Keyword: Transactional Issues (technology, IP, privacy applications)

6 Questions Blockchain Founders Should Ask When Launching a Product or Token

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As any founder knows, operating in the blockchain space requires navigating a myriad of regulatory regimes. While every product and token are different, below are 6 key questions that any founder should ask themselves as they launch their product or token:

  1. Are you advertising to the public? If a company advertises to the public, anti-fraud and consumer protection laws are relevant. Regulators in the U.S. from the Federal Trade Commission and the Consumer Financial Protection Bureau, along with state attorneys-general, enforce rules to ensure advertisements and public statements do not contain (among other things) statements or promises that are false, misleading, or deceptive. Companies should screen public messages with their counsel before publishing them.
  2. Where do you plan to launch your product or token? Companies should be aware of sanctions programs in jurisdictions in which they plan to operate. In the U.S., the Office of Foreign Asset Control (“OFAC”) enforces compliance with U.S. sanctions programs. Conducting transactions with sanctioned persons or in a sanctioned jurisdiction is an offense and OFAC may impose penalties on a “strict liability standard.”  This means that OFAC can hold violators civilly liable regardless of whether they knew they participated in a transaction with a sanctioned person or entity. Many companies have policies and internal controls (e.g., customer screening and IP address blocking) meant to prevent prohibited transactions.
  3. Would a person reasonably rely on the Company’s efforts to profit from their purchase? If a blockchain company issues or plans to issue tokens or other digital assets, it is imperative that the company complies with securities laws. The lodestar for determining whether a token is an “investment contract” (one type of security) is the Howey Test. In short, pursuant to the Howey Test, a token is a security if a purchaser could reasonably depend on the efforts of a third party (i.e., the company) to generate a profit. While the interpretation of the Howey Test is more nuanced than that, understanding how consumers are going to think about your token is important in assessing the level of risk that launching the token might impose. The actual application of the Howey Test is fact intensive, and therefore requires comprehensive review and application of the token and the Company’s distribution plans.
  4. Will employees have access to sensitive information that could impact prices? If a company’s employees will have access to material, non-public information regarding prices of the company’s publicly traded digital asset or any other asset trading on a platform controlled by the company, the company should implement policies to prevent employees or other insiders from profiting off of that information (by implementing, for example, insider trading policies). These policies should dictate how and when an employee, consultant, or director is allowed to buy and sell the company’s digital assets or any other asset trading on the company’s platform.
  5. Will the Company transmit someone’s money? Blockchain companies acting as an “administrator” or “exchanger” of “convertible virtual currency” (“CVC”) may be deemed a money transmitter under federal law. In short, if a company has the authority or power to issue, remove, or exchange a cryptocurrency or virtual currency, the company may be required to register as a “money services business” under the federal Bank Secrecy Act, which requires companies to assist the U.S. government in detecting and preventing money laundering. In addition, 49 states also have “money transmission laws.” Each state has different laws with respect to CVC, so a state-by-state analysis will be required to determine where the company should file for money transmission licenses.
  6. Will the Company collect customer information? Consumer data protection has received a sizable amount of attention from both legislatures and regulators over the past several years, including the implementation of GDPR in the EU and the CCPA in California (just to name a couple prominent laws).  Any company that is collecting, storing, or transmitting consumer information should review its online privacy policy and terms of use, as well as its internal policies around how that information is stored and where that information is transmitted.  Even if still under the control of the company, data transferred from one jurisdiction to another may violate applicable data privacy laws.

The 6 questions above will help frame some of the more common regulatory issues that companies in the blockchain space need to pay attention to, but that list is certainly not exhaustive.  With an increased focus on blockchain companies by regulatory agencies, it’s important that founders operate within and understand existing regulations, and also make a plan for how they will adapt as those regulations change.

