Game-Changing Technology Of Cryptocurrency

Cryptocurrency 2018: When The Law Catches Up With Game-Changing Technology

Blockchain technology and the virtual currency, or cryptocurrency, that uses this technology are revolutionizing the way businesses function and deliver goods and services. Even as cryptocurrency becomes a widely debated topic, gaining the critical attention of regulators and policymakers, individuals and businesses are investing billions of dollars in cryptocurrency annually.

To understand how blockchain and cryptocurrency may impact you, your business, and your industry, it is important to understand what cryptocurrency is and how the underlying blockchain works. This article provides a brief introduction to these concepts as well as a primer on cryptocurrency legal issues.

Blockchain and Cryptocurrency

In short, blockchain is a digital, decentralized ledger that uses software algorithms to record all transactions distributed across a peer-to-peer network. Using blockchain, or “distributed ledger” technology, users can confirm transactions without the need for a central certifying authority, such as a central bank. Each party, or “node,” participating in the blockchain network maintains a copy of the distributed ledger and acts as a “witness” to each transaction. The “transparency” of the transactions is a cornerstone of the technology. The transactions are grouped into “blocks,” validated, and then added to the shared ledger.

While blockchain is the foundation of cryptocurrency, it has other uses. The potential applications of blockchain reach far beyond cryptocurrency. Various industries, including financial services, healthcare, retail, and the public sector, are exploring, developing, or already using the technology. Blockchain brings enormous promise; the transparent and immutable system is touted as safe from fraud, identity theft, tampering, and (at least initially) political control.

Despite blockchain’s other practical uses, cryptocurrency is in the spotlight. Cryptocurrency offers a peer-to-peer payment option that allows users to securely send or receive electronic payment. Cryptocurrency is decentralized digital currency secured through encryption techniques to control the creation of monetary units and to verify the transfer of funds.[1] Unlike traditional currencies, cryptocurrency eliminates the role of a third party to process electronic payments. Because cryptocurrency is permanently recorded on a digital ledger using blockchain, all transactions are recorded and visible to all users, prohibiting third parties from tampering with payments.

Broad adoption of the technology has fueled the use of cryptocurrency to fund businesses and investments, leading to the creation of cryptocurrency exchanges, which allow people to buy, sell, and transfer cryptocurrencies. Today, billions of dollars are traded in cryptocurrency. Despite this incredible volume and rapid growth, there is little regulation and oversight. We are only beginning to see litigation, enforcement, and regulation in this blossoming industry.

Legal Issues in Cryptocurrency

A critical distinction will be whether cryptocurrency coins or tokens are securities that should be regulated by the Securities and Exchange Commission (the “SEC”). This issue has received exposure in recent months due to the growing use of cryptocurrency in Initial Coin Offerings (“ICOs”). Similar to an initial public offering, companies use blockchain to issue customized cryptocurrency coins or tokens in exchange for other established cryptocurrency, such as Bitcoin, to raise capital. If cryptocurrency tokens are considered securities (a hotly debated topic), then they must be offered and sold in the U.S. or to U.S. investors in accordance with U.S. securities laws.

The SEC’s Investigative DAO Report And Latest Guidance In July 2017, the SEC released its investigative report on the Decentralized Anonymous Organization’s (the “DAO”) coin offering.[2] The SEC concluded that the facts and circumstances of a particular ICO determine if it is a security. The SEC analyzed whether tokens issued by the DAO constituted “investment contracts” under the United States Supreme Court’s long-established standard in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). Under this test, an investment is a security under the Securities Act of 1933 and the Securities Exchange Act of 1934 if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived primarily from the entrepreneurial or managerial efforts of others.[3], [4]

While the SEC concluded that the DAO tokens constituted unregistered offerings of securities, it declined to bring an enforcement action, instead issuing its investigative report (the “Report”) as an advisory opinion. While the Report does not classify all ICO token offerings as securities offerings, it serves as a warning to new and existing coin offerors and paved the way for private litigation.

The SEC offered additional caution to the ICO market on December 11, 2017 when it issued a cease and desist order to Munchee Inc., a smartphone app developer that sold digital tokens to raise funds (the “Munchee Order”)[5] , and Jay Clayton, the SEC Chairman, released a “Statement on Cryptocurrencies and Initial Coin Offerings” (the “Clayton Statement”). [6], [7] The Munchee Order emphasizes that the SEC will apply the facts and circumstances analysis under Howey to ICOs irrespective of token labels or classifications by offerors. Similarly, the Clayton Statement scrutinizes the characterization of tokens and includes an example for when token use may not be considered securities. Through this latest guidance, the SEC has clearly signaled its intent to monitor the ICO market and proactively enforce securities regulations.

Litigation - Class Action Lawsuits

As the popularity of cryptocurrency grows, important questions about how to properly categorize cryptocurrency within the existing U.S. regulatory framework need to be answered. Recently filed class action lawsuits against alternative coin startups may be the first cases to clarify what cryptocurrency is and how it should be governed.