In our first post, we introduced you to the Swiss legal framework on the classification of tokens.
In this second post, we will tackle the hot topic of securities laws. The question of whether a token is a security is one of the most controversial topics around crypto legislation. Especially under U.S. laws, the *Howey test* and its (more recently very broad) application by U.S. regulators has caused much uncertainty both for token issuers as well other market participants.
We will examine Swiss legislation and FINMA (Swiss Financial Market Supervisory Authority) practice on the topic to identify the key points for the question of when a token is considered a security.
Swiss legislation on security tokens
Securities are defined as ‘standardized certificated or uncertificated securities, derivatives and intermediated securities that are suitable for mass trading.’ The legal definition is confusing – essentially, there are three key criteria:
- Tradability: Tradability is given if a security is (i) publicly offered for sale in the same structure and denomination or (ii) placed with more than 20 clients, insofar as they have not been created for individual counterparties. Most fungible tokens are tradeable in that sense.
- Formal appearance: Securities can have different formal appearances as defined in Swiss law. According to FINMA, tokens issued on the blockchain meet the form requirement of an uncertificated security, which fulfils the criterion of formal appearance.
- Associated rights: A security requires to be associated with a right in the legal sense. A right (or an obligation) is a legal relationship between parties. One party (the creditor) can request a specific action or omission, and the other party (the debtor) is required to act or omit according to that relationship. Many tokens arguably do not confer a legal right to the token holder but are limited to technical functionalities without any legal remedy or claim against any counterparty.
FINMA practice on security tokens
In its ICO Guidelines, FINMA gives indications of when a token qualifies as a security:
- Payment Token: Payment tokens are generally not securities but can be in certain cases such as pre-functional tokens, pre-sale tokens and certain stablecoins.
- Utility Token: Utility tokens are not treated as securities if they are functional at the time of issuance. They can be treated as securities if the token has an investment purpose at the point of issuance.
- Asset Token: FINMA treats almost all asset tokens as securities as they are analogous in their function to a traditional security, with the notable exception of fiat currency stablecoins without the economic function of a capital markets instrument (e.g. USDC or XCHF) and tokens that represent ownership in a real asset such as a painting (we will talk more about it in the upcoming third blogpost of this series).
Key Criterion for a security qualification: Investment purpose
While the legal definition follows a more formalized and predictable structure, FINMA applies a more economic point of view that leaves broad room for interpretation. However, from FINMA practice, we can deduct that the key criterion is whether an investment purpose is linked to the token. This translates essentially to a case-by-case analysis of the economic function and use case of a token. There are a few points to consider:
- The term ‘investment purpose’ in itself is unclear. However, we can assume that – following traditional securities law – a certain connection to the capital markets is required. That can be the case if e.g. the token serves as a means to raise capital to develop a project or if the token has capital-market-instrument-like properties such as a mechanism to distribute revenue (similiar to a dividend) to its holders.
- On the contrary, an investment purpose solely by the buyer of a token is not sufficient. There are many tokens that are not considered securities although potential buyers will view such tokens as an ‘investment’ with the hope of a future price increase (you may buy BTC because you think it will be worth more at some point in the future). The fact that there is speculation around a token and its price is not enough to consider a token a security.
- In your assessment, you should also consider if and how a token is marketed as being an investment or embedding a claim against third parties.
- Lastly, as it stands, Swiss law requires that a legal right/claim is linked to the token. However, from current FINMA practice, it is unclear if and under what circumstances a token not embedding any legal claim might still be considered a security by FINMA if it has the economic function (i.e. investment purpose) of a security.
Takeaways on tokens as securities
Consider the following key takeaway points:
- The classification payment / utility / asset token is of limited value with regard to the securities qualification. Each of these initial classifications can lead to the qualification as a security.
- On the one hand, the legal definition of a security is very formal and requires that a token is tradeable and requires that there is a legal right attached to the token.
- On the other hand, FINMA practice is much more driven by a holistic view of the economic function of a token. Essentially, you need to determine whether an investment purpose is linked to the token and whether the token is similar to a classical capital markets instrument.
Howey test and security tokens
Under U.S. securities laws, the infamous Howey test is used to determine whether you’re dealing with a security (or an investment contract, to be more precise). The Howey test asks whether there is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” Based on recent case law, the SEC seems to qualify almost any token as a security.
As part of U.S. regulation, the Howey test does not apply to the securities qualification under Swiss law. While the need for an ‘investment purpose’ follows a similar logic to the criteria set out by the Howey test FINMA has provided a more nuanced and clear approach to market participants: Although certain topics remain unclear, the FINMA guidelines and practice of issuing no-action letters leave market participants with a relatively high degree of legal certainty.