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This article describes the structure of and applicable Japanese law to liquid staking, which has been expanding rapidly in recent years, and its most significant protocol, LIDO.

I. A Summary of Legal Analysis

II Basic Overview of Liquid Staking, ETH Staking, and LIDO

1 Liquid Staking

Liquid staking is a DeFi (decentralized finance) mechanism whereby a person receives a staking fee for a crypto asset while receiving an additional alternative asset (a staking-proof token) and can invest said alternative asset in another DeFi.

2 Proof of Stake and Staking

Proof of Stake (POS) is the authentication mechanism of the blockchain by a person who has a certain level of involvement (stake) in the crypto asset.

Unlike the Proof of Work (POW) mechanism used in Bitcoin and other cryptocurrencies, authentication can be performed without requiring a large amount of calculations, thus reducing electricity consumption and making it more environmentally friendly.

3 ETH Staking

Ethereum has been structured using POS instead of POW from ETH 2.0. In Ethereum staking, (1) you can become a validator by depositing 32 ETH, (2) the validator authenticates each transaction on Ethereum and thereby receives a certain amount of ETH as a reward, and (3) if the validator intentionally provides false information, he/she will be penalized by forfeiting a part of the deposited ETH (thrashing), (4) a validator is always required to be online, and if they are down, they will also be penalized to a certain extent.

4 How LIDO Works

LIDO is the world’s largest protocol for Liquid Staking. At present, it is estimated that more than 30% of the staking volume of Ethereum is done via LIDO. LIDO is supposed to work as follows:¹

Prepared by So&Sato Law Offices from published materials

①LIDO allows users to stake ETH without maintaining their staking infrastructure and without economically locking up their assets.

②When a user wants to stake ETH to LIDO, the user should send ETH to LIDO’s smart contract. In response, the user receives a 1:1 token called stETH.

③stETH is a token that represents the deposit of ETH to LIDO for staking, and when a user sends stETH to LIDO to burn stETH, the user will receive ETH. stETH can be freely bought and sold, and if there is another DeFi that accepts stETH, the user can earn double rewards by using stETH on another DeFi (however, DeFi protocols that accept stETH still seem to be limited).

④LIDO will use ETH received through the smart contract to perform staking. LIDO will receive 10% of the reward obtained from staking, which will be distributed to the person in charge of the staking (node operator) and the LIDO DAO. The remaining 90% will be distributed to the users. The distribution to the users is made by adding the number of stETH in the address of stETH, and the number of ETH managed by LIDO is always the same as the number of stETH.

⑤LIDO uses multiple node operators. Node operator candidates apply to LIDO, stating that they wish to become node operators, their experience and technical capabilities, etc., and are then voted on by the DAO, which is composed of LIDO token holders, the LIDO’s governance tokens, to determine whether they are eligible to become node operators.

⑥Note that ETH has thrashing risks and penalties. LIDO hedges against such risks by using a large number of node operators. LIDO also manages some ETH separately and uses it as insurance against thrashing risk.

⑦LIDO is an open-source, peer-to-peer protocol and is not operated by a single operator, etc., as the LIDO DAO makes the decision on its operation.

III Liquid Staking and Japanese Law

When offering liquid staking like LIDO, it is necessary to consider whether the trading and custody regulations of the Crypto Assets Act apply and whether the fund regulations of the FIEA apply.

1 Regulation of the Issuance of Crypto Assets

When a user contributes ETH to LIDO, the user will receive stETH, and conversely, when a user sends stETH to LIDO, the user will receive ETH.

The question arises as to whether this action constitutes an exchange of ETH for stETH. If it is considered an exchange of crypto assets, the regulations of the crypto asset exchange services might apply.

StETH, however, is issued to prove the deposit of ETH, and we believe the issuance of such stETH does not constitute a sale or exchange under civil law and thus does not constitute an exchange of crypto assets (and vice versa).

2 Custody Regulation of Crypto Assets

The contribution of ETH to LIDO might be considered a deposit of crypto assets to LIDO and raises the issue of whether the custody regulations of the Crypto Assets Act apply to LIDO.

However, it appears that the contribution to LIDO is a contribution to a smart contract, and LIDO cannot use said ETH except for staking (i.e., it does not control the private key) due to the structure of the smart contract.

Under the Japanese custody regulations, “If a business operator does not possess any of the private keys necessary to transfer the crypto assets of a user, the business operator is not considered to be in a position to proactively transfer the crypto assets of the user. In such case, the business operator is basically not considered to fall under the category of “managing crypto assets for others” as defined in Article 2.7.4 of the Payment Services Act. (Result of Public Comment No. 9 on the Draft Cabinet Order and Cabinet Office Ordinance Concerning Amendment to the Payment Services Act, etc. of 2019). If the smart contracts can technically prevent the free transfer of ETH by people related to LIDO, we believe LIDO is not considered to be subject to the custody regulations under the Crypto Assets Act.

3 FIEA Regulations

The question arises whether LIDO or liquid staking is considered a fund (collective investment scheme), given the mechanism of receiving ETH contributions, the node operator managing it, distributing a portion of staking fees to users, and users bearing the risk of thrashing and other penalty risks.

The definition of a fund under Japanese law is generally as follows (Article 2, Paragraph 2, Items 5 and 6 of the FIEA). If a fund investor’s right is tokenized, the tokens are considered electronically recorded transferable rights (Article 2, Paragraph 3, Pillar 1 of the same law).

If the issuer itself is offering or private offering the tokens, registration as a Type 2 Financial Instruments Business is required (Article 2, Paragraph 8, Item 7, (g), Article 28, Paragraph 2, Item 1, and Article 29 of the same law, Article 1-9-2, Item 2 of the Order for Enforcement of the FIEA), and if the third party is offering or private offering the tokens, registration as a Type 1 Financial Instruments Business is required (Article 28, Paragraph 1, Item 1 and Article 29 of the FIEA).

The concept of “other rights” in (A) above is very broad, and it is said that (i) through (v) are merely an enumeration of examples, regardless of the legal form. It can be argued that tokens issued in fully decentralized finance are not “rights” because they are not considered “rights” in the usual legal interpretation, but there is currently a prevailing view that some rights are recognized for Bitcoin, etc.², and in relation to this article, we assume that some kind of right is recognized even for smart contracts.

Nor does it fall under any of the exceptions in (C) above.

The main issue is the interpretation of (B) above, which states “dividends of income or distribution of properties that arise from a business conducted by using money” and “invested or contributed.” If we simply take the point that ETH is sent to the smart contract, it is used in the business of the POS, and the award from staking ETH is distributed to users, it would seem to satisfy both the “dividends of income or distribution of properties that arise from a business conducted by using money,” and “invested or contributed” requirement.

