Keyword: U.S. law

The Token Taxonomy Act: A Fatal Drafting Ambiguity

As we’ve previously written, the Token Taxonomy Act (TTA) is an ambitious and potentially impactful piece of legislation that, by exempting digital tokens from the securities laws, might remove regulatory inhibitions from the maturing digital token industry. The bill is not without fault, however. As it stands, the language of the bill requiring that a digital token’s consensus be inalterable is ambiguously written and the SEC could use a strict interpretation to preclude many digital assets from qualifying as digital tokens.

The proposed additional language of Section 2(a)(20)(B) of the Securities Act of 1933 reads that to qualify for the exemption, a digital token:

(i) must be recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and

(ii) after consensus is reached, cannot be materially altered by a single person or group of persons under common control.

In other words, a digital token must use an inalterable and objectively verifiable process. This language is designed to include in the definition only those digital tokens that are or will be in widespread enough use so that no one single party can influence the nature of the outstanding tokens in a way that adversely affects digital token holders.

The proposed language creates the possibility that the SEC could strictly apply the requirement that a token “cannot” be materially altered. As it stands, proof-of-work and even proof-of-stake digital assets are susceptible to a 51% attack, which could alter the digital token’s consensus. “Proof-of-work” and “proof-of-stake” refer to different systems used to verify and process transactions on a blockchain.

A “51% attack” is an event in which a party takes control of the requisite computer power underlying a token’s blockchain such that the party can control the token platform’s operation. Typically, a party seeking such control needs to possess 51% of the outstanding tokens, but the threshold amount can be lower for individual digital assets. A party that has successfully executed a 51% attack can change the ledger history so that it can, for example, double-spend tokens.

The SEC could negate the potential application of the TTA because the recent 51% attack against Ethereum Classic shows that the risk of attack against proof-of-work digital assets, especially those with a low market capitalization, is real. And although the proof-of-stake system makes a 51% attack prohibitively expensive, the SEC could justifiably claim that it is theoretically possible. An irrational, non-economic actor could still stage a 51% attack against a proof-of-stake digital asset with an intent to destroy it rather than to make profit.

In the end, the ambiguity in the bill’s language might not have a deleterious effect. It is hoped that a regulator would not strictly interpret the bill’s language to exclude the intended beneficiaries because of a hypothetical possibility of a 51% attack. So, too, the digital asset industry will likely continue to innovate new and more secure protocols that could potentially eliminate the threat of 51% attacks, making potential exclusion from the bill’s benefits a moot point. Nonetheless, as the TTA undergoes revision, the potential ambiguity in the proposed language should be remedied.

Transactors in Digital Tokens – New Bill Offers Hope

On December 20, 2018, Representatives Warren Davidson (R-Ohio) and Darren Soto (D-Fla) offered some early holiday hope to digital token issuers by introducing the “Token Taxonomy Act” (the TTA). If passed, the TTA would exclude “digital tokens” from the federal securities laws and would undoubtedly have profound effects for the U.S. digital token economy. The TTA is an ambitious piece of legislation that faces an uncertain future. Nevertheless, Representatives Davidson and Soto should be commended for attempting to provide some regulatory relief and certainty to an industry that has been yearning for it.

In addition to exempting digital tokens from the securities laws, the TTA would amend the Internal Revenue Code and classify the exchange of digital tokens as like-kind exchanges under Section 1031, and allow digital tokens to be held by retirement accounts.

The TTA would also amend language in the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that state-regulated trust companies, which include broker dealers, investment advisors and investment companies, would be able to hold digital assets for customers.

According to the TTA’s authors, the intention behind the bill is to provide much-needed regulatory certainty to digital token issuers and to ensure the U.S. remains competitive against other countries like Switzerland, where blockchain startups are thriving.

However, the TTA’s benefits are hypothetical at this point, since it is likely to be opposed by the SEC. On November 30, 2018, SEC Chairman Jay Clayton opined at a New York Times-hosted event that SEC rules were made by “geniuses” and “have stood the test of time.” He stated that he did not foresee changing rules “just to fit a technology.” While he was not referring specifically to the TTA, these comments indicate an unwillingness by the SEC to change its longstanding rules to accommodate a nascent technology.

Even if the bill is passed, it would permit the SEC to determine whether a particular digital unit qualifies as a security and therefore is subject to the SEC’s regulation. The SEC thus would have the power to halt an offering and force compliance with the applicable securities laws. The TTA would spare issuers from any penalties if they have acted in good faith and take reasonable steps to cease sales. But with an unclear, and a potentially costly or lengthy, appeals process, the SEC could discourage issuers from taking the risk of attempting to qualify and sell digital tokens from the start. This provision would blunt the intended deregulatory impact of the TTA.

