The Maze of Blockchain Regulations
On January 16 Sila co-founders Shamir Karkal and Angela Angelovska-Wilson got together to talk about How to Bring a Blockchain Product to Market-Legally.
The CEO & CLO shared a very informative, and at times hilarious, conversation. Here’s a few of the topics covered:
- How to launch a successful Initial Coin Offering (ICO)
- Avoiding pitfalls when dealing with the SEC
- Managing crypto market volatility
Watch the replay:
Shamir Karkal: Hello everybody and welcome to another webinar in our series of webinars here at Sila.
So I have with me today Angela Angelovska-Wilson, my co-founder and good friend at Sila. So you guys already know who I am, right. My name is Shamir Karkal, co-founder of Simple, did a bunch of stuff in the FinTech world and now I’m co-founding the start-up for Sila. We have a FinTech platform but really today is not about talking so much about Sila but talking a lot more about building products in the blockchain world and doing it legally.
So we’re going to spend a lot of time focusing on the legal aspects. The first thing that I want to do is actually tell you guys about Angela and what I will say is, having known Angela now for almost two years I think, she may not be the best FinTech lawyer in the US but she is the best FinTech lawyer right now and I know a few.
So with that said, I’ll let Angela introduce herself.
Angela Angelovska-Wilson: Thank you, Shamir. That is a very kind and very big compliment, much, much appreciated. So I’ll try to justify some of that trust. So my background is, you know, I got really interested in technology way back when when there was this thing called the internet that was coming on. My very first job actually was being a webmaster. I also worked on the proprietary networks. Those of you who are ancient can actually remember AOL and CompuServe, each of whom had their own programming languages. I was just recently actually reminiscing with somebody about using Rain Man which was the coding language for AOL.
Shamir: So what you’re telling me, Angela, is that you’re a lawyer who actually knows how to code?
Angela: Well, I don’t know. My coding skills have really gone down since that time.
Shamir: Didn’t you say your first job was as a coder?
Angela: Yes, yes.
Shamir: All right, fine. Keep going, keep going.
Angela: So I have always been very, very interested in technology and the law and how the two of them intersect and how they work. So I actually chose to study under Walter Effros, who was the leading authorities in e-commerce and applicable laws at the time and that was way, way back.
Shamir: And this is when you went to law school?
Angela: This is when I went to law school, yes. It was just a few years ago, you know. I did it when I was like 10 or something like that. And so I actually started out my career in fin law and I did something that was very unusual at the time which is I kind of created my own practice, which now is called FinTech but I was part of a group at Fried Frank and I actually shared my time and responsibilities between two departments at the firm. One was the financial regulatory department under Tom Vartanian and then also intellectual property. So that’s basically all you could do. There was no such thing as FinTech way back when.
Shamir: And not a lot of technology either.
Angela: No. Especially not a financial technology. So fast forward a number of years, I spent most of my legal career at Latham & Watkins raising though the ranks over there. I always was very, very interested in actually again how the technology and financial services intersected together. Probably the biggest user in financial services of technology has always been payments and so I specialized in payments and have worked with startups from when they were just a one or two-person idea all the way to some of the behemoths in the space.
Shamir: Small startups, you know, like Venmo, Square, sure, those kinds of things.
Angela: Yeah, some of those. And I typically tell people that the way that I’ve thought about FinTech is that there was this huge push and ability of people to really innovate on the products and they were all building this wonderful silver bullet, shiny trains that could do all kinds of things and had all kinds of functionalities. But what was happening, and I saw this repeatedly, was that they were taking these lovely silver bullet trains that were capable of doing amazing stuff and putting them onto the rickety rails of the 18th century which is really what the rails of the financial system in the US, especially with respect to payments, are.
Shamir: Oh come on, Angela. ACH, I mean respect for that. That was created in 1973. It’s only about 45 years old.
Angela: Which is not very old since I was born in 1973 so that’s pretty young.
Shamir: It is true although we have gone through about five generations of technology in between and that does mean that a lot of US payment systems are highly outdated, until somebody started trying to build new rails-
Shamir: And I think that’s where your blockchain story starts, right?
Angela: Yes, and so the very, very first time that I actually saw bitcoin, I got super excited. This was back in 2012, January of 2012. I know this well. And I got super excited because it was the first time that I actually saw somebody put in different rails and I drank all the kool-aid, whatever you want to call it, went down the rabbit hole like everybody else and was super excited about the potential of technology. At the time way back when in 2012, there weren’t that many lawyers that had even heard of bitcoin let alone doing legal work related to it.