However, liquid staking is very different from ordinary funds in the following respects, and, arguably, liquid staking is not a fund to which the FIEA applies.

(1)In the case of a regular fund, the money and other assets contributed are fully owned by the fund operator, and the fund operator can technically use them in various ways, although they are contractually bound. In the case of liquid staking, the ETH contribution is made to the smart contract, and LIDO or node operators are not free to use it; ownership (ownership-like rights) over ETH is always considered to be held by the user,

(2)In the case of a regular fund, the money received is used to purchase shares, fund a business, etc., and changes from money to shares, etc. In LIDO staking, the ETH sent to the smart contract is not specifically changed into anything else but is maintained as it is.

(3)The only reason ETH is locked is to ensure that there is no thrashing in the event of fraudulent reporting in the validation process or penalties if a node goes offline.

(4)Based on (1) through (3) above, if we compare the legal nature of staking to a traditional economic act, it can be thought that the user is merely locking ETH into a smart contract as a kind of collateral to secure default liability and is merely receiving compensation for providing third party collateral. The provision of such collateral and the receipt of compensation do not satisfy the requirements of “dividends of income or distribution of properties that arise from a business conducted by using money” and “invested or contributed,” as referred to in the fund.

4 Argument that the Operator Does Not Exist and Therefore Is Not Subject to Regulation

In the case of DeFi, it could be argued that the operator does not exist in the first place and is not subject to regulation. Japanese law is a legal system that regulates persons and legal entities, such as operators. A completely decentralized financing scheme would not be subject to regulation. However, we need to carefully consider whether there really is no operator for DeFi. In general, DeFi aims for the operator to be non-existent, but even so, it is unclear whether many DeFi are truly completely operatorless.

Further, if the scheme is subject to financial regulations under the law, assuming there is an operator, the intermediary for the scheme could be subject to regulations even if there is no operator for DeFi itself. It would prevent, for example, an unlicensed Japanese company from sending customers to the DeFi.

Therefore, when examining the legal issues of DeFi, it is necessary to consider two issues: (i) if there is an operator, whether it is subject to legal regulation, and (ii) whether an operator exists.

However, it is unclear from the published documents whether the LIDO DAO is truly decentralized, so this article mainly discusses (i) above.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may, therefore, change in the future. This article does not recommend the investment in LIDO or liquid staking. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

Ⅰ Introduction

Recently, Web3 companies often ask us whether they can issue and sell tokens linked to ownership or value of real world assets (“RWA tokens”) in Japan. The types of linked real assets include artwork, real estate, whiskey, vintage cars, government bonds, securities, gold, etc.

Applicable Japanese regulations to RWA tokens vary depending on the types of tokenized assets and the scheme. We will provide an overview of the applicable regulations to RWA tokens and then substantive legal issues of RWA tokens.

Ⅱ Crypto Regulation

Japanese law differentiates crypto assets, which are regulated, and NFTs, which are not regulated, and most RWA tokens are structured as NFTs.

If RWA tokens fall under the category of crypto assets, selling and purchasing the tokens as a business requires a crypto asset exchange license. For example, Zipang Coins, which are RWA tokens representing gold and issued by a Japanese major trading company group, are structured as crypto assets, and only licensed exchanges can sell them as a business.

On the other hand, most RWA tokens are structured as NFTs. From the legal viewpoint, the difference between crypto assets and NFTs is whether they can be used as a payment method. FSA has submitted a guideline and answers to public comments and stated that if tokens satisfy the following requirements, they are not crypto assets and are not regulated under the Payment Service Act.

Ⅲ Fund Regulation

If RWA tokens are considered securities, to sell and purchase the tokens as a business requires a financial instruments business operator license. If the token holder has the right to receive a dividend or more than 100% principal redemption, they are generally considered securities. The definition of the collective investment scheme (fund) in Japan is as follows. As the definition covers “all rights” that can receive a dividend or more than 100% principal redemption, you should carefully analyze whether the tokens are considered securities when its structure includes a profit distribution element.

Ⅳ Goods Deposit Transaction Regulation

Another regulation that is related to RWA tokens is the Goods Deposit Transaction regulation. In Japan, there have been some controversial transactions in which (i) a merchant sells some goods to buyers, (ii) the merchant accepts deposits of the sold goods from the buyers for more than 3 months, and (iii) the merchant promises to pay some fee such as a rental fee to the buyers or promises to buy-back the sold products more than the sales price. These kinds of transactions were often used as financial investments without regulation. The Goods Deposit Transaction regulation now regulates these kinds of transactions. The regulation requires an explanation to buyers if the transaction involves the above (ii) and (iii) elements and requires approval from the government if the transaction involves the above (i), (ii), and (iii) elements. Please note that there has been no case the approval was obtained yet, and, thus, no one knows the difficulty of obtaining the approval.

We are often asked the way to give economic benefit to RWA token holders. Simply giving the economic in principle causes the issues of both or either of fund regulations and goods deposit transaction regulation and makes token issuance not feasible.

Ⅴ Prepaid Payment Instruments

There are RWA tokens that give a right to acquire products or use products such as hotel rooms, etc. Issuance of tokens linked to the right to acquire or use real assets is, in principle, subject to prepaid payment instrument regulation under the Payment Services Act. Some RWA tokens give those rights to holders and are subject to the regulation. For example, Not A Hotel NFT, which gives a holder to stay in a luxury residence, is subject to the regulation.

There are two types of prepaid payment instruments. The first type is the private-type prepaid payment instrument, which can be used only against the issuer or its closely related persons. The issuer of the private prepaid instrument shall file a notification to the Finance Bureau and deposit half amount of the unused amount, except for the case when the issuer only issues instruments that have less than 6 months’ expiration date or the unused balance at a certain reference date is 10 million yen or less.

The second type is the third-party type prepaid payment instrument, which can be used against other than the issuer or its closely related persons. The issuer of the third-party type prepaid payment instruments shall register with the Finance Bureau, except for the case when the issuer only issues instruments that have less than 6 months’ expiration date.

Ⅵ Secondhand Goods Business Regulation

A business that sells, purchases, or exchanges once-used goods such as used cars, used bags, used jewelry, and published artwork is, in principle, subject to the secondhand goods business regulation. A person who conducts the secondhand goods sales and purchase business shall file a notification to the police agency and shall conduct KYC of its customers. It is conceivable, however, that this regulation would not apply to the division and sale of the right of secondhand goods, and thus RWA tokens, which related to the divided right of real goods, are exempted from the regulation.

Ⅶ Other Regulation

In addition to the above, sales, etc., of assets might require consideration of asset-specific regulations. For example, to sell alcohol needs an alcohol sale license, and the seller of RWA tokens UniCask, which relates to a barrel of whiskey, takes the alcohol sale license.