Although its future is uncertain, the TTA shows that there are government leaders that are listening to the concerns of the digital token issuers. If the TTA is introduced in the 116th Congress, it will be a piece of legislation worth tracking. Even if this particular bill is not enacted, it might point the way to other legislation whose passage might provide some regulatory relief to those who transact in digital tokens.

Dragged to the U.S. Courts (Part 3): The Importance of a Valid Forum-Selection Clause

We have said it in both part 1 and part 2 of this series: for a U.S. court to exercise its powers over a foreign defendant, it must have personal jurisdiction. But even if the court finds that it has jurisdiction, the defendant can request the court to transfer the case to an alternative forum, even to a different country, under the common law doctrine forum non conveniens. In In re Tezos Securities Litigation, the Swiss defendant Tezos Foundation failed in its attempt to transfer the action to Switzerland because of the operation of its forum-selection clause. In this final part of our series discussing jurisdictional questions for blockchain and cryptocurrency companies, we address two crucial factors that non-U.S. companies should consider when crafting a forum-selection clause.

Once a defendant moves to transfer the case by implicating forum non conveniens, the court will undertake a fact-intensive balancing of private and public factors, such as the location of witnesses and evidence, the enforceability of any judgment, avoidance of unnecessary conflicts of law, and administrative congestion. Generally, courts give great deference to the plaintiff’s choice of forum and transfer the case only if the balance of factors “strongly favors” the defendant. But this analysis changes when the parties have agreed to a valid forum-selection clause. As many courts have noted, and Judge Seeborg repeated in In re Tezos, “Because a valid forum-selection clause is bargained for by the parties and embodies their expectations as to where disputes will be solved, it should be given controlling weight in all but the most exceptional cases.”

In the Tezos case, the Swiss defendant argued that there were no exceptional circumstances preventing the court from giving controlling weight to its forum-selection clause, which stated that “[t]he applicable law is Swiss law [and] any dispute . . . shall be exclusively and finally settled in the courts of Zug, Switzerland.” This forum non conveniens motion, however, failed because the court found that the plaintiff had not been put on notice of the forum-selection clause and thus could not have consented to it.

While forum selection is a complex subject, the Tezos decision demonstrates one necessary requirement for any binding forum-selection clause, dispute-resolution clause, or indeed even contract – consent. Below are two factors from In re Tezos and other cases relating to online businesses that blockchain and cryptocurrency companies should consider if they want their forum-selection clauses to bind their website users:

  1. Choose clickwrap over browsewrap: A clickwrap or clickthrough agreement requires the user to engage with the website, usually by checking an “I agree” or “I accept” box. A browsewrap agreement attempts to bind users of the website by inferring assent to the terms and conditions. Generally, it is easier to prove notice and consent where a clickwrap agreement has been used, since the user is required to take affirmative action to show agreement to the terms and conditions. A browsewrap agreement may also bind the user, but this requires either (i) a showing that the plaintiff had actual knowledge of the agreement, or (ii) the website putting a reasonably prudent user on “inquiry notice” of the terms. The Contribution Terms of the Tezos ICO did not include a clickwrap agreement for the forum-selection clause. And, as discussed next, the browsewrap agreement itself was poorly executed.
  2. When using a browsewrap agreement, make the forum-selection clause visible: The question of whether a user has notice of the terms is likely to depend on the design and content of the website. If a link to a website’s terms of use (which includes the forum-selection clause) is “buried at the bottom of the page or tucked away in obscure corners of the website where users are unlikely to see it,” the courts are likely to refuse to enforce the browsewrap agreement (see Nguyen v. Barnes & Noble Inc., 763 F.3d 1171 (9th Cir. 2014)). Similarly, some courts have found that browsewrap agreements were not enforceable where the link to the terms and conditions was not visible without scrolling down to the bottom of the page, which was not necessary to do to complete the purchase (see Specht v. Netscape Commun’ns Corp, 306 F.3d 17 (2d Cir. 2002)).