Angela: I actually spent some time doing a lot of work with what are now some of the large companies in the distributed ledger space, but I believed so much so in it that I actually left my position as a partner in a AmLaw 100, one of the big global law firms, Reed Smith, and jumped ship and was part of the founding team of Digital Asset Holdings and spent the last four years there as the General Counsel and Chief Legal Officer.
And so I really do believe in this technology quite a bit and even more so that I actually left Digital Assets Holdings to co-found Sila and I have also been very privileged to be also a co-founder of one of the first boutique law firms in the country that specializes in distributed ledger technology and blockchain.
My co-founder, Louis Cohen, and I believe that this space really needs good legal advice in order to help others navigate through what seems like an endless amount of acronyms and legal lingo about what your product is and how to help the community really focus on building, developing and providing that backbone for developing the next generation of the internet-
Shamir: Internet 3.0.
Shamir: And we’re going to dive into that in a second. Before that, though, I do want to say I see more and more people are beginning to listen to this. As you guys are listening, there should be a little box in the corner of your screen somewhere which says say something nice. If you guys have questions, please do ask them and if you don’t, I might actually ask you guys some questions. So be prepared.
But before we get into that, I have a few questions for Angela myself.
Shamir: So you’ve been seeing FinTech for probably longer than it’s been around … so we have a question from Pat Doyle. Yes, we-
Angela: A very good start.
Shamir: Pat, I will get to you. That was actually one of the questions that I was going to ask her but before that, I do want to cover one topic which is you’ve been doing FinTech for like a couple of decades, as long as it’s been around honestly and then blockchain for six, seven years now.
So you’ve seen the full evolution of the sort of regulation and the legal perspective on blockchain and I kind of came to it much later and much more from a technical perspective. And it seems to me like after the early years just ignoring it, pretty much every global regulator has now kind of woken up and has some sort of a perspective or maybe the beginning of a perspective on blockchain.
So maybe you could give us sort of the history of that evolution, how that went, because I know there was a while that at least outside in it looked like blockchain is all about money and you need to figure out things like FinCEN and state money transmission laws. And then after a while it was all like it’s all about SEC and CFTC and now who knows even anything any more. So tell us how that all went, Angela, and then we’ll take your question, Pat.
Angela: So you know way back when, obviously one of the very first use cases and applications of blockchain technology was bitcoin and the ability to transfer value between users without going through the established financial system. And so if you remember way back when, bitcoin is really not the first virtual currency. That was –
Shamir: Not by a long shot.
Angela: There were a number of different iterations that came before it and with each iteration that was coming through, it was very necessary for the regulators to understand how this technology was being used. And one of the very first uses of a lot of technologies is really the illicit or criminal activities and so-
Shamir: Or even activities like gambling, drugs, porn and everything else. That’s kind of what the early use cases were for the internet too, let’s be honest. Long ago before … even in web 1.0, right?
Angela: Very much so actually. If you, and I’ve done this, if you actually compare some of the discussions that were happening in Congress at the very beginning of the internet and some of the discussions that were happening as people were looking at the regulation of bitcoin and virtual currencies, you can actually just copy and replace some of the words and it’s about the same. And so I won’t quote Avenue Q, who has a great song title about what the internet is for so you’ll have to look it up.
Shamir: I will.
Angela: But it was very natural that the regulators were going to focus on the transfer of funds and the ability of these virtual currencies to actually be used in money laundering and for the funding of illicit activities. And so one of the first things that we have actually is if any of you remember Liberty Reserve. Liberty Reserve is actually one of the very first cases about the application of money laundering regulations to the new world and virtual currencies world.
Shamir: This was like almost ’98, ‘97?
Angela: Liberty Reserve started operating around 2001. It actually operated for about 11–12 years. It was 2013 that it was shut down due to [inaudible] activity but, most importantly, is that it was the very first regulation that we are actually seeing on the subject of virtual currencies is actually out of FinCEN in 2011 where FinCEN expanded the definition of what constitutes a money services business and basically added that anything that can be used as a substitute for currency was subject to FinCEN regulations.
Shamir: And before we talk about that any more, in fact before we move on from that, but for those of you guys who don’t know, FinCEN is the Financial Crimes Enforcement Network. Angela will keep me honest here but it is a department, a part of the US Treasury and it is the main organization that’s responsible for monitoring and implementing all the laws around anti-money laundering. There’s a lot of laws around anti-money laundering in case you weren’t aware starting from the 1970 Bank Secrecy Act going all the way to the 2002 Patriot Act.
