Blockchain and the Law

EU Commission’s “A European strategy for data” Includes Blockchain Shout-Out

On February 19, 2020, the European Commission (Commission) released a communication entitled “A European strategy for data”. It lays out a vision for a “European data space” and a plan – through legislation, technical standards and public-private initiatives – for the EU to become a future leader in data and to create a more permissive data economy. For a more in-depth summary, see our New Media and Technology Law Blog.

One interesting point (among others of course) is the Commission’s highlighting of blockchain technology in its report. First referencing blockchain on page 10, the Commission highlights blockchain on page 11 in a framed provision:

New decentralised digital technologies such as blockchain offer a further possibility for both individuals and companies to manage data flows and usage, based on individual free choice and self-determination. Such technologies will make dynamic data portability in real time possible for individuals and companies, along with various compensation models.

The use of blockchain as a means of controlling the access to, and use of, data elements is one of the oft-discussed means of securing access to personal data. However, certain core features of blockchains (such as “immutability”) raise challenges in the context of applicable laws, including, for example, the feasibility of compliance with data subjects’ rights to request deletion of their data from the blockchain pursuant to the California Consumer Privacy Act (CCPA) or the E.U.’s General Data Protection Regulation (GDPR) or other law or regulation.

It seems likely that such challenges and issues will be resolved, as has often been the case with new technologies, through technological innovation or the evolution of legal frameworks, and that the use of blockchain to manage the exchange of personal information will proliferate. It is interesting to see the Commission recognize that in its document.

Blockchain 51% Attacks – Lessons Learned for Developers and Trading Platform Operators

Once purely theoretical, “majority” or “51%” attacks on public blockchains have dealt participants a reality check: The fundamental assumption of Satoshi Nakamoto’s 2008 Bitcoin whitepaper (that computing power will remain sufficiently decentralized in blockchain networks that rely on a “proof-of-work” consensus mechanism) can in practice actually be exploited to enable double spending.

“The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes…. If a majority of CPU power is controlled by honest nodes, the honest chain will grow the fastest and outpace any competing chains. To modify a past block, an attacker would have to redo the proof-of-work of the block and all blocks after it and then catch up with and surpass the work of the honest nodes.” – Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System

These incidents have provided opportunities for developers of both public and private blockchains, as well as operators of blockchain-based digital asset trading platforms, to learn from the first generation of blockchain deployments. Continue Reading

Supply Chain Blockchain Initiative Receives Federal Antitrust Exemption

TradeLens – a blockchain based shipping consortium – received an important antitrust exemption last week from the Federal Maritime Commission.  The exemption allows five major container line shipping companies within the TradeLens consortium to cooperate in providing data for use on the TradeLens platform. The platform was developed by IBM and Maersk GTD.  Generally speaking, the TradeLens platform offers APIs for digital communication of supply chain event data and allows for sharing of documents with permissioned parties in the supply chain, with the intent of lowering costs associated with documentation and bureaucracy. The associated Cooperative Working Agreement (the “Agreement”), which became effective on February 6, 2020 when the deadline for the Federal Maritime Commission to reject the Agreement passed without incident, enables the various container line parties that are signatories to the Agreement to exchange information related to supply chain events and collaborate on further developing the platform without fear of antitrust exposure under federal law (e.g., the U.S. Shipping Act of 1984, as amended).

Under the Agreement, the parties are expressly permitted to discuss the “terms and conditions of the Parties’ provision of data to the platform, permitted uses of such data, and input into products and services to be offered on the [TradeLens platform]….”, as well as the terms surrounding the placement of bills of lading and similar documents on the blockchain.  The Agreement also authorizes the parties to collaborate on the data provided to the TradeLens developers and on establishing terms governing the storage, protection and use of data related to the operation of the platform. The Agreement carves out certain marketplace competition-related information from the antitrust exemption, however.  For instance, the Agreement does not authorize the parties to discuss “vessel capacity to be deployed by any of them” or terms and conditions or rates and charges related to providing ocean transportation services to their customers.

It is not surprising that we are seeing continued deployment of blockchain in the supply chain space, given the potential benefits of cost reduction, improved security of transactions and the increased ability to use data analytics to optimize distribution and logistics networks.  Still, as we’ve previously discussed in two of our Practice Notes, Blockchain and Supply Chain Management and Best Practices: Smart Contracts, and in various posts on our blog, despite the potential advantages of adopting blockchain solutions in supply chains, legal and practical concerns need to be appropriately addressed for participants to fully realize those benefits.  Among those concerns, antitrust is front and center. When companies decide to test or operate a supply chain blockchain solution, it is necessarily a collaborative affair, raising potential antitrust issues (particularly when competitors within the same industry are collaborating and sharing data about their operations).  Thus, as the TradeLens Agreement illustrates, the success of a blockchain initiative depends not only on the technology but also on resolving some important legal issues to allow the necessary collaboration and interoperability.