Ⅷ Substantive Legal Issues

Compared to a simple sale of real world assets, RWA tokens require more careful consideration of what rights will be transferred and how to perfect the transfer. Holding RWA tokens does not necessarily mean having ownership of real assets, and transferring RWA tokens does not necessarily mean automatically transferring the ownership of the real assets.

For example, when you transfer real estate, you need to file a real estate transfer registration, and without it, you cannot insist that you are the owner of the real estate to third parties, and just transferring tokens on a blockchain may not suffice this requirement. To transfer tangible property in Japan might be possible just by transferring tokens, but careful consideration is necessary. The law regarding the transfer and perfection of real assets may vary in different jurisdictions, and generally, the laws in the country where the real asset is located apply.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may, therefore, change in the future. This article does not recommend investment in RWA tokens. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

1 What is DAO?

A DAO is a decentralized autonomous organization that drives a business or project forward using smart contracts without a specific owner or manager. Overseas clients sometimes ask our firm whether they can sell DAO tokens in Japan.

2 Summary of regulation on sales of DAO tokens to Japanese residents

Below is a chart you need to consider before selling DAO tokens to Japanese residents.

<Chart to be considered>

3 Community DAOs and financial regulation

Community DAOs often issue governance tokens.

To consider the financial regulation of sales of DAO tokens in Japan, we must look at (a) whether the DAO provides some kind of dividend or more than 100% redemption of the principal (“Dividend, Etc.”), (b) whether the DAO has any legal entity nature that is similar to a joint stock company or LLC and whether the tokens represent nature similar to shareholders rights, and (c) whether DAO tokens can be used as a payment method.

3.1 DAO tokens that distribute Dividend, Etc.

Tokens in most community DAO do not have any dividend feature or profit distribution feature for token holders.  If there are such features, the regulation on investment DAO tokens will be applied.  Please see item 4 below.

3.2 DAO tokens issued by a company

If a DAO is structured in the form of a company, which happens rarely, and the DAO token awards member rights of the company to token holders, the right might be deemed as securities.  Type 1 Financial Instruments Business Registration is required for the sale of those tokens.

3.3 DAO tokens issued by non-company

In general, many DAOs are formed without clarification of the legal form.  Some DAOs just use a smart contract and do not have any form of legal entity.  Under Japanese law, such DAOs may be classified as partnerships or “associations without a juridical person.”  The rights of partnerships and associations without juridical persons do not fall under securities unless there are Dividend, Etc.

The sale of DAO tokens without Dividend, Etc. and so on issued by an organization other than a company should be classified as a crypto asset or NFT.

If the tokens fall under the definition of crypto asset, their sale shall be made by a licensed crypto asset exchange business operator.

However, if the DAO token is considered an NFT, there are no restrictions on its sale.

The distinction between a crypto asset (FT) and an NFT

In 2023, the Financial Services Agency (FSA) issued guidelines stating the distinction between a crypto asset (FT) and an NFT: (https://www.fsa.go.jp/news/r4/sonota/20221216-2/20221216-2.html).

The guideline states that if the asset does not have “means of payment” characteristics, it is not a crypto asset and that having “means of payment” characteristics can be determined by the following criteria: In general, if (a) DAO tokens cannot be used as a payment method, and (b-1) the price of the token is more than JPY 1,000 or (b-2) the issued number of tokens is less than 1M, the tokens are considered NFTs, and their sale is not regulated.

4 Investment DAOs and Financial Regulation

4.1 Investment DAO tokens are generally considered securities and regulated by FIEA

Under the FIEA, DAO tokens that pay Dividend, Etc. generally fall under the category of “electronically recorded transfer rights.”  Thus, in order to sell electronically recorded transfer rights, you must either register as a Type 1 Financial Instruments Exchange Business Operator (Type 1 FIEBO) and conduct the sales yourself or have a Type 1 FIEBO do it for you.  Furthermore, when soliciting 50 or more persons and issuing 100 million yen or more, the solicitation of the tokens becomes a public offering (Article 2, Paragraph 3 of the FIEA), which requires the submission of complex offering documents and continuous disclosure.

4.2 Exemption from FIEA might apply to some tokens, but it is not easy to use

As an exception, if sales are made only to qualified institutional investors (QIIs, professional investors) or wealthy individuals (with financial assets of JPY 100 million or more) who are 49 or younger, and if technical restrictions are in place to prevent other individuals from becoming DAO token holders through resale, then the sale falls under the exception category called “special business for qualified institutions, etc.,” and self-offering only requires a simple notification under Article 63 of FIEA.

We have heard that many investment DAOs in the US are issued to QIIs, and many investment DAOs limit their sales to avoid US security regulations.  The problem in Japan is that the definition of “professional investors” is much narrower than in the US.  In Japan, one criterion for becoming QII is that corporations and individuals must have at least JPY 1 billion in securities.  In the US, a person who has more than USD200,000 annual income can become a QII, and in the EU, a person who has more than EUR500,000 in financial assets (in addition to satisfying other requirements) can be a QII.  These requirements are much easier to satisfy than the requirements in Japan.

Japan also has a narrower exception to submit offering documents.  In Japan, offering documents are required for offerings exceeding JPY 100 million.  In contrast, exemptions apply for offerings less than USD6 million in the US (sales by Reg A Tier 1) and less than EUR5 million in some countries in the EU.

In light of the above, the issuance of investment DAOs is not popular in Japan but is still possible if you obey Japanese regulations.

EOD

I. What is a Blockchain Game?

A blockchain game is a game that uses the blockchain and uses crypto assets, tokens or NFTs (Non-Fungible Tokens).

In a typical game the following occurs:
(1) user purchases game assets that belongs to the game operator rather than the user,
(2) such game assets cannot be freely transferred, sold, or lent out, and
(3) even time-consuming data disappears after game distribution ends.

Whereas in blockchain games, it is said that the following occurs:
(1) the user is the holder of the token (game asset),
(2) the token can be transferred, sold, or lent out to third parties,
(3) third parties can also use the token, and
(4) as long as the blockchain exists,¹the recorded digital assets will exist in perpetuity.

Ⅱ. Laws to Consider and Conclusions

When providing a blockchain game to Japanese residents, the laws listed below should be taken into account. Here is a summary of the laws that pertains to this matter:

III. Legal Considerations

The following is a discussion of each legal issue.

1. Crypto Asset Law and Security Act

(a) Where is the problem?
Under blockchain games, the game operator frequently sells game characters, items, weapons, and land etc. as NFTs to users in exchange for ETH or other crypto assets.

Japanese law does not regulate sales of pure NFT, but regulate sales of crypto assets and sales of securities. Thus, whether sold tokens are not deemed as crypto assets or securities are crucial issue.

