The technology underlying bitcoin and many other cryptocurrencies—the blockchain—can be useful for any activity needing transaction verification or a trusted repository of information. Blockchain technology is particularly advantageous as it allows unfamiliar parties to interact with each other quickly and securely without high legal and transactional costs or the need to trust a central intermediary. As such, the technology is being used for applications beyond digital currency, including smart contracts, property registries, and financial ledgers. Blockchain technology may also implicate federal securities law, which, in turn, could impact decentralized crowdfunding platforms and startups that use the blockchain to raise capital.

Early attempts to offer securities in exchange for bitcoins online have resulted in enforcement actions and penalties by the Securities and Exchange Commission (SEC). More sophisticated companies have raised capital through the sale of their own cryptocurrencies while asserting that these crowd sales are not securities but rather an indirect pre-sale of access to the technology. This issue is arising more frequently with the growing number of blockchain-based crowdfunding startups.

Crowdfunding—the use of the internet to raise money through small contributions from a large number of investors—allows smaller-scale entrepreneurs and projects to raise more capital than they would be able to via the traditional financing system. Most crowdfunding campaigns are conducted on a trusted third-party platform such as Kickstarter, Indiegogo, or GoFundMe. Investors trust the third party to either correctly send donated money to the desired project or return money if the target campaign amount is not reached.

A blockchain-based crowdfunding platform eliminates the need for this trusted third party. It allows startups to raise funds by creating their own digital currency and selling “cryptographic shares” (represented by digital tokens) to early investors. Unlike most traditional crowdfunding services, investors receive non-negligible value as a reward for investing and can benefit from token value appreciation. The tokens also remain tradable, giving investors the option to sell their equity stake in a project. Several blockchain-based crowdfunding platforms have been successful in obtaining significant investment funding for bitcoin infrastructure and other blockchain-powered applications.

However, it is unclear whether exchanging digital tokens (representing equity) for funding is legal. Some have argued that cryptographic tokens issued by decentralized projects are likely to meet the SEC’s definition of a “security” and trigger regulatory scrutiny. However, since companies operating exclusively with cryptocurrencies may not have any connection with a financial intermediary, it could be argued that they operate outside the scope of SEC financial regulations. On the other hand, the blockchain enables creators of projects and tokens to be anonymous; the SEC could argue this warrants agency scrutiny and regulation given the higher risk of fraud among shares issued by decentralized projects.

Unfortunately, the SEC rarely issues guidance on such issues preemptively, and most startups do not have the financial capability to hire a securities lawyer to advise them. The resulting uncertainty about how a particular blockchain-based crowdfunding campaign or application will be treated under US federal law might mean entrepreneurs simply decide to innovate elsewhere. This theory is buoyed by the fact that many regulatory agencies in other countries are more accepting of new technologies. For example, the United Kingdom’s Financial Conduct Authority (FCA) recently initiated Project Innovate—a program of support for businesses attempting to launch novel financial products. The FCA pledged to “identify areas where [the] regulatory framework needs to adapt to enable further innovation in the ‘interests of consumers.’” Blockchain-based crowdfunding campaigns—cheaper and faster than crowdfunding conducted via third parties such as Kickstarter while allowing investors to receive liquid value in exchange for their contribution—are undoubtedly innovations in the “interests of consumers.”

Clearly, our federal securities laws were not drafted with cryptocurrencies or the blockchain in mind. Accordingly, securities lawyers and law firms advising startups regarding early-stage financing will benefit by keeping abreast of government alerts, agency guidance documents, and court rulings that shed light on how traditional securities law concepts will be applied to blockchain-based innovations. Failure to do so, combined with regulatory ambiguity, may drive blockchain entrepreneurs and innovators offshore, which could reduce demand for legal services and eliminate jobs for young lawyers in the United States.

Neil Issar

One Response to Statutory Stumbling Block? Legal Implications of Using the Blockchain for Crowdfunding

  1. Jackson Sattell says:

    Great post, Neil. I remember touching on this topic in my Securities Regulation class, where it sounded like this would definitely fit into the definition of “security”. Whether it fits the definition or not, however, I think you correctly touch on the idea that it is time for the securities law to evolve. Otherwise, these companies are just going to base themselves in other more cryptocurrency-friendly countries, where this entrepreneurial activity can continue unimpeded.

    Hopefully lawmakers are not afraid of change or the daunting task of re-writing securities laws, because this type of behavior (finding new ways to promote business) will continue; and the available technology is making that easier than ever. So it is probably time to keep up with technology, rather than force technology to slow down to the pace of the law.

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