Smart Contracts

A smart contract is programmable computer code that automates functions but is not immutable. Smart contracts can be transferred automatically from one party to another provided certain conditions are met. A smart contract is just a program that is based on an agreement from multiple parties. The smart contract is created to ensure automated compliance to the agreement by the parties by hardcoding compliance. They can be based on any number of variables just as a traditional paper contract can. They are a simple concept and are gradually working their way into mainstream business governance as an improvement to any formal agreement. This reduces the effort of staff, legal assistance, and executives to ensure contractual obligations are met by outside parties, and for managers to ensure internal compliance.

Distributed Ledger Technology (DLT)

Another very simple concept blockchain technology has created is Distributed Ledger Technology (DLT). This improves the process of verifying large amounts of data and their transactional value quickly and efficiently. It also can use a decentralized and encrypted system to ensure greater privacy and security. Decentralized exchanges are mainly unregulated exchanges that provide for trading of key functional digital currencies that involve utility tokens (e.g., BTC, BCH, ETH, LTC, XRP). Information is the most valued asset for corporations. DLT allows that information to be sent and managed more efficiently and with greater security, thereby improving another area of corporate governance.

Digital Asset Enhancements

Digital assets are electronic currency powered by the blockchain that are backed by an asset (e.g., real estate, bonds, intellectual property, revenue or royalty income streams, etc.). Digital assets are significantly more versatile for managing the capital lifecycle. Digital assets allow companies to issue fractional shares in their company, automatically pay out dividends, ensure reporting to investors, manage multiple jurisdictions and their regulations automatically, verify ownership without the need for a transfer agent, and improve consensus mechanisms for shareholder voting. Digital assets are greatly improving the process of managing all those levels of corporate governance.

Digital assets are also improving the way directors of boards interact with a company in a similar way. Boards are often scrutinized for their lack of transparency to shareholders. The use of digital assets can manage the entire process of transparency more efficiently. This reduces the cost of capital, friction costs, informational asymmetry, and the cost of management while improving profitability.

Governance relates to voting rights in this context. Voting rights are typically accorded on a share basis and are like tokens. An investor owning an equity token would have a vote in key corporate decisions made by the issuer. Security tokens allow an investor to participate in company decisions with more efficiency and greater transparency.

Like voting shareholders in publicly traded companies or preferred shareholders in VC-backed companies, security token holders would be given rights to participate in certain governance decisions related to their assets. Some of the guiding questions that drive governance decision-making are centered around the following inquiries: How will rules be established? Will the founders set the rules, or will there be an independent board of directors? Do contributors get voting rights? If yes, what are the limits of such voting rights? Can contributors elect the board? What structures and processes exist to oversee the direction of the company to ensure it stays on course?

Institutional Imperatives in Digital Currency

Digital currency is electronic currency used for commercial transactions powered by blockchain technology. The relevance of these underlying currents is that institutional investors such as venture capitalists are starting to affix themselves to these digital issuers and increasing the capital output. Institutional investors see a greater opportunity for liquidity on multiple channels through an STO. There is a defined process for the transfer of ownership and custody. The ability to hardcode and define governance for token holders also enables a more efficient process in terms of managing and codifying “shareholder” rights. The efficient and effective execution of shareholder rights and more broadly, stakeholders including customers, governments, regulators, suppliers, vendors and the like, are cornerstones of sound corporate governance

STOs are enabling a more efficient and effective implementation of governance protocols. Security tokens can accelerate investor liquidity while maintaining compliance with securities statutes. The STO achieves that without changing the current capitalization table to account for the transfer of ownership. Liquidity can be materialized in some jurisdictions within just a few months to a year. This is an attractive proposition for new age venture capitalists. Most companies don't succeed and typically have a two-year runway. This serves as a hedge for institutional and sophisticated investors.

