Morris Manning & Martin, LLP

An Introduction to Blockchain Technology and its Legal Implications

10.03.2017

What is a Blockchain?

A blockchain (or distributed ledger) is a peer-to-peer distributed and public (or private/permissioned) immutable ledger that maintains a record of all transactions occurring on the ledger. Such records are saved in a chain of units called blocks. In most blockchains, each new block contains cryptographically hashed data and is built upon the previous block in the chain, enabling the data in the blockchain to be trustworthy. Digital signatures (e.g. in the form of the private key of a public key/private key pair) are commonly used to enable identification of a participant in the transaction. In a proof-of-work model, the computing power needed to support the distributed ledger is generally provided by the users/miners, which are often paid small amounts of the applicable cryptocurrency for their efforts.

Much of the promise in blockchain technology (or distributed ledger technology) arises due to its ability to solve two common computer science challenges: (1) the Byzantine General’s Problem, and (2) relatedly, the double-spend problem. The Byzantine General’s Problem is solved through the consensus mechanism of the blockchain. Different blockchains often use different mechanisms for reaching consensus within the network, such as proof-of-work and proof-of stake. The double-spend problem is solved by announcing all transactions across the network (or publicly) and having a system for participants to agree on transactions and their sequence within a network (i.e. reach consensus). For a more detailed overview of the underlying technology, consider reading the original Bitcoin white paper available here.

What Does Blockchain Technology Enable?

In general, blockchain technology enables the decentralization of the movement and management of data and digital representations of assets or other value. More specifically, due to the distributed nature of a blockchain and its ability to enable trustable transactions between computers through its distributed consensus mechanism, blockchain technology enables the authentication and settlement of transactions without centralized intermediaries or authorities.

We rely on intermediaries and centralized authorities (e.g. governments, banks, payment networks and technology companies) to provide trust within a network or system. With blockchain technology, many of these intermediaries can now be replaced with software running on a distributed, decentralized network of computers (normally, the computers of the participants in the network). A “smart contract” at the center of the network can encode and enforce the governance structure agreed upon among the community of participants.

What are the Primary Benefits of Blockchain Technology?

As further exemplified by the use cases below, the ability to decentralize a trustable network enables, among other things: (1) a significant decrease in operating costs, (2) an increase in the security of data, (3) if desired, an increase in the transparency of transactions, and (4) the creation and maintenance of immutable records. Costs are significantly reduced by removing intermediaries from transactions, creating a trustable database devoid of the need for further reconciliation across the network, and minimizing the cost of running the network to the cost of computing power and maintaining the software providing the governance. This allows the value created by network participants to be captured by those participants, as opposed to the intermediary at the center that has traditionally been tasked with ensuring that each participant is behaving in accordance with the governance structure of the network.

Blockchain technology enables a much greater degree of data security built into the technology itself than exists where centralized intermediaries are responsible for securing and protecting large amounts of participant data. Given the distributed, decentralized nature of the network, there does not need to be a central database or other repository storing personal or proprietary information. While records of transactions may be publicly broadcast, more sensitive information can be encrypted or remain “off-chain”, as appropriate. On-chain records are also immutable, which means data (e.g. historical transaction information) cannot be fraudulently altered.

What are Token Sales (ICOs)?

One of the most prevalent applications of blockchain technology and cryptocurrencies today is the use of token sales (commonly referred to as Initial Coin Offerings or ICOs). In a token sale, a person or entity creates a cryptocurrency token (commonly in the form of ERC20 tokens on the Ethereum blockchain) to sell to the market to raise capital for some purpose, such as building and supporting the underlying solution that the token supports. The token may have different types of use cases within the solution, such as being used as the exclusive medium of exchange for transactions within the solution (e.g. Storj), acquiring influence within the community (e.g. Steemit), or representing an ownership interest in a digitized asset (e.g. Tether and Orebits).

Token sales generally allow companies to avoid giving up equity in their company to raise capital for growth, but the creators of the project are often giving up a share of their interest in the solution itself. More successful token sales are generally structured in a way that drives the value created by the solution back to the token holders and not just to the company or organization that created it (with the company often participating in the financial upside of their solution’s success through retaining a significant number of the tokens).