I think even Dodd-Frank tweaked some of those and there might have been more. I haven’t really checked in the last few years. Congress likes to pass a lot of laws on this topic and I think between 1970 and 2002 there were another 12 laws on this topic of anti-money laundering and know your customer. So there’s a lot of law around it and FinCEN is kind of responsible for most of it. And they did issue guidance in 2011?
Angela: Yeah, they issued the rule that amended the definition of what constitutes a money transmission but the actual guidance with respect to what is virtual currency and giving three separate categories of where everybody falls in, users, exchangers and administrator and how they are-
Shamir: Oh yeah, I remember that.
Angela: … subject to regulation under FinCEN was in 2013.
Angela: And so that guidance, that FinCEN guidance with respect to virtual currency, actors and lead functions that they perform, it’s still very relevant today and it is one of the bases on which, for example, there is an exemption for miners of bitcoin, bitcoin miners from being subject to the money transmission or money services business regulations.
There’s also a very clear indication from FinCEN that exchangers are subject to the registration and must be registered with FinCEN and then, of course, being a money services business and being an exchanger or being a [inaudible] transmission, is also subject to state regulation.
So to make things a little more complex for lawyers and users, in the US we actually have two levels of regulation. We have federal regulations and we also have state regulations and there are certain institutions, such as national banks and certain trust companies, that are exempted from the state regulation. But pretty much on every level, as a company in a financial services business, you’re typically subject to state as well as federal regulation. And being in compliance with one doesn’t always mean that you are in compliance with the other.
So we have a question about what about wallets and how do they actually fit into-
Shamir: So we’ll get to that, and Pat. So one thing that it’s important to make clear is that there is no silver bullet. Like there is no do this one thing and you escape all regulation. The only way to escape all regulation in this space is not to do anything, right.
So Pat, to kind of answer a subset of your question. If an application only requires ETH, are there any legal considerations we should make? The answer is there are probably a lot depending on what the application is actually doing and how it is using ETH or anything else, you know. And just by using ETH and only ETH doesn’t mean you escape any of the regulations.
FinCEN made that clear in 2011 and 2013 and so if you are doing money transmission using ETH, for example, you are still required to register as a money services business with FinCEN. You are still required to comply with state laws, you are still required to comply with federal laws. You know, ETH by itself does not exempt you from anything. In fact, nothing exempts you from anything.
Angela: Yeah, I mean one of the things that my colleagues at DLx and I spend a huge amount of time and, as you can tell, Shamir has been spending a lot of time with me, so he can roll out a lot of these things off the top of his head is what we really spent a lot of time is really thinking through the regulatory implications on how people are using the technology. And so it is very difficult to look at a product and say this is not subject to anything or this is subject to everything.
So we spend a lot of time actually understanding the technical underpinnings and helping our clients navigate how they are going to structure their product in order to allow them to be able to come to what the end goal is for their business without gumming it up with some of the legal process that may not be necessary.
That being said, there are certain things that just cannot be avoided. So for example if you are planning to do an ICO, an Initial Coin Offering which were the very powerful offering for the blockchain space- Shamir: For a while.
In 2017 and 2018 I think we saw, depending on what resource you go to, we’ve seen anywhere between $15 billion to $30 billion in ICOs. Some of that, of course, was dependent on the price of some of the virtual currencies that were being used like ETH and BTC for the funding of a lot of the ICOs. But there is very little way you can escape some of the securities regulation. And so now we’ve talked about kind of the money regulation and FinCEN and the states who are regulating really what I would call the transmission of something of value.
So the way that I usually give guidance on this is, look, if you are in the process and you are enabling the transmission and you cannot remove yourself from the flow, the diagram, you are most likely … and what you have is a substitute for a currency, then you are most likely subject to some of the money transmission laws.
Shamir: Before we go there, though, let me explain one thing because Angela mentioned that there’s two levels of regulation in the US. There’s state and there’s the federal. But there’s also sort of three buckets within that, right. So you have to think of like the money regulation which is the state money transmission laws and there’s departments in pretty much every state that implement those and monitor those and regulate those.
And then you have the federal agencies in the money world which is like FinCEN for sure, but also the bank regulators like the FDIC, the OCC and the Federal Reserve.
Then you have the securities world and so there you have the SEC and you have FINRA which is a self-regulatory organization and they regulate the whole securities world. But even there you have two levels because the states also have securities laws and those are also implemented by the states. And then you have the commodities world, what’s called the commodities and futures. So that’s the CFTC and, again, there’s also state level laws.