IRS Issues New Guidance for Virtual Currency Donations

The U.S. Internal Revenue Service (IRS) quietly added two new questions and answers regarding virtual currency donations to its answers to Frequently Asked Questions on Virtual Currency Transactions (FAQs) on December 26, 2019.  The two new answers address the responsibilities of charitable organizations when accepting donations of virtual currency, including cryptocurrency.

The original FAQs, issued on October 9, 2019 in conjunction with a concurrently issued Revenue Ruling (Rev. Rul. 2019-24, 2019-44 I.R.B. 1) (together with the FAQs, the “October Guidance”), re-confirmed the IRS’s position, announced in Notice 2014-21, 2014-16 I.R.B. 938, that virtual currency is “property” for U.S. federal income tax purposes and provided direction on how the rules generally applicable to property transactions apply in the context of virtual currency.

We discussed the October Guidance, which addressed the taxation of a wide scope of virtual currency transactions, in an earlier post. The October Guidance was the first official guidance on the taxation of virtual currency transactions in more than five years and thus attracted significant attention. It specifically addressed the donor side of taxation related to virtual currency donations, and applied the general rules applicable to non-cash donations to donations of virtual currency.  In addition, the October Guidance also provided information concerning the tax consequences of cryptocurrency “hard forks” as well as acceptable methods of determining tax basis for virtual currency transactions.

Donor Acknowledgment Responsibilities

In order for a donor to properly claim a tax deduction of $250 or more for a donation of virtual currency, the charitable organization must provide the donor with a contemporaneous written acknowledgment.

In order for a donor to properly claim a tax deduction of more than $5,000 for a donation of virtual currency, the charitable organization must sign the donor’s Form 8283, Noncash Charitable Contributions, if the donor presents the Form 8283 to the organization for signature.  Form 8283 requires a qualified appraisal for donated property over $5,000.  The organization’s signature represents acknowledgement of receipt of the virtual currency on the date specified and that the organization understands the information reporting requirements imposed on dispositions of the donated property; it does not represent the organization’s agreement with the appraised value of the property.

IRS Reporting Requirements

For IRS reporting purposes, a charitable organization should treat a donation of virtual currency as a non-cash contribution.  The tax-exempt organization is responsible for reporting such a contribution on its Form 990 annual return (and the associated Schedule M, if applicable).  In addition, the tax-exempt organization must file (and provide the original donor a copy of) Form 8282, Donee Information Return, if it sells, exchanges or otherwise disposes of any portion of the donated virtual currency within three years of the date it originally received it.  This would include situations where the organization sells or exchanges the virtual currency for real currency.

Impact on Charitable Organizations

The acknowledgement by the IRS of the application of the tax rules generally applicable to donations of property to virtual currency donations could be viewed as a positive development for tax-exempt organizations, as it may open up potential new avenues for funding.  However, the implied appraisal requirement for donors making larger donations to be able to appropriately claim the related tax deduction may discourage donations of significant amounts.  Appraisals are not required for publicly traded securities, and the IRS could have taken the view that virtual currency is comparable to publicly traded securities for purposes of the appraisal requirements, but this new guidance shows that the IRS is taking a different view.  Potential donors will likely find it expensive and difficult to find a “qualified appraiser,” which the IRS requires to have earned a recognized appraiser designation (which does not yet exist for virtual currency), or meet certain minimum educational requirements and have two or more years of experience valuing the type of property being appraised (which will be difficult to meet as virtual currency is so new), among other requirements.  Whether this additional guidance will encourage donations of virtual currency to tax-exempt organizations remains to be seen.

Illinois Embraces Smart Contracts with New Blockchain Legislation

As we highlighted in our recent Practical Law Practice Note, Smart Contracts: Best Practices, various state lawmakers are paving the way for widespread use of blockchains and smart contracts in commerce. For example, on January 1, 2020, the Illinois Blockchain Technology Act (BTA) went into effect, resolving some legal uncertainties around the legal status of blockchains and smart contracts in Illinois.

“Smart Contracts,” as defined by the BTA, are contracts stored as electronic records which are verified by the use of a blockchain. Smart Contracts can be deployed in a variety of legal and non-legal contexts, ranging from car rentals to supply chain management. However, one question that has loomed over smart contracts is how courts will review their enforceability, given that smart contracts may not resemble typical, written agreements. Some legislatures, and now Illinois, have sought to address this issue head-on, rather than waiting for courts to decide.