What are Smart Contracts?

Another innovation blockchain technology enables is the use of “smart contracts.” A smart contract is a computer protocol intended to facilitate, support or enforce the performance of a contract. For example, smart contracts can (1) manage agreements between users within a network, (2) serve as 'multi-signature' accounts, so that a transaction is authorized only when a designated number or percentage of participants authorize it, (3) provide utility to other contracts in a manner similar to how software libraries often work, or (4) store information about an application, such as user records. Sets of smart contracts often work together to achieve different parts of a desired outcome or process (e.g. one smart contract handles payments and another handles identity management).

Smart contracts can take different forms. A smart contract could be as straightforward as taking a traditional contract and incorporating computer executable code into the agreement where appropriate (e.g. conditional payment terms), while retaining plain English for the rest. For example, if the agreement has payment obligations tied to the occurrence of a specific event (a date, deliverable, etc.) then the smart contract could include executable code that executes such payment upon the occurrence of the specified event. The executable portion of the contract would be run in a manner that enforced such terms, so that the appropriate payment would be automatically made when the corresponding event occurred (perhaps by initiating an ACH pull from a designated account or a transfer of a cryptocurrency held in escrow or a specified account).

Smart contracts could also take the form of computer code only. The most prevalent example of such smart contracts would be those that run on top of the Ethereum blockchain. Such smart contracts are Turing-complete, supporting a broad set of computational instructions. Many recent token sales leverage Ethereum smart contracts to create and govern the token being sold. The smart contract (or set of smart multiple smart contracts) often creates the governance structure governing the token and the network within which the token operates, allowing for decentralized governance established and enforced by the smart contract.

Examples of Use Cases

The number of use cases for blockchain technology is remarkably open-ended. Blockchain technology has the ability to not only change the way we organize current networks, systems, marketplaces and ecosystems, but will also enable completely new business models and organizational structures that were previously impractical or impossible. Below are just a few use case examples currently in the marketplace or being developed.

Payments (Bitcoin)

Currently, the most well-known use case for blockchain technology is as a currency/medium-of-exchange to be used for payments. Bitcoin is one example, but there are also other cryptocurrencies designed primarily for use as a medium of exchange, such as Litecoin and Monero. At its core, Bitcoin is just a ledger of transactions and their sequence. The ledger tracks every transaction that has ever been made on the Bitcoin blockchain. Due to each new block leveraging cryptographically hashed data and being built upon the previous block in the chain, together with the underlying consensus mechanism, each transaction recorded on the blockchain can be trusted as accurate and legitimate. To send or receive bitcoin, both sender and recipient must have a wallet (i.e. software connected to the Bitcoin blockchain). When a participant directs the network to send bitcoin from its wallet to a recipient’s wallet, the software (together with the miners) ensures that the sender is using a valid private key and has the bitcoin in the wallet to send.

Social Media (Steemit)

Blockchain technology enables social media users to interact with each other without a centralized intermediary. One example is Steemit, which is similar to Reddit and Medium. As opposed to having a centralized authority in the middle that governs the network and captures the value created by participants (e.g. advertising revenue), a smart contract sits between participants, and the participants are able to capture the value created by them. If someone wants to promote a post or advertise to the community, they can pay for such opportunity in the native cryptocurrency. On the other side, content creators and users are rewarded with the same cryptocurrency proportionally to their contributions, as defined by the agreed upon governance structure encoded into the smart contract at the center of the platform. Accordingly, content posters that receive a high number of upvotes are compensated for their contributions.

Data Storage (Storj)

Blockchain technology also enables decentralized cloud storage, where individual participants within a network can buy and sell cloud storage space from one another, as opposed to buying from a centralized cloud storage provider. Sellers can rent out their available storage space to buyers. The smart contract/protocol at the center of the marketplace governs the community and enables the sharing of storage space. Buyers and sellers may transact in the native cryptocurrency created for the platform. The stored data is encrypted in a manner that prevents the seller from accessing or viewing the buyer’s data. The data is also often “sharded” and multiple copies of each piece (or shard) are stored on multiple hard drives to increase the likelihood the data is accessible if one or more of the applicable sellers is offline when a buyer wants to access their data.