So you have to think of it as these three buckets and within each there are two levels and, yes, it is extremely complex. And by the way, that’s only the US so let’s not forget that there are 200-plus countries in the world and many of them have their own laws funnily enough. And so when you are talking about something that might be global in nature, then you have to be aware of at least a few other regulators outside the US as well.
And so at least it felt for a while up until 2014, ’15 maybe, that, hey, virtual currencies, crypto, bitcoin, whatever you want to call it, that whole space is all about money, it’s all about FinCEN and state money transmission, licensing and figuring out MSBs. And so the first wave of companies that came out like … I’m just going to name a few. There were a lot but like Coinbase and SubCo, I think most of them went out and got state money transmittal licenses because they wanted to be regulated because they didn’t like going to jail honestly.
And so they went out and got state money transmission laws. I’m assuming they registered with FinCEN and they followed the regulations in that sort of money bucket, kind of the way that PayPal did back in the cay 20 years ago and so many others have done since then.
But then along comes the ICO boom and all of a sudden- Angela: Well, actually let’s go to the CFTC because the CFTC comes before the SEC- Shamir: ICO boom, yeah.
Angela: Before the ICO boom and so the next wave I think of companies and regulation and regulators really attuning to the bitcoin space was actually the CFTC.
Shamir: That’s right.
Angela: And the CFTC, because it has a jurisdiction over derivatives, and derivatives are retail commodity transactions and it’s a really broad definition. Basically just about anything can fall into the derivatives. So one of the first actions that CFTC had was in September of 2014 where TeraExchange went thorough and got the certification from the CFTC for bitcoin index swaps, the operation of bitcoin index swaps.
They fully registered, TeraExchange got full registration in 2016. So during this time, as Shamir have given an indication as we are talking, you can see how the business models, the applications that people are using for distributed ledger technology, is changing and how the regulators are responding to some of the different areas that are being brought by the industry, you know, forward to the regulators and saying, look, we are not planning, we don’t want to play in the gray area. We Are not criminal activities, we do see the opportunity, we do see the ability of this technology to be transformative and we do see a potential to really bring different type of innovation into financial services and how do we do that.
So again, we have kind of the very first wave which was the money aspects but now we are looking at what I would call a more sophisticated financial products because that’s when we are going into swaps and derivatives and other CFTC regulated activities.
Shamir: And it’s almost like there was a product evolution, like the first use case for bitcoin and then some of the other platforms that came out after bitcoin was let’s just transfer these things between people. And so if you’re transferring something of value between accounts, addresses, people, entities, whatever, that kind of feels like it’s going to fall into the money transmission bucket, right?
Shamir: But then as the sophistication increased, people were like, well, it’s not just bitcoin. We have other things too. There’s Ethereum and all these other platforms and tokens so some people started trading between them, and the trading of currencies or commodities has always been part of the CFTC’s regulatory regime and so that’s why the CFTC got involved which kind of makes sense.
And then, keep going, Angela because I think you’re going to get to the next one.
Angela: Right, so then in the 2017 we saw kind of an explosion in the ICO market-
Angela: … the initial coin offering market, and we saw a huge amount of both interest. We saw a lot of what I would call viral growth of in the public understanding what crypto currencies are and how there is a potential there and we saw a huge boom in ICOs in 2017.
Angela: As part of that boom, again, not unusual when the regulators see that there is a huge amount of activity and there’s not a clear regulatory path forward, the regulators start asking questions of the people that are doing some of these things.
And there is a tendency, and we’ve seen this through many, many cycles, which is where we say, hey, if this is innovation, then it’s new and therefore it’s not subject to anything that is already existing. I think that the skill that is really necessary is to really understand what I call like the principles behind the law.
So one of the principles behind the enactment of the Securities Exchange Act and, again, my co-founder Louis and my colleagues at DLx are much, much better securities lawyers than I am so I always defer to them. But one of the principles of the Securities Act is that it was designed for investor protection and what we saw in the 2017 ICO boom, there really wasn’t a lot of investor protection. But we also saw in 2017 and 2018 a lot of retail investors getting really excited about some of the astronomical returns in value that we saw between bitcoin and ether shooting up and the return rate is just fantastical.
