Mitigating the Legal Risks of Issuing Securities on a Cryptoledger

By July 10, 2014Bitcoin Business
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While in the long-run there will likely be new opportunities that open up, below are real, present risks involving the cryptocurrency world, especially with those individuals developing appcoins and crowdfunding/crowdequity platforms. For instance, section III of the JOBS Act has not been written up, let alone implemented.

As a Swiss friend in finance likes to remind me: Rule #1 of Bitcoin: do not believe any news about Bitcoin -- always do your own research. And in this case, talk to an attorney. In the event of lawsuits, not everyone has enough money to live abroad and permanently hang out in Panama, Switzerland or Japan -- thus if it sounds too good to be true, it probably is.

I spoke to several attorneys about specific risks under this umbrella such as:

1)  Securities are legal constructs and require legal structuring to be valid and binding obligations of their issuers. 

As Preston Byrne, a London-based attorney I spoke to put it bluntly:

"[Virtually] nobody has done this correctly.  To date I have not seen a single crypto-security that has been properly structured." 

Purchasers of securities issued on a cryptoledger may find that what they think they possess is in fact nothing of the sort - for example, a "cryptoequity" may purport to represent an ownership interest in a company, but will only be so if it is recognized as such in the jurisdiction of the issuer's incorporation.  Extensive due diligence and legal advice are essential before entering into any such investment. 

According to Austin Brister, a Houston-based attorney, “Aside from the validity concerns, most of the foreign crypto-startups I follow should realize that they will likely be subject to U.S. Security laws, whether they like it or not.  For example, even though the SEC has taken a more and more “foreign friendly” position over the last few years, U.S. securities laws can and do frequently govern non-U.S. issuers of securities.

This means that, even if these startups did pack up and move to Sweden, they still may be subject to many securities rules administered by the SEC, including prospectus disclosures, periodic reporting requirements, and all the various protections such as insider trading, tipping, fraud, etc. 

For most of these startups, the fact that they have established a foreign home base will, at best, allow them to qualify as a “foreign private issuer.” However, this isn’t a complete “U.S. Securities Shelter” or loophole, but rather simply allows “foreign private issuers” to qualify for reduced reporting and disclosure requirements.  

Of course startups could potentially seek to remove themselves sufficiently from the United States capital markets to not be subject to its various securities laws.  Certainly, Morrison v. National Australia Bank and its progeny indicate growing resistance by US courts to exercise their extraterritorial jurisdiction in dealing with US federal securities laws.

However, many of the startups I have talked to specifically plan to target the US markets, and have considered the move overseas merely as some fictitious SEC loophole.”

Similarly, James Duchenne, an Australian attorney comments that, “an analogy that I’ve heard for the issuance of tokens to fund and, subsequently use in, a project is like buying game credits to play in a game; if the game disappears, the credits are useless. Thus the only thing to worry about, they contend, is misrepresentation and non-performance. However, it’s not that simple and following SEC v. Shavers, promoters must be extremely careful as to how they structure, issue, offer and approach their fund raising efforts, especially where in substance the scheme can be seen as a common enterprise with the expectation of profits.

As to issuing “shares of stock” in an undertaking (and worst, labeling it as such) in crypto-currency without proper compliance in the relevant jurisdiction will likely bring the wrath of local governmental agencies (and those that exert extraterritorial jurisdictions), so it’s not a good idea for a promoter or an investor to get involved in these.”
While it varies upon jurisdiction, the Howey test is one definition of a security under current US federal law.

2) Government bodies like the SEC, CFTC and FinCEN will likely prosecute those who violate the “accredited investor” statutes. 

As Byrne bluntly put it:

"[To] my knowledge, every pre-sale that has hit the market is or should have been subject to these statutes or jurisdiction-appropriate public offering rules.  To my knowledge, again, not a single one has actually complied." 

Each jurisdiction has different requirements for users to meet, and failure to do so could result in fines and perhaps worse.  Bob might think issuing a securities contract in a foreign country (like Switzerland) might mitigate this risk, but if Swiss legal formalities are not complied with and/or any of the buyers turn out to be US citizens, then the SEC may step in.  As shown by the SatoshiDice case, this is unlikely to change anytime soon.  Firms like SWARM and Moolah (and their “Pie” fundraiser) should take note.

Duchenne concurrently notes that, “playing in “securities” on exchanges like Havelock is like entering a virtual game of Russian roulette after having digested volumes of inadequate prospectus-like information. Bloated with this “intelligent” data and what passes for news on the Internet, users go around thinking they’re buying “shares” in the next Facebook. That is, until Neo&Bee happens.”

3) Bar associations and their members (attorneys) could and likely will prosecute organizations and developers for "unauthorized practice of law" (UPL). 