Sharing Economy (Arcade City)

Blockchain technology enables the decentralization of various sharing economy business models. For example, Arcade City is creating a decentralized version of Uber. Whereas Uber provides the software, identity management, data management and analytics, and other services in connection with its solution (and takes a meaningful portion of the proceeds from transactions in exchange for doing so), a decentralized ride-sharing service could solve those challenges through a set of smart contracts on a blockchain, enabling all of the same services to be provided without the intermediary. The core software could be recreated on a blockchain, identity management and the reputations of drivers and riders can be managed through smart contracts, payments can be made through cryptocurrency within the same platform for minimal cost, and driver and rider data can be removed from centralized databases and controlled by the participants themselves. This could enable a ride-sharing service where the driver and rider recapture the centralized firm’s share of the transaction revenue, driving down costs for riders while increasing revenue and profitability for drivers.

Digital Rights Management (SingularDTV)

Another area that blockchain technology is poised to disrupt is the distribution and protection of certain kinds of intellectual property, particularly digital media such as music, movies, and books. In general, media distribution currently relies on large and powerful media companies and distribution channels to deliver content and defend intellectual property rights from infringement and misappropriation. Blockchain technology enables control and monetization of digital rights at a more granular level. For example, a musician could include their music on a blockchain. The blockchain, together with other software, can encrypt and protect the data to limit unauthorized access and use. The same blockchain could also handle micropayments directly between musician and the consumers that listen to their music, mitigating the need for musicians to rely on intermediaries to distribute their music.

What are the Primary Legal Implications?

A new technology itself is generally not something that is prohibited or restricted by regulators (at least not in the United States and many other jurisdictions). It’s the use cases of a new technology that often run into regulatory constraints or restrictions. The same is true for blockchain technology and cryptocurrency. Laws and regulations relating to blockchain technology and cryptocurrencies can be divided into two categories: (1) enabling and (2) prohibitive. An overview of some of the primary laws, rules and regulations impacting blockchain technology and cryptocurrency use cases is provided below. 

Enabling Legislation

There is certain legislation (both in the United States and internationally) that enables blockchain technology to be more fully utilized for all of its various use cases. One example is digital signature enabling legislation. Subject to certain exceptions (e.g. consumer loan documents), digital signatures are generally recognized as a valid signature throughout the United States and many jurisdictions throughout the world. This allows smart contracts to authenticate and validate transactions in a legally binding manner and also allows private keys and other digital signatures to be recognized as a valid form of signature.

Another example of enabling legislation is the recent legislation enacted in the State of Delaware that authorizes companies registered in the state to issue and trade shares/securities on a blockchain. While this single step is arguably more of a clarification of existing laws than an overhaul of the existing legal framework, this type of legislation provides certainty to the marketplace that leveraging blockchain solutions in connection with the issuance and management of securities (which should enable efficiency and transparency benefits) is legitimate and legally authorized.

Prohibitive Legislation

On the other hand, most laws, rules and regulations prohibit or restrict certain types of activities, or require certain actors to behave in a certain way. Several such existing regulations apply to blockchain technology and cryptocurrency, depending on the specific nature of the use case. The primary areas of law impacting blockchain technology and cryptocurrency are as follows:

Securities Law

Many blockchain use cases, particularly token sales and other issuances of cryptocurrency, potentially implicate U.S. and international securities laws. In the United States, the primary test for whether or not something is a security (or investment contract) is called the Howey Test. The Howey Test provides that the thing being assessed (e.g. a token) is a security if three elements are met: (1) there is an investment of money, (2) in a common enterprise, and (3) an expectation of profits predominantly from the effort of others. Whether or not each of these three elements is met often depends on the specific facts and circumstances of the item being offered. Additionally, there is a robust body of case law that further informs and clarifies what each of the three above elements mean and encompass.