So a lot of retail investors were really going in without understanding what was it that they were signing up for. And I think one of the marquee, I’ll call them marquee events was actually the offering of [pesos 00:30:56] because there was just so much excitement in the marketplace about this cool new thing and how people were going to get on the ground floor of that. And so it’s not- Shamir: It’s like, you know, bitcoin shot up and everybody was like, damn it, I should have bought bitcoin back in 2010 or 11 or 12 or 13 and then along came Ethereum which [inaudible] the ICO in many ways because there was the Ethereum bootstrapping or whatever you want to call it … it wasn’t called an ICO back then and then Ethereum shot up. So now suddenly people were like, well, it’s too late to get in the ground floor of bitcoin or Ethereum but there’s another 500 ICOs happening. Let’s get in on the ground floor of them.
Shamir: But it’s interesting you mention the investor protection piece was, of course, the history of all these laws is that back in the 1920s there wasn’t any investor protection laws in the US and then there was the Great Wall Street Boom of 1920s and then the Great Crash of 1929 which led to the Great Depression. And most of these laws came out between the 1930s and then the 1940s as a reaction to that to protect the retain investors from sort of that same sort of boom and bust cycle.
And that’s when the Securities Act was in the 1930s and there were more in the ’40s and so that’s when as we really started seeing that this went from sort of money transmission to actual trading of different types of virtual currencies and indexes on them and swaps on them and trading pairs between currencies, virtual and real. And that is, of course, all kind of the CFTC’s business and then now suddenly a huge wave took off of people, retail investors beginning to put money into projects or platforms, whatever you want to call them, using this new structure called an ICO. And that is where the SEC and the Securities Exchange Act becoming a lot more relevant.
And it feels like a lot of people felt like, hey, if I’m doing an ICO, it is not an IPO so it doesn’t need to comply with any securities law and so it’s … and then I think the SEC corrected them on that and then now there was a lot of talk about security tokens versus utility tokens. So bring us up to speed on all of that and after that we will dive into Pat and Murat’s questions.
Angela: All right, that sounds good.
As we were preparing for this webinar, I was telling Shamir that each one of these topics can be just an hour or more of discussion and we haven’t even really scratched the surface-
Shamir: On any of these.
Angela: … of everything that is out there. So depending on the interest, we might be willing to do a couple more on specific regulatory issues [crosstalk]-
Shamir: Honestly, that 2013 guidance and I think there’s been clarifications that have come out after that, every sentence in that we could probably spend like 20–30 minutes on it because it’s all complex, right? But let’s go on with ICOs, yes.
Angela: Yes, so 2017 I think one of the seminal events of 2017 … it feels like it was 20 years ago and it probably is-
Shamir: Not even two years, not even two years.
Angela: … in blockchain years is the Dow Report. So the Dow Report came out in July of 2017 and that was kind of the first I’ll call it yellow orange flag that the SEC raised and gave people an indication of whoa, what are you actually doing and what is going on here. Securities laws in the United States are still applicable. They haven’t changed because now the business model has changed and there is a different platform and a different technology that is underlying things.
So we spent a lot of 2017 and 2018, within the industry as well as the legal landscape, figuring out what it really meant and one of the things that came out of that was a proposal on the SAFT.
Shamir: And for those of you who don’t know that, that’s the Simple Agreement for Future Tokens. In the venture capital world, there used to be … there still is something called a convertible note which is how a lot of early stage companies raise money and used to raise money. In fact, I did a lot of convertible notes for Simple like nine years ago.
And then along came this accelerator called Y Combinator and they created this thing called a SAFE which is a Simple Agreement for Future Equity and it sort of simplified the convertible note and made it a lot more straightforward. And obviously in the ICO world there was like a huge ICO boom and then I think everybody, I think in early ’18 or late ‘17-
Angela: Yeah, late ‘18.
Shamir: … people were like ICOs that means now it’s not actually unregulated. The SEC is going to be looking at this so let’s just do an SAFT, which is a Simple Agreement for Future Tokens and that’s going to be exempt from anything SEC-related. But I don’t think it’s as simple as that, is it Angela?
Angela: No, it’s not. And-
Shamir: It never is.
Angela: It never is. Especially when you have something as lofty as protecting ordinary investors for the entire United States. When that’s your mission, it becomes very difficult to make things very simple. And so the SEC I think spent a lot of 2017–2018 really looking at what was happening in the ICO market and then we started seeing some enforcement actions and I would say-
Shamir: And we’re still seeing them.
Angela: Well, we haven’t finished.