(b) What are crypto assets?
Under the Fund Settlement Act, the seller, Crypto Asset is defined as follows:

Selling or providing custody of crypto assets are highly regulated and must generally be handled by registered crypto asset exchange operator and also it is not feasible for a blockchain game operator to obtain registration.

At this moment, whether tokens are considered as crypto assets is determined by the number of issued tokens and whether the tokens can be used as some form of payment. NFTs are generally not considered as crypto assets, but if a game operator says it is an NFT, and the NFT has payment features etc., it may be considered a crypto asset.

(c) What are Securities?
Japanese Financial Instrument and Exchange Act (FIEA or Security Act) governs the issuance or sales of securities. Securities includes stocks, bonds, mutual funds, collective investment scheme etc. We have been often asked by blockchain game operators whether it is legal in Japan to sell NFTs, such as land, which generate “income” or “dividend”. If NFTs generate income without the participation of players, they may be classified as securities. Thus, when selling profit-generating tokens, the game should consider including features of players’ effort, such as editing land to attract customers.

2. Gambling offenses

(a) General Remarks
The crime of gambling under the Penal Code is established by (1) contesting the gain or loss of property profits by (2) winning or losing by chance. In addition, not only money but also “property interest” is considered to be the object of gambling, and rice, land, and debt collection are all considered to be “property interest” subject to the crime of gambling. Crypto assets are also considered to fall under the category of property interest.

(b) Gacha (Loot Box), Reveal and Gambling Law
Some blockchain games have features of Gacha (loot box) and reveal. Users pay money or crypto assets to a gaming company and get NFTs randomly. For example, users pay 1ETH to get a game character NFT. Game characters may include Julius Caesar, Guanyu, Genghis Khan, Napoleon, George Washington etc, and those characters have different strength, powers, rarity etc, and what users can get is not revealed to users.
It was believed that these sales might be considered as gambling because (i) users pay property value, (ii) users receive property value which differs by chance, and (iii) there is winning or losing (of property value) by chance. However, in 2022, blockchain industries talked with a famous criminal law professor and some regulatory authorities and issued the guideline which states certain Gacha and reveal is not considered as gambling. Although the guidelines have no effect to police or criminal courts, the industry is now considering how following the guidelines may reduce the likelihood of criminal penalties.

The requirement is that the issuer and operator of games do not sell the same NFTs at different prices (for example, if the issuer sells NFTs that include Napoleon with 1ETH via Gacha, the issuer is not allowed to sell Napoleon NFT at a different price in another method), and do not buy back NFTs in a secondary market (for example, the issuer cannot buy back Napoleon NFT in 0.5ETH or 1.5ETH). In such cases, there is either winning or losing), and the issuer and operator shall not overstate the value of some NFTs in Gacha over other NFTs in Gacha.

(c) Synthesis
The same theory that applies to Gacha may apply to synthesis, but because synthesis is not discussed in the guidelines, we take a more cautious approach to synthesis.

3.Premiums and Premiums Law

(a)Initial Start
Developers often ask us of blockchain games if it is possible to give NFTs, game currency, crypto assets, other property to users free as a login bonuses, playing bonus and ranking bonuses etc. When conducting such distribution, it is necessary to consider the relationship with the Premiums and Representation Law.

(b) About the Premiums and Representation Law
The Premiums and Representation Law prohibits the offering of excessive premiums.
Premiums are (1) offered as a means of inducing customers, (2) offered incidental to a transaction, and (3) economic benefits such as goods or money. As the definition of economic benefits is broad, crypto assets, NFTs, in-game currencies, and other benefits might be considered as economic benefits.

Excessiveness will vary depending on whether the sweepstakes is general sweepstakes, joint sweepstakes, or all-inclusive sweepstakes, Still, it will be based on the following criteria to the extent that it is considered relevant to the game.

(c) Ranking Rewards and the Premiums and Representation Law
In traditional smart phone games, the top-ranking players frequently receive in-game currency. The economic value of in-game currency has been treated as zero or very low by game operating companies, and there is no issue under the Premiums and Representation Law.

In blockchain games, crypto assets and NFTs, which can be sold outside of the game might be given as prizes. In this case, the general sweepstakes restrictions apply. The transaction value determines the amount of the prize. Although it is difficult to determine how much the transaction value is, a reasonable approach would be to set the minimum charge as the transaction value and allow rewards of up to 20 times the minimum amount or 100,000 yen, whichever is lower.

(d) Play to Earn and the Premiums and Representation Law
If we consider a Play to Earn game as a game where players (a) purchase NFTs or game currency and (b) earn some reward (e.g., NFTs or game currency) by playing, the reward portion may be subject to the Premiums Regulation.

However, whether earned NFTs or game currencies will be considered “premium” is unknown. There is an argument that the Premiums Law does not apply to Play to Earn games because the rewards are not “extras (premiums),” but rather the purpose of purchasing NFTs and playing the game itself. Lottery winnings and game-play prizes, for example, are not considered “premiums,” but rather “the purpose” of the transaction itself (gambling law shall be discussed lottery winnings and game-play prizes). This issue has not been resolved in Japan, and careful deliberation is required.

Reserved Matters
The contents of this document have not been verified by the relevant authorities and are merely a description of arguments considered reasonable under the law. It is only the current thinking of our firm, and our firm’s thinking is subject to change.
This document does not recommend using blockchain games or purchasing NFTs.
This document is intended for blogging purposes only. Please consult your lawyer if you need legal advice on a specific case.

Introduction

Clients often ask us whether it is possible to structure a Decentralized Autonomous Organization (DAO) in Japan. Currently, Japan does not have regulations targeting DAOs, unlike Wyoming State or the Marshall Islands. So, we have written this article summarizing what is typically considered when forming a DAO in Japan.

1.DAO

1.1 What is DAO?

A decentralized autonomous organization (DAO) is a new legal structure with no central authority and members committed to acting in the organization’s best interests. DAOs are used to make decisions in a bottoms-up management style and have gained popularity among cryptocurrency enthusiasts and blockchain technology.

1.2 Classification of DAOs

There are several classifications of DAO described below:

1.3. Example of an Existing Overseas Law

A few places where DAOs are regulated are Wyoming State and the Marshall Islands. Below is a short description of forming a DAO in the Marshall Islands.

2. Financial Regulations on DAOs

2.1. Points to Consider

When structuring a DAO, one must consider the financial regulations and the legal form characteristics.

Here are several points to keep in mind:

1. Security regulation under the Financial Instrument and Exchange Act (“FIEA”) may apply when tokens have the possibility of dividends or redemption of the principal of more than 100% (dividends and redemption of the principal of more than 100% are from now on collectively referred to as “dividends, etc.”). As a general rule, token sales of such DAO must be conducted by a Type 1 Financial Instrument and Exchange Business Operator (“Type I license”) or by obtaining a Type 2 Financial Instrument Exchange Business Operator license (“Type II license”).