5 Things to Know About Token Warrants

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Venture capital investors in blockchain companies often require formal rights to receive tokens or other digital assets created by those companies. Typically, these rights are provided through an instrument called a “token warrant.” While token warrants are most frequently issued in priced rounds, they have become increasingly prevalent in connection with SAFE or other convertible rounds. Here are five things that any blockchain company or investor should know when evaluating token warrants:

  1. Token Warrants Can Confer Broad or Narrow Rights. Companies and investors should pay close attention to the types of tokens that warrants entitle their holders to acquire. Token warrants may provide holders with rights to receive one specific type of token only, such as the first governance token issued by a company. However, token warrants typically provide holders with rights to receive any future tokens created or issued by a company or its affiliates – as well as any future tokens issued by an acquiror of the company’s intellectual property or any entity established by or on behalf of the company to issue tokens or operate a blockchain-based protocol or other technology associated with the tokens. Token warrants may also provide holders with rights to receive tokens created or issued by the company’s founders.
  2. Exclusions May Apply. Token warrants often outline specific types of tokens that are not acquirable under the terms of the warrant. Often known as Excluded Tokens, they generally include tokens that are generated pursuant to mining, staking, or reward systems. Depending on the applicable company’s business, Excluded Tokens may also include non-fungible tokens, stablecoins, or certain tokens issued in the ordinary course of business. Typically, the company and its investors will negotiate what is considered an Excluded Token based on the company’s business model.
  3. The Number of Tokens Issuable to Holders Can Be Calculated Several Ways. Token warrants specify the share of tokens holders can acquire under the warrant. This typically depends on three key variables:
    • The set of tokens from which the holder’s share is calculated: The holder’s share may be calculated from the number of tokens minted, from the number of tokens minted and issued to the company’s “insiders,” which includes the company’s stockholders and holders of its convertible or exercisable securities, or otherwise. In the “insider” structure, the holder would not be entitled to any share of tokens that are reserved for community members or other non-“insiders.” In addition, token warrants may provide holders with rights to tokens issued in inflationary events or in connection with other increases in the token supply.
    • How to calculate the holder’s share: The holder’s share may be a hard-coded percentage, but it is more typically based on the holder’s fully diluted ownership of the company. In the latter structure, the holder’s share will typically equal its fully diluted ownership as a percentage of the total cap table. But investors may negotiate a “super” pro rata share, which is a multiple (e.g. 1.25x, 1.5x) of the investor’s fully diluted ownership.
    • When to calculate it: The time at which a holder’s share is calculated can make a difference in how many tokens the holder has a right to acquire. For example, the holder’s share may be calculated as of the date of warrant issuance, the date of the applicable token launch, or the date the warrant is exercised.
  4. “Lockup” Provisions Govern the Transferability of Tokens. Token warrants typically specify the “lockup” restrictions that will prevent holders from transferring tokens acquired under the warrant for certain periods. Lockup schedules in token warrants may include provisions that prohibit any transfers of tokens for one year after the tokens are acquired, release some tokens from lockup at the one-year mark, and then release the balance over successive monthly increments. For example, a lockup schedule may prohibit 100% of the tokens from being transferred until the one-year anniversary of the exercise date, and then permit the transfer of 50% of the tokens on the one-year anniversary and 1/24th, 1/36th or 1/48th of remaining tokens over the next two to four years. A common provision requires an early release of the lockup provision if certain “insiders” (particularly founders or board members) have a less stringent lockup period. Token warrants may also provide the token issuer with rights to impose additional transfer restrictions on tokens in light of regulatory requirements or in connection with centralized exchange listing requirements.
  5. Beware of Token Warrants that Compensate Service Providers. Token warrants are not ideal instruments for compensating a company’s service providers (e.g. employees, contractors, advisors). The Internal Revenue Code subjects deferred compensation – including token warrants – to a variety of complex and generally unfavorable tax, vesting and exercise rules. Therefore, companies should generally limit issuing token warrants to investors.

Get to Know This Acronym for a Crypto Regulatory Alternative: DAOs

Governmental authorities are moving toward tighter regulation on cryptocurrency projects. Decentralized autonomous organizations (DAOs) present a potential alternative, with many cryptocurrency projects planning to launch as, or convert into, DAOs.

At the most basic level, DAOs are organizations moderated by self-enforced rules encoded by software on behalf of their members—in many instances, the governance token holders. In theory, no single person or team manages the DAO; rather, this function is decentralized and conducted privately through various democratic on-chain voting mechanisms.

In practice, of course, different DAOs are at varying stages of decentralization from the team that created the DAO.

Where Do DAOs Fit in the Regulatory Scheme?

Given the novelty of this governance structure, at least from a legal perspective, it is not surprising that the regulatory response to date has largely been to try to fit DAOs within traditional corporate structures.

For example, Wyoming’s recent DAO law is designed to allow DAOs to fit within an LLC structure. This bill is designed with several benefits in mind, including protecting DAO participants from theories of liability based on general partnerships and giving a corporate form for recently passed legislation that allows DAOs to register as LLCs.