Shamir: By the way, guys, typically for regulators form like the start of investigating something to like an enforcement action happening and then it becoming public, you have to expect a 12 to 18 month time frame. It could easily be 24 or longer. If it’s really, really super straightforward like this is straight outright fraud, somebody’s just taking money and running off with it, then it can happen quicker. But nothing is ever that simple so the regulators need to understand it. They’ll ask whatever questions. They’ll do an investigation. There’ll be back and forth and then eventually they’ll come up with an enforcement action. Thee might be proposed settlements, all sorts of discussion. Then it hits the press.
So whenever you see something hit the press and you read about it, understand that it probably started more than 12 months before it got to the press. So the enforcement actions that we have seen are not the end. In fact, they’re probably more like the beginning and there might be a lot more coming out.
What do you think, Angela?
Angela: Well, I mean I think some of the enforcement actions, especially the initial ones that we saw from the SEC, were every much, you know, I will call them the low-hanging fruit. They were definitely fraudulent. There was definitely pyramid schemes that were being involved and so these were kind of the easy things for picking like these were obviously the fraudsters that were intentionally targeting some of the communities and some of the products in the virtual currency space for their own benefit.
Angela: So no shocker there I would say.
Now, the question that we do have was and everybody else in the industry had was like yes, we understand the fraudsters and completely agree they they should be in a very different bucket. That is not an acceptable behavior for the community or anybody else.
But what about companies that actually want to be legally compliant? How do we go about it? How do you issue an ICO? How do you divide between the fundraising process and the necessity of a token to be part of the product? And so, where does that line in the sand lie? What is the magic dust that you sprinkle where we go from something being a security to being a utility, which is actually in my view … again, I’m not the SEC expert. We have others at DLx that do this-
Shamir: And you’re definitely not the SEC either.
Shamir: But please, be the SEC for us.
Angela: Is where’s the line in the sand where you were talking like, oh, this is a security and then it magically becomes not subject to the securities laws. Like how? When does it happen? And that answer has really not … we do not have an answer to that question yet. So-
Shamir: What about the Howey Test?
Angela: Well, yes, so there is a very, very old law that I find it amusing that so many people are now talking about the Howey Test and-
Shamir: H-O-W-E-Y if you want to google it, please do. It’s the result of a case from like the 1940s. It set the precedent of if it meets these things, it’s definitely a security. I don’t think it ever said that if it doesn’t meet these criteria, it’s not. So you’ve got to be careful. There’s no like … as I said, there’s no silver or gold bullet anywhere. Go ahead.
Angela: Right. So under the Howey Test, there is a lot of jurisprudence so a lot of things that have been built on it but the basics of the Howey Test to determine whether or not an investment contract is a security, all of the above must be present. So it has to be an investment of money. Again, we have had some discussions, a lot of spirited discussions I guess in the space about whether the investment of money, if you were just taking ETH and BTC, whether or not that was actually an investment of money.
I’m going to say-
Shamir: It probably is.
Angela: I’m sorry but pretty much [crosstalk 00:42:10]-
Shamir: If it’s valuable, just because it’s not called money, that doesn’t mean … like gold instead of money, that doesn’t exempt you. Sorry.
Angela: Yeah, again what I’m trying to show here is the ability of people to dissect things and not really think about I’ll call it the technicalities or the mechanics and not really think about the principle behind these protections and laws and regulations. And so-
Shamir: To make money, that’s the first thing. And bitcoin and ETH probably count as money for this purpose, yeah.
Angela: Right. And a common enterprise, so usually a project is a common enterprise. With an expectation of profit.
Angela: I’m going to say that’s pretty … it’s been pretty clear that a lot of people went into the ICO market with an expectation of a profit and that profit is derived from the entrepreneurial or managerial efforts of others.
So when we talk about a lot of the platforms and a lot of the ICOs that have happened, there was an expectation of profit from those that invested into the ICO where they would benefit from the efforts of others, the people that were actually building the platforms and the networks and things like that.
And so there was a lot of discussions about when and how does the Howey Test apply to the ICO market and then we got a little bit of I’ll call them bread crumbs to follow by the SEC in a June 2018 speech by the director of corporate finance, William Hinman. And this speech has been lauded by many, many, many as the SEC’s stand. I will tell you that the SEC’s commission, as well as the disclaimer at the beginning of his speech, clearly states that those are not the rules of the SEC and the SEC will speak and the Commissioners will actually speak on policy and guidance through what I would call the regular channels and not through a speech from one of the staff.
But again, we will take any guidance we get in this space and try to really understand where the regulators are coming from and how their concerns can be addressed. Because all of this legal stuff is really about how do you build a product, how do you build a product that you can put in the marketplace and you can focus your time and energy on doing product innovation, going after customers, building your business, instead of really worrying about some of the legal impediments to bringing that product to a market.