2. When selling Fungible Tokens without dividends, etc., it is necessary to have a Crypto Asset Exchange Operator conduct the sale or to obtain a Crypto Asset Exchange Operator license.

In contrast, these financial regulations generally do not apply when selling NFTs without dividends, etc.

3. You also need to consider the tax benefits. If you want to pursue tax advantages in an Investment DAO with dividends, etc., you can use a partnership or GK-TK scheme. If tax advantages are not particularly important, an association without rights, a general incorporated association, or a limited liability company can be considered a scheme to issue tokens. For the issuance of Fungible tokens or NFTs without dividends, etc., it may be better to have no particular legal structure.

2.2. Reference Table of Conclusions

The table below summarizes the legal scheme and financial regulations that should be considered in establishing a DAO.

The following regulations apply to token sales of Investment DAOs with dividends, etc. (assuming dividends or principal redemption of more than 100%).

On the other hand, a DAO without dividends, etc., is also possible. Its regulations are as follows:

With respect to possible legal forms for DAOs, the following comparisons can be made:

*1 Legal entities include limited liability companies, stock companies, and general incorporated associations. LLCs are generally easier to establish and operate than joint-stock companies. If you want to have a more public image, use a general incorporated association.
*2 Membership rights of a limited liability company, stocks of a stock company, membership rights of a general incorporated association.

2.3 Tokenization of Rights

Tokenization of rights of funds or partnership, where there is an investment of funds (including money and crypto assets), investment management, dividends, or redemption of the principal of more than 100%, would be broadly considered a collective investment scheme (fund) under Japanese law. Below is the summary of the Definition of a Collective Investment Scheme.

The revised Financial Instruments and Exchange Act, which came into effect on May 1, 2020, created the legal concept of Electronic Record Transfer Rights. The rights of tokenized collective investment schemes usually fall under the Electronic Record Transfer Rights below.

The sale of this electronic record transfer right requires a Type 1 Financial Business registration. If soliciting more than 50 people, it will be a public offering (Article 2, Paragraph 3 of the Financial Instruments and Exchange Act), and a securities registration statement must be submitted based on Article 5 of the FIEA.

If the sale is limited to qualified institutional investors or wealthy people of 49 or less, and even if there is resale, there are technical restrictions so that other people cannot become DAO token holders.

When the Investment DAO is formed, it can be sold in such a limited form at first, and after it grows, it can be sold to the general public while complying with increased regulations.

2.4 Tokenization of Company Membership Rights and Financial Registration Regulations

Regarding tokenization of company membership rights, a Type I FIBO license is necessary when a third party sells the rights, and Type II is essential in the case of self-solicitation. In the case of tokenization of company membership rights (shareholders rights) of a joint stock company, a Type I license is necessary in the case of solicitation by a third party, and no license is required in the case of self-solicitation.

2.5 Regulations on Public Offerings, etc.

 If any of the following applies, it becomes a public offering. In principle, it is necessary to submit a securities registration statement.

2.6 Financial Regulations for DAOs without Dividends

If DAOs have no dividends, etc., they are not considered securities, but different financial regulations may apply.

Disclaimer

The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may therefore change in the future. This article does not recommend investment in DAO. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

Ⅰ. Introduction

We posted (1) an article titled “Crypto Fund“( in Japanese) on 1 June, 2018, and (2) an article titled “Funds Regulations in Japan” on 30 June, 2020.

In 2021 and 2022, we received many inquiries regarding setting up crypto funds. Considering (i) the amendments in 2020 to the Payment Services Act(PSA), (ii) the rise of NFT, DeFi, and stablecoins, and (iii) changes to the taxation of crypto assets,  we therefore are updating  (1) the article titled “Crypto Fund.”

In general, the term “crypto fund” can be used in a variety of ways, such as where (i) the fund’s financial source is crypto assets which include Bitcoin and Ether, (ii) the fund’s investment targets are crypto assets or crypto related businesses for instance BTC, ETH, SAFT, ICO tokens, NFT, stablecoins, security tokens, DeFi, and stocks of crypto related companies, and (iii) the investor’s rights are tokenized.

Therefore, the following is an overview of the regulations that apply to each type of structure.

Since this article focuses on crypto funds, other kinds of funds (investment in fiat currency and securities management) are not mention in this article, except in section VIII.1. For regulations on other kinds of funds, please refer to (2) the above article titled “Funds Regulations in Japan. “

Ⅱ. Regulations on Fund Raising

1. Regulations on Fund Raising in Fiat Currency

Under the Financial Instruments and Exchange Act (FIEA), soliciting investments in money (fiat currency), using it to conduct business, and distributing the proceeds from the business falls under a collective investment scheme (Article 2(2)(v) of the FIEA).

Soliciting investments in a collective investment scheme (public offering or private placement, Article 2(8)(vii)(f)) falls under the Type II Financial Instruments Business (Type II FIB) (Article 28(2)(i) of the FIEA) in principle, and public offering or private placement is not allowed without registration as a Type II Financial Instruments Business Operator (FIBO) (Article 29 of the FIEA). This is also the case for crypto funds where the means of fundraising is money, and the investment targets are crypto assets.

There are some exceptions to this fund regulation under the FIEA, such as (i) cases where the fund completely outsources the solicitation to another Type II FIBO and does not solicit any acquisitions on its own, (ii) cases where the fund uses the exemption so called Specially Permitted Businesses for Qualified Institutional Investor (QII) (Article 63 of the FIEA) (Article 63 Exemption or QII etc. Exemption), and (iii) cases where the fund is more than 50% funded by overseas investors and the domestic investors are limited to certain investors such as QII (Overseas Investor’s Exemption)( Article 63-8 of the FIEA).

Whether or not the issuer does not conduct any solicitation for acquisition is determined by the circumstances in each case. Solicitation for acquisition refers to the solicitation of an application to acquire newly issued securities and similar activities (Article 2, Paragraph 3 of the FIEA). Solicitation is generally understood to be an act that attracts and encourages investors to acquire a particular security, whether in writing, verbally or through advertising.

Specially Permitted Businesses for QII is an exemption that allows a fund manager to engage in fund services by making a simple notification to the Financial Services Agency (FSA) when all investors in the fund are QII or when the investors include one or more QII and 49 or fewer persons who are expected to have certain investment abilities. However, that exemption has been subject to tighter regulations under the 2015 amendment to the FIEA. Before the amendments, the scope of 49 or fewer investors included general individual investors. It should be noted that after the amendment, individual investors whose total amount of investable financial assets (referring to securities, etc., but not including crypto assets) is 100 million yen or more and who have been in a security account for one year would be able to invest.