Digital currency is not only favorable for VC firms and family offices. The benefits extend to founders and key team members—indeed, even the company itself can benefit from additional liquidity through digital issuance. These parties take some comfort in knowing that they can continue their innovation without having to compromise everything immediately. This may include the cost of capital, share dilution, divesting assets, or reallocating resources toward suboptimal use.  They can also generate partial liquidity to utilize for their own financial needs to continue their work. The universe of viable options is broadened.

Even if an STO includes an equity component, it can be spread over multiple investors. This can be a more collaborative approach without stifling decision-making. This is favorable for founders because while they still have investors to account to, they can imbue potential innovation at a greater pace. Liquidity is king in the new age of digital issuers, but governance will also play a key role in the accessibility, efficiency, and portability of new age security offerings.

What Role Will DAOs (Decentralized Autonomous Organizations) Serve in Corporate Governance?

A DAO is an organization of people who communicate with each other via a “network protocol,” communicating with one another through an online set of rules but reaching governance consensus with offline diplomacy. DAOs are the end points of the “gig economy,” which so far has been championed by platforms like Uber and Airbnb, for example. However, they are likely to be truly global cooperatives and their value distributed to stakeholders—not just shareholders and executives.

Decentralized Autonomous Organizations (DAOs) will be superior to that of today's corporate firm structure. For investors, DAOs will eventually become a less risky investment class compared to shares in a regular company that is centralized by control. This will be achieved by offering more predictable and stable ROI (return on investment) and favorable passive returns than most stock dividends while also minimizing two of the greatest risks in corporate operations—human error and executive self-interest. According to the World Economic Forum, “The potential for blockchain lies in its architectural ability to shift, and potentially upend, traditional economic systems—potentially transferring value from shareholders to stakeholders as distributed solutions increasingly take hold.”

The nature and origins of “the firm” are rapidly changing in the digital age where intangible assets such as intellectual property and the corporate brand are now regarded as the most important driver of corporate value compared to tangibles accumulated in the industrial model. This poses challenges for firms still operating in the “old model” including:

• Difficulty in valuing intangible assets in digitally native organizations;
• A gradual and continuing decline in corporate accounting and auditing standards;
• New forms of fundraising, such as Security Token Offerings (STOs)—less costly than traditional and often overpriced and expensive IPOs;
• STOs which can blend equity rights and debt with governance;
• Growing social responsibility for corporations to account for “external costs,” such as ESG and CSR;
• Mounting social costs for corporations such as climate change value-at-risk; and
• The concentration of share value and corporate earnings in growth and tech stocks invested through passive strategies, thereby increasing systemic risk in the capital markets.

Facebook's Proposed Libra Coin: The DAO in Practice

In June 2019, Facebook announced their intention to launch their own proprietary stablecoin, Libra coin, to serve as a payment gateway on their platform of 2.4 billion monthly active users. The Libra coin would be operated under the umbrella of Calibra, a Swiss registered nonprofit organization consisting of a consortium of 100 private organizations that have equal voting rights. Libra is mainly targeting the over–US$600 billion annual market for cross-border remittances. This space has been mainly dominated by major banks and may pose a threat to the existing competitive landscape. The U.S. Federal Reserve and major U.S. banks have expressed concerns over Facebook's initiative and view it as a threat to the U.S. dollar and its functional stability in FX markets.

The goal of Libra coin is to send money instantaneously across borders securely and at low-cost. Libra would be presumably asset-backed by financial assets to include bank deposits in various currencies and short-term government securities (e.g., U.S. Treasuries), which will likely reduce the coins' short-term volatility while engendering trust and stability. Facebook intends to turn its crypto-project Libra into a DAO utilizing a native governance token (the Libra Investment Token). This is a significant development for a company notorious for its centralized control. Facebook's fundamental business model is to harvest and monetize data—reams of data with over 2.4 billion users and targeting the over 1 billion unbanked in Africa. In China and India respectively, for example, there are nearly 200 million and 100 million people with a mobile phone but without a bank account. This represents a significant opportunity for a digital currency to serve as a payment gateway at costs much lower than traditional money service businesses such as Western Union.