The BTA provides four permitted uses for blockchain and smart contracts:

  1. A smart contract, record, or signature may not be denied legal effect or enforceability solely because a blockchain was used to create, store, or verify the smart contract, record, or signature.
  2. In a proceeding, evidence of a smart contract, record, or signature must not be excluded solely because a blockchain was used to create, store, or verify the smart contract, record, or signature.
  3. If a law requires a record to be in writing, submission of a blockchain which electronically contains the record satisfies the law.
  4. If a law requires a signature, submission of a blockchain which electronically contains the signature or verifies the intent of a person to provide the signature satisfies the law.

In effect, these permitted uses prevent a court from denying smart contracts contractual or evidentiary effect solely by virtue of their status as a smart contract or electronic record stored on a blockchain, though courts will still have to review on a case by case basis. Tennessee and Arizona, among other states, passed similar legislation regarding contractual enforceability of smart contracts. Vermont passed a similar law handling the evidentiary effect of digital records such as smart contracts. Wyoming has also been active in adopting regulations related to digital assets, smart contracts, and blockchains.
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SEC Swings Into 2020, Warning Investors of Initial Exchange Offerings

The SEC’s Office of Investor Education and Advocacy issued an alert on January 14, 2020, warning investors of initial exchange offerings and the potential for fraud. This follows the 2020 examination priorities the SEC released at the beginning of the year, which touched on virtual currencies and digital assets, and signals continued monitoring of market and technological developments in the digital asset space.

Initial exchange offerings (IEOs) are token sales conducted on online trading platforms, where companies outsource most of the work of a token sale to the platform. While the purpose remains the same as initial coin offerings (ICOs) – to raise capital – platforms perform the work of marketing and selling the tokens, due diligence on the companies requesting an IEO on their platform, and AML and KYC diligence on customers – all for a fee, of course. IEOs gained popularity in 2019 as the new favored form of raising capital in the crypto community following multiple actions by the SEC against companies engaged in ICOs and fraudulent ICOs.

In its alert, the SEC highlighted several ways in which IEOs may clash with federal securities laws, including:

  1. Potential registration requirements under federal securities laws governing offerings an sales of securities. The SEC’s previously released framework for analyzing digital assets applies to this analysis.
  2. If an IEO involves securities, the online trading platform involved may need to register as an exchange (or qualify for, and operate under, an exemption such as an alternative trading system) and comply with certain regulations.
  3. The online trading platform may be acting as a broker or dealer in an IEO. Brokers and dealers are (also) subject to additional legal and regulatory requirements.

While the SEC’s alert is late for certain investors, it should also serve as a word of warning to companies considering, and trading platforms engaged in, IEOs. As noted above, certain laws and regulations continue to apply to IEOs, as they did to ICOs. Whether the SEC intends to take action against IEOs remains to be seen, but companies should be wary of potential actions down the road and should focus on structuring IEOs and any token trading platform they operate to be compliant with applicable laws and regulations.

Among an Array of 2020 Examination Priorities, SEC Signals Continued Interest in Cryptocurrency

On January 7, 2020, the Securities and Exchange Commission (SEC)’s Office of Compliance Inspections and Examinations (OCIE) released its 2020 examination priorities. The majority of OCIE’s priorities for the coming year involved financial regulatory issues that do not directly involve cryptocurrency – for a more detailed review of those priorities, please see the Client Alert posted on our firm’s website.

Tucked away in the SEC’s 22-page document, OCIE identified two examination priorities concerning virtual currencies and digital assets:

  • First, OCIE advised that it will continue to “examine SEC-registered market participants” engaged in cryptocurrency activities, specifically for: (1) investment suitability, (2) portfolio management and trading practices, (3) safety of client funds and assets, (4) pricing and valuation, (5) effectiveness of compliance programs and controls, and (6) supervision of employee outside business activities.  OCIE stated that the rapid growth of digital assets presents various risks, including “for retail investors who may not adequately understand the differences between these assets and more traditional products.”
  • Second, OCIE will continue to examine the core functions of transfer agents involved in the settlement of securities transactions and their role in maintaining proper records and safeguarding funds and securities. Specifically, OCIE noted: “Examination candidates will include transfer agents that serve as paying agents for issuers, transfer agents developing blockchain technology, and transfer agents that provide services to issuers of microcap securities, private offerings, crowdfunded securities, or digital assets.”

OCIE’s sustained interest in the risks associated with cryptocurrency is certainly not surprising, as evidenced by the SEC enforcement activity in the latter half of 2019 (which included, among other things, attempts to halt what it deemed non-compliant token distributions). Indeed, looking ahead, other regulators such as the IRS, FinCEN and CFTC are also watching the cryptocurrency space closely.  Thus, regulated entities engaged with blockchain and digital currency should understand the OCIE’s 2020 examination priorities in maintaining policies addressing regulatory compliance concerns.