Shamir: Completely. So on that trend, Angela, I know we only have another 15 minutes or so and we could go on and on about the different enforcement actions and everything else-
Angela: I think everyone on this webinar can figure out very quickly that I can go on for hours on this.
Shamir: Yes, and it is actually fascinating. But there was an ICO boom, there was an ICO bust but sort of also there was a real crackdown on a lot of these ICOs because they were a securities offense. Let’s not beat around the bush. If it looks like a security and it acts like a security, it is a security and you should follow the guidelines and the rules around securities offerings of which there are quite a few.
And people who didn’t they’ll probably have a call from the SEC or may already be talking to them. Some of those enforcement actions have come around. The SEC picked the worst case ones first and cleared those out and the rest I’m sure will come as well at some point.
Angela: But that’s not to say that every ICO has to be a security- [crosstalk]-You know, Jay Clayton the head of the SEC has stated that, well, pretty much everything I’ve seen is a security and subject to it and that may be true but again I think that there has to be a rule for innovation in this product space where you can actually bring a product to the market that does have a token as part of it and not be clearly in one bucket or another. Because again, if you are a security, it’s not just what you do on day one. It is really the impediments to your business as your business and your product is evolving.
So if your token is considered a security, then you can’t trade it except for-
Shamir: Except for an exchange.
Angela: … an exchange and through a broker dealer or an ATS, alternative trading systems, you know which again is going to really become an impediment to the development and the strength of certain products.
There are other reasons of why a product needs to have a token and what the functionality of that token is, and that is where I think figuring out what is your product and in which regulatory bucket it will fall is extremely important. Because just saying it’s not this, it’s not that or we’re not doing an ICO so, therefore, we don’t have to worry about securities laws. Well, that’s not necessarily true. Or we’re not doing a transfer of value so therefore we don’t have to worry about money transmission.
Again, we do have some business models that are out there so [inaudible] and decentralized exchanges and those business models that are going forward where it’s not very clear where their products are going to fall in the regulatory scheme. That’s why I think one of the most important things for the industry overall is to engage with the regulators and to teach them about what is it that makes this product unique, what is it that this product will address in the marketplace and then how does this product take into account … again, going to back to what I was saying earlier, some of those principles of why these regulations exist, right?
So it doesn’t really matter what you’re doing as a US business, you are subject to sanctions laws and you have to comply with them.
Shamir: Yeah, even a multinational business for that matter, right?
Angela: Absolutely. Any business, actually any person.
Shamir: Actually, yes. You can’t trade with like Iran or [inaudible] or those sanctioned countries no matter what basis you’re doing it on.
Shamir: So those are things that are just the law regardless of anybody. It applies to everybody. So one question here, so let’s take on Pat’s specific question. So what legal advice would you give to a teen creating a product that does not plan on creating a utility token. I’m assuming they’re not creating a security token either. They’re building an application that requires ETH. What are the legal considerations that they should think make or think about at least?
Angela: So the number one is going to be … again, I’m going to do a disclaimer since I’m a lawyer. This is not legal advice. You should- Shamir: Get a lawyer and legal advice, please. This is a one-sentence question or two-sentence question and maybe like a five-sentence answer.
Right, so this is not legal advice. But one of the things, again going back to what does the product do.
Angela: What does your platform do, what are the things that you will continue to exercise control over, what are the things in the mechanics that you’re implementing to address some of these things.
So as you’re building the product, I highly recommended you talk to somebody that can help you understand which bucket you fall into and how to develop and design your product to stay as much as possible in an area that is regulatory and legally compliant without doing a huge impediment on your business plans. I think that’s the magic sauce that we, as lawyers, try to bring to the table is let’s make sure that this product can work in a good legally regulatory compliant way but it doesn’t present a stop for the business to go forward but find ways that can actually work.
Sometimes it will create some friction. I completely understand and take ownership of the fact that sometimes there are certain things that really create friction in the product, for example, a KYC- Shamir: I was going to go with that.
But how are you going to-
Shamir: So for example, so across these three buckets, like the money, the securities and the CFTC, one thing that’s common is KYC which is Know Your Customer which means that you as a business in any of these buckets need to know who your customer is and the typical way that’s done in the US is by collecting first name, last name, date of birth, address, social security number and maybe some other information.