The Libra coin could serve as a leading payment gateway among its 90 million small business customers spanning not just consumer products and brands already advertising on Facebook, but potentially including financial services. This includes banking, savings and deposits, investments, insurance, and other financial products. In effect, the Facebook payment gateway would require registration and license as a de facto shadow bank, a regulated CFTC (Commodity and Futures Trading Commission) entity, or money transmitter license. Going into the details of the cost-benefit analysis of the Libra coin is beyond the scope of this chapter. However, in the final analysis, instead of Libra usurping the central banks authority or undermining sovereign currency legitimacy, Libra is likely to be a vehicle for Facebook to achieve its wider goal of becoming the industry benchmark for digital identity. If Facebook can achieve this milestone, it would have access to all personal data. In a digital age of data monetization and artificial intelligence, data is the currency that begets power and sustainable competitive advantage.

The implications of Facebook becoming the industry proxy for digital identity through its Libra stablecoin for the governance of boards are numerous. First, with nearly unfettered access to sensitive personal data of users, this gives Facebook the ability to better optimize and monetize personal financial data that may have otherwise been protected or limited. Second, although it is initially a “permissioned” blockchain with the goal of converging toward a “permissionless” blockchain, the decentralized nature will make it like Bitcoin and Ethereum, in which anyone with technical capabilities can operate. This will expose the coin to certain risks. Although permissionless blockchains can reduce infrastructure costs, they are also slow, open, and are constrained by scalability and privacy issues. This especially applies to financial services organizations, a space Facebook is clearly aiming toward penetrating on a large scale. The recent exit in October 2019 of key members of the Libra Association, including Visa, PayPal, MasterCard, and Stripe, indicates that the strength of increased government regulatory scrutiny may present material obstacles to Facebook's initial coalition of 28 corporate backers. The spate of exits by large players, including the absence of a major U.S. payment processor, is evidence that without regulatory clarity in this emerging space, more companies are likely to exit. The recent congressional testimony of Facebook's CEO, Mark Zuckerberg, before various members of Congress further demonstrates the delayed pace of this significant initiative and its potential impact on the U.S. dollar. This will also likely delay Facebook's strategic program implementation in its quest to compete directly against banks. Third, Calibra has developed specific governance protocols for its association members. Although in theory each corporate member has equal voting rights, this has yet to be demonstrated given Facebook's dominant market power and ownership of the Libra coin. In summary, Facebook's proposed launch of Libra through the Calibra entity is fraught with challenges and risks, let alone Facebook's checkered history of extensive privacy violations.

What Role Does Board Governance Serve in a Digital Currency Environment?

Governance has more to do with voting rights in this context. Voting rights are typically imparted on a share basis similar with tokens. An investor that owns an equity token would have a vote in key company decisions. Currently, most publicly traded companies or reporting issuers send out a quarterly newsletter or “alert” to investors. That alert announces upcoming meetings at which investors could exercise their votes. With security tokens, an investor could be part of company decisions with more efficiency and greater transparency. Governance is not discussed much when it comes to digital issuance, but it plays a key role in the benefits for both the digital currency issuing organization and the investor.

The definition of a security can be broad and unnecessarily overreaching. It can mean an equity position in a company, or a dividend payout/revenue sharing, convertible debt, an asset-backed security like a REIT (Real Estate Investment Trust), intellectual property rights, and even royalty components. Security tokens make it viable to have a multilayered security that has hardcoded protocols that ensure both the investor payouts and the issuing organization remain compliant down to the individual investor digital wallet. That makes jurisdictional compliance far less costly for the issuer. Smart contracts have enabled this.

