The global blockchain frenzy is creating a new — and swiftly evolving — paradigm for investment managers and regulators alike. This "disruptive" technology is challenging traditional ideas about how issuers raise capital, how investors invest, how value is transmitted through the financial system and how regulators regulate and adapt to new technologies. As interest in blockchain technology soars as fast and as high as the price that one bitcoin has ascended in the past year, many players in the capital markets are applying existing securities laws to new digitally-driven financial products and services.
Blockchain technology, which has been likened to the "second generation" of the internet, has begun to fulfill its "promis[e] to disrupt business models and transform industries,"1 including through the introduction of digital assets and tokens, as well as related derivatives.
As regulators, investment managers, lawyers, and others develop and promote legally compliant practices with respect to these new financial innovations, guidance published by the U.S. Securities and Exchange Commission (the "SEC") is likely to have far-reaching implications for organizations, whether brick-and-mortar or virtual, that intend to raise money by selling digital tokens — including sales that may be construed as investment offerings. This guidance includes, among other things, a 21A Report released in July 2017 that focused on The DAO token sale ("The DAO Report")2 and a December 2017 Cease-and-Desist Order (the "Munchee Order")3 with respect to the Munchee Inc. token sale.
This article analyzes how investment management laws may apply to innovative digital financial products. The issues are varied and often complex since many, if not most, of the relevant U.S. securities laws were written long before the invention of the internet, let alone blockchain technology, cryptocurrencies, or the like.
BASIC BLOCKCHAIN BACKGROUND4
What is blockchain? Blockchain (also known as distributed ledger technology, or "DLT") is a technology that theoretically could allow almost anyone with a computer and an internet connection to effect and verify transactions in a decentralized manner.
With a traditional, centralized ledger system of transactions, a single trusted recordkeeper maintains a single master version, or "golden copy," of a database or ledger on which all parties can rely. That single recordkeeper can be a government agency or regulator, bank, transfer agent, or another financial intermediary or trusted party.
By contrast, a blockchain (or, at least, a public blockchain)5 can be compared to a giant, decentralized, publicly available database that is another type of "golden copy." Additions to the distributed ledger are applied through encrypted codes, which are aggregated with all previous ledger entries, or blocks. The nature of the public blockchain allows anyone to enter a transaction that is nearly immutable and verifiable. Anyone with access to the computer protocol program (sometimes called a "node") can see each blockchain transaction; each node sees the same, identical ledger entry. On certain public blockchains, such as the Bitcoin blockchain, various node operators can validate transactions and earn compensation for performing this power-consuming computer processing task. The term "mining" generally refers to the process (in a "proof of work" consensus system like Bitcoin) by which transactions are verified and added to the public blockchain, and a new unit of relevant cryptocurrency is awarded to the miner.6
To effect a transaction, a user simply adds a transaction using a public key, which is recorded on the ledger (e.g., transfer one Bitcoin). By entering a private key, the transaction is recorded on the ledger that is particular to the sender and receiver (e.g., transfer one Bitcoin to Jay). The record of the transaction is recorded as a string of data visible to everyone who can access the ledger, but the anonymity (or, more precisely, the pseudonymity) of the buyer and seller is preserved.
Footnotes
1 Tapscott, Don and Tapscott, Alex, Realizing the Potential of Blockchain: A Multistakeholder Approach to the Stewardship of Blockchain and Cryptocurrencies, World Economic Forum White Paper (Jun. 28, 2017), available at http://www3.weforum.org/docs/WEF_Realizing_Potential_Blockchain.pdf .
2 Securities and Exchange Commission, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Release No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf .
3 Munchee Inc., Securities Act Rel. No. 10445 (December 11, 2017), available at https://www.sec.gov/litigation/admin/2017/33-10445.pdf .
4 We intend this summary to be an extremely simplified and generalized description of blockchain technology; it is included for illustrative, and not technical, purposes.
5 A private, or permissioned, blockchain, may be similar in many ways to a public blockchain, but access is limited to authorized users. For purposes of the background of this article, we focus primarily on public blockchains.
6 According to one source, Bitcoin mining consumes more electricity per year than Ireland. Hern, Alex, Bitcoin mining consumes more electricity per year than Ireland, The Guardian (Nov. 27, 2017), available at https://www.theguardian.com/technology/2017/nov/27/bitcoin-mining-consumes-electricity-ireland .
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