NFT – Legal Token Classification, Exercises of Law

Download NFT – Legal Token Classification and more Exercises Law in PDF only on Docsity! Page 1 | 14 PARTNERS SUBCONTRACTORS NFT – Legal Token Classification About this report This report is the first of a series of brief papers relating to the main legal aspects of non-fungible tokens (NFTs). The aim is to highlight NFT characteristics and provide an extensive but not exhaustive overview of the legal classification and frameworks across the globe. The report places a special focus on EU laws, but it is not limited to this. Disclaimer The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of the European Commission. The Commission does not guarantee the accuracy of the data included in this study. Neither the Commission nor any person acting on the Commission’s behalf may be held responsible for the use which may be made of the information contained herein. Acknowledgments The EU Observatory & Forum would like to expressly acknowledge the following co-authors (in alphabetical order) for their direct contributions to this report as members of the EU Blockchain Observatory and Forum Expert Panel, or as external contributors: ● Claudia Di Bernardino - Partner, TMSHELL Law Firm ● Andres Chomczyk Penedo, PhD Researcher, Vrije Universiteit Brussel ● Dr Joshua Ellul - Director of Center for DLT, University of Malta; Chairperson, Malta Digital Innovation Authority ● Dr Agata Ferreira, Assistant Professor, Warsaw University of Technology ● Axel von Goldbeck, Partner, DWF ● Dr Robert Herian, Senior Lecturer in Law, The Open University ● Alireza Siadat, Partner, Annerton ● Dr Nina-Luisa Siedler, Partner, DWF Page 2 | 14 Introduction Whilst the term token can mean different things in the sector (depending on the context within which it is used, for the scope of this report we refer to tokens in a generic sense without requiring or implying a strict definition. However, we will primarily differentiate between those tokens that are non-fungible and those that are not. Tokens can be defined as digital assets created on a blockchain or distributed ledger. In order to define NFTs, it is worth explaining the concept of fungibility and non-fungibility. An asset is considered to be fungible when there is the possibility of replacing it with an identical one, both in terms of quality and quantity (e.g. money). Similarly, an asset is non-fungible when such a substitution for an identical item is not possible given the intrinsic individuality of the good itself (e.g. a work of art). A fungible token is a token equal to every other of its kind and capable of mutual substitution. In fact, one fungible token can be traded or exchanged for another fungible token (of the same kind). On the contrary, an NFT is a peculiar type of token that is indivisible and unique. This category of tokens, as the name suggests, are characterised by their non-fungibility and interchangeability. They cannot be exchanged for the same amount of the same type precisely because they are unique and because each has different characteristics. NFTs, in fact, grant a mark of originality since each of them consists of information and data that cannot be replicated and that differentiate it from any other NFT, thus making it irreproducible. In this they differ from exchange tokens (e.g. Bitcoin) that are instead fungible in nature. To summarise, it can be stated that NFTs are characterised by the following elements: - uniqueness: in that an NFT is or represents a unique object, whether digital or otherwise, which may be associated unequivocally with a user or to a virtual wallet; - indivisibility: cannot be split up into parts; - non-fungibility/interchangeability: NFTs are not fungible and replicable. NFTs can enable tokenised proof of title to digital versions of underlying digital assets (e.g. images, videos, other digital content) or physical assets (e.g. paintings, sculptures, other tangible assets). Whilst such tokenised proof can be generated, ownership as prescribed by law may differ. In fact, one of the main characteristics of NFTs is that they can technically represent any type of asset, both digital and physical. Whilst token standards have emerged (e.g. ERC-721) that may provide a means of categorising tokens, today there is yet no single standard to represent all types of infungible tokens. This could be a challenge given that NFTs are not tied to any specific blockchain platform. More so, they can incorporate a variety of rights that may make them fall into one or another type of classification, potentially [1]: - Asset tokens: represent a specific right over a tangible or intangible asset. The person who creates (mines) the token decides the type of right owned to the person to whom the token is assigned; - Utility tokens: provide the holders with a right of access to goods or services so that they have exclusive access to functionality within a blockchain platform; - Security tokens: represent ownership of an asset and grant token holders similar or equal rights to those of securities. These tokens include shares, bonds and, in general, financial instruments. NFTs represent an evolution of the physical ownership of a specific asset. The digital token includes a set of information recorded on the blockchain that represents the asset linked to the token. As a result, it is also possible to precisely identify its owner who can assert rights on the asset and also choose to exchange it. In practice, the tokens digitise something, and their exchanges and transfers can take place safely and without intermediaries. In fact, these digital assets can be exchanged in special marketplaces, thus creating a process of tokenisation from reality to digital. All the information, procedures and purchases can be easily tracked with the support of the blockchain that allows to monitor the transfer of ownership and pay the original author in the future, if required. Page 5 | 14 The mere assignment of a unique identifier to a crypto value should thus not be sufficient to classify it as unique or non-fungible. Potential application of MiFID II Since the MiCAR legislative process is pending and currently there is no existing EU legislation that would explicitly regulate NFTs, the applicability of other potentially relevant EU laws needs to be considered when classifying NFTs. This includes a set of EU laws governing financial markets, like the Directive 2014/65/EU on markets in financial instruments (MiFID II), a cornerstone of the EU’s regulation of financial markets. If an NFT could fall within the category of financial instruments under MiFID II, a full set of the EU financial regulations framework would apply to NFT issuers and service providers, including the Prospects Regulation, Market Abuse Regulation, Transparency Directive, the Settlement Finality Directive, the Market Abuse Directive, or the Short Selling Regulation. Financial instruments are defined in Article 4(1)(15) of MiFID II as those instruments specified in Section C of Annex I that provides a list of financial instruments. The exact definition of a financial instrument will depend on how each individual EU Member State transposed MiFID II into its respective national laws. As a result, there are divergences in the definitional scope of a financial instrument across various Member States. Page 6 | 14 Various types of financial instruments listed in Annex I to MiFID II include ‘transferable securities’, ‘money market instruments’, ‘units in collective investment undertakings’ and several derivative instruments. The most relevant for NFTs appears to be the category of ‘transferable securities’ defined under Article 4(1)(44) of MiFID II. Under such Art 4(1)(44) read in conjunction with Art. 2(a) of a Prospectus Regulation, NFTs seem unlikely to fall within the definition of securities. Further, to fall within the definition of a ‘transferable security’, an NFT would need to belong to a class of securities. Although MiFID II does not explicitly define the term ‘class’ and not all EU Member States developed a specific definition of a ‘class’, the common interpretations of this term imply fungibility, or interchangeability or replicability. Therefore, non-fungibility would effectively exclude an NFT from the category of transferable securities under MiFID II. However, in the case of F-NFTs that are fungible, they could potentially qualify as fungible financial instruments under MiFID II. In each case, careful consideration should be given to the standard used for the token (e.g. ERC 721 vs. 1121) since some standards used for NFTs do not allow the swap of the token against another token that may not allow free trade. Given the divergences in interpretations of MiFID II provisions, the diversity of NFTs, early stages of their development and dynamic evolution, until there is regulatory certainty, additional guidance or a dedicated set of laws, careful analysis of each NFT instrument is needed. This would particularly concern tokens not covered by MiCAR, as the applicability of MiCAR and MiFID is mutually exclusive. Summary MICAR will provide a single regulatory framework for crypto assets that do not already qualify as financial instruments under MiFID. Such crypto assets may be fungible crypto assets but no (true) NFTs, whilst fractional NFTs may qualify as crypto assets. Although non-fungibility could effectively exclude an NFT from the category of transferable securities under MiFID II, given the differences in interpreting MiFID II provisions, the diversity of NFTs, early stages of their development and dynamic evolution, until there is regulatory certainty, additional guidance or a dedicated set of laws, careful analysis is needed of each NFT instrument (including F-NFTs). Page 7 | 14 Germany Germany acknowledges several categories of financial instruments in tokenised form. In addition to the EU MiFID security and e-money, Germany has just recently enacted new law for electronic securities. As of 2020, its banking law includes a new financial instrument called crypto assets (Kryptowert). Prior to that amendment, crypto currencies like Bitcoin were recognised (and still are) as units of accounts. (i) Crypto assets pursuant to sec. 1 (11) sentence 4 German Banking Act (Kreditwesengesetz, KWG) According to the legal definition in Section 1 (11) sentence 4 KWG, crypto assets are digital representations of a value that has not been issued or guaranteed by any central bank or public body and does not have the legal status of a legal tender, but are accepted by natural or legal persons as a means of exchange or payment on the basis of an agreement or actual practice, or used for investment purposes and can be transmitted, stored and traded electronically. This definition is based on the definition of virtual currencies in Art. 3 No. 18 of the Directive (EU) 2018/843 (AMLD5) amending i.a. Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing (AMLD4). However, the German definition of crypto assets extends such a term to instruments for investment purposes that are not included in the AMLD5 definition of virtual assets. Instead, Germany referred to the definition of virtual assets in the FATF recommendations that the FATF issued in October 2018 and which had been developed more or less parallel to the AMLD definition from May 2018 (forming base for the current proposal of Markets in Crypto Assets Regulation – MiCAR). While there is much debate about certain elements of the definition of crypto assets, the legislator stated quite clearly in the reasoning for the definition that the extension to digital assets serving investment purposes are meant to cover any tradeable asset. Fungibility, however, is no express criteria for crypto assets. Therefore, NFTs, as long as technically tradeable (irrespective of actual trades or listing), will most likely be regarded as crypto assets and, hence, as financial instruments under German law. As a result financial regulation is extended quite far into an area that would be usually seen in the non-financial sector. (ii) German Electronic Securities Act (Gesetz zur Einführung von elektronischen Wertpapieren, eWpG) On 10 June 2021, the German law to introduce electronic securities entered into force. It enables two new types of electronic securities in addition to the traditional, paper-based securities: one based on a central intermediary providing the required electronic register and another based on a decentralised electronic Page 10 | 14 Common law jurisdictions Introduction This section considers the regulatory position and challenges regarding blockchain-based financial products and assets, notably NFTs, in a selection of common law jurisdictions. Central to development of policy and practice in common law jurisdictions on crypto assets has been the UK Jurisdiction Taskforce, Law Tech Delivery Panel’s Legal Statement on Cryptoassets and Smart Contracts (November, 2019). Launching the statement in 2019, Sir Geoffrey Vos, Chancellor of the High Court, said that “[t]he objective is to provide much needed market confidence and a degree of legal certainty as regards English common law in an area that is critical to the successful development and use of crypto assets and smart contracts in the global financial services industry and beyond.” The discussion here in part reflects on the relative success of that objective within common law jurisdictions where, according to recent research by the UK’s Financial Conduct Authority (FCA), public awareness of crypto assets is growing, but understanding has either fallen or remains poor. (i) UK The UK does not directly regulate NFTs, nor have legislative or regulatory bodies made a definitive statement on NFTs or NFT regulation at the time of writing. The position on four main crypto asset/token types (exchange tokens, e.g. Bitcoin, security tokens, utility tokens, and stablecoins) is more advanced, but remains in a state of flux across different government departments and regulatory authorities, including Her Majesty’s Revenue and Customs (HMRC), FCA, Bank of England and the Treasury. In accordance with international financial regulatory standards, the UK regulates exchange tokens for money laundering purposes. Since January 2020, the FCA has had regulatory powers to allow supervision of how crypto asset businesses manage the risk of money laundering and counter-terrorist financing. UK crypto asset businesses must comply with money laundering regulations and register with the FCA, although the FCA acknowledges crypto assets remain, generally, outside the ‘regulatory perimeter’. Security tokens, which may cover aspects of NFT use where this reflects promotion of the NFT as a speculative investment, accompanied by the suggestion of a promoter that the NFT will increase in value because of the actions of the issuer or the promoter, are not directly regulated. However, they would likely fall within the domain of the FCA’s securities regulation in terms of rights regarding ownership position, repayment of a specific sum of money and entitlement to a share in future profits. This would, for example, mirror the position of the Securities and Exchange Commission in the United States. HMRC, who have led on crypto asset definitions in the UK, considers NFTs separately identifiable assets regarding capital gains tax (CGT). This reflects an approach to “pooling” for the benefit of simpler tax calculations, which HMRC does not consider viable for NFTs or exchange tokens such as Bitcoin or Ether that must have their own associated ‘pooled allowable cost’. HMRC largely views crypto assets as individual investment vehicles for capital appreciation, hence the emphasis on CGT. However, although not regulation per se, HMRC warns individuals that income tax and national insurance could be payable where crypto assets are accepted from an employer as payment or through engagement with mining, transaction confirmation or airdrops, key areas that could well act as modes of crypto asset market regulation if taxed at an individual and organisation level. (ii) Australia Like the UK, Australia does not directly regulate NFTs. Instead, Australia’s approach considers regulation or the potential for regulation on whether the NFT represents or certifies, or causes stakeholders to treat an NFT, like a regulated financial service, product or asset, such as a security. Australia’s financial regulatory framework comprises three agencies, each with specific functional responsibilities: the Australian Prudential Regulation Authority (APRA) responsible for prudential supervision; the Australian Securities and Investments Commission (ASIC) tasked with market integrity and consumer protection across the financial system; and the Page 11 | 14 Reserve Bank of Australia (RBA) in charge of monetary policy, overall financial system stability and regulation of the payments system. ASIC’s position on digital currencies is not clear, with a review of the Digital Asset Framework in Australia yet to be undertaken by the Commissioner and the federal government. The primary published guidance in Australia falls behind clearer guidance in the UK and Singapore, with ASIC’s Information Sheet 225 ‘Initial coin offerings and crypto-assets’ (INFO225) first published in September 2017 and subsequently updated in several iterations. It aims to provide “high-level regulatory signposts for crypto-asset participants as a starting point.” Like the UK, ASIC emphasises that blockchain and crypto asset use cases could be financial products requiring the token-issuing entity to hold an Australian financial services licence (AFSL) to operate, with a clear emphasis towards token sales. Unlike HMRC in the UK, the Australian Tax Office (ATO) has not provided progressive definitions or statements on crypto assets, with much of the ATO’s work limited to 2014 taxation guidance. (iii) New Zealand New Zealand does not directly regulate NFTs or crypto assets, including exchange tokens such as Bitcoin. Mirroring other jurisdictions, New Zealand’s approach is one of regulatory capture where crypto assets facilitate key activities that fall within definitions of financial services. These include exchanges, wallets, deposits, broking and initial coin offerings (ICOs). If these activities involve crypto assets that are classed as ‘financial products’ under the Financial Markets Conduct Act 2013 (FMCA), this creates obligations such as general obligations regarding licensed markets (s.314 FMCA) ICOs have also been subject to the fair dealing requirements in Part 2 of the FMCA. These are broad principles that prohibit misleading or deceptive conduct, false representations and unsubstantiated representations. Summary At the time of writing, the jurisdictions briefly discussed continue to work towards comparative if not the same regulatory objectives regarding crypto assets, by seeking to provide “much needed market confidence and a degree of legal certainty.” Yet in all cases, crypto assets remain outside or beyond regulatory perimeters. Far from providing tailored approaches to the technologies in question, these objectives build on a combination of existing regulation (regulatory capture), general ‘wait and see’ principles and market-focused self-regulation aimed at promoting and not stifling innovation. Insofar as NFTs fall within more mature definitions of crypto assets, regulatory approach to NFTs will probably mirror that of crypto assets in the short to medium term. In terms of the legal evolution of NFTs, we ought not to underestimate the role of judge-made law in common law jurisdictions. The ability of courts, tribunals and associated dispute resolution services to define and shape crypto assets and NFTs, especially under existing property, trusts, and contract law, concepts and theories, will be crucial in the next 5 to 10 years. To some extent, the process has begun in two leading cases from the UK and New Zealand, AA v Persons Unknown [2020] 4 WLR 35 and Ruscoe v Cryptopia [2020] NZHC 728, and via the recent UK Jurisdiction Taskforce Digital Dispute Resolution Rules (June 2021), but legal certainty remains in question. Page 12 | 14 Latin America Although Latin America is seen as one of the leading regions in digital asset adoption and development, the regulatory landscape has been slow to react towards this phenomenon. In this respect, very few countries have adopted legislation or regulation and, even in those cases, they had a reactive approach towards digital assets, rather than a constructive and proactive perspective for the industry. This also has an impact on existing and potential classifications regarding tokens as a type of digital asset. Moreover, there is no unique supranational organisation that can help regarding unifying criteria and terms, as in the case of the EU. The few available specific legal rules applicable to digital assets, in particular crypto assets, have focused on anti- money laundering, following FATF’s recommendations, and taxation. When it comes to identifying a regulatory framework for tokens classification, most efforts in this respect have been made by academia and civil society organisations rather than regulatory agencies. For example, a recent report conducted by an Argentine Bitcoin NGO within an Inter-American Development Bank funded project provided a theoretical framework for tokens in the Latin American context that classified them in (i) payment tokens, (ii) utility tokens and (iii) asset tokens depending on the function that the token seeks to fulfil (Chomczyk, 2020). In this regard, an NFT, depending on its particular details and functioning, would sit between an asset or utility token. This section provides a brief overview of jurisdictions where crypto assets have seen adoption. In this respect, we shall cover the following jurisdictions: (i) Argentina; (ii) Brazil; (iii) Colombia; and (iv) Mexico. While each jurisdiction has its distinct and own rules, there are shared traits amongst them. For example, the definitions for the term ‘security’ are similar to each other. (i) Argentina In Argentina, there is no legal formal framework from any legislative or regulatory body that provides for a classification or definitions for tokens. Nevertheless, there is fragmented regulation that deals with the crypto- economy, such as Resolution No. 300/2014 from the national Financial Information Unit (Unidad de Información Financiera) that deals with virtual currencies (monedas virtuales) from an anti-money laundering perspective or the national Law No. 27,430 that amended the income tax law to include a specific tax rate for profits resulting from sales of digital currencies (monedas digitales). Consequently, there is a diversity of definitions that results in a lack of coordination regarding the exact applicability of each obligation and the correspondence between frameworks. It is worth noting that the definition for securities (valores negociables) under the Argentine Capital Markets Act (Ley de Mercado de Capitales) is broad and could, in certain situations, be applicable to NFTs, in particular if its issuance is done with short-term speculative purposes. If NFTs are not subject to securities regulations, then they would be governed by private law under the Civil and Commercial Code. On the enforcement front, a considerable number of regulatory agencies, such as the Argentine Central Bank (Banco Central de la República Argentina) or the National Securities Commission (Comisión Nacional de Valores) have issued non-binding opinions on different issues regarding the crypto-economy, like ICOs that provide some ideas on possible interpretations of existing rules. For example, ICOs were hinted to be considered as an initial offering of securities under Argentine law. In this respect, if an NFT meets the criteria to be considered as security, then it might be treated as such. However, none of these regulatory bodies have moved forward with formal and general rules as mentioned above. While some legal proceedings have taken place in the last couple of years, particularly in criminal law, none has provided a classification or definition for tokens either as obiter dictum or ratio decidendi of such lawsuits. (ii) Brazil