It was bound to happen. The words you had been dreading. Your major client calls you to set up a meeting about a new proposed blockchain project, and they want your guidance and advice.
Before they catch you looking like a deer in the headlights, here’s some practical advice, with the right questions to ask.
First of all, talking about a “blockchain project” is like talking about an “internet project.” It can be anything from cybersecurity, to online banking, to retail sales, to mobile applications, to photo sharing, to match-making. Really, it can be anything.
Blockchain is a technology, often referred to as “distributed ledger technology” or “DLT.” Like the internet, there are “applications” or “platforms” that run using blockchain technology. It’s not all that complicated.
So you need to find out first, what exactly do they plan to do with the blockchain technology?
There are two distinct paths this conversation can take:
- Are they planning a product or service involving cryptocurrencies, “virtual currencies”, bitcoin, or Etherium? Or, perhaps some other similar token offering? or
- Are they considering other non-cryptocurrency use cases, such as using the blockchain for supply chain management or data file sharing?
Is This Is About Cryptocurrencies or Tokens Issued on Blockchain?
The most successful and well-known application on blockchain is bitcoin, a digital asset that is issued and tracked, purchased and sold on the blockchain. These digital assets, called cryptocurrencies, get their value essentially because of public trust, a general belief in the security the system, and the ability that they can likely (there’s no guarantee of course) be exchanged for dollars, euros, and other fiat currencies through cryptocurrency exchanges around the world.
There are hundreds of cryptocurrencies or “virtual currencies” out there—though the three most popular ones are bitcoins, Etherium, and Ripple’s XRP. You can go online to a cryptocurrency exchange such as Coinbase, Binance, Bitsy, or Bitgo to see pages of cryptocurrency listings and how much they cost.
If the project involves digital assets such as cryptocurrencies, you’ll need to be familiar with seven critical regulatory issues.
Anti-Money Laundering Laws. The Financial Crimes Enforcement Network (FinCEN) issued virtual currency guidance in March 2013. Will this apply to your client’s activities? Will they need to register with FinCEN as a money services business? It all depends on the underlying facts and circumstances. You’ll need to review the FinCEN guidance and subsequent rulings carefully.
State Money Transmitter Licensing Laws. Many states require licensing for entities that issue, receive, or hold other people’s money or “monetary value.” So far 11 states have clearly expressed an intention to regulate certain cryptocurrency activities (AL, CT, GA, HI, ID, IL, KS, NC, NY, TX, and WA). You’ll need to review those laws, and also determine if perhaps an exemption applies.
Federal and State Consumer Protection Laws. These govern the “terms and conditions” that will apply to the client’s program. Are there fees charged? Have you disclosed the risks? Cryptocurrency products are considered high-risk by many state regulators. Your clients’ customer agreements and disclosures are likely to be scrutinized by regulators. UDAAP (unfair, deceptive, or abusive acts or practices) laws are likely to apply. Transparency and plain language are important.
Technology and Banking Services. The client will also need to consider how it will hold the cryptocurrencies, whether its bank will provide banking services with respect to its cryptocurrency activities, and of course it will need to contract with cryptocurrency technology providers to hold and move cryptocurrencies securely.
International Scope. Does the client want to offer the cryptocurrencies outside the U.S.? Each country has its own laws in this area. Some countries prohibit the sale of cryptocurrencies, others permit it with appropriate licensing, and others are silent on it. For a high-level summary, the Library of Congress distributes a good summary of global laws in this area.
Client’s Issuance and Sale of Its Own Token or Cryptocurrency. If the client in issuing its own token or cryptocurrency, then the issues become even more complicated. In addition to the above laws, the client will need advice on securities laws. The Securities and Exchange Commission has indicated that the sale of many tokens/cryptocurrency to the public could trigger securities laws and constitute the sale of an unregistered security. Similarly, if the client is thinking of offering futures contracts, swaps, and trades, it could trigger commodities laws. Just because your client is dealing with digital or virtual assets, that doesn’t mean U.S. securities and commodities laws don’t apply.
Client’s Acceptance of Cryptocurrencies in Exchange for Its Sale of Goods/Services. In that case, there are companies that offer this service. You’ll need to understand the terms of the offerings, whether the cryptocurrencies are converted prior to the merchant’s receipt, which party absorbs the risk of volatility. The client will also need to understand any related tax reporting issues.
Is This About OTHER Uses of Blockchain/Distributed Ledger Technology?
If this is not about tokens/coins, then what other use is your client looking for? The beauty of distributed ledger technology is that it is useful anytime you need to share valuable assets that historically required a central authority to authenticate. There has been much written about these use cases:
- Authenticated deeds and land records
- Authenticating votes, whether political or others
- Supply chain management
- Distributed payments to multiple parties
- File sharing or document sharing
One thing about blockchain use cases over the last few years is that not all use cases are ideal for the blockchain. You may want to explore with the client why they believe their use case is a good fit for blockchain technology. The World Economic Forum issued a white paper in 2018 providing some guidance on how to assess what use cases are likely to be successful on the blockchain, and which ones are not.
Once the client has determined the framework for its blockchain use case, you’ll need to consider your client’s plans on two levels.
Underlying Technology. Where are they acquiring the technology? Has the contract been prepared and negotiated? Have they considered the handling of IP rights arising from the new technology? Who will own the rights?
The open source nature of blockchain technology may impact the nature and extent of any IP or patent rights. Will the technology be monetized, and if so, how will the revenues flowing for the product be allocated? Will the work be subcontracted off-shore? Is there a service-level agreement covering the timing and approvals of the tech work? Will there be a pilot or a beta test before roll-out? What do the parties anticipate would be success criteria?
A good technology/IP lawyer can anticipate the many issues arising from blockchain technology development agreements.
The Product or Service Itself. Just because the new product or service is working on the blockchain, that doesn’t mean that the existing laws and regulations on the product or service will no longer apply. If you’re providing an app that makes global payments to not-for-profits, you’re still going to need to comply with state and federal remittance laws and money transmitter licensing laws. If the client’s use case is innovative and unusual, you might want to talk to a regulator first to get his or her perspective on how the use of blockchain might impact the overall product risks.
This is just the tip of the iceberg, but it will give you a head start to helping both you and your client move in the right direction.
Keep in mind that there are a wealth of resources that you can utilize to get greater understanding of the distributed ledger technology—such as the Global Legal Blockchain Consortium, the upcoming Consensus 2019 conference in New York City, the host of blockchain and fintech white papers, and blogs found on the internet, including https://www.fintechlawblog.com/.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Judie Rinearson, a partner in K&L Gates’ New York and London offices, concentrates her practice in fintech and emerging payments, including cryptocurrencies and blockchain. She co-chairs the firm’s global Fintech group and has spearheaded the firm’s ongoing Blockchain Initiative.