While this may sound anti-competitive, they have decades of both statutory and case-law to back them. As one NYC-based attorney I spoke with noted:

"There are always exceptions to the anti-trust laws such as bar associations -- and usually the only people that ever challenge it are bad lawyers.  More than likely you will get slapped with unauthorized practice if you try to do lawyerly things or give advice.  Unfortunately most people such as developers do not know anything about legal stuff so this could end badly for them."

Pamela Morgan, a Chicago-based attorney explained:

"Companies outside of the Bitcoin ecosystem - like Legal Zoom - continue to face similar UPL lawsuits. Sometimes they win.  They are basically paving the way to certainty, one way or the other, for these types of businesses.  Though the industry could fight to change the laws if companies like Legal Zoom lose the UPL cases, the more likely outcome, at least in the short term, is that start-ups in the space would become less attractive to investment due to increased legal risks.  Regardless UPL lawsuits present a real risk to those seeking to provide code based legal solutions to the public."

Continuing she notes, "Many of the organizations competing in the space have not completed business organization paperwork, thereby exposing the owners to unlimited civil liability.  Meaning the owners personal assets could be used to satisfy the debts of the organization. While it may not be easy to uncover the identities of the owners of these companies, given the right motivation (such as a government seeking taxes, another organization seeking money damages, etc.) it can be done."

Brister thinks that, “It’s important to note that, in practice, these laws focus almost entirely on the protection of the ordinary consumer. Companies like Legal Zoom are becoming more and more safe for the ordinary consumer, because the entire population is becoming more and more “do it yourself” centered, and is much more familiar with the risks and challenges associated with playing the “pro se internet lawyer.” But this is a poor analogy for cryptocurrencies, blockchain technologies and so-called “smart contracts,” because the average consumer is light years away from understanding crypto technologies, and appreciating the various risks.

In other words, just because Legal Zoom can argue that the average person can safely fill in the blanks for a pre-drafted DIY Last Will and Testament, doesn’t mean that the average person is safe in navigating the intricacies and risks associated with converting their affairs into complex algorithms, managing their assets over irreversible P2P systems, and coding their seemingly simple agreements into the proper syntax, operators, and cryptographic protocols.  Can it be done?  Sure. But I believe we are a long way out. 

However, I don’t believe bar associations will be keen to computer programmers drafting and negotiating smart contracts without being licensed to practice law, which establishes the character, fitness and competence required to step in the shoes of another person and represent them in their legal affairs.”

4) These same protocols and ledgers currently have no way to indemnify users since they often lack legal personality and cash-flow, and have no assets. 

Accordingly, recovery in the event that a given altcoin or appcoin “startup” network fails could turn out to be extremely difficult in practice.  Consequently if for example, an altcoin or appcoin “startup” does have funds, they may be able to indemnify specific users (namely exchanges) through corporate insurance (a bond).  If you plan to go down this route be sure to try and get such assurance on paper, that is standard operating procedure and this space is no exception.

Concluding, Brister explained:

“Consumer protection laws can be far reaching and quite unforgiving. Ordinary businesses do just fine in navigating these laws, even if they don't realize it, because they can adjust their interactions with consumers in "real-time" in order to be reasonable, well-centered, and act in good faith in dealing with consumers. However, the problem with smart contracts, decentralized autonomous organizations, and the like, is that they are hard-wired to act in one way, whether it makes sense or not. 

Unforeseeable circumstances practically always present themselves to businesses of all types, and by definition, these circumstances cannot be foreseen or planned for.  These systems need to adequately plan for this possibility, and be prepared to be properly insured or adequately bonded in the event things go wrong, and customers are hurt.  Similarly, consumers should be aware that they are not dealing with living breathing people, but rather a machine subject only to 0's and 1's.”

In addition, one problem with integrating blockchains and their functionality (e.g., smart contracts) into existing financial institutions is that the protocols and ledgers have to go through each of those companies internal compliance channels which takes many months and perhaps years.  For instance if something like a blockchain passed compliance checks, it would only be useful if their counterparties also had blockchains, which would mean going through other compliance venues -- yet blockchains currently do not add much value to the back end (yet) of the organizations, Citi and Goldman Sachs do not double-spend one another.

Maybe something like Secure Asset Exchange will become more commonplace once the legal issues are resolved.  But remember there are already dozens of trading platforms used by financial professionals today, thus, not only do these new smart contract-based systems compete with one another, but also seasoned incumbents.  Therefore, while blockchains could act as an intermediary in a back office for clearing and settlement or for derivatives intermediation, it may not be able to efficiently do so in a competitive environment.

Efforts like Common Accord and Bithalo may change this equilibrium. In the meantime be sure to contact an experienced legal professional before pursuing any of the aforementioned options.

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