter, Web3Blast.
Finding the best legal strategy for your token type
At Legal Nodes, we regularly support Web3 teams with legal analysis of their token plans. Figuring out the right token legal strategy, and understanding all the different risks and opportunities that come with facilitating a centralized or decentralized token launch is critical to a project’s success.
If you’d like assistance with any legal aspect of your Web3 project, whether preparing for investment rounds or looking for ways to remain compliant as you grow, we can help. Speak to us today to get started.
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