With this guide, we aim to help founders who want to launch a token, to understand the legal implications of different token types and their issuance. We will cover what token legal opinion is and why you need it, what token types there are, and the different regulations for each token type issuance. Let's dive in!
Issuing tokens: a quick overview
The distribution of tokens in a Web3 project typically comprises of three stages
- developing a smart contract;
- issuing the token; and
- distributing it.
The third stage can take many forms: private token sales, airdrops, staking rewards, token mining, token minding, token swap, and public token sales via launchpads or listings on cryptocurrency exchanges.
Each distribution method has its own legal requirements. They range from preparing required documents (for example, a SAFT or a Token Sale Agreement for a private token sale) to receiving authorization from public authorities (such as VASP Authorizations on the Cayman Islands or a token legal approval from FINMA in Switzerland for a public token sale).
Token Legal Opinion: what is it, and why do you need one.
Most of the token distribution mechanisms require correct legal structuring. There were a couple of landmark cases in the cryptocurrency industry against Web3 projects that were issuing tokens with securities characteristics and yet they did not have the required authorisation and licenses in place. Several regulators have found these kinds of actions to be a violation of the securities laws. Not only did those Web3 projects need to refund all the funding they had attracted, they also had to pay heavy fines.
Before issuing tokens, the founders need to receive a Token Legal Opinion to protect their project against such risks. The Token Legal Opinion is a legal note on the token's legal status (legal qualification), prepared by a qualified, licensed legal professional. It explains the legal nature of the token (Token Legal Design) and advises on the legal requirements for issuing the latter.
Types of tokens and token use cases
Lawyers usually start by clarifying the scope of rights, which founders of the Web3 project want to associate with their token to prepare a Token Legal Opinion. In other words, these are the rights that the tokenholders will have after purchasing the tokens.
There can be many rights, and it's best to define them through token use cases. These use cases explain how the tokenholders can use the tokens and what benefits they will receive.
Here are the common examples of token use cases for each token type:
- Protocol tokens - launching decentralized applications (smart contracts) on a blockchain protocol
- Access tokens - receiving access to the software functionality
- Loyalty tokens - receiving discounts, such as reduced fees for services or digital goods
- Community tokens - receiving access to communities, such as entrances to events or invitations to various community platforms
- Payment tokens / stablecoins - making payments
- Asset-backed tokens - providing rights to a real asset, such as plots of land, square meters of real estate, or grams of gold
- Security tokens - receiving dividends and rights to participate in profit distribution
- Governance tokens - participating in voting on the future development of the project
- NFT (non-fungible tokens) - providing rights to non-fungible objects, including works of art.
Token legal qualification: how it works
After figuring out token use cases, lawyers begin working on their legal qualification. To prepare a legal qualification, they use:
- regulatory guides issued by the regulatory authorities for different token types. Regulators in Switzerland, the United Kingdom, and Singapore have issued their own guides; and
- regulatory tests, which let you “put your token to the test” via several questions that help determine its legal status. Tests include the U.S. Howey test and the Financial Instrument test in Malta.
Each jurisdiction develops its token legal qualification, i.e. how they qualify a token from a legal standpoint. However, we can summarize all the approaches into four main token categories: utility tokens, security tokens, financial instruments, and digital goods. Here's what types of tokens fall into each category of legal qualification:
- Utility tokens: protocol tokens, access tokens, loyalty tokens, community tokens
- Security tokens: dividend tokens, asset-backed tokens, some governance tokens, some stablecoins
- Financial instruments / eMoney: payment tokens, stablecoins
- Digital goods / assets: NFTs
Structuring the token issuance
After determining the legal qualification of the token, the second phase of legal work begins. Here, the legal professionals determine the regulatory requirements for issuing and distributing tokens.
Issuing and distributing tokens could trigger various laws depending on the token's legal status. Utility tokens could need special authorizations or token approvals from the regulator. Security tokens or financial instruments require issuers to take care of licensing and filings with public authorities overseeing the securities and stock markets. In turn, digital goods require compliance with customer protection and e-commerce legislation.
To structure a token issuance, you would need to engage several types of lawyers:
- An international lawyer who knows the best jurisdictions for each kind of token to help you choose one and create a legal structure
- A lawyer from the chosen jurisdiction who will be able to file all documents for entity registration, obtaining authorization etc.
- Ideally, a virtual legal officer who will be able to oversee and manage all the processes for you: including communicating with lawyers, tracking deadlines and converting your changing business goals into new legal tasks for the lawyers.
Finally, choosing the best jurisdiction to issue tokens
The analysis of legislation applicable to a particular token type allows founders to choose the most favorable jurisdiction for the project. In this process, lawyers consider the legal certainty about the token type and regulatory burden that a project is going to face, such as the scope of authorizations and licenses needed for token issuance.
Here are the most token-friendly countries for specific token types:
A well-thought-out legal structure for token issuance within a Web3 project not only shields the founders from risks of violating the law and receiving fines from regulators but also eases listing tokens on secondary market platforms, such as cryptocurrency exchanges, wallets, etc.
In addition, the token status and associated regulatory restrictions for its issuance is something that investors typically bring up during the fundraising process for Web3 startups. Incorrectly structured tokens mean high regulatory risks to investors, which would likely become a dealbreaker for prospective investments.
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Disclaimer: the information in this article is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.
Nestor is a Co-founder & Head of Web3 Legal at Legal Nodes. Having over seven years of legal consulting experience, Nestor loves working with innovative startups and Web3 projects, helping them navigate the regulations and scale on global markets.