There’s no requirement that you have to do it only that way but you have to do it some way and so you kind of have to know your customers and dealing completely with anonymous entities from anywhere on the planet will be a problem no matter which bucket you’re in. So if you’re going to be in any of those buckets, then you will have to know who your customers are and figure out some way of collecting that information, storing it and updating it on an ongoing basis.
Another thing across all of those buckets, you’ve got to follow the sanctions laws, right, like you can’t do … if you’re operating in the US at all in any way, then you can’t do business with the countries that the US sanctions.
By the way, other countries sanction other countries. The UK also has sanctions. Europe also has sanctions and, for all I know, every country in the world has sanctions.
So if you’re going to be in those countries, you have to follow those sanctions laws as well and figure out how to deal with that. The US does not like you using payment systems or any of the US kind of financial and legal infrastructure to do things like drug smuggling or child porn or all these bad activities and so, depending on what you are doing, you want to try and build some reasonable ways to ensure that your systems are not being used for those sorts of bad activities if you’re going to be operating in the US at all.
And by the way, those are banned in most countries globally and those are really not things you should be doing anyway. So sticking your head in the sand and saying I don’t know anything isn’t really a good option. And, by the way, I think the Patriot Act, the penalties for knowingly breaking the Patriot Act is like a $500,000 fine and three years in prison. And unknowingly breaking the Patriot Act is only a $100,000 fine and one year in prison.
So even if you don’t know and you didn’t know and you still broke the law, they’ll still come after you. So do educate yourself, do find a good lawyer, understand what you are actually trying to do and how that fits into the legal framework and try to then build in the product features and the product tweaks so that you can get to what you want to do. You can serve your customers and build your product and go out and change the world but do it in a legally compliant fashion to the extent that it is possible, and usually the regulators and the prosecutors they do understand that some of this is gray and it hasn’t been very clear.
They don’t necessarily try to go after the good people. They try to go after the bad people but don’t rely on the good graces of regulators or prosecutors. Do take the time to educate yourself and do things as well as you can.
I think we have three more minutes so let’s try and quickly tackle Murat’s question which is what about wallets.
Angela: So I think that about wallets one of the first questions about wallets that any good lawyer will ask is how does it actually work.
Angela: And so if you are holding the private keys of the wallets and you have access to it, then it is likely that you would fall within the definition of money transfers in some of the states. It also [inaudible] who are the parties along the way, is your wallet part of a regulated change that actually has an MTL, money transmission licenses. If so, they’re probably falling under that.
So there’s a lot of considerations to be taken as to how the wallet operates, if it is literally just a piece of software and you’re putting it out there and you have no way to control it, it’s I’ll call it-
Shamir: And it’s running on the user’s machine or the user’s servers I mean, whatever, but it’s not running on your servers.
Angela: Right, so then the likelihood that you are a provider that is subject to some licensing and regulatory matters is diminished and you would probably fall within the bucket of software provider, but again you really have to look at what are the functions that you’re providing to the user and what your role initially and on an ongoing basis is going to be in order to be able to do the legal analysis.
Again, not legal advice.
Shamir: Exactly. One thing I should say is that one option which is becoming I’d say increasingly viable … it depends entirely on what you are trying to do, is for the parts of your product or business which are subject to regulation … so for example if you’re transferring funds and you’re subject to money transmission or you’re trading tokens and you’re subject to CFTC or whatever it is, working with regulated entities, and there are a few in the space.
There are companies like Coinbase, Circle, Sila and others who do have regulatory compliant systems for performing activities and if you can work with those companies to do the regulated activities, that’s one way of doing that, right.
So you say, hey, sort of in the traditional FinTech world, I’m going to offload my payments processing to Stripe and I’m going to have my deposits held at a Bancorp bank or some other bank and they have the licenses to be able to do that sort of thing.
You can try and set up analogous systems in the crypto world. You can go try working with some of those guys. Some of them will work with crypto companies, some of them won’t. So that is an increasingly viable option and you should explore that as well.
I feel like we’ve said a lot but we didn’t necessarily give anybody any golden or silver bullets. Frankly, there aren’t any. And if there is enough interest, we might do more of these.
Angela: Yeah, absolutely.
Shamir: With that we are out of time so I think I’m going to have to conclude. Thank you so much, Angela.
Angela: Thank you. As always, a pleasure.
Shamir: And thank you guys for asking so many questions and for being such good listeners and this is recorded and it will be available I think on the site for a while and yes, stay tuned.
We might do a few more of these. Thank you guys.
Angela: Thanks everyone. Have a good day.
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