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Utility and Security Tokens: The Legal Implications

Blog • 5min read
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Written by

Hunain Naseer
Published on September 17, 2018

This article dives into the legal aspects of the two types of tokens issued during ICOs.

Not all tokens are created equal, especially when it comes to legal considerations for both companies and individual investors. There are two types of tokens (security and utility tokens), and while the lines between them can get blurred, it is vital to understand the legal specifics associated with these instruments.

What is a utility token?

Utility tokens are cryptographic assets that serve as digital coupons or certificates for products and services developed by a company. They function as a unit of account within the project's ecosystem and do not represent company shares.

Legal implications for companies

Relaxed requirements and a watchdog-free environment for sales make this type of token very popular among startups and companies that aim to raise funds via initial coin offerings (ICOs).

Benefits

Utility tokens fall outside the definition of investment interests, thus becoming exempt from securities laws and regulations. It means the companies issuing them are spared the tiresome process of registering with the relevant authority and ensuring compliance with strict security legislation. Unlike securities, these tokens can be sold to anyone with little to no limitations.

Pitfalls

Properly structured utility tokens have a solid use case and no investment characteristics. In reality, however, they are quite rare. A token with a weak or hazy use case may eventually come to the attention of market authorities that tend to espouse the “substance over form" philosophy. In the US, for example, the Securities and Exchange Commission (SEC) looks at how the tokens are actually used, not what they are meant to be by their issuers. As a result, the assets may be re-classified as security tokens with all the consequences arising from it, including penalties and requirements to comply with all the applicable regulations.

Legal implications for investors

Being non-regulated assets, utility tokens are riskier for investors. Buyers have none of the guarantees associated with traditional asset classes, which means no one will protect their interests or compensate them for losses if the issuers pull a disappearing act with the money in tow.

While utility tokens are not meant to be investment tools, many people buy them with the aim to profit from a future price increase. However, if investors do not understand the economics of the project and the use case of the token, they might fall victim to an unfair issuer.

What is a security token?

Security tokens are digital versions of a traditional investment tool that give their holders ownership rights in a company. The value of such crypto tokens is based on an external tradable asset, and they should entitle their owners to dividends, interest, or a share of the company’s future profits.

Regulators in various jurisdictions apply different methods to determine whether an asset is a security. Thus, the US SEC uses the Howey test designed in 1946. It qualifies a token as a security if it involves an investment contract which meets particular criteria. Specifically, there should be a financial contribution to a common enterprise, with the main reason for such an investment defined as an expectation of future profit from the efforts of a third party.

Legal implications for companies

Tokens recognized as a security are subject to the same strict federal regulations that apply to equities and bonds. The legal clarity and protection inherent in security tokens could be beneficial for both companies and investors although in some countries, including the USA, security tokens are prohibited. Their sales can be allowed only with the permission of the SEC or another regulatory body and only on condition of full compliance with securities laws.

When opting for an ICO with security tokens (known as security token offering (STO)), a company should make sure it meets all its regulatory obligations (for example, compliance with KYC/AML procedures) otherwise penalties may follow. It should also offer its investors such benefits as dividends, profit shares, and voting rights. In addition, it must be prepared for numerous limitations, including the degree of expertise necessary for investors to buy into these tokens. Besides, there are certain restrictions concerning the exchange of such tokens: they can be traded only on licensed security token trading platforms, which adversely affects their liquidity.

Legal implications for investors

Security tokens protected by long-standing laws look more appealing to investors, offering them much-needed credibility, accountability, and safety, which are seen as pressing issues in the crypto market. Thus, government-regulated security tokens act as a bridge between traditional finance and blockchain ecosystems. They safeguard the holders' rights and define more clearly the issuers' obligations.

However, security tokens still represent only a minor share of the market, which results in low liquidity and rather poor availability due to regulatory restrictions.

Round-up

Security token Utility token
Registration  

Must be registered with the applicable security regulatory authority, such as US SEC, FINMA, etc.

No registration with securities authorities is required.

Licensing

Can be traded only on a platform with a financial security license

No special requirements for trading are applied; can be traded on any platform

Investor pool

Can be sold only to qualified investors; country-specific restrictions may apply

Available to anyone willing to buy it

Investor guarantees and protection

Investors are protected by the applicable securities legislation.

There are no guarantees or protection from fraud and issuer’s misconduct.

Functions

Functions as equity or a derivative and represents a company’s share; it entitles holders to future profits, dividends, and revenue share.

Serves to provide access to products and services supplied by the company; used as a means of payment within a closed ecosystem and does not give its holder a right to future profits.

 

Published on September 17, 2018