At first blush, this might appear to be a step in the right direction. However, structuring DAOs within this traditional corporate framework is in some ways counter to the original vision of DAOs as decentralized and democratic entities. Such LLCs may inevitably require managers to exercise a significant level of discretion while carrying out the voting of the members, akin to how traditional LLCs would function in a central manner.

Then how can a DAO—which may only exist in the ether—thrive in today’s society and regulatory frameworks? Key to answering this is to examine what off-chain (i.e., real world) functions DAOs can or cannot perform. We explore two examples.

Can a DAO Enter Into a Contract?

Generally, a DAO cannot enter into a traditional contract. However, a DAO can operate by using so-called “smart contracts,” which execute based on an internal, automated trigger—following rules that resemble basic “if then” statements. The “ifs” can be straightforward, objective benchmarks: if a stock achieves a certain threshold, then a payment corresponding to a fixed fee will be issued.

But when the “ifs” are more subjective and require nuanced judgments (e.g., achievement of a service provider milestone), these simple contracts face limitations. Moreover, an entity-less DAO is limited to cryptocurrency transactions, as it is not able to open a traditional bank account in its own name.

Solving these limitations of a DAO will be critical to presenting DAO as a true corporation alternative. For instance, with respect to the subjective evaluation that a DAO may perform, there is building acceptance of committee-based review and approval as a means to provide the if in a smart contract. The committee’s affirmative vote can trigger the execution of contract provisions whether directly or through a transfer of a token to signify the approval.

Regarding the fiat limitation of a DAO, continued proliferation of decentralized exchanges and increased adoption of stablecoins may provide a functional alternative.

Can a DAO Have Legal Rights?

DAOs may also struggle at enforcing their legal rights, as there is no entity to be a plaintiff in litigation. A key function of traditional contracts is enforceability. If a counterparty breaches, one can sue in court for damages.

Smart contracts, however, lack legal enforceability. This creates risk for parties relying on smart contracts, as legal recourse is unavailable if the counterparty breaches. Without traditional enforcement mechanisms, in the smart contract sphere, participants are primarily driven by reputational risk and financial incentive.

This structural distinction may also lead to DAOs and their counterparties utilizing structures designed to mitigate these risks, including extra-contractual forms of incentives to encourage desired performance by a counterparty (e.g., a carrot) and escrows for proof of payment (e.g., a stick).

Another important consideration is whether a DAO can legally own an asset that requires a corporate structure. For instance, can a DAO own intellectual property? Generally, no.

IP and other property must be owned by a legal entity or individual. Nonetheless, DAOs can look to some open source software communities to provide potential road maps for distributed ownership under a common framework.

While none of these provides the traditional legal framework of an enforceable contract, careful smart contract structuring could form the basis for approximating some key contract characteristics in a manner sufficient for many purposes.

The stronger the push to fit cryptocurrency projects into the existing corporate structure, the stronger the pushback will be from the cryptocurrency community. Rather than focusing solely on how to fit a DAO into the existing regulatory frameworks, sophisticated projects can identify and address legal and operational limitations of entity-less DAOs to achieve permissionless access, decentralization, and democratic governance.

Previously published by Bloomberg, September 24, 2021 with co-author Joon Kim (Mina Foundation)
Get to Know This Acronym for a Crypto Regulatory Alternative: DAOs (bloomberglaw.com)

Three IP Issues to Watch Out for When It Comes to NFTs

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Seemingly overnight, non-fungible tokens (NFTs) have exploded onto the market and into the public consciousness. The eye-popping prices that some have commanded—and their potential to revolutionize the concept of ownership itself—have investors, creators, platforms, and brands champing at the bit for a piece of the action.

The concept seems straightforward enough: a digital file—an image, GIF, audio or video file, or even virtual real estate or video game tokens and virtual gear—gets minted as a unique copy on the blockchain, which can then be collected, displayed, and traded; their authenticity and chain of title immutably recorded, forever. Given the nature of NFTs, IP issues associated with their creation, display, trading, sale, and storage have to be carefully analyzed. Before rushing into this heady space, here are a few things you might want to think about.

Who has the rights to mint and sell an NFT? Minting tools and DIY NFT tutorials are now widely available on the Internet, meaning that anyone could conceivably turn a file into an NFT. But just because you can, doesn’t mean you should, and the ease with which an NFT can be minted means that grifters and con artists may be trying to make money off of your work or goodwill. Obviously, copying, selling, or publicly displaying works without authorization from the original creator (or the company that commissioned the work for hire) (1) can constitute copyright infringement, (2) can constitute trademark infringement, if consumers are confused about the source or sponsorship of the NFT, (3) can infringe design patents, assuming substantially similarity, or (4) can violate one’s right of publicity, if the NFT depicts individuals. Remember, copyright infringement can occur not only with exact copies, but also if the work depicts unique characters; trademark infringement can occur not only with copies of logos, trademarks, or other brand identifies, but confusingly similar ones as well.

  • Minters and sellers should ensure they have the requisite rights and permissions to the files they’re minting and selling.
  • Platforms should have policies in place to ensure the same and be prepared to respond to takedown requests to enjoy the protections afforded by the DMCA. As online marketplaces, they should guard against allegations of direct and indirect infringement by ensuring that they don’t knowingly and actively facilitate the creation of infringing works, or somehow create an implied association that they are the brand offering the items displayed.
  • Brands and creators have a great opportunity to build loyalty in their followers and customers, but they should be vigilant about theft of their works and police conduct that could weaken or dilute their marks. Consider using vendors that can help track infringement online or block NFT spammers from stealing and monetizing your works. Don’t sit on your rights and help unscrupulous profiteers develop defenses like laches, waiver/estoppel, or acquiescence.

What IP rights are being licensed, bought, or sold? NFTs are unique in more than one way. When you buy or sell an NFT, the rights you trade may be different from platform to platform or even NFT to NFT. Buying an NFT does not necessarily mean you own the right to display it, for example, or the right to use it for commercial purposes of your own. Sellers may (and indeed often would) retain certain rights even after handing over the deed to the digital asset. Indeed, smart contracts that may be embedded in an NFT could automatically execute certain actions, such as a payment of royalties, with each subsequent sale.

  • Minters and sellers (or…licensors?) deciding between platforms should read the fine print, and ensure rights are clearly granted or retained. If you don’t want buyers/licensees to have certain rights, like minting more NFTs from the NFT they purchase or modifying it in any way, make that express.
  • Platforms should clearly disclose the material terms of NFTs they carry on their platform to avoid litigation risk from potentially unhappy buyers and sellers.
  • Brands need to pay attention to what they’re signing away to properly protect their goodwill. Review your registrations to see whether the classifications listed give you enough coverage for NFTs. Design patents may be an additional way to protect high value designs, and add a layer of protection beyond consumer confusion. 

What IP issues are implicated when the NFT changes hands? Know that when you buy an NFT, what actually changes hands is the token that points to where the digital asset lives – often on another server. (Digital files are simply too large to feasibly be written onto the blockchain.) So what would happen if the company on which the NFT is hosted fails? Or someone forgets to renew the domain name? Some solutions that build in a failsafe rely on multiple copies of the file that are called up by the same NFT. What does this mean when it comes to application of the first sale doctrine?

  • Everyone should get clarity and define the parties’ respective responsibilities regarding NFT persistence to determine responsibility for hosting and maintaining the digital file, which requires understanding where exactly it lives and how it is retrieved for display by the owner. Particularly for high-value, one-of-a-kind works, consider drafting out exactly what happens if the buyer calls it up and it’s temporarily unavailable for myriad technical reasons.

Cryptocurrencies and Online Promotions: Legitimate Activities or Fraudulent Schemes?

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The Internet is a double-edged sword, presenting business opportunities undreamed of 20 years ago – and the potential for fraudulent practices on a scale previously unimagined: Ponzi, pyramid and illegal “multi-level marketing” (MLM) schemes that use the reach of the Internet to victimize tens of thousands of people. Where do cryptocurrencies and efforts to market them fit into this mix of legitimate and fraudulent activities? Help comes to us from the FTC’s recent (January 2018) guidelines on the lawfulness of MLMs, which can be extrapolated to cryptocurrencies and their marketing.

Learn more from this recent IP Landscape post.

What Do CurryKittens, Stephen Curry and Trade Secrets Have in Common?

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In May 2018, Axiom Zen released cryptocollectibles, unique digital tokens created using blockchain technology, called “CurryKittens.” In a complaint filed under the federal Defend Trade Secrets Act, founder Starcoin claimed that Axiom Zen, a once-prospective business partner, misappropriated Starcoin’s trade secrets by using Stephen Curry’s likeness in the CryptoKitties platform.

We break down the court’s decision in our Trade Secrets Watch post.