A fundamental problem with the Tezos ICO Contribution agreement was that it did not actually include the forum-selection clause but instead had a single sentence, on page ten of the twenty-page agreement, directing users to “refer to the legal document that will be issued by the Foundation for more details.” Adding to the problems, the court noted that the relevant website did not even hyperlink to this legal contract with the forum-selection clause. Finally, Judge Seeborg added that even if Tezos Foundation had added hyperlinks and some language indicating a user’s “purported agreement,” the browsewrap agreement might still be held unenforceable, particularly against individual consumers.

After finding that the terms of the ICO did not provide sufficient notice that the plaintiff had agreed to Switzerland as the forum, the court applied the traditional forum non conveniens analysis and dismissed the transfer motion. Judge Seeborg added, however, that if discovery later shows that the plaintiff was, in fact, aware of the forum-selection clause, then he may consider dismissal or transfer of the case to the courts of Switzerland.

Dragged to the U.S. Courts (Part 2): Avoiding Personal Jurisdiction as a Non-U.S. Blockchain Company

Without personal jurisdiction over a defendant, a court cannot exercise its powers. And when it comes to non-U.S. companies who want to avoid being dragged to court in the U.S., Alibaba Group Holdings Limited v. Alibabacoin Foundation, No. 18-CV-2897 (S.D.N.Y.) and In re Tezos Securities Litigation, No. 17-CV-06779-RS (N.D. Cal.) show that the traditional jurisdictional analysis applies to blockchain technologies as much as to traditional companies. To further minimize the risks of U.S. litigation, blockchain-related companies should also heed the lessons derived from case law related to online businesses – other creatures of the modern age. This is the second part of our series discussing jurisdictional questions for blockchain and cryptocurrency companies. The first part, which can be read here, focused on how the location of the blockchain nodes may affect the court’s analysis.

U.S. courts can exercise personal jurisdiction over a foreign defendant who has either a continuous and systematic presence in the state (general jurisdiction) or “minimum contacts” with the state such that the exercise of jurisdiction “does not offend traditional notions of fair play and substantial justice” (specific jurisdiction). “General” or “all purpose” jurisdiction permits a court to hear all claims against the defendant, while “specific” or “case-linked” jurisdiction permits only those claims which stem from the defendant’s forum-related contacts (see Walden v. Fiore, 571 U.S. 277 (2014)). While some states have adopted additional long-arm statutes, the federal due process requirements must always be satisfied.

Most courts analyze the “minimum contacts” for specific jurisdiction in a three-part inquiry: (1) Does the claim arise out of the defendants’ forum-related contacts? (2) Did the defendant purposefully avail itself of the forum’s laws? and (3) Is exercising jurisdiction reasonable? We will now look at the second prong of the test and the steps that non-U.S. companies setting up operations can take to avoid purposeful availment.

In both Alibabacoin and In Re Tezos, the courts found that a foreign blockchain company with few physical contacts with the United States had purposefully availed itself of the U.S. laws. These cases conform with the principles found in case law related to online businesses. Following is a list of the relevant factors that courts have found showing purposeful availment by Belarus and Dubai defendants in Alibabacoin, by a Swiss defendant in In Re Tezos, and by various other online companies in other cases:

  1. An interactive website accessible in the U.S.: The courts in both Alibabacoin and Tezos agreed that an interactive website available in the U.S., alone, is not sufficient for personal jurisdiction. But the more functional the website, the more likely a court is to find personal jurisdiction (with additional factors present). For example, in Alibabacoin, the court found it relevant that the defendants’ website allowed a user to (1) register a cryptocurrency wallet, (2) access and download content about the Alibabacoin cryptocurrency and white paper, and (3) interact and contact sales representatives with questions.
  2. Using U.S. servers: If the claims brought against a foreign defendant stem from its online activity, the location of the servers can be relevant. In the Tezos case, the court found that the Swiss defendant’s use of Arizona servers was relevant to the securities law claims and personal jurisdiction (although insufficient on its own to establish jurisdiction). And in Alibabacoin, a trademark case, the court stated that “whether Alibabacoin’s Wallet website is actually hosted on servers physically located in New York may also be relevant to the personal jurisdiction inquiry.”
  3. Blocking IP address or providing notice to U.S. viewers: A very recent U.S. appellate court case noted that to avoid purposeful availment of U.S. laws, online businesses should consider blocking U.S. IP addresses (Plixer International, Inc. v Scrutinizer GmbH, 2018 WL 4357137 (1st Cir. 2018)). Even if the technical solution does not keep out all U.S. visitors, the Plixer court stated that the blocking attempt shows intent to avoid U.S. customers and is thus relevant to the jurisdictional analysis. If blocking is too aggressive a business strategy, foreign companies can try to avoid jurisdiction by adding notices on the website that their services or products are not available and intended to be used in the U.S.
  4. Marketing and advertising in the U.S.: Avoiding U.S.-specific media and U.S.-specific discussions can further improve a company’s chances in the jurisdictional analysis. In the Tezos case, the court found that the Swiss defendant using a “de facto U.S. marketing arm” and mostly marketing the ICO in the U.S. showed purposeful availment. The same was illustrated in the Alibabacoin case by the finding that over one thousand New Yorkers visited the defendants’ website and at least one New York resident purchased the tokens.
  5. Employees or agents working in the U.S.: If possible, non-U.S. companies should avoid moving their employees to the U.S., hiring in the U.S., or using U.S. agents. This was an important issue in the Tezos case: the court noted that the defendant “kept at least one employee or agent in the United States,” and this was “responsive” to the purposeful availment test.
  6. Working with U.S. service providers: Although for any contacts in question to create jurisdiction, they must give rise to the claims at issue (step 1 in the “minimum contacts” test), limiting reliance on contacts with U.S. service providers outright can lower the jurisdictional risk. In In re Tezos, the Swiss defendant’s use of a “de facto marketing arm in the U.S.” was an important factor in the court’s analysis. In Alibabacoin, the non-U.S. defendant had dealings with a U.S. company (Digital Ocean), which hosted the Alibabacoin website. But, in contrast to Tezos, because the plaintiff had not showed that Digital Ocean had an “active role” in administering the website or that Digital Ocean’s servers were hosted in New York, the court did not rely on this relationship as a basis for finding jurisdiction. Moreover, contacts with U.S. businesses can overlap with the previous point on marketing. For example, if a company used Google Ad Words to target areas of the U.S., it might increase the chances of the courts finding jurisdiction.
  7. Voluntary sales to the U.S.: Depending on the facts, claims and the state’s long-arm statute, even a few intentional sales into the U.S. may prove purposeful availment. For example, in Alibabacoin, the court highlighted that the plaintiff “presented evidence that at least one New York resident ha[d] purchased Alibabacoin on three occasions.” And in In Re Tezos, the court stated that a “significant portion” of the 30,000 ICO contributors were in the U.S. Similarly, after analyzing the federal case law on this issue, the Plixer court held that a German cloud computing company which “voluntarily service[d] the U.S. market” and made around $200,000 should have “reasonably anticipated being haled into U.S. court.” That court also noted that the Oregon Supreme Court had found jurisdiction over an out-of-state defendant that had sold over 1000 battery chargers totalling about $30,000 (Willemsen v. Invacare Corp., 352 Or. 191 (2012) (en banc)), while a district court in New Jersey did not exercise specific jurisdiction over a defendant who had made fewer than 10 in-state sales totalling $3,383 (Oticon, Inc. v. Sebotek Hearing Sys., LLC, 865 F.Supp.2d 501 (D. N.J. 2011)). Accordingly, voluntary and intentional sales to the U.S. should not be made and, if sales occur, blocking U.S. website visitors, or at least providing clear notice, becomes crucial.

When analyzing specific personal jurisdiction, the courts generally examine these factors together, and it is difficult to rank them in order of importance. The U.S. Supreme Court is expected in the coming years to decide on when online contacts are sufficient to create specific personal jurisdiction. Until then, In Re Tezos, Alibabacoin, and case law on online businesses serve as good guidance for non-U.S. blockchain companies.

Dragged to the U.S. Courts (Part 1): Jurisdiction and the Location of Blockchain Nodes

Following the 2017 ICO boom and the more recent declines in cryptocurrency prices, blockchain-related litigation has substantially increased. U.S. courts have seen most of that action: American regulatory agencies have been more aggressive than their foreign counterparts (the SEC alone has over 200 open investigations), and private parties regularly bring individual suits and class actions. Altogether, close to 100 cases have been filed.

In two recent cases, the courts—for the first time—ruled on jurisdictional questions related to foreign companies by considering the technical aspects of blockchain technology. The opinions in In Re Tezos Securities Litigation and Alibaba Group v. Alibabacoin Foundation illustrate the following three points:

  1. The physical location of the verifying nodes can affect the court’s jurisdictional analysis.
  2. On personal jurisdiction, existing case law related to foreign online businesses serves as useful guidance for blockchain companies seeking to avoid U.S. litigation.
  3. Strategic dispute resolution and forum selection clauses can save the day.

Considering the importance of these issues for avoiding U.S. litigation and the space required to provide enough legal background to meaningfully discuss them, each issue will be addressed in a separate On the Chain post. Today we will address the first point: location of the nodes (the individual devices part of the larger data structure maintaining a copy of the blockchain and, in some cases, processing transactions).

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The physical location of the verifying nodes can affect the court’s jurisdictional analysis

When a foreign defendant is sued in a U.S. court, the court must determine that the U.S. laws in question can be fairly applied and the court has personal jurisdiction over the foreign party. While well-developed legal principles continue to govern the analysis, when a party is a company that uses blockchain and distributed ledger technologies, its reliance on multiple nodes that are physically located across the world raises unique jurisdictional questions. The following two cases tackle this issue.

In re Tezos Securities Litigation, No. 17-CV-06779-RS (N.D. Cal. Aug. 7, 2018)

In In re Tezos, Judge Seeborg addressed whether U.S. securities laws apply extraterritorially to a foreign company that sold tokens to U.S. residents in an ICO. As the readers are probably aware, the Tezos ICO was one of the largest to date, raising over $230 million in July 2017. Tezos Foundation, a Swiss defendant, argued that the sale of the security was not a “domestic transaction” and therefore the Exchange Act did not apply. The Court then posed the question, “where does an unregistered security, purchased on the internet, and recorded ‘on the blockchain,’ actually take place?”

Although the Contribution Terms of the Tezos ICO stated that Alderney (an English Channel Island) was the “legal site” of the transactions and the place where the “contribution software” resided, the Court held that the transaction occurred in the U.S. for the following reasons: (1) the plaintiff participated in the ICO from the U.S. (paying in Ether), (2) payment was made through interactive website that was hosted on an Arizona server, (3) the website was primarily run by an American co-defendant located in California, and (4) plaintiff’s contribution of Ether to the ICO “became irrevocable only after it was validated by a network of global ‘nodes’ clustered more densely in the United States than in any other country.”

Alibaba Group Holdings Limited v. Alibabacoin Foundation, No. 18-CV-2897 (S.D.N.Y. Oct. 22, 2018)

But not all judges give this much weight to the location of the nodes. In Alibaba v. Alibabacoin, Judge Oetken also addressed questions of jurisdiction and the location of blockchain nodes. In Alibabacoin, a trademark case, the Dubai- and Belarus-based defendant (Alibabacoin) argued that the Court lacked personal jurisdiction over it because its ICO sales did not occur in the U.S., since the transactions “consist of ledger entries made in Minsk, Belarus, following observation of changes in ‘blockchain data’ outside the United States.”

In asserting U.S. jurisdiction, Judge Oetken did not buy this argument. The Court held that the place where the transaction is put on the ledger is not relevant, comparing this situation to an everyday online purchase: “it would constrain common usage to say that the transaction occurs at the potentially remote location of the servers that process the buyer’s banking activities and not at location where the buyer clicks the button that commits her to the terms of sale.” The Court concluded that the plaintiff had demonstrated with reasonable probability that personal jurisdiction over Alibabacoin existed, based on other factors, which will be addressed in the next post.

In the future, the courts are likely to continue to focus on blockchain data structure

In Re Tezos appears to be the first time the courts have considered the location of the nodes to be relevant for jurisdictional analysis. But the cases also show that the courts are only beginning to wrestle with this issue.  Jurisdictional analysis will always depend on individual facts and the claims asserted. For example, when focusing only on the fourth factor of Judge Seeborg’s analysis (the location of the nodes), all projects using ERC-20 tokens, which depend on the same cluster of Ethereum nodes, could be considered to operate to some extent in the U.S. Furthermore, the importance of the nodes in jurisdictional analyses is likely to rise because the cases currently in courts are mostly ICO-related. That is, most of the ongoing litigation does not stem from the operation of the blockchain technology but is related to fraud, trademark disputes, and failures to register with various regulatory agencies.

Soon when more blockchain projects become operational and disputes arise in relation to such issues as on-chain transactions, hacking, security failures, and disputes over the governing of the networks, the importance of the data structure of these networks will increase. As a result, the influence of nodes as a factor in the courts’ analyses is also expected to increase, and many foreign blockchain companies that are avoiding the U.S. may, nevertheless, be dragged to U.S. courts.

As will be discussed in the upcoming posts, there are steps a company can take to avoid litigating in U.S. courts, including the set-up of its operations, drafting of its contracts with customers and partners, and litigation strategies pursued in court.