Crypto Equity Crowdfunding : magic Internet equity, app-coins, or both?

The last week of October saw the crypto-currency community seized by the dread of government crackdown as rumours spread that the US Securities and Exchange Commission (“SEC”) had turned their attention to the crypto 2.0 world. The panic was, unsurprisingly, premature. The purported SEC letters received by various crypto-currency and crypto-equity businesses merely sought further information about the business operations, fundraising activities and finances of the recipient companies. It was alleged but not confirmed and in fact later denied, that certain bitcoin based companies have been targeted by the SEC for the offering of unregistered securities. This surely won’t be the last time crypto 2.0, digital assets, and securities law appear together on the news-cycle. Questions related to new types of digital finance and securities law will surely only grow with the success and expansion of second generation services which have origins in digital currency, such as Bitcoin.

Though difficult to qualify, “crypto 2.0” generally means second generation cryptography based services that build software layers on top of existing financial systems including bitcoin and traditional fiat currency. Crypto 2.0 services include the creation of and trade in complex financial products that enable a range of different types of investment. Some crypto 2.0 services, such as Ripple, offer real time asset exchanges. Others, such as Mastercoin, allow users to trade just about anything of value online peer to peer. Another crypto 2.0 player generating a lot of buzz is Bitshares X, a distributed database and ledger that also provides for the trading of different digital math-based assets.

Most of these new financial services are built on top of ‘DAC’s. DAC stands for distributed (or decentralized) autonomous corporation. A very simplified definition of a DAC is that it is a protocol, software and network that can perform any number of functions, depending on how it is programmed. Activity on a DAC can be directed in a number of ways. For example, BitShares X is a family of distributed autonomous corporations. It describes its DAC as “as an exchange where currencies, commodities, and stock derivatives can be traded with most of the features used by professional traders including shorts and options. The bank takes a cut on every transaction and pays these transaction fees to the delegates and then shareholders…”. Shareholders are holders of BitSharesX, a digital coin or asset that can also be traded and whose value is related to the success of the BitSharesX exchange. All the transactions that go through BitSharesX charge a fee. This fee is paid to the “delegates” who support the network and verify transactions. They maintain servers, process transactions, and take a charge via the network fees. Other fees may be distributed back to holders of BitSharesX. Some compare it to owning shares in a stock exchange company, such as the Nasdaq. One key difference, however, is that Nasdaq is a legal entity, a corporation with a governance structure. BitSharesX has its own ‘governance structure’, but these “corporate by-laws” exist as a software protocol. Shares in BitSharesX are not shares in a legal entity incorporated under a statute. While these assets may not be stock in a corporation, they may, according to their characteristics, be considered an investment contract. This means that BitSharesX units may be considered securities.

Activity on a DAC can be directed in a number of ways. One such was is through the appcoins issued by the DAC. Appcoins are the tokens that users need to interact with the DAC. These tokens trade on exchanges such as BitShares, a crypto asset exchange affiliated with but distinct from BitSharesX. Other types of assets that trade on BitShares are BitUSD, BitEUR, and BitCAD – all crypto assets whose unit value is meant to track the US dollar, the Euro, and the Canadian dollar. These are stand alone assets and not based on DACs.

Applications of second-generation cryptography services that are getting the most traction are those used for financing and for asset trading. Seedcoin, for example, invests in bitcoin related start-ups through a bitcoin denominated fund. People purchase equity in ventures by sending bitcoin and can view un-registered prospectuses online. There is also Cryptostocks, a crowdfunding platform that allows users to invest in a wide range of products. Swarm is another decentralized crowdfunding start-up.

The first legal question that comes to mind is whether crypto crowdfunding involves the selling of equity, and would thus qualify as equity crowdfunding. While crowdfunding online has become a popular way to raise money for individual projects, securities regulators have not yet allowed companies to raise money by selling equity using the crowdfunding model. This is changing, slowly. Many provincial regulators, such as Saskatchewan, have put out calls for public commentary on proposed rules that would allow for equity to be sold through crowdfunding, provided certain conditions are met. One of the major questions flowing from crypto equity crowdfunding projects and DAC related fundraisers that raise money (or Bitcoin) by selling other appcoins is whether this constitutes selling equity. Alternatively, one can also speculate that these activities resemble more closely the type of crowdfunding used today on kick-starter – whereby people send money to pre-purchase a product. In this case, the product is an appcoin or token that that allows the purchaser to interact with a software program and trade for other appcoins. Some cases are clearer than others as to whether the type of asset being bought represents equity in a venture and would thus be subject the securities laws. In such a case these crypto-equities may be able to operate through crowdfunding exemptions that will eventually be implemented.

Without doubt the crypto-equity sector of the growing financial tech (fintech) industry will draw the scrutiny of securities regulators who are mandated to protect the investing public. At face value, many of the crypto 2.0 businesses appear to be involved in soliciting investments from the general public. Less certain though, is how securities law will apply to these novel virtual assets whose underlying characteristics are varied and difficult to define. Even more confusing is the fact that virtual assets are referred to by those using them with the same vocabulary as financial products traditionally treated as securities and governed by the relevant legislation. This, despite that fact that it is far from certain which types of digital assets would qualify as such. If there’s anything is be sure about it’s that this rapidly innovating technology isn’t slowing down anytime soon.