If the item (e.g. token or cryptocurrency) being offered is a security, then there are certain requirements that must be met before such item can be lawfully sold. The scope of these requirements also depends on the type of securities offering. For a completely unrestricted issuance, the securities must be fully registered (much like the securities of publicly traded companies), and there are various ongoing disclosure and reporting requirements tied to such securities. For less administratively burdensome offerings, different types of exempt offerings may be available, which generally include restrictions on the types (e.g. accredited or international) and number of investors (e.g. no more than X non-accredited investors). Exempt offerings generally require fewer disclosures and fewer ongoing reporting requirements. Companies or organizations considering a token sale or other issuance of cryptocurrency should consider the securities law implications of their planned offering and, if such offering is deemed to be a security, the most effective way to carry out a lawful offering.

MSB/Money Transmission Laws 

Subject to certain exceptions, money transmission (and more broadly, money service business) laws, rules and regulations generally apply where an intermediary is involved in the movement of money or value between two third-parties. Many blockchain solutions and cryptocurrency platforms arguably fit this description, particularly after accounting for the guidance provided by the Financial Crimes Enforcement Network (FinCEN).

The FinCEN guidance states that an “administrator” or “exchanger” that (1) accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN's regulations, unless a limitation to or exemption from the definition applies to the person. An “exchanger” is a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency. An “administrator” is a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency. FinCEN went on to state that a “person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter. In addition, a person is an exchanger and a money transmitter if the person accepts such de-centralized convertible virtual currency from one person and transmits it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency.”[1]

Almost all U.S. states have their own comparable regulatory regime designed for the purpose of consumer protection where otherwise non-regulated financial services providers are controlling consumer funds. The European Union and other jurisdictions have similar regulatory frameworks. Additionally, many states are adopting similar cryptocurrency-specific legislation, such as the BitLicense in New York. Each blockchain company or initiative, especially those involving the issuance, administration or exchange of cryptocurrencies or other digitized assets, should consider the applicability of these laws, rules and regulations to their operations.

Tax Regulations

Some blockchain technology use cases, such as token sales, have interesting tax implications. For token sales where the token is not a security, the proceeds of the sale will generally constitute some form of revenue (e.g. deferred revenue). Accordingly, a successful token issuer could be left with a substantial tax bill following a sale. Each company considering a token sale or other similar use case should consider their available options to mitigate the tax burden, such as organizing the company in, and conducting the sale from, a jurisdiction with more favorable tax rates. For example, Ethereum organized in Switzerland prior to conducting their token sale in order to benefit from lower corporate tax rates.

Additionally, the IRS currently classifies bitcoin and other cryptocurrencies as “property” and not as a currency. Accordingly, individuals and organizations receiving, holding, or otherwise transacting in cryptocurrency are required to account for fluctuations in value. For example, if a company receives $1000 in bitcoin for payment for their product and the company exchanges the bitcoin into U.S. Dollars after bitcoin has appreciated 50% in value, then the company will have $500 in capital gains due to bitcoin’s appreciation, in addition to any tax burden from the $1,000 sale of their product.

Blanket Restrictions Generally

While the United States has not gone so far as to completely ban certain blockchain-related technologies or use cases altogether, other jurisdictions around the world have taken such actions. For example, China recently banned all token sales, as well as the ability to operate a cryptocurrency exchange. Other jurisdictions have at times banned or restricted use of bitcoin and other cryptocurrencies. Anyone considering a blockchain-related initiative (particularly a token sale or other cryptocurrency issuance) should pay close attention to the various restrictions and prohibitions around the world.

Summary

Blockchain technology and cryptocurrency represent a potential paradigm shift in the way we transact with each other and how we organize. The number of potential use cases, both in place of existing business models and those never before considered possible, is wide-ranging and open-ended. Many commentators have suggested that this new technology could have a greater impact than the creation of the Internet and recent activity around blockchain technology may suggest that they are correct.

At the same time, these new and innovative use cases present interesting and novel legal challenges, particularly relating to securities law and applicable financial regulations. Each company or organization pursuing a blockchain-related initiative should be familiar with the regulatory framework applicable to that initiative. Additionally, due to the rapid growth of the industry, we can expect to see new regulations (and clarifying guidance on existing regulations) emerge over the next few years as lawmakers try to catch up with the disruptive change being brought about by blockchain technology.


[1] Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, FIN-2013-G001, Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (2013), https://www.fincen.gov/resources/statutes-regulations/guidance/application-fincens-regulations-persons-administering.