Legal Issues for Lawyers Advising Clients Involved in Blockchain Technology

Presented by: James Cox

Clear Law Institute | 4601 N. Fairfax Dr., Ste 1200 | Arlington | VA | 22203

www.clearlawinstitute.com

Questions? Please call us at 703-372-0550 or email us at [email protected] All-Access Membership Program

● Earn continuing education credit (CLE, CPE, SHRM, HRCI, etc.) in all states at no additional cost ● Access courses on a computer, tablet, or smartphone ● Access more than 75 live webinars each month ● Access more than 750 on-demand courses Register within 7 days after the webinar using promo code “7member” to receive a $200 discount off the $799 base price. Learn more and register here: http://clearlawinstitute.com/member Clear Law Institute, © 2018

LEGAL ISSUES FOR LAWYERS ADVISING CLIENTS INVOLVED IN BLOCKCHAIN TECHNOLOGY

James A. Cox

DISCLAIMER

This presentation should not be considered or construed as legal advice on any individual matter or circumstance. The contents of this document are intended for general information purposes only and may not be quoted or referred to in any other presentation, publication or proceeding without the prior written consent of Jones Day, which may be given or withheld at Jones Day's discretion. The distribution of this presentation or its content is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of Jones Day.

TABLE OF CONTENTS

1 Cryptocurrencies

2 Introduction to blockchain technology

3 Smart code and smart contracts

4 Applications of blockchain technology

5 Legal and ethical issues

1 Cryptocurrencies

CRYPTOCURRENCY

• Virtual currency intended to fill same role as government currencies • Peer-to-peer electronic cash system • Not backed by any government • Bitcoin first decentralized cryptocurrency • Created in 2009 by Satoshi Nakamoto

CRYPTOCURRENCY

Bitcoin Price Chart

CRYPTOCURRENCY

Source: https://www.shutterstock.com (ID 670354525) 7

CRYPTOCURRENCY

• Market Capitalization: Approximately $215 billion as of November 8, 2018 • Daily Trading Volume: Approximately $10-20 billion • Largest by market cap: • Bitcoin ($112B), Ether ($21B), Ripple ($20B), Bitcoin Cash ($10B), EOS ($5B), Stellar ($5B), Litecoin ($3B), Cardano ($2B), Monero ($2B) • Still small in comparison to other metrics • Daily Trade Vol.: USD ($4.4T), EUR ($1.5T), CLP ($12B) • Mkt. Cap.: Apple ($1T), Alphabet ($839B), Microsoft ($877B)

CRYPTOCURRENCY

• ICOs have become popular form of raising capital to start-up companies • Over $5 billion raised last year; surpassed that this year • Companies issue digital coins that carry some rights • Investors pays in the form of an established cryptocurrency such as Bitcoin or Ether • Large capital raises: Tezos, Filecoin, Bancor Protocol • Legal gray area

2 Introduction to blockchain technology

CENTRALIZED SYSTEMS

Bank Ledger

• A central intermediary (e.g., a bank) transfers actual value between two parties and is normally the final authority • All parties involved in a transaction may keep and use their own copies of ledger, but the local copy isn’t authoritative • There is a single point of failure: • if a centralized ledger is lost through IT failure, physical disaster, malware attack, etc., information is lost due to the single point of failure

CENTRALIZED SYSTEMS

Bank Ledger

• Typical examples of centralized databases are relational databases we are all familiar with • Centralized databases may themselves be distributed for redundancy and efficiency purposes without changing their centralized character • The point of difference is whether there is a centralized network participant with unique validation or authentication responsibilities different from ordinary participants

DISTRIBUTED (DECENTRALIZED) SYSTEMS

• Each network participant has its own copy of the ledger • Every local copy of the ledger is authoritative • No central point of failure or attack • Key challenges: • All transactions must be sent to all participants for updating their local ledgers • All copies of ledgers must remain consistent

DISTRIBUTED (DECENTRALIZED) SYSTEMS

WHAT IS A BLOCKCHAIN?