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Budget implementation bill would require digital currency businesses to play by FinTRAC rules

In the 2014 federal budget, the Canadian government made unequivocal its concern that virtual currencies, specifically Bitcoin, are an emerging risk that threatens “Canada’s international leadership in the fight against money laundering and terrorist financing”. The Government promised to introduce anti-money laundering and anti-terrorist financing regulations for virtual currencies and to provide FinTRAC up to $10.5 million over five years to implement these changes.

Making good on that promise, the budget implementation bill, Bill C-31, introduced on Friday March 28, 2014, includes important amendments to the Proceeds of Crime (Money Laundering) and Terrorist Financing Act (the “Act”) that would subject digital currency to the application of the Act. Like other money service businesses and foreign exchanges, once enacted, these changes would require certain virtual currency businesses to comply with record keeping, verification of identity, reporting of suspicious transactions and registration requirements under the Act.

Other amendments to the Act attempt to deter businesses from operating outside of Canada for the purpose of avoiding the Act’s compliance regime. Under the proposed changes, reporting, KYC (“know your customer”) and licensing requirements would also apply to money service businesses that do not have a place of business in Canada but that provide services, which include dealing in virtual currencies, foreign exchange dealing, remitting or transmitting funds, and issuing or redeeming money orders, to persons or entities in Canada. A new provision would prohibit certain Canadian financial service providers, including money service businesses, businesses dealing with virtual currencies, and securities dealers, from having a banking relationship with any money service business that does not have a place of business in Canada unless those foreign entities are registered with FinTRAC. For digital currency businesses operating in Canada this means that when opening or maintaining an account or providing services to a foreign money service business such as international electronic funds transfers, and cash management they must ensure that the foreign entity with which they are dealing is registered with FinTRAC where such registration is needed.

It is important to note that the inclusion of virtual currency is merely part of a wider scale crusade to strengthen Canada’s anti money laundering and terrorist financing efforts. For example, the Act imposes additional obligations on money service businesses with respect to customer identification and record keeping specifically for dealings with certain individuals such as politically exposed foreign persons. New categories have been added to expand these obligations to dealings with politically exposed domestic persons and international organization members.

At these early stages there are still many questions as to how these changes will apply to the virtual currency industry. It is still not clear what types of virtual currency activities would be subject to the law. The proposed amendments apply to businesses in Canada that are engaged in the business of providing the service of “dealing in virtual currencies, as defined in the regulations”. While we can be somewhat confident in expecting this definition to include bitcoin and alt-coin exchanges, much needed clarification should come from corresponding amendments to the regulations.

The imminent arrival of compliance requirements to the virtual currency industry means that bitcoin businesses starting up in Canada should set up their business model and practices in ways that facilitate compliance with not only anti-money laundering laws, but privacy and consumer protection laws as well. Having these types of policies have become best practices in the virtual currency industry. Not only is it less costly to implement these policies at the early stages of a business rather than changing the status quo later on, federal and provincial regulators may not grant a grace period for digital currency-service businesses before requiring them to have a license. Moreover, having these policies and practices in place can help your business acquire consumer confidence and increase the value of your business.

Despite the initial skepticism of the federal government and FinTRAC towards the role of Bitcoin in the Canadian financial system, many continue to view the government’s regulatory stance to be investigative, rather than hostile. Anticipation is tainted however, by fears that Canada, currently a hotbed for innovation and growth for Bitcoin and distributed ledger technology, may stifle potential with onerous and misguided legislation. While it is perhaps too early to speculate on the broader effect of these proposed amendments, at the very least they suggest a desire to make virtual currency businesses play by the same rules as their fiat counterparts. The Senate Committee on Banking Trade and Commerce’s decision to study virtual currency until June 2015 also conveys an investigative approach. In light of these developments, industry players can continue to be guardedly optimistic that impending legislation regarding virtual currency can be the result of careful deliberation and thorough consultations that take into account the important views and perspectives of industry stakeholders while balancing with the need to protect the public and fight crime.

We will continue to monitor the ongoing initiatives by Canadian regulators and industry as the virtual currency landscape in Canada continues to evolve and will provide market participants with information about any new developments as they arise.

For more information on this topic please contact:

Jillian Friedman, attorney        jillian@bitcoinembassy.com

A cautionary note:

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

 

Protection Standards on the Horizon for Cryptocurrency Exchanges as First Class Action Filed

By: Jillian Friedman

Last month saw the collapse of a foundational member of the Bitcoin community, Mt. Gox. A class action lawsuit, that will likely be one of many, has been filed in Illinois against former the bitcoin exchange industry leader, its parent companies, and Mark Karpeles, Mt. Gox’s sole director (Gregory Greene v Mt. Gox Incet al, U.S. District Court, Northern District of Illinois, No. 14-01437). The exchange has filed for bankruptcy protection in Japan and, subsequent to the institution of class action proceedings, in the United States as well.

