legal money

This article is the second in a monthly column from FinTech GC Ksenia Sussman examining how the legal profession should adapt to current, and future, changes in technology.

In 2017, Munchee, a technology company that developed a restaurant review app, sought to raise $15 million through an "initial coin offering." Put simply, an initial coin offering, or ICO, is the equivalent of a traditional IPO. Munchee's ICO sought to fundraise its operations by issuance of the MUN tokens, a payment token to be used on Munchee's platform as well as traded on secondary exchanges. The MUN token was intended to incentivize activity on Munchee's social network, which it described as "Yelp Meets Instagram." The ICO sale began in October 2017.

It didn't take long for the Securities and Exchange Commission to step in and stop Munchee's ICO—and others like it. In December 2017, the SEC issued a cease-and-desist order. The SEC argued that the tokens were securities because they were "investment contracts," regardless of any utility they may serve.

The Munchee case is a harbinger of an increasingly complex and vexing challenge that lawyers face, both today and into the future. Namely, how to manage risks and provide advice to clients in a world where more and more assets are becoming digital in nature.

As lawyers, we're at a crux. Today's legal and regulatory environment is geared toward a twentieth-century economy dominated by physical assets. However, we're being called upon, particularly in the world of financial services, to provide counsel in the context of offerings, transactions, and contracts dealing in digital assets. And there's no clear framework in place—statutory, regulatory, or case law—for lawyers to fall back upon.

Pushing forward despite uncertainty is, of course, the job of a lawyer. And the challenges posed by digital assets pose an exciting opportunity. Today's lawyers, especially those early in their careers, will be at the forefront in terms of establishing the legal ground rules for tomorrow's economy. Doing so effectively, however, will require a clear understanding of the assets and technology that are driving our economic evolution.

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Digital vs. Digitized Assets

A lawyer's ability to help a client manage risk in a transaction hinges upon the lawyer's understanding of the assets at issue. For example, the implications of whether a commodity, such as oil, or a security, such as Apple stock, is at issue are pretty clear. Things can get a bit murkier in the digital world.

Apple stock is an asset that can become "digitized" by placing it on the blockchain (a means of storing and managing digital information in a public or permissioned database). Instead of signing over a physical stock certificate, a transaction can occur digitally on the blockchain pursuant to, for example, a smart contract. However, the fact that the asset was digitized does not change its nature as a security.

A purely "digital" asset presents more complexities. Bitcoin, a form of cryptocurrency, is probably the most well-known digital asset. Munchee's MUN token was also a digital asset. Rather than being a digitized form of another asset, a digital asset is one that is "born" on a network. The market for digital assets is growing rapidly, from a global market capitalization of approximately $10 billion in 2016 to over $240 billion by the end of October 2019.

The challenge digital assets pose to lawyers—and, for that matter, government regulators—is that despite their promise to revolutionize financial transactions, most don't fit neatly into existing regulatory categories.

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The Howey Test is the Beginning, Not the End of the Story

While the regulatory landscape related to digital assets is still uncertain, regulators are wading—and weighing—in. For example, in July 2017, the SEC provided some guidance on the application of the federal securities laws to the issuance of digital assets. The SEC clarified that it would apply the test outlined in SEC v. W.J. Howey Co. (the "Howey test") to determine whether a digital instrument is an investment contract, and therefore a security. The SEC explained in a Section 21(a) report that:

"[T]he federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.

Since then, the SEC has applied the Howey test in the context of ICO cases—the Munchee case, and others—but has provided little guidance on whether Howey will be applied to other digital asset classes.

The point is, there is little guidance for lawyers to rely upon when considering the regulatory classification of digital assets. Nonetheless, clients are turning to lawyers to help them manage risks in this uncertain environment. The Howey test is an important place to start, but lawyers must dig deeper. It will take time for regulators, courts, and legislative bodies to provide clear answers. Until then, lawyers must take it upon themselves to spot and assess risks related to digital assets through knowledge gained through education and experience.

As with all difficult legal problems—that is, the types of problems that general counsel like me need to solve, and often, rely on outside lawyers to assist with—there are no obvious "right" answers. But there are frameworks for considering the issues that can and should be employed. Here are some issues to consider when you're faced with a question concerning the regulatory classification of digital assets:

Digital or Digitized?: If an asset is merely a digitized form of a security or commodity, then it likely falls within the relevant existing regulatory framework. If it is purely digital, born on a network, then it's necessary to probe further.

Consult Existing Guidelines: While the SEC has not provided formal guidance, it has indicated that the Howey test is relevant in evaluating certain digital assets, such as digital coins or tokens. Accordingly, questions such as whether the asset is "sufficiently decentralized" and whether there is an "expectation of profit" are relevant. Most digital asset exchanges also provide helpful guidelines that can help a lawyer go beyond the Howey test. Understanding the technical specifications of a blockchain network is also helpful for lawyers in answering questions relating to control of the network, so lawyers should work closely with the developers and coders and learn how the network works.

Consider Analogous Scenarios: Lawyers who are helping clients navigate in uncharted waters must draw upon lessons learned in analogous scenarios to inform their advice and risk assessments in areas with little regulatory, legislative, or case law guidance. This means looking back to see how governing bodies have shaped regulatory frameworks for emerging assets in the past, as well as looking sideways to consider how trends affecting other asset classes today will impact digital assets. For example, there is a growing amount of information to draw upon to suggest how the SEC is treating ICOs. That information provides strong clues as to how the SEC will view other digital asset offerings with characteristics similar to ICOs. The SEC and CFTC have also dedicated "hubs" for FinTech related information, such as FinHub and LabCFTC. Following enforcement actions, as all lawyers should, would also shed some light on the issues, such as the recent SEC case against Kik and settlement decision with Block.one. In this space, social media, such as Twitter, is actually a relevant source of information and following current thought leaders is extremely important in order to stay on top of the issues.

This article is not meant to provide any answers as to how different classes of digital assets are or will be treated from a legal or regulatory standpoint. Indeed, for the most part such answers don't exist. What is clear is that, by asking the right questions, today's lawyers will help shape how digital assets are treated in the future.

Ksenia Sussman is general counsel at digital asset advisory firm BitOoda.