• A blockchain is a way of recording a continuous stream of data packets • Example: – The flow of transactions in a financial system – Each transaction reflects some underlying simple operation, such as “A transfers 1 BTC to B” • The transactions are collected into similar-sized blocks • As each is generated, the blocks are recorded serially in some storage medium (memory, disk) • Each block includes a link to the immediately prior block, creating a chain

WHAT IS A BLOCKCHAIN?

• At their core, blockchains are very simple. • A data structure • Linking blocks of data into a chain has been well understood for decades • Satoshi Nakamoto used that well-understood data structure together with key additional refinements and additions to create blockchain technology

KEY INNOVATIONS IN BLOCKCHAIN TECHNOLOGY

Consensus Digital Signatures Hash Values Code Execution Mechanism

• Defines • Makes content of • Miners calculate • Transactions ownership of each block valid nonce and cause execution coins immutable hash values for of programming • Authenticates • Used as link to blocks code valid transactions prior blocks • All nodes accept chain reflecting most proof of work

DIGITAL SIGNATURES

• Digital signatures are derived from public-key cryptography • Each person has a generated key pair: one public and one private • What’s encrypted with private key can only be decrypted with public key (and vice versa) • Encrypting with private key is a digital signature

DIGITAL SIGNATURES

• Bitcoin uses digital signatures to authenticate valid transactions • Valid coins are defined as chains of digital signatures • To initiate a transaction, a sender digitally signs it using his private key • A transaction can be directed to a specific recipient by restricting further spending of the coin using someone’s public key • The recipient can spend coins he’s received by digitally signing a further transaction using his own private key

HASH VALUES

INPUT (Text) SHA1 HASH

“We the people of the United States” 1482a4775eefc767a7fa975971e6531c0b73e73c

“We the people in the United States” 6586a9712086a1a7288afc00dac7cfdcc07a08ab

“We” b3780dbafddf7e06add542122118f38cc06884b5

• Hashing functions • Create a number of fixed size (hash) from input text of any length • Different input texts very unlikely to lead to same or similar hash – Any small change in input causes big change in hash – Hash becomes like a fingerprint for the data hashed 20 www.ClearLawInstitute.com (703) 372-0550 10 Clear Law Institute, © 2018

HASH VALUES

INPUT (Binary) SHA1 HASH

00000001 bf8b4530d8d246dd74ac53a13471bba17941dff7

00000011 9842926af7ca0a8cca12604f945414f07b01e13d

00000010 c4ea21bb365bbeeaf5f2c654883e56d11e43c44e

• Hashing functions (cont’d) • Hash is easy to calculate but very difficult to reverse-engineer – Even one bit difference in inputs leads to very different hashes – Cannot predict hashing result without actually running hash calculation

HASH-VALUE-LINKED BLOCKS

CONSENSUS

• A key problem for blockchain technology is to make sure everyone’s copy of the ledger is the same • The problem is particularly acute when the blockchain is public, as in Bitcoin • Anyone can connect to and participate in the Bitcoin network • In a public blockchain, consensus must be achieved in the face of possible • Errors (of communication, of calculation, or others) • Malicious actors

CONSENSUS

• Private or permissioned blockchains can use simpler consensus methods • Voting • Specialized authoritative nodes • Whatever method is used, it must call for all nodes, including any initial dissenters, to accept the valid results of the method

CONSENSUS

• Bitcoin’s solution, mining, relies on the random-like distribution of hash values across their full range • Miners compete by repeatedly performing the following steps until a proposed timestamped block is validated 1. Choose a nonce (number used once) and place it in a field in the block 2. Calculate the SHA256-based hash value of the block 3. If the calculated hash value is less than a pre-specified difficulty level the block is valid and can be added to the blockchain 4. Otherwise, go back to step 1, choosing a different nonce

CONSENSUS

• Once a block is validated, it is added to the blockchain and distributed to other network participants • Successful miners receive a mining reward of new Bitcoins or transaction fees • If other miners are still trying to validate blocks when they receive a valid block with some of the transactions already included, they have to start over with a new potential block of transactions

CONSENSUS

• As miners find valid timestamped blocks and distribute them, other nodes on the network accept the blocks and incorporate them into their own blockchains • The timestamping and proof of work reflected in a valid block’s hash value ensure that the blockchains of all nodes will contain the same blocks in the same order • A malicious node can manipulate the consensus system only if it possesses more computing power than all other nodes combined (a 51% attack)

CONSENSUS: PUBLIC OR PRIVATE BLOCKCHAIN

Blockchain System (Public or Private)

Decentralized system with distributed ledger

3 Smart code and smart contracts

SMART CODE

• Every Bitcoin transaction uses Bitcoin’s scripting language - a limited programming language similar to Forth • Input fields specify prior unspent outputs that will be consumed in the transaction. – Typically, the input field will contain a signature from owner’s private keys authorizing the spending • Output fields govern further use of the coins spent – Typically, the output field will contain a requirement that the recipient authorize further spending with a similar signature from her private key

SMART CODE

• Though limited, Bitcoin’s scripting language supports more complex actions Multisignature – Multisignature – Multisignature – Single payee OR AND X of Y

Send 1 BTC from Send 1 BTC from Send 1 BTC from Send 1 BTC from Alice to Bob Alice to either Bob or Alice to Bob and Alice to two of Bob, Carol Carol Carol, and Ted • either one can • both have to sign • two of the three sign with his with their private must sign with private key to keys to spend the their private keys spend the output output to spend the output

SMART CODE

• Bitcoin’s scripting is simple • There are other blockchain platforms implementing powerful scripting languages that are Turing complete – Turing-complete languages can theoretically encode any algorithm capable of operating on a modern computer architecture

SMART CONTRACTS

Computer programming or script that can automatically execute when certain events happen on a blockchain and that can Smart Code perform additional functions, such creating or validating other transactions

Smart code that, in conjunction with any other written documentation and applicable user interface, meets the Smart Contracts requirements of an enforceable contact under applicable law

SMART CONTRACTS

A and B are users on the same distributed ledger. They enter into a smart contract based on price of gold.

A agrees to sell 1kg of gold to B at the prevailing USD spot price at a particular day/time, but only if the spot price is greater than $40,000 at that time.

Smart contract would use the following logic–

• On Day/Time, OBTAIN Spot Price from SOURCE

• IF Spot Price >$40,000 then:

TRANSFER 1 kg of gold from A to B

TRANSFER $x from B to A WHERE x = Spot Price amount for 1kg of gold in US Dollars at Day/Time

ELSE

SMART CONTRACTS

• Can smart contracts replace traditional contracts? – Judgment provisions: “reasonable efforts,” “materiality” – Legal and interpretive background: applicable law, forum selection, jurisdiction – Off-chain processes governed by block: inputs (oracles), outputs – Non-blockchain activities

SMART CONTRACTS

• Smart contract platforms – Platform as intermediary – Permissioned, permissionless, and hybrid platforms – Market participants – Off-chain inputs and outputs

SMART CONTRACTS

• Are smart contracts enforceable? – Formal requirements (offer, acceptance, consideration) – Signed writing – ESIGN – UETA – What is the contract? – Code, natural language, or both – Meeting of the minds

SMART CONTRACTS

• Smart contract risks – Platform-related risks – Execution risks – Costs – Performance flexibility – Contract amendment, reformation, and termination – Mistakes and malfeasance – Legal and regulatory

SMART CONTRACTS

• Dispute resolution • Jurisdiction and applicable law • Governing language (programming or natural) • Disputes with platform intermediary vs. among participants • Specialist courts (e.g. patent) • Arbitration

4 Applications

SMART CONTRACTS

WHAT MAKES A GOOD BLOCKCHAIN USE CASE?

Identifying a good blockchain use case is not always easy!