2. Regulations on Fund Raising in Crypto Assets

Until the amendment of the FIEA in 2020, soliciting investments in funds with crypto assets was not subject to the FIEA regulation. However, due to the amendment, crypto assets are now considered as money equivalent in relation to fundraising (Article 2-2 of the FIEA). Fund raising with crypto assets is now subject to the same regulations as fund raising with money.

(Summary of Regulations on Fund Raising )

Ⅲ. Regulations on Investment Management of Funds

1. Regulations When Investments are Primarily in Securities or Derivatives

With respect to funds the term investment management business is understood as the management of money or other property invested by a person connected with investments primarily in securities or derivatives which are based on investment decisions requiring the valuation and analysis of such instruments. In this context, “primarily” means that generally more than 50% of the assets under management are invested in securities or derivatives. To conduct an investment management business, a company must register as an Investment Management Business Operator (Article 28(4) of the FIEA). Similar to Type II FIBO, persons engaging in the investment management business must meet certain criteria, including minimum capital requirements and hiring proper personnel (e.g. a compliance officer with eligible knowledge and experience) for operating the business.

The securities include stocks as well as general security tokens. In order to avoid this regulation, it is necessary to set a limit on the investment objectives to the effect that no more than 50% of the investment should be in securities or derivatives. Similar to the above II.1, there are some exemptions. For example, registration as an investment management business is not required if (i) the fund meets requirements such as full outsourcing of management to other investment management companies, (ii) the fund is conducted as Article 63 Exemptions, or (iii) the fund is set up in a foreign country and investment from Japan is limited.

2. Regulations When Investments are Primarily in Crypto Assets

If the investment target is mainly crypto assets, the FIEA does not apply to the management. Since the management of crypto assets is for investment purposes and not for business purposes, the PSA does also not apply. When investing in NFT, SAFT, DeFi, stablecoins, the FIEA and the PSA do not apply to the management, as it does when investing in crypto assets.

(Summary of Regulations on Investment Management)

Ⅳ. Regulations on the Content of Investors’ Rights

1. Regulations on the Distribution of Money and Crypto Assets

A fund is generally set up by using a silent partnership agreement, a limited partnership agreement, or an overseas partnership agreement (collectively, partnership agreement), and investors have rights under such partnership agreement. In a crypto fund, it is assumed that there are cases where (1) the fund’s investment is solicited in crypto assets and then dividends or principal redemption in money, (2) the fund’s investment is solicited in money and then dividends or principal redemption in crypto assets, and (3) the fund’s investment is solicited in crypto assets and then dividends or principal redemption in crypto assets.

Since the transfer of the crypto assets is not a sale or exchange thereof, we believe that the PSA does not apply except in cases of legal evasions, such as formally soliciting investment in a fund with money and immediately redeeming the principal with crypto assets.

2. Regulations on the Tokenized Interest

With the 2020 revision of the FIEA the concept of Electronically Recorded Transfer Rights (ERTR)

were introduced. Article 2(3) of the FIEA defines ERTR as follows:

Some crypto funds may also consider tokenizing their rights. Interests in a fund which are tokenized are generally considered ERTR. Given their (potentially) increased liquidity they are subject to the same regulations as more liquid Type I Securities. Third parties engaging in the sale of tokenized interests must therefore register as Type I FIBO (Article 28 (1) (i), Article 2 (8) (ix) of the FIEA).

The self-solicitation of tokenized interests by a fund is subject to the same registration requirements as the self-solicitation of funds in general. A fund must therefore register as a Type II FIBO and, if ≥50% of the money is invested in securities or derivatives, as an Investment Management Business Operator, unless an exemption applies. The QII exemption ¹ and the exemption in case of entrustment of all sales and investment activities to third parties also apply to tokenized funds.

For more detailed information on security token offerings (STOs), please click here.

(Business Regulations and Notifications Requirements under the FIEA for the Sale and Management of Tokenized Funds)

Ⅴ. Disclosure Regulations

Since ERTR are generally subject to the same regulations as Type I Securities, disclosure requirements apply if investors’ rights are tokenized. An issuer of ERTR is therefore obliged to prepare a prospectus (Article 13 (1) of the FIEA) and to register the offering with the FSA (Article 4 (1)). In addition to the initial disclosure, ongoing disclosure requirements apply (Article 24). Something different only applies in the case of private placements. These are placements with QII, professional investors or a small number of investors (≤ 50 investors) only.
If investors’ rights are not tokenized, disclosure requirements apply to public offerings of type II securities, which fall under the category of Rights in Securities Investment Business, etc. (Article 3 (iii) (a)) that mainly invest in securities. In the case of Type II Securities, if the number of holders is less than 500 in response to a solicitation for acquisition, it does not fall under public offerings (Article 2 (3) (iii) and Article 1-7-2 of the FIEA Enforcement Order), and disclosure requirements do not apply.

(Disclosure Regulations)

* Technical measures must have been taken to restrict resale.
** When the total issue price is less than JPY 100 million the obligation to file a securities registration statement does not apply (Article 4(1)(v) of the FIEA).

Ⅵ. Fund Scheme

1. Fund Scheme if Investing in Crypto Assets

Funds are generally structured using various types of partnership agreements. In Japan, investment Limited Liability Partnership (LLP) agreements are often used to set up PE funds and VC funds, etc. However, LLP is legally only allowed to engage in certain businesses (Article 3 (1) of the Act on LLP), and it does not include the acquisition and holding of crypto assets or stablecoins. Therefore, if the investment target is crypto assets or stablecoins, LLP cannot be used, and silent partnership agreements should be considered².

2. Fund Scheme if Investors Rights are Tokenized

Suppose a fund tokenizes rights under a partnership-type agreement and transfers the token to investors. In that case, it seems necessary to consider whether simply tokenizing existing rights on the agreement will work properly.
For example, the following issues should be considered:

• Whether rights under partnership agreements are validly transferred only by transferring the tokens³
• If the governing law is not specified as in the case of The Dao, what will be the tax and accounting treatment in Japan

Ⅶ. Supplement

1. Investment in Crypto-Related or Blockchain-Related Companies

Funds that are financed in cash and invest primarily in shares of crypto-related or blockchain-related companies are sometimes called crypto-related funds.
As a fund that invests primarily in securities, such as this fund is, in principle, required to be registered as a Type II FIBO for its public offering or private placement and as an investment management business operator for its management (refer to II1. and III1.).

2. Management of Own Funds

When a company launches an “in-house fund” to invest its own funds in shares of crypto-related or blockchain-related companies, it may also be called crypto-related funds.
However, this does not fall under “investment of money or other properties invested or contributed from a person who holds the following rights or other rights specified by the Cabinet Order” (Article 2 (8) (xv) of the FIEA), so fund regulations under the FIEA do not apply.