For example, Canadian Tire fiat currency is the equivalent of a digital currency that has the functionality of a utility token. Canadian Tire fiat currency is issued only to users within its existing ecosystem, allowing users to redeem its value for equivalent goods and services without paying—or promising—dividends. The currency offered by Canadian Tire has an intrinsic value within its respective ecosystem, and value is not derived outside of this system. It is effectively a closed system providing a means of payment while being engaged in loyalty and other programs to incentivize users. Each of the four prongs of the U.S. SEC Howey test are not satisfied in claiming Canadian Tire fiat currency operating as an equivalent security token under the dictates of the SEC regime.

Canadian case-law further supports this position as illustrated in Pacific Coast Coin, where the Supreme Court of Canada (SCC) elucidated “a common enterprise” as a scenario where investors' fortunes are interwoven with and depend upon the efforts and successes of those seeking the investment of third parties. The Pacific Coast Coin test is the Canadian equivalent of the U.S. Howey test. The only difference between Canadian Tire fiat currency and a digital currency via a utility token is that Canadian Tire fiat currency is paper-based; digital currency, in contrast, is electronically built and powered on the blockchain.

By comparison, an established U.S. company, Ripple, has its own native digital currency with ticker symbol, XRP. XRP is widely classified as a utility token and is considered one of five functional currencies. XRP is broadly traded and is liquid on major digital asset exchanges. Ripple is aiming to replace and compete with the archaic and slow SWIFT banking network for international, cross-border fiat currency remittances.

Smart contracts are really “dumb” programs that act as a written script of agreement between two or more parties. These contracts can be affixed to a security token. Security token compliance platforms like Polymath, Harbour Capital, Securrency, or Sec uritize, for example, have designed the technical pieces using these smart contracts to issue various types of tokens easily and to manage the process effortlessly. These firms have a series of “off-chain” processes including anti–money laundering and “know-your-customer” checks to identify customers, match investors to blockchain wallet addresses, and confirm an investor's eligibility to participate in trading. Blockchain wallet addresses allow funds from a wallet, a user requires the recipient's “receive” address or QR code. To receive funds from a wallet, a user can share his or her address or QR code with the sender. Interestingly, and for technical reasons, a Bitcoin (BTC) or Bitcoin Cash (BCH) address will change each time a user requires it, but an Ether (ETH) address will always stay the same.

The Role of DASIs and Their Potential Impact in Corporate Governance

DASIs will revolutionize the way we invest in organizations at any stage. Each party, including regulators, will benefit broadly. The digital age is moving with incredible speed and ferocity throughout the world. Digital currency can solve some issues, but it is not as groundbreaking as the possibility of hybrid security offerings that can eventually be linked to these digital currencies. For anyone doubting how a security can eventually become an openly traded currency, just look to the case of Ethereum—an open-sourced platform. Ethereum had components of a security offering during its ICO but has become so useful as a digital currency and so decentralized that it is no longer considered a security by the SEC and other leading securities regulators around the world. It has been widely viewed as a commodity that is open-sourced where its value is not derived by any of the four properties of the Howey test.

Jurisdictional Considerations for STO Launch

When launching an STO, a global strategy and framework must be developed. Blockchain is global and borderless, and the same applies to your STO. Domestic biases will likely impair your ability to complete the STO funding cycle. The reality is that, for now, digital currency trading activity is heavily concentrated in Asia. For example, reports show as of 2018 that 60 percent of all digital currency buyers and sellers are in Japan while nearly 8 percent are in the United States and less than half of a percent in Canada. When marketing an STO, demographics matter and should form part of your strategy to determine which countries to focus on and which ones to outright avoid.

Generally, companies conducting STOs should block countries that are, at a minimum, considered high-risk STO jurisdictions. These are countries that are not friendly to digital currencies and/or are hostile to digital assets in any form via regulation or other punitive measures. High-risk countries that STOs should avoid include Indonesia, Bangladesh, and Nepal. Lower-risk countries that STOs should avoid include Macedonia, Algeria, Bolivia, Ecuador, and Libya. Recent FATF (Financial Action Task Force) reports in June 2019 have demonstrated these countries are considered high-risk from a KYC/AML perspective.