Requirements Solutions

A business problem to be solved Must have business value and ROI

With Participants, Assets and An identifiable business network Transactions

Consensus, Immutability, A need for trust Finality or Provenance

OTHER APPLICATIONS

• Real Estate • Republic of Georgia • Cook County, Illinois • Potential Advantages • Reduce costs and complexity • Eliminate errors • Increase ability to audit

OTHER APPLICATIONS

• Trading, clearing, settling • Overstock.com rights offering in 2016 • DTCC pilot project for credit default swaps • Utility Settlement Coin • Potential advantages • Quicker transaction times • Reduction in errors/inconsistencies

OTHER APPLICATIONS

• Supply-chain management • Tracking food from farm to store • Tracking shipping containers • Tracking diamond trading • Potential advantages • Increase transparency • Increased ability to audit • Improve traceability when problems arise

APPLICATION: SUPPLY CHAIN – IBM AND MAERSK

OTHER APPLICATIONS

• Intellectual Property • Binded – timestamping IP • Mediachain – attribution issues • Ujo – licensing music • Potential Advantages • Easier to prove ownership • Verify authenticity • Control digital rights Imogen Heap. Photograph: Phil Frisk for the Observer

OTHER APPLICATIONS

• Energy • Counterparty matching • Transaction reporting • Transaction settlement • Bitcoin mining operations • Renewable attributes tracking • Peer-to-peer trading platforms – Distributed microgrids • Inventory and other information tracking • Other corporate applications

ADVANTAGES AND DISADVANTAGES: SHOULD YOUR CLIENT USE BLOCKCHAIN TECHNOLOGY?

• Disintermediation • Transparency and immutability • Resiliency • Automatic rule enforcement • User autonomy • Performance and scalability • Complexity, errors, and vulnerabilities • Privacy

5 Legal and ethical issues

LEGAL ISSUES

• Securities and Commodities Regulation and Enforcement • Antitrust issues • Data privacy and security • Tax issues • State laws • Money transmission issues • Jurisdictional questions and enforceability • Liability and governance

SECURITIES LAW ISSUES

• The DAO Report (SEC Release No. 81207; July 25, 2017) • SEC analyzed whether the DAO Tokens are securities under federal securities laws (Section 2(a)(1) of the Securities Act and Section 3(a)(10) of the Exchange Act) • Important implications: – All securities offered and sold in the U.S. must be registered with the SEC or must qualify for an exemption (Section 5 of Securities Act) – Entities operating securities exchanges must register as a national securities exchange or seek an exemption – Investment companies need to register or must qualify for exemption

SECURITIES LAW ISSUES

• “Security” includes: – Stock, bond, note, … investment contract • “Investment contract” is: – Investment of money – in a common enterprise – with a reasonable expectation of profits – derived from the entrepreneurial or management efforts of others

S.E.C. v. W.J. Howey Co. 66 S.Ct. 1100 (1946)

SEC ACTIONS

• SEC v. REcoin Group, DRC World, Zaslavskiy, 17-cv-5725 (E.D.N.Y.) • SEC v. PlexCorps, 17-cv-7007 (E.D.N.Y.) • In the Matter of Munchee Inc., Release No. 10445 • SEC v. AriseBank, 18-cv-186 (N.D. Tex.) • SEC v. CentraTech, 18-cv-2909 (S.D.N.Y.) • SEC v. Titanium Blockchain, 18-cv-4315 (C.D. Cal.) • Other guidance

SEC ACTIONS

CFTC ACTIONS

• CFTC considers Bitcoin and other virtual currencies to be commodities – Authority over transactions involving derivatives tied to virtual currencies – Fraudulent conduct involving virtual currency traded in interstate commerce • CFTC said that virtual tokens may be commodities or derivatives contracts – Depends on facts and circumstances of the case • Enforcement Activity – CFTC v. My Big Coin Pay, 18-cv-10077 (D. Mass.) – CFTC v. Dillon Michael Dean, 18-cv-345 (E.D.N.Y.)

STATE ENFORCEMENT ACTIONS

• NASAA Enforcement Sweep (“Operation Cryptosweep”) (May 21, 2018) – Coordinated actions in the U.S. & Canada – 70 investigations and 35 enforcement actions in May 2018 • TSSB Enforcement Sweep, Investor Alert (April 10, 2018) – 32 investigations resulting in nine C&D orders in less than six months – Texas is the first state to issue C&D order to halt cryptocurrency investment offering • Other State Enforcement Activity – Florida, North Carolina, Kansas, Massachusetts have issued warnings and/or brought enforcement actions 57

PRIVATE LITIGATION – CLASS ACTIONS

• In re Tezos Securities Litigation, 17-cv-067790-RS (N.D. Cal.) – Multiple lawsuits stemming from sale of Tezos token, or “Tezzies” • Ripple Labs, 15-566271 (Cal. Super.) – Allegations that sale of XRP tokens are a violation of U.S. and state securities laws • Nano, 18-cv-02049 (E.D.N.Y.) – Class demands that Nano “rescue fork” $170 million worth of XRB into a new cryptocurrency

STATE LEGISLATION

• Delaware: Corporate recordkeeping – Del. S. 69, 149th Gen. Assem. (2017)

• Arizona: Corporate recordkeeping – ARIZ. REV. STAT. 10-140

• Vermont: Evidentiary statute – VT. STAT. ANN. tit. 12 § 1913(b)-(c)

• New York: BitLicense – N.Y. COMP. CODES R. & REGS. tit. 23, Part 200

STATE LEGISLATION

ETHICAL ISSUES

• ABA Model Rule 1.1 – A lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation. • ABA Model Rule 1.2(d) – A lawyer shall not counsel a client to engage, or assist a client, in conduct that the lawyer knows is criminal or fraudulent, but a lawyer may discuss the legal consequences of any proposed course of conduct with a client and may counsel or assist a client to make a good faith effort to determine the validity, scope, meaning or application of the law.

ETHICAL ISSUES

• ABA Model Rule 1.16 – a) Except as stated in paragraph (c), a lawyer shall not represent a client or, where representation has commenced, shall withdraw from the representation of a client if: – (1) the representation will result in violation of the rules of professional conduct or other law; …

ETHICAL ISSUES

• ABA Model Rule 1.16 – (b) Except as stated in paragraph (c), a lawyer may withdraw from representing a client if: *** – (2) the client persists in a course of action involving the lawyer's services that the lawyer reasonably believes is criminal or fraudulent; – (3) the client has used the lawyer's services to perpetrate a crime or fraud; …

ETHICAL ISSUES

• ABA Model Rule 2.1 – In representing a client, a lawyer shall exercise independent professional judgment and render candid advice. In rendering advice, a lawyer may refer not only to law but to other considerations such as moral, economic, social and political factors, that may be relevant to the client's situation.

Additional resources

ADDITIONAL RESOURCES

• Jones Day White Paper on Blockchain for Business • update to be published later this year • Jones Day three-part video series • Blockchain: Our Approach to Advising Clients • Blockchain: Impact on Industry, Trade, and Individuals • Blockchain: Risks Related to Regulatory Issues and Security • White Paper: Texas Enforcement Sweep Finds Widespread Fraud in Cryptocurrency Offerings

ABA BLOCKCHAIN BOOK (AUGUST 2018)

QUESTIONS?

With more than two decades of legal experience and a background in computer science, Jim Cox has successfully advised clients on their most challenging and difficult matters in litigation and arbitration, including complex technology-related disputes, international disputes, class actions, and disputes involving corporate acquisitions. Jim is now applying that experience to the innovative fields of cryptocurrency and the blockchain, advising clients on Bitcoin, Ethereum, and other virtual currencies, as well as on broader applications of blockchain technology. .

70 www.ClearLawInstitute.com (703) 372-0550 35