3. Tax Issues of Crypto Funds

We are not experts in tax issues, but we describe here for your reference since tax issues are often a significant issue when setting up a crypto fund.⁴
If a company owns actively traded crypto assets in Japan, it is taxed at market value at the end of the term (so-called unrealized gains tax).
When a crypto fund is set up with TK-GK scheme, the silent partnership investors are not considered to own the assets, but GK is deemed to own, and therefore, in principle, unrealized gains are taxed in GK. However, if such unrealized gains are distributed to investors based on the silent partnership agreement, GK will not be taxed on that portion (effectively pass-through), while the portion equivalent to such gains will be treated as income of the investors (both individual and corporate investors).

When a crypto fund is set up with an overseas partnership, it is taxed as if investors themselves own assets of the fund (pass-through). Therefore, corporate investors of the overseas partnership are subject to unrealized gains tax.

Unrealized gains tax might be avoided by using a scheme in which a company is set up in a foreign country that does not tax unrealized gains and Japanese investors invest in the company as a silent partnership, and then unrealized gains are not allocated to the investors. However, it is necessary to consider Anti-Tax Haven Rules when using this scheme. If the overseas company’s shareholders are domestic companies or domestic individuals, the overseas company may be deemed to be a paper company or not meet the economic activity standards, and income of the overseas company might be deemed as income of the shareholders.

Therefore, you should consider the following factors and consult with legal and tax professionals to structure a crypto fund.

• Attributes of primary investors (Japanese company, Japanese resident, foreign company, or foreign resident)
• Whether tokens to invest in are subject to unrealized gains taxes (if the tokens are listed on a crypto exchange or DEX, whether you can sell them before the end of the fiscal year).
• Whether shareholders or GPs of overseas entities can move to Singapore or other countries.

Disclaimer

The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may therefore change in the future. This article does not recommend the investment in crypto funds. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

Non-fungible tokens (NFT) have been a topic in the Japanese crypto industry since early 2018. With the NFT craze in 2021, they have become increasingly popular and seen more mainstream adoption. It does, therefore, not come as a surprise that the Japan Cryptocurrency Business Association (JCBA) and Blockchain Contents Association (BCA), as two of the leading industry associations in Japan, issued NFT guidelines more recently.

In this article, we are taking a closer look at the state of the Japanese NFT market and the legal and regulatory environment for NFTs while considering the JCBA and the BCA guidelines.

I.　The State of the Japanese NFT Market

1.　Blockchain Games

Traditionally, items purchased in a game could only be used within the game and not be transferred to other players. This has changed with blockchain games, where game items are represented by NFTs. By allowing players to control the NFTs, they become able to buy, sell, exchange, and lend items represented by NFTs to other players – even outside of the game. According to the JCBA, the use of NFTs further ensures that the game assets do not disappear after the termination of the game. What is most likely meant is that the NFT does not cease to exist. Yet, it may lose its value as the represented asset might not be used anymore due to the termination of the game.
Popular blockchain games on the Japanese market include My Crypto Heroes, Crypto Spells, and Contract Servant.

Source: JCBA Guideline, page 4.

(1) My Crypto Heroes
My Crypto Heroes by double jump.tokyo was released in November 2018. The game is an RPG in which players can gather, build their character, and win items by completing challenges and fighting enemies. Both heroes and items are represented by NFTs and can be freely transferred peer-to-peer or traded on NFT markets.

My Crypto Heroes fast became the world’s number one blockchain game and still has the highest number of (active) users and transactions.

(2) Crypto Spells
Crypto Spells by Crypto Games is a card game in which players use cards represented by NFTs to fight with the computer and other players. There are several ways to acquire new cards, including battles and trading/exchanging them with other players within and outside the game.

(3) Contract Servant
Contract Servant by Axel Mark is a card game in which players have a deck of eight cards (servants). There are two types of servants – common servants and token servants, where the token servant is issued as an NFT. The tokens can then be traded among players through a market function. Players are further able to earn rewards from league battles each week.

(4) Other Notable Games
Other notable blockchain games in Japan are Crypton, Crypton Racing, and Brave Frontier Heroes. Further, double jump.toyko launched MCH+, a blockchain game development program that is based on the knowledge gained from My Crypto Heroes.

2.　Crypto Art

In February 2021, Christies sold a Beeple artwork for JPY 7.5 billion. The artwork itself is stored on the InterPlanetary File System (IPFS) and represented by an NFT on the Ethereum blockchain. In Japan, a number of crypto art related services have been launched more recently. The major platforms are nanakusa, NFT Studio, and Token Link.

(1) nanakusa
In March 2021, Smart App released nanakusa – a marketplace for crypto art. nanakusa allows crypto artists to mint NFTs and sell crypto art via the platform. Purchasers of crypto art may further sell artworks – or more precisely, the NFT representing the artwork – via the trading platforms. From the information provided, it seems that royalties are paid to the crypto artists for all secondary sales.

(2) NFT Studio
In March 2021, CryptoGames released NFT studio. The platform allows artists to mint NFTs on Ethereum and Polygon for their crypto art. Similar to nanakusa, NFT studio includes features that allow artists to participate in the price for secondary sales.

(3) TOKEN LINK
In January 2021, Platinum Egg released Token Link, an NFT market for game items. Only a few months later, in April, Platinum Egg implemented an auction mechanism for crypto art.

3.　NFT Market

(1) Coincheck NFT Market
In March 2021, Coincheck, the operator of one of the largest crypto exchanges in Japan, launched an NFT market. Currently, the only NFTs listed on the market are from Crypto Spells and The Sandbox. More NFTs will be listed in the future. The company has 2 million active users and hundreds of billions of yen in crypto assets under custody. As such, Coincheck will be an important partner for content providers and a gateway to the Japanese market for foreign projects.

When applying for listing, from our experience, projects must provide Coincheck with information about the blockchain used, the primary sale, IP content, and, where applicable, transaction volumes on other markets. As Coincheck is a member of the JCBA and a head of the NFT committee of the JCBA, it is also valuable to check JCBA guidelines in more detail.

(2) Participation by Major Companies
While Coincheck’s NFT market is the first of its kind in Japan, other major companies, including Mercari[1], LINE[2] and GMO Internet group[3] have announced that they are considering launching their NFT market. The entry of other major players is a clear sign that NFTs are gaining increasing mainstream traction on the Japanese market.

II.　NFT Guidelines of Japanese Organizations

Currently, there are no laws and regulations that specifically deal with NFTs. Depending on their design, NFTs may, however, fall under the definition of crypto assets, prepaid payment instruments, or money orders under the Payment Services Act (PSA) or the Banking Act or constitute securities within the meaning of the Financial Instruments and Exchange Act (FIEA). Whether this is the case must be analyzed on a case-by-case basis. The guidelines prepared by the JCBA and the BCA aim to provide some more clarity in this regard.

(1) JCBA guidelines
The JCBA is one of the leading industry associations in Japan. Its members range from crypto-asset exchanges to other crypto asset service providers. The NFT committee of the JCBA issued NFT guidelines on April 26, 2021. The guidelines are meant to provide local and foreign NFT issuers with more clarity when applying for a listing on a Japanese NFT market.

The following chart provides a good overview of the key considerations when determining the legal and regulatory environment for NFTs.

In the case of blockchain games, it is also necessary to consider gambling laws. According to Japanese criminal law, gambling is a criminal offense. It is defined as a game of chance where players can win monetary prizes, except for small gifts. While the definition is rather blurry, NFT issuers implementing mechanics similar to gatcha should consider gambling regulations carefully.

Blockchain games that include incentives for users, such as the free issuance of NFTs, must further comply with the Premiums and Representations Act. The Premiums and Representations Act regulates the free provision of goods and services by a business which aims to induce potential customers to buy the business’s products or services.

The Premiums and Representations Act stipulates limits for lotteries, competitions, etc. While the total amount differs, the following limits must generally be considered for lotteries and other competitions.

Source: Prepared by our office based on the Consumer Affairs Agency website, etc.

The JCBA guidelines further provide that NFT issuers should implement measures that prevent users from using NFTs for money laundering and terrorist financing; consider security risks for storing NFTs and implement measures to deal with thefts or losses; properly explain to users that there is the risk that the NFT might become worthless if the service is terminated; and consider that NFTs are highly likely to be used for criminal purposes, including money laundering.

(2) BCA guidelines
The BCA was established by SNS and gaming companies and is involved in a number of initiatives aiming at the protection of minors and the elderly when using blockchain applications. On March 24, 2020, the BCA published the BCA guidelines on blockchain content (incl. NFTs) to protect consumers and promote self-regulation. A revised version of the paper was published on December 25, 2020.

The interpretation of the laws and regulations, including the PSA, FIEA, Gambling Laws, and Premiums and Representations Act, is largely in line with the interpretation by the JCBA.

With respect to gambling, the BCA guidelines hold that blockchain games should avoid or at least carefully consider implementing any of the following mechanics: (i) in-game gachas (vending machine type mechanics) that issue NFTs or other in-game items; (ii) collection of fees to participate in rewards.; (iii) randomized creation and burning of NFTs and other in-game items with monetary value; and (iv) collection of fees to participate in competitions where the collected fees are distributed to the participants depending on their ranking.

The BCA guidelines further include self-regulation for member companies that include (i) the prohibition of loss compensation, (ii) the prohibition of insider trading, (iii) the monitoring and prevention of market manipulation, and (iv) the obligation to disclose material information to all users.
In addition, the guidelines hold that the issuance of NFTs may involve scams and other fraudulent practices, such as the termination of services shortly after selling the NFTs. To prevent fraudulent practices, member organizations are advised to (i) provide all material information to their users, (ii) secure the necessary funds and resources to ensure that the content shown to the users is actually delivered, and (iii) conduct test sales of NFTs and extensive beta-testing to enable users to understand the content of the services and NFTs prior to the actual launch.

III.　Future Issues

Given the fact that NFTs are a relatively new phenomenon that is still evolving, many issues are yet solved. The following explanations are meant to provide some guidance for matters not included in the BCA and JCBA guidelines but relevant for the industry.

(1) NFTs and External Services
In most cases, the data represented by NFTs is stored off-chain. This raises the question of how consumers can be protected from later changes to the service and what companies can do to avoid claims for damages. In the case of blockchain games, NFTs typically represent assets that are stored on the servers of the blockchain game company. If the company now decides to change its terms of use or to terminate its services, this may ultimately render the NFT worthless and, in some cases, non-functional. To ensure that the game company does not face any claims for damage, this scenario must sufficiently be covered in terms of use. The same applies to crypto art, where the artworks are stored on the servers of a marketplace. If the data is stored and subsequently deleted on the InterPlanetary File System (IPFS), the situation is much more unclear and requires further consideration.

(2) NFTs and IP
For NFTs that are used for crypto art or in blockchain games, it is necessary to consider the relationship between the content provider and the holder of the NFT carefully. Two aspects are of utmost importance. First, the rights that are represented by the NFT should be clearly stipulated in the sales documentation of the initial sale. This also includes the question of how the rights represented by the NFT are transferred. Second, the relationship between the off-chain data and the NFT, as well as the retention of the off-chain data, should be considered carefully to avoid potential actions for damages. In cases where the content provider participates in all further sales, this should be clearly indicated in the contract as well. In the future, it is possible to discuss what rights should be granted as best practices.

(3) Issues concerning the trading of NFTs
If not explicitly provided in the contract, it is unclear under Japanese laws whether the rights represented by an NFT – i.e., the economic substance – are transferred (i) if both parties agree to the transfer and the transfer is recorded on the blockchain or (i) by mere agreement. To increase legal certainty and to ensure that the data recorded on the blockchain accurately reflects reality, the terms of sale should clearly stipulate that transfers only become effective if it is recorded on the blockchain. While there is no legal precedent, we believe that this solution is most practical and reflects the parties’ intentions.

(4) Taxation of NFTs
The taxation of NFTs another issue to be considered. In February 2019, the Japan Cryptocurrency Tax Association (JCTA) found that the taxation of income from the sale of NFTs is “an issue that has not been clarified in tax law.” The document finds, however, that “NFTs have an independent value, and if income is generated from the sale or exchange of NFTs, it will generally be taxed as miscellaneous income.”

(5) Secondary distribution of NFTs and rewards for creators
For many projects, content creators are rewarded when a secondary sale takes place. Examples are the above-mentioned nanakusa and NFT Studio, who both pay royalties to the content creator for secondary sales. In other cases, the content creator might want to transfer all his IPs to achieve higher prices for the initial sale. It is likely that both models will exist side by side in the future, but best practices still have to evolve. Further discussions are necessary in that regard.

Disclaimer
The content of this article has not been confirmed by the relevant authorities or organizations mentioned in the article but merely reflects a reasonable interpretation of their statements. The interpretation of the laws and regulations reflects our current understanding and may therefore change in the future. This article does not recommend the use of or investment in NFTs. This article provides merely a summary for discussion purposes. If you need legal advice on a specific topic, please feel free to contact us.

EOD

[1] On April 2, 2021, Mercari announced that it established a new company to plan and develop blockchain-related services, including NFTs.

[2] LINE tweeted recently that it is building an NFT platform. The tweet states that it intends to build services that make it easy to mint, buy, sell, and exchange NFTs.

[3] GMO announced developing a marketplace that allows users to buy and sell NFTs representing digital art and music from famous artists.