Incidentally and not surprisingly, none of these countries form part of the G-20, which is where the majority of STO buyers are likely to be identified with serious interest. It's the G-20 countries in combination with FATF guidance and recommendations that are material. The G-20 countries have had delayed digital currency regulation recommendations since mid-2018. The biggest challenge to succeeding with this initiative will be regulatory coordination among the G-20 due to countries' varying capital market structures, maturity, political risks, and liquidity preferences. Luckily, blocking the jurisdictions above shouldn't materially affect the universe of token solicitations or the efficacy of the STO funding campaign.

What Role Will Smart Contracts Serve in Corporate Governance?

Smart contracts are computer programmable code that automate functions but are not immutable. They can be transferred automatically from one party to another provided certain conditions are met. Aaron Wright, associate clinical professor at Cardozo Law School and director of The Cardozo Blockchain Project, recently stated: “The internet forced attorneys to better understand copyright law [and] similarly, blockchain will require a better understanding of securities law and an understanding of the underlying technology of smart contracts.” For reporting issuers, it is crucial that directors have at least a cursory understanding of fundamental securities law principles relating to the fiduciary obligations of directors. The automation and enforcement of smart contracts will be significant to boards as they grapple with shareholder rights, activism, and other oversight functions such as insider trading, quarterly reporting, and proxy voting.

Given that blockchain is both anonymous and decentralized, it is highly secure. This is critical for legal transactions since every single transaction on the blockchain is sent to and verified by every node on a very large peer-to-peer (P2P) network. P2P transactions are electronic money transfers made from one person to another through an intermediary. This is usually referred to as a P2P payment application. Each node on that network validates each blockchain event via a challenge-response system, which it then resends to all other “verifiers” on the node. In the end, independent nodes arrive at a consensus, and “declare” the transactions as valid; notably, any attempts to corrupt this data are then in turn made unsuccessful by being ignored. This concept comprises the core systematic differentiator between traditional legal processes and—now with the aid of blockchain technology—are termed “decentralized” (i.e., P2P) transactions.

How Smart Are Smart Contracts?

Against this background, a smart contract is not necessarily “smart” in that the operation is only as smart as the information feed it receives and the machine code that directs it. One implication of many is that a smart contract may not necessarily be a legally binding contract. For example, it may be a gift or some other non contractual transfer; it may be part of a broader contract. The result of this is that to the extent that a smart contract violates the law, it may be neither binding nor enforceable.

They use digital signatures through private cryptographic keys held by each party to verify participation and assent to agreed terms. Private cryptographic keys are a sophisticated and encrypted form of cryptography that allows a user to access his or her cryptocurrency or digital currency. Smart contracts also allow access to refer to external information data to trigger action(s). In this sense, smart contracts use oracles—a mutually agreed upon, network-authenticated reference data provider which may be an independent third party. This is a source of information to determine actions and/or contractual outcomes, such as commodity prices, interest rates, or the probability of an event occurring. In addition, smart contracts can automate execution processes through self-execution whereby a smart contract will take actions without further actions by the counterparties (e.g., disburse payments).

What Are the Main Benefits of Smart Contracts?

There are various benefits associated with smart contracts:

1. Standardization—standardized code and execution may reduce costs for negotiations and agreements.
2. Security—transactions are encrypted and stored on a distributed ledger that is immutable.
3. Economy and speed—automation reduces transaction times and unnecessary manual processes.
4. Certainty—well-designed smart contracts execute automatically, thereby reducing counterparty risk and settlement risk.
5. Business innovation—automating the flow of digital assets and payments may foster new products and business models.

The above use cases become particularly attractive for financial markets and participants. For example, in the buying and selling of derivative instruments, firms can streamline post-trade processes, real-time valuations, and margin calls. For firms that have securities outstanding with shareholders, they can simplify capitalization table maintenance by automating dividends, recalibrating share issuances, and stock splits. This provides for a more seamless experience for shareholders and reduces the margin of error for board and regulatory reporting.

