I’ll be departing from my usually-styled articles in this piece below, providing an anecdotal view of a real case study on one of the bigger challenges that BCAS faced ever since its inception in 2017 – getting a favourable ruling on the classification of a DeFi governance token by a prominent regulatory authority in the EU/EEA. The token in question was YFI, the governance token of Yearn Finance, and I’ll be referring to the country in question as the Diligent Ultra Conservative Kingdom (DUCK), since I do not want to name it directly and ruffle any feathers. And yes, this article has a more tongue-in-cheek tone to it than usual (“are you not entertained?”).
With the full flow of DeFi summer in 2020 starting to ebb a bit, at the end of it we were approached by one of our clients to classify YFI under the laws of DUCK, which by and large implemented the Markets in Financial Instruments Directive (MiFID II) in a minimal manner i.e. almost implementing it as-is. This meant that the assessment we were about to undertake would largely also be applicable in other EU Member States which have likewise implemented MiFID II in a minimal manner, and the assessment was namely to see whether YFI classified as a financial instrument or not.
Before delving into the juicy details of this saga that spanned almost 2 years, it is important to note that any technical details of YFI relate to its status back in the relevant period, and that the below obviously does not constitute legal or financial advice. NFA, NLA, and now, LFG.
The ringing of the war siren
The client in question had also tasked us to review a batch of other tokens, some of them being governance ones, and we had only started working in earnest on DeFi a couple of months prior (August 2020). This was pretty much terra incognita for us, so we donned our Christopher Colombus attire and set out to classify these tokens. It was plain sailing for a while, until we landed on the YFI island, and there, we met monsters. The monsters were of two primary forms – voting rights, and the right to receive a cut of the profits generated by Yearn Finance.
For those who are not familiar with Yearn Finance in its earlier days, it is basically a suite of DeFi products with the aim of creating risk-adjusted turns for depositors of various assets via lending protocols, liquidity pools, and community-made yield farming strategies on Ethereum. The core products back then were:
- yVaults (community-developed yield farming robots that follow a unique strategy to maximize the yield of deposited assets)
- Earn (yield-aware dynamic money markets that serve as building blocks for yVaults)
- Zap (a tool that allows users to swap between various stablecoins and a basket of interest-bearing stablecoins (yTokens) or pools (yCRV))
- yInsure (pooled insurance which provides coverage against financial loss for various smart contracts and product offerings)
Yearn Finance was essentially controlled by the holders of YFI who staked their tokens into the Governance pool/contract, entitling them to submit and vote on proposals (subject to quora), and also to receive a portion of the protocol’s profits (revenue being generated by Yearn’s products, and costs mainly being operational expenses such as developer compensation and community grants). On the latter point, YFI stakers could only claim their share of undistributed profits after voting, within a recent period, on a proposal, binding the right to receive profit with the duty of voting.
Up until YFI came along, most of the token governance models we had seen gave their holders the right to receive revenues generated, not profits. We had built a sound argument that the right to receive revenues is different to the right to receive profits, the latter being a cornerstone of transferable securities (namely equity). MiFID II did not contemplate the receipt of pure revenues for equity holders, and therefore receiving revenues as opposed to profits was generally deemed to be fine. With profits, however, the siren of war rang loud and clear. The generals of BCAS’ legal team were summoned to the war room, and organised chaos ensued.
The war room
One of our lawyers came barging in with a classic banger: “if it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck", supporting his argument with a provision within the company laws of DUCK which states that securities include instruments equivalent to shares in companies, partnerships, or other entities. I took out the proverbial, metaphorical, and entirely fake duck hunting gun and shot the argument down, asking politely where the company, partnership or other entity in question was. The reply, interestingly, was that Yearn Finance, or specifically its DAO, could be seen as an unregistered civil partnership.
Another one of our lawyers leapt to my support, and argued that Yearn Finance is nothing more than a suite of smart contracts deployed onto the Ethereum blockchain. To put it another way, it is nothing more than open-source software (MIT licence), and that comparing code to a legal entity would be unreasonable and may set a dangerous precedent with unforeseen consequences. To drive the point home, we argued that this is an open-source project with no single entity in charge, no board of directors to speak of, and no centralisation of power. “It is a system performing as per its digitally-encoded rules, being the deployed smart contracts, governed by the collective work of its contributors and community members”, we cried in triumph as we believed that would be the end of the argument.
But that was not the case.
The call to arms
Armed with this set of arguments, we reverted to our client, who read through them and nodded sagely. Being a prominent exchange seeking to list YFI, the client asked whether this was a “dead-cert” so to speak, or whether there existed doubts within our legal team. Attempts to throttle the dissident lawyer proved unsuccessful, at which point we had to admit that we were breaking into untested and unproven grounds, and that there was room for a counter-argument to possibly succeed.
It was then egregiously suggested that we approach the competent authority of DUCK to opine on the matter, at which point I fell off my chair. This had never been done before, and if we were already in terra incognita at that point, we were about to fly off to Mars. I tried explaining that this would be both a time-consuming and costly process, but the battle plan had been set, and we had to hastily get ready to march to war.
We formalised the legal opinion, classifying YFI as a non-financial instrument (non-security), and, after sealing it with hot wax, entrusted it to our electronic messenger to the competent authority of DUCK (which I will be referring to as the CA). After a few nail-biting weeks, we received confirmation that we had inadvertently caused a civil war between the CA’s various departments, and there was no general consensus on whether our classification of YFI was indeed correct or not. A few days later, we received news that the CA had, in turn, decided to obtain a legal opinion from a third party law firm.
Since we were concerned that this legal opinion might suffer the same fate of those dreaded email chains of twenty years ago, and be misconstrued or misunderstood in similar fashion, we offered our direct involvement to explain the literal technicalities of our arguments, offering to walk the CA and the external law firm through the workings of Yearn Finance and its back-end structure. However, we were stone-walled, and the only thing left to do was to wait for the external law firm to revert with its sacred decree.
The (non)sacred decree
The external law firm decreed, to the sound of drum rolls, that in their opinion YFI classified as a financial instrument, much to our wailing and gnashing of teeth. The reasoning presented from their end was the following:
"It is functionally comparable to 'shares and other securities equivalent to shares or interests in companies, partnerships or other legal entities' within the meaning of MiFID II and the token holders hold classical rights and perform classical tasks which are typical for a company operated in the form of a partnership.
The token holders discuss the project in particular on the platform (https://gov.yearn.finance/) and appear externally as Yearn.Finance including their own website. Furthermore, the project has its own funds (the aforementioned Reserve Wallet) and can implement these decisions by adapting the Smart Contract - mediated by the Governance Smart Contract - and through an organization (in the form of websites and Smart Contracts). Token holders are thus authorized to make (project) strategy, financial and resource planning. Influence is not limited to votes, e.g., on the specific handling of the trading strategy, but classical entrepreneurial topics such as the remuneration of employees are discussed and decided by vote. The community of token holders forms the supreme body and obviously runs an operational business (including the use of manpower to further develop the business in accordance with the strategy determined by the token holders).
The Governance Token Holders are therefore to be regarded as a simple partnership or, in general, as an outside company."
Undeterred, we prepared to mount the counter-offensive, as the CA had afforded us a few weeks to table a formal reply to the external legal opinion. We had used the waiting time astutely, preparing other lines of argumentation that had hitherto been unpresented, and, amongst the many lines of defence that we laid out, these were the main points that we presented in our counter-reply:
A) Our ace in the sleeve was an argument that we shaped for the first time and continued using successfully for other governance tokens that were similarly structured. In essence, we stated that YFI, in and of itself as an ERC-20 token, does not confer any rights to the holder insofar as voting rights or rights to receive profits were concerned. Contrary to shares and other securities equivalent to shares or interests in companies, partnerships or other legal entities, the holders of which are automatically entitled to the corresponding rights they receive in relation to the shares or other securities they hold, holders of YFI had to actively, at their own sole discretion, act on staking the YFI token within a specific contract (the Governance Contract). This was therefore to be treated as an ‘extrinsic right’ separate and distinct from other ‘embedded rights’ that might be present, and that if a holder does not actively decide to stake the token, then the YFI holder does not have any right to vote or receive part of the profit distribution.
B) Without prejudice to the Point A above, we also stated that there is no ‘management body’ in Yearn Finance, a definition which we plucked from the then-early draft of MiCA which stated the following:
‘management body’ means the body of an issuer of crypto-assets, or of a crypto-asset provider, which is appointed in accordance with national law, and which is empowered to set the entity’s strategy, objectives, the overall direction and which oversees and monitors management decision-making and which includes persons who direct the business of the entity.
We emphasised the various factors that need to be satisfied (cumulatively) to constitute a ‘management body’. In Yearn Finance, it was evidently clear that one or more of such elements were not met, therefore meaning that such governance structures do not satisfy the requirements being imposed in a (then) draft regulation that was being proposed by the European Commission and shall be applied across all EU/EEA Member States, including DUCK. Without a management body existing, and with such being a substantive element of a legal entity, it was unreasonable to argue that Yearn Finance constitutes a legal entity.C) Lastly, we stated that even if by some extreme stretch of the imagination, the Yearn Finance protocol was to be equated to a company or similar legal entity, the YFI holders had no right of ownership over the protocol itself, with the right of ownership being an essential one in shares or other comparable instruments. Alternatively, on the secondary hypothesis that the Yearn Finance protocol is deemed to be a partnership, still the same argument applies in that YFI holders are not proprietaries of the protocol, and that therefore there is no ownership element and no personal liability attaching to the YFI token holders.
The Basilica Gun
Point A was to be the equivalent of the Basilica Gun used by Mehmed II to take down Constantinople, and we were confident that we could overturn the initial decision. However, we had a seriously uphill battle ahead, as the external legal opinion had swayed the CA completely to that contrarian frame of mind, and we had to weigh every single word carefully in order to make the argumentation as watertight as possible. The Basilica Gun was fired, and we waited for its impact… for months on end.
The fall of Constantinople
On a crisp summer day in 2021, we received a formal and official decision by the CA, stating that we had convinced them to reverse their initial decision, and that they concurred with the points we presented, especially Point A. In short, the CA concluded that YFI was not a financial instrument. Champagnes were popped, hands were shaken, and the festivities were widespread!
The festivities were indeed widespread… and shortlived.
The Basilica Gun disintegrates
Before our client went ahead with the listing of YFI, we recommended that we go through the technical documentation, governance proposals, and forum threads once again in order to check whether anything changed since the day we were first engaged to assess YFI and Yearn Finance (after all, almost a year had passed).
To our shock and horror, we discovered that Yearn Finance had sunset the Governance Contract, transitioned to Snapshot, and implemented a weighted voting system, allowing users who either hold or stake YFI in the following places to vote:
- User’s wallet (emphasis added)
- YFI yVault V2 (equivalent to holding the yvYFI token)
- Balancer YFI/WETH LP token
- Uniswap YFI/WETH LP token
- Sushiswap YFI/WETH LP token staked in MasterChef
- MakerDAO YFI collateral
- Unit Protocol YFI collateral
Effectively, our staking argument was rendered obsolete, as it was no longer an essential component in order to be entitled to the right to vote.
It was veritably a literal moment of “Don’t Shoot The Messenger” when we had to inform the client that, once again, there was a considerable risk that YFI could be regarded as a financial instrument. I had to rally the troops once again, and think hard about how to build a solid argument in the face of fresh adversity.
The counter-counter offensive
The main changes that had been implemented since we first analysed Yearn Finance were the following:
- YFI staking rewards could be used to buy back YFI on the open market
- Bought-back YFI could be used for contributor rewards and other Yearn initiatives
- Participation in governance was allowed without the need to stake, and additionally also included those instances where YFI was staked in third-party protocols
- Retirement of the YFI governance vault as it no longer had a relevant use
However, there was also one other change which proved to be more important than the rest, and positively at that. This was the removal of profit distributions altogether, and it proved to be important because it helped reinforce the secondary arguments previously laid out, most notable of which was that YFI holders have no proprietary/ownership rights.
We emphasised the fact that shareholders commonly have the right to receive dividends (depending on class & ranking), whereas YFI holders no longer had that right at all. Worryingly, there were discussions within the Yearn community to re-introduce that right, and we made it clear in the revised legal opinion that if that were to happen, and profits were distributed to holders of YFI without the requirement of staking, then our arguments would be further eroded to the point that it would have been difficult to stay behind our affirmation of YFI not constituting a financial instrument.
Luckily, at the time that we delivered the second legal opinion, this did not come to pass.
The dangerous death throes of a felled beast
We delivered the second legal opinion towards the latter end of 2021, but for reasons unknown, the client was only ready to list it in the summer of the following year (2022). By now, dear reader, I am sure you are quite sympathetic to our cause. I risked being thrown out of the office when I went back to the legal team with a request for a third legal opinion, but the branding of the pitchforks was deftly quelled, and we set to work once again.
The counter… ah, forget it.
As you would expect, various other changes were implemented in the meantime, summarised as follows:
- Re-introduction of Yearn Governance as a staking-based governance system (hurrah!)
- An evolution of the role YFI plays in Yearn Governance by way of the following:
- The introduction of a YFI staking vault (xYFI), consisting of YFI that's been bought back with Treasury earnings, and distributed as rewards to those who stake YFI in the xYFI vault. This was ‘Phase 1’ of the newly-implemented Yearn Governance system.
- Phase 1 was then to be replaced by Phase 2, which introduced ve-style locking of YFI (veYFI) for up to four years where a longer locking duration gives a greater share of voting power and share of YFI rewards. An early exit from the lock was possible by paying a penalty that was rewarded to the other locked token holders.
- Restricting the YFI eligible to vote in Yearn Governance as only those staked in xYFI (from Phase 1 onwards) or vote-locked in Yearn (from Phase 2 onwards)
This time round, not only could we fall back on the winning argument that staking is required to benefit from, and receive, governance-related rights, but we added a new argument wherein we stated that for all intents and purposes, veYFI was to be regarded as separate and distinct from YFI, and that the latter, being the token that we were tasked to evaluated and the subject of the legal opinion, granted no governance rights whatsoever to the holder. veTokens are usually non-transferable and therefore highly unlikely to be listed by crypto exchanges, and hence are normally completely outside the scope of legal opinions that we are engaged to deliver.
In the end, triumphantly and conclusively, we felled the dreaded beast, and confirmed that YFI did not classify as a financial instrument. For the third time.
I hope you enjoyed reading through this pulse-racing saga as much as I enjoyed writing it. This was but one of the many times that BCAS crafted novel legal arguments, exercising its legal engineering prowess and harnessing its in-house technical team to the fullest in order to break into new ground in the world of crypto-asset regulation. A new monster lies ahead, the size of which the world has not yet seen, going by the name of MiCA. We are confident that we will tame it, but it is also a guarantee that in the next two years, chaos will ensue as the world comes to grip with novel token taxonomies, exemptions within exemptions, and contrasting views. But in the end, isn’t that what we crypto lawyers live for?