If you’re looking for a financial regulation blog, stop here. There’s lots being written on that topic from regulators themselves, people drafting proposed regulation, administrative law experts who believe blockchain will die on that peculiar hill, and by friends and colleagues of mine. I’m talking about blockchain law as an area of instruction, an area of practice, and an area of urgent concern. If you’re still interested, read on.
Blockchain Law: A Much-Needed Area of Instruction
My law students in past years had thought my interest in blockchain was amusing, even funny. When I presented a slide on Ethereum in 2016, a student quipped that this was in the context of how startups could raise money, and selling digital assets for working capital was an unrealistic, futuristic fantasy. A year later, startups were raising money on the Ethereum network through ICOs, and students were suddenly interested in blockchain law.
Graphic Credit: Cointelegraph
Another thing happened in 2016. That autumn, I was reviewing the Innovation Management course that I teach at Northwestern (many students who take this course end up on “innovation teams” at top companies or go directly to work for startups), and I included on that syllabus a Harvard Business Review piece by Erica Dhawan aimed squarely at C-level executives and provocatively titled “Why Your Innovation Team Needs a Lawyer.”
Graphic Credit: Harvard Business Review
Through this article, my students realized the importance of having a lawyer on an innovation team, especially when it comes to blockchain companies.
Many blockchain companies are essentially untethered innovation teams with no parent company. The supervisory company relationship is instead a relationship with exchanges, investors, ecosystem core developers, and others who place boundaries (technical, financial, governance, etc.) around what the blockchain company (or, alternatively, “project”) can do. Everything else is fair game and can be — and should be — attacked with maximum entrepreneurial zeal, hence the need for a lawyer who’s familiar with a range of issues, including contracts.
Blockchain Law: Are Smart Contracts Even Contracts?
The problem with blockchain law is that it isn’t an area of law; it’s a collection of issues that breach every boundary and taxonomy we who teach at law schools imagine. I was honored to spend some time last week with Joshua Klayman discussing legal issues that arise in the blockchain space, and she appreciated this class of questions at a level I rarely see among either scholars or practitioners. The idea of “blockchain law” is a radically interdisciplinary legal area, and the question of whether tokens are securities is only the beginning.
Take so-called smart contracts, for example. Most people with legal training in the blockchain space actually hope that smart contracts aren’t contracts.
The realm of contracts — jurisdictio ex contractu — is a messy place that runs conceptually counter to many of the principles and ideals of the smart contract. First of all, in the United States, all contract law is state law, meaning there could be dozens of ways the same smart contract is interpreted when a party wronged by breach pleads for relief. Worse, smart contracts may or may not contain venue and dispute resolution provisions that, ahem, “less smart” contracts written on paper often contain.
Even if these contracts improve, they may themselves be securities in some jurisdictions. In other cases, they may be option contracts. The post-ERC20 implementations (or “v2.1 and v3 blockchains,” as many of us have taken to referring to them) have even more complex ways to trigger and phrase (IOTA and 223, respectively, for instance) contractual concepts like recourse, indemnity, reimbursement/claims, liquidated damages, and so on. And the complexity doesn’t stop there.
Some of the smart contract forms recently discussed allow the drafter to specify how goods are delivered, on what timetable, in what condition, and by what means of transit. Under some countries’ laws, that immediately makes this type of smart contract a bill of lading. In other jurisdictions, if it lists the goods to be transported but does not state payment terms, it’s merely a manifest. Still, in other jurisdictions, it may be an option contract if it could also facilitate the purchase of the cargo in question.
And current-implementation smart contracts are merely a county on the blockchain continent.
The Boilerplate ICO’s Rise and Fall: A Need for Lawyers Familiar with Blockchain
From contracts to property to sales (Article 2) to secured transactions (Article 9) to administrative law to civil procedure to federal courts to various intellectual property courses, it’s hard to think of an area of law untouched by the business plan (or product plan) of the typical blockchain entrepreneur. And blockchain businesses are not unique in this regard — most technology startups require combinations of legal skills and theories typically segregated from each other by a law school’s curriculum.
The problem this presents is twofold: 1) young lawyers (the ones most likely to work for startups and most likely to fit a startup’s budget) have essentially no exposure to crucial issues the project or company is likely to face early on in its trajectory, and 2) entrepreneurs are forced to choose between affordable and effective legal counsel on critical issues that may have appreciable impacts not only the company’s current operations but also its future liabilities.
Perhaps no example better illustrates this than the ICO mania of Q1/2018. FRST is not ICO-funded, but the founders were approached during this period by multiple opportunistic attorneys who claimed to have an “ICO in a box” that would raise “millions of dollars.” These were not “ICOs in a box”; instead they were — in many cases — dangerous offering packages wherein entrepreneurs with no legal training were encouraged to engage in cut-and-paste exercises within complex documents.
Sadly, many less literate entrepreneurs in the blockchain space made ICO offerings using documents they had failed to read or understand. I have heard, firsthand, people say, “so-and-so lawyer says my token isn’t a security,” entirely oblivious to the reality that no attorney can know with certainty the status of a given financial instrument (attorneys can give advice on this matter but cannot make decisive determinations) and a contract saying the sky is green does not make it so.
Other entrepreneurs had documents drawn up by competent counsel but failed to listen to (or affirmatively ignored) warnings regarding selling tokens to US persons; failed to conduct even the most rudimentary diligence as to buyers’ identities or reputations; or failed to adhere to standard procedures in documenting the sale of an item (whether that item is or is not a security), such as retaining copies of the executed purchase and sale agreements or offering agreements in case they’d be needed later.
Still, others hired less competent, overly junior, or more flimsily-vertebrae counsel who they pressured or paid into drafting documents that met fundraising needs but lacked the safeguards and typical pieces of language more experienced and principled attorneys would have used. In several cases, it’s likely the entrepreneurs involved violated state or federal laws by using these documents and likely the attorneys involved may be subject to disciplinary action for the roles they played.
Navigating Blockchain Law: Use Experienced Counsel
Perhaps the ICO mania of 2018 ERC20 was a one-time blip, perhaps it wasn’t.
But as startups and projects in the blockchain space grow, they’ll need able, experienced counsel to deal with a range of issues, regulatory authorities, and jurisdictions. Due to the fast-moving nature of the space and the international orientation of blockchains, entrepreneurs are likely to encounter complex legal issues earlier in the company’s journey than in more traditional areas of innovation. The heightened degree of scrutiny blockchain companies are subject to in many jurisdictions means the decisions made are higher stakes than the legal choices a typical early-stage venture might make, and the cost of regulatory noncompliance may be a fatal wound to a startup’s credibility, financing, or both.
It astounds and worries me that so many promising blockchain projects and companies have no legal counsel or only seek the assistance of counsel once things have already gone wrong. It also concerns me that so many young attorneys with little transactional experience, limited understanding of regulatory structures or regulatory authority, and no experience navigating areas of fundamental taxonomical uncertainty (“is this a security?” “might this be consumer fraud?”) are taking senior roles advising these projects or promoting themselves as “blockchain experts” while having spent less than a year in the space. The professionalization and evolution of the space is not helped by a chorus of minor league experts struggling to reach harmony; there’s still heavy lifting to be done.
If you run a crypto project or company and have not thought about legal or compliance seriously, or are convinced that the SEC, CFTC, IRS, or others have “bigger fish to fry,” or are relying on hand-me-down form documents you received from other blockchain entrepreneurs in the space, or from an “expert” you met at a local hacker meetup or shared workspace, you may want to think more deeply about your project or company’s position. This is a terrible stage, industry, and area to cut corners and save pennies. The only way blockchain firms will crawl over the popularization curve and begin climbing the professionalization curve is to have “A-Team” people involved directly with senior management who identify and tackle issues before they become problems.
Karl T. Muth is the CEO of FRST and an expert in financial regulation and markets rule-making; his comments on these topics have been cited in law review articles, in Congressional debate, and by the Commissioner of the SEC. He holds teaching appointments at Northwestern University in economics, law, organizational behavior, public policy, and statistics and teaches an advanced course at Northwestern’s Pritzker School of Law that discusses unconventional financing instruments, venture capital, venture debt, salvage/insolvency/vulture scenarios, and the purchasing of distressed assets. FRST recently hired Jana Krupoff as its General Counsel; Jana is a fintech and intellectual property expert who has held in-house counsel roles at Citadel, Northern Trust, and Omnium. This blog is not legal advice; if your project or company has or may have legal problems, you should consider retaining counsel and discussing the problems you see or suspect.