Although the bankruptcy filing temporarily suspends the class action, the suit raises important questions about the standard of care incumbent on crypto currency exchanges and similar services in safeguarding and protecting information and assets from being accessed, stolen, or otherwise harmed. Calls for regulation from the conventional financial services industry and within the Bitcoin community have been a primary outcome of the Mt. Gox debacle. This is not surprising because significant regulatory interventions, especially in the financial services sector, tend to follow crises, whether they are real or perceived (Christopher Nicholls, Financial Institutions: The Regulatory Framework, LexisNexis, 2008 at 36). However, this lawsuit may also shed light on industry practices and the technologies behind them, of which many are currently being developed, that aim to cultivate a robust self-regulating and transparent environment for Bitcoin exchanges and services that manage and or hold assets.

The claim filed by Gregory Greene individually and on behalf of class members, includes several causes of action stemming from the closure of the site and loss of what is currently estimated at $475 million dollars worth of bitcoins, as measured at today’s price. The chief allegations are consumer fraud and that Mt. Gox “wrongfully induced Plaintiff and the Classes to purchase its services and provide it with Fiat Currency and bitcoins (sic)” (par. 64). The underlying substance of these claims is that Mt. Gox made false representations regarding the utility, safety, privacy and security of the Mt. Gox website and exchange. Specifically, Mt. Gox falsely promised that the service would protect user’s bitcoins and fiat currency and safely and quickly allow them to buy, sell, trade, or withdraw the same at any time. To be successful under this claim, it must be demonstrated that, had consumers known of Mt. Gox’s true business policies, practices and procedures, the class members would have paid substantially less for Mt. Gox’s services, or would not have paid at all (par. 56). For the allegation of “fraud in the inducement”, the plaintiff will seek to prove that Mt. Gox perpetrated a fraudulent scheme in falsely leading consumers to believe that the exchange was safe and secure, and that users’ would be able to freely deposit and withdraw fiat currency and bitcoin at any time (par. 68). Though not specifically addressed, users are also irate over Mt. Gox’s reassurances that the site was merely experiencing temporary technical difficulties, when it is largely speculated that the company was in fact insolvent.

In addition to punitive damages, the amounts that the plaintiff is claiming is based on the injury suffered. According to the proceedings filed, this amount is the price of bitcoins and fiat currency that were lost, stolen or “misused” by Mt. Gox, as well as the loss of value in those bitcoins that the claimants were prohibited from selling. Damages claimed also include the difference between the price the claimants paid for Mt. Gox’s services as promised and the diminished value of those services in light of the actual utility, safety and security of Mt. Gox (par. 60-61, 69).

Perhaps most interesting to the broader evolution and maturation of the bitcoin exchange industry, will be whether any legal precedent arises from the court’s analysis of the claims of Mt. Gox’s negligence and breach of fiduciary duty, should this case ever go to trial. Establishing the fault of negligence and a breach of fiduciary duty often depends on established legal and industry standards to demonstrate a divergence therefrom and subsequent fault. The proceedings accuse Mt. Gox of “failing to implement industry-standard protocols and exercise reasonable care in light of foreseeable risks in maintaining, protecting and safeguarding the Plaintiff’s bitcoins and Fiat Currency within Mt. Gox’s control” (sic) (par. 74).

The finding that Mt. Gox failed to maintain appropriate data management and security measures necessarily requires an examination of what procedures are currently in place on bitcoin exchanges, and whether these measure are sufficient. It could also provide guidance on what the standard of security procedures should be in order to avoid legal liability. The proceedings assert that Mt. Gox “had a duty to employ procedures to detect and prevent the improper access and misuse of Plaintiff’s and the Classes’ bitcoins and Fiat Currency and also to allow them complete access to the same (sic).” (par. 73).

The bitcoin exchange industry is rapidly evolving, new entrants continue to emerge and no one exchange can be said to have market hegemony. Given the infancy of this industry, it is not obvious what the standard of care is for a bitcoin exchange and whether industry standard protocols can be said to exist. This is why today, more than ever, the Bitcoin ecosystem requires that a robust, transparent and accountable self-regulatory regime be developed and implemented to provide confidence to all users: early adopters, new entrants, and larger institutional investors, alike. The issues raised in this suit are one way that the Mt. Gox fallout could be good for Bitcoin. Not only does the collapse eliminate weaker operators, it will prompt more robust self-regulation and best practices among bitcoin exchanges and service providers in order to compete for the confidence of users. Many “bitcoin 2.0” projects are currently developing tools to implement procedures that will mitigate the risks of storing and transacting with digital-assets and fiat currency on an exchange.

The end of Mt. Gox may be seen as an opportunity for the development of industry best practices; a process that will benefit from the participation of businesses and industry groups such as The Bitcoin Foundation and the Bitcoin Alliance. More specifically, it may also incentivize the Bitcoin industry to expedite the implementation of cryptography based self-auditing and protection mechanisms. These cryptographic-based tools, which include, inter alia, escrow solutions, mechanisms to prove solvency, and disclosure of proprietary information, seek to eliminate information asymmetry and will likely be important to industry player’s competing for consumer confidence.

A cautionary note: The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.