Builder and Backer/Buyer Considerations in Blockchain

I’ve spent the last few months engaging in a number of blockchain conversations. As a finance lawyer versed in structured finance and the monetization of payment streams and with prior experience at the Securities and Exchange Commission (SEC), World Bank and Barclays, I’ve been really excited to learn more about the emerging blockchain ecosystem. After attending Blockstack Berlin, events courtesy of Columbia University’s Blockchain Alliance and #Startup Columbia, NYCVC’s Blockchain Industry event at Two Sigma last week and Skinnovation, I wanted to contribute by synthesizing some of the legal dialogue and related literature and by highlighting a few non-exclusive considerations with an eye to specific stakeholders — here I focus on entrepreneurs and their financial partners.

Of course, as a practicing lawyer, I must add that this is not legal advice and these views are mine alone.

To level-set, I’m not writing to tout the virtues of decentralization or owning (much less monetizing) your identity or eyeballs in the digital age; irrespective of your assessment of Mark Zuckerberg’s Senate hearing last week or experience with crypto, the recordation of assets on public ledgers can touch all of us and it is happening (and even sovereigns are on board!). There are too many applications to highlight here but suffice it to say that every aspect of daily life stands to change if recorded on distributed (arguably trustless) public ledgers: from payment transfers initially by way of Bitcoin to property transfers by way of ‘smart contracts’ compiled on the simpler/more modular Ethereum protocol to land registries, birth certificates, art and even how we compose our thoughts and share them with each other.

So in what can sometimes feel like a rather divided time, I feel more than ever that we are uniquely positioned to work together toward a more equitable world order. That said, here are some initial considerations to think about as you engage on or off chain:

If you are a tech entrepreneur/doer/creator domiciled in the U.S. or seeking to access the U.S. capital markets: Capital raising is evolving and you are no longer limited to making promises to repay or parting with equity in order to finance your project. If you are building a ‘fat’ protocol layer à la Ethereum or an application on one such decentralized platform, issuing tokens (utility, security/protocol or otherwise) can give you a great deal of runway and won’t limit you to traditional fund partners like VCs, hedge funds or other accredited investors.

Accepting investor fiat in exchange for the promise to build a platform or application on which users will consume services (utility token) or from which users will otherwise derive value (security token) entails thinking through securities (SEC), commodities (CFTC) and other considerations including but not limited to accounting and tax implications (at issuance/sale or resale), money transmitter rules (FINCEN) and AML/KYC. I only touch on securities implications below but all are critical and running afoul of same can carry weighty fines or jail time — suffice it to say, consult your advisors.

So how do you issue coins or tokens? In October of 2017, Cooley and Protocol Labs debuted a forum and framework for token sales inspired by Y-Combinator’s SAFE, called the SAFT (Simple Agreement for Future Tokens) which quickly became the industry standard for token issuances, which issuances soon ballooned to $4BN in the subsequent 1–2 months alone. Under the SAFT framework, the actual SAFT contract is a security that’s issued to accredited (read: financially sophisticated) investors under certain exemptions from the securities laws like Regulations D, S, A or A+ (without which the issuances would be illegal), whereas the future token issued to investors is according to the authors distinct from the security and instead is a commodity (outside the purview of the SEC but within the auspices of the CFTC). In November of 2017, the Cardozo Blockchain Project and Professor Aaron Wright published a cautionary response to the SAFT highlighting in part the risk of enveloping the tokens, even if functional or commoditized, into the securities framework, since courts don’t care about the technical timing distinction between promotion (pre-token issuance) and actual delivery (post-promoter efforts) — rather, they care how the public came to learn about your token sale (marketing, promotion, promises of utility or financial gain) and what expectation investors had when deciding to invest.

There is a host of thoughtful literature on how the SEC is (and should be) exercising its mandate of protecting the retail investor (maybe you, definitely me) from losing their shirts on token sales, including this comprehensive year in review analysis and look ahead so I won’t regurgitate that here but the key takeaway is that the U.S. legal framework for capital raising prizes substance over form so it looks to both what you are selling and how you’re selling. Recently they’ve found some token sales to qualify as securities insofar as they amounted to an investment contract that promised a profit, which profit turned on the efforts of a promoter or third party. This is what folks refer to as the “Howey Test” (see the SEC’s recent DAO report and cease-and-desist order ahead of the Munchee coin issuance, each citing the Howey test to find the respective tokens qualify as securities). Again, there is reasoned disagreement as to whether the investment scheme or SAFT itself is the only security or whether the subsequent token to use the network or app also qualifies, but even if you comply with the securities laws in either issuance, you still have commodities (including heightened scrutiny if the SAFT falls outside the CFTC-mandated 28-day physical delivery forward contract exemption and becomes a “swap”) and other regulatory hurdles ahead.

In summary, civil and criminal penalties can attach to securities, tax or other regulatory breaches, which can in turn render folks bad actors in the eyes of regulators and consequently bar them from serving on boards or running companies so it makes sense to consult with experts here so you can keep building.

If you are an investor or related token ‘participant’: Whereas the 1933 Securities Act concerns itself with initial securities offerings and was designed to “prohibit deceit, misrepresentations, and other fraud in the sale of securities”, the 1934 Exchange Act regulates the trading of securities and all those involved — including marketers, brokers and other market-makers, which can include investors. Liability can attach to investors by way of participation in an initial coin offering or subsequent resales if non-compliant: for instance if conspiring to defraud other investors, for soliciting investors to purchase unregistered securities, for failure to disclose compensation for any token endorsements or for reselling without a proper safe harbor or exemption.

In its 2014 cease and desist order against Erik Vorhees, the SEC found shares in websites ‘SantoshiDICE’ and ‘FeedZeBirds’ to be unregistered and un-exempt securities and Vorhees’ prospectuses and solicitations of investors in same to violate the securities laws. In a more recent 2017 statement, it cautioned celebrities and other promoters against participating in coin offerings without disclosing the full nature and amount of compensation earned for doing so. Depending on the nature of your participation (are you simply writing a check or are you advertising an offering to your network?), clout and ability to mobilize followers to co-invest with you, regulators (federal or state) might not look favorably on your involvement in a token sale.

In keeping with the tenets of a free, truth-seeking market, resellers or investors exiting tokens, to the extent they acquired them privately in reliance on one of the initial issuance exemptions like Reg D or Reg A(+), are also subject to resale restrictions when exiting coins — so the 81 or so accredited investors in the $1.6BN Telegram ICO are subject to resale restrictions should they trade out of their positions.

I know there are lots of other builders and facilitators in this space for whom considerations might differ — if you’re a separate stakeholder and want to connect, I’d love to learn what you are up to and how you’re moving ahead contributing to this exciting and collaborative community. What are your worries? What do you want to learn more about? What upcoming events are you most excited to attend?

You can reach me here and @irinamarinescu.

Special thanks to Brittany Laughlin and Kishan Shah for reviewing this post.