What Are Some Legal Limitations of Smart Contracts?

Current law and regulations apply equally regardless of what form a contract takes. Contracts or constituent parts of contracts that are written in code are subject to otherwise applicable law and regulation. Legal frameworks apply to smart contracts and may be subject to multiple legal frameworks depending on their application or product characterization. This may span various regulatory statutes, spanning federal and state securities laws and regulations, such as the Bank Secrecy Act (BSA), the USA Patriot Act, and anti–money laundering (AML) rules and regulations. Smart contracts are by no means perfect and contain structural and legal limitations, some of which are outlined below.

Extending Security Token Protocols with Voting Rights While Shoring Up Efficiencies

STOs via the DLT for voting provide a necessary level of transparency. The chief benefit of switching traditional voting systems to the blockchain is the enhanced level of transparency the blockchain provides. The blockchain would—definitively—preclude bad actors from cheating the system. It would ensure participants do not double-vote since there would be an immutable record of both their vote and identity. Deleting votes would be impossible since the blockchain is immutable. Those charged with counting votes would have a final record of every vote counted that could be verified by regulators or auditors at any time. On the blockchain, everything is both immutable and verifiable. Results can also be encrypted, which would encourage transparency while at the same time maintaining a crucial sense of privacy.

Reporting speed is essential for efficient capital markets. Results entered and stored on the blockchain are not just immutable and transparent, however—they're also immediately available. That means conducting shareholder proxies on the blockchain is not only safer but also more efficient. Compared to the way current shareholder voting is conducted for reporting issuers, for example, the differences are stark. It currently takes hours to count votes for board elections to fill the slate—and sometimes results are muddled on account of human or machine error, which extends the process even longer. The blockchain, however, offers a reality in which that human error is stripped from the equation and results are counted immediately. Blockchain enables voting results to be available to shareholders immediately after completion of the voting process.

Private issuers can benefit significantly from these more efficient voting processes. What becomes clear is the more you investigate the blockchain as a mechanism for governing voting processes, the more you find its application extends further than general voting mechanisms. Individual companies and organizations could reap the same benefits by utilizing the blockchain internally. For example, companies could use tokens to grant employees and stakeholders voting rights. The more tokens or STs (security tokens) an employee or voter is granted, the more weight their potential vote may carry. Granting tokens is also a way to incentivize favorable behavior, such as consistent accuracy.

In contrast, the AGM (Annual General Meeting) voting process for public companies consists of intermediaries and inefficiencies that can result in a lack of shareholder engagement. Proposals are often voted by proxies instead of by shareholders, often weeks before the meeting. Few or a limited number of shareholders attend AGMs in person. Large institutional shareholders may be granted engagement opportunities with management of the issuer that are not otherwise afforded to individual shareholders. This may give rise to preferential treatment, asymmetrical voting opportunities, and benefits select shareholders. These factors can result in a lack of transparency in the voting process and disproportionate voting power among shareholders. Blockchain technology has several potential applications that can remedy these inefficiencies and restore shareholder trust, confidence, and engagement. This provides more equitable distribution of voting while also democratizing shareholder voting.

The immutable nature of a blockchain and the ability to create a specified set of rules for its use make blockchain technology an appealing option as an automated, secure method of counting shareholder votes at an AGM. For example, Broadridge Financial Solutions Inc., a corporate services company that provides a variety services for annual meetings, was recently granted a patent for proxy voting using blockchain technology. In 2018, Broadridge tested a pilot blockchain-based voting system at the annual meeting of Banco Santander, S.A. The technology was successfully used to create a digital register of the proxy voting at the meeting and was used by more than 20 percent of voting shareholders.

Voting Systems as a Blockchain Use Case

Stock exchanges around the world have been exploring the use of blockchain-based voting systems for years. Foreign stock exchanges, such as the Abu Dhabi Securities Exchange, use blockchain-based voting systems for shareholders of issuers. In 2016, Nasdaq and the Nasdaq-operated Estonia central securities depository developed a web-based user interface for shareholders of listed companies on Nasdaq Tallin. The interface allowed shareholders to vote before or during annual meetings, transfer their rights to a voting proxy, monitor how the proxy voted, and review previous meetings and transactions. The system relied on blockchain technology to record ownership, issue voting rights, and allow shareholders to vote. This application is particularly acute as the blockchain was not only used to register votes, but also to provide a credible and immutable audit trail of previous meetings and transactions for shareholders to view. Similar applications of blockchain technology could help resolve information asymmetries in shareholder votes.

U.S. State legislation has started to address similar uses of blockchain in corporate governance. In 2017, the state of Delaware passed legislation allowing Delaware-registered corporations to use blockchain technology in order to keep any corporate records, including stock ledgers, books of account, and minute books. In 2018, the state of Vermont passed legislation allowing the creation of blockchain-based limited liability companies that can legally use blockchain and smart contracts to provide their governance, including voting procedures. In addition, the SEC continues to study the “proxy plumbing” problem and scheduled a public roundtable on the issue in 2018. As blockchain technology continues to develop, so will its practical uses for issuers in both AGMs and corporate governance.

The Extraterritorial Reach of the SEC

As a lead statutory securities regulator, the SEC yields tremendous authority, policy influence, power, and enforcement in which the agency's ferocity should never be underestimated. The SEC has been known to exercise its extraterritorial reach far outside its borders, as far as Australia in the case of SEC v. National Australian Bank, for example. Unlike other, smaller securities regulators (e.g., Ontario Securities Commission (OSC) in Canada), the SEC has a US$1.6B budget (compared to US$100M US for the OSC, where over 80 percent of all capital market activity is in Canada). Such a budget allows the SEC to investigate, enforce, and prosecute securities breaches both at home and around the world—the long arm of U.S. securities laws. The SEC can and will prosecute nonresident companies that breach U.S. securities laws. However, the SEC only has jurisdiction over breaches of its own rules under the Securities Act (1933) and Securities & Exchange Act (1934).

If a nonresident, foreign company breaches U.S. securities laws, it doesn't necessarily escape U.S. securities regulatory scrutiny; U.S. securities laws are the most stringent in the world and carry the greatest fines, penalties, reputational damage, and prison sentences for breaches. This is no different than in the digital currency space where many security tokens are often being sold and marketed as unregistered utility tokens, often violating U.S. securities laws.

SEC Howey as a Litmus Test

The well-referenced and established SEC Howey test is used to determine whether a token issued is either a security token or a utility token. For example, the best example of a true functional utility token is Canadian Tire fiat currency distributed by Canadian Tire Corp., a reporting issuer on the TSX (Toronto Stock Exchange). This currency nullifies each of the four prongs of the Howey test. In practice, however, very few utility tokens have satisfied this litmus test.

We're also seeing a coordinated approach among securities regulators to fend off bad actors in the digital currency space. In 2018, for example, there was a regulatory sweep between the OSC and SEC in cracking down on several ICOs that were considered shady and suspect. This coordination should give comfort to token investors and purchasers in Canada and the United States, especially given how quickly both regulators reacted and investigated.

In fairness, although the SEC has taken a hardline approach to token issuers generally, actual enforcement has not been nearly as harsh as the regulatory environment would predict. We've seen the start of a few class-action lawsuits filed against Paragon Coin on behalf of the investor class, and SEC enforcement action against Tezos and Munchee, for example. The SEC's enforcement case against Canadian-based Kik Interactive for various alleged material misrepresentations made to U.S. investors in their US$100M ICO, is an example of the expansive extraterritorial reach of the SEC and U.S. securities laws. Similarly, the SEC's recent enforcement action against the Telegram Group Inc. $1.7B ICO in January 2018 to build its blockchain platform while failing to register its ongoing digital currency offering with the agency as a security is further evidence of the SEC extending its extraterritorial reach. The SEC alleges that Telegram and its subsidiary company, TON Issuer Inc., failed to provide investors with information concerning its business operations, financial condition, risk factors, and management, which securities rules require. Of the 171 investors worldwide that participated in the Telegram ICO, just over 20 percent (or 39 purchasers) were sold to U.S. investors, with the majority of large investors residing outside the United States. Between the SEC enforcement actions against both Kik Interactive and Telegram, this may create a chill in the market, thereby preventing companies from raising capital in the United States through a digital currency offering. We should expect these actions, with the United States being the largest and most powerful capital market globally.

Regulatory Arbitrage with STOs

Regulatory arbitrage is a practice whereby digital currency issuers capitalize on loopholes in regulatory systems to circumvent unfavorable regulation. Arbitrage opportunities may exist through a variety of tactics, including restructuring transactions, financial engineering, and geographic relocation. The most STO-friendly jurisdictions are Singapore, Malta, Switzerland, Japan, and various Caribbean islands (e.g., Jamaica, Grand Cayman, Barbados, Gibraltar). These countries are digital-currency-friendly and receptive to STO marketing for the sale and distribution of tokens. We will continue to see more regulatory arbitrage where STOs are marketed in jurisdictions that have the least path of regulatory resistance.

Regulatory arbitrage is likely to be more nuanced and multifaceted. For example, a token issuer has both digital currency securities regulation and tax regulation as major risks and concerns. It's perfectly conceivable, for example, for an STO issuer to select Switzerland for its banking jurisdiction, Panama for taxes, Malta for its exchange (e.g., Binance, the largest digital currency exchange in the world, processing US$5.6B in digital currency transactions, formerly based in Hong Kong, recently moved its operations to Malta), and Isle of Man for its gaming. In effect, this creates a form of “virtual jurisdiction” that catapults regulatory arbitrage to new heights.

However, there are limits to regulatory arbitrage as utility tokens are often viewed as security tokens by U.S., Canadian, and many other leading securities regulators around the world. The state of Wyoming, for example, is viewed as the most crypto-friendly state in the United States. Caitlin Long is the former chair and president of Symbiont, a developer of blockchain products for capital markets, and most recently led the Wyoming Blockchain Coalition—which passed a slate of blockchain and cryptocurrency-friendly legislation in the state in 2018. Long spent 22 years in traditional finance at Morgan Stanley and Credit Suisse and echoes this sentiment:

Utility tokens trade, clear, settle and custody on blockchains, and the trading, clearing, settlement and custody infrastructure of Wall Street is not set up to integrate with blockchains. So, if every utility token is always a security, that effectively means that you can't trade a utility token.

Cryptocurrency, otherwise referred to as “digital currency,” is based on cryptography, an advanced and arcane branch of mathematics that is powered by blockchain technology. Long's comment is supported by the SEC's position that 99 percent of all utility tokens are considered securities and should be regulated accordingly. This imposes a higher regulatory burden on issuers to comply with STOs.

Implications of Regulatory Arbitrage for Digital Currency Issuers

It is clear that regulatory arbitrage has been exploited in the digital currency space as issuers seek to raise capital in jurisdictions that have the least amount of regulatory resistance and scrutiny. Jurisdictions such as Malta, Singapore, Switzerland, Cayman Islands, and Estonia have developed hospitable environments to digital currency issuers. The absence of formal digital currency legislation in these countries is being developed while still in its infancy stages. The following are a series of implications that may result from regulatory arbitrage in impacting corporate governance outcomes:

1. By issuers shopping for loopholes in certain jurisdictions that have either lax securities or other weak regulatory enforcement mechanisms for utility tokens (or nonregistered securities with a local securities regulator), directors of issuers are cautioned to conduct enhanced due diligence on the principles and management of the issuer before assuming such roles. The director role and potential fiduciary liability as a result of getting involved with questionable or suspicious characters who have nefarious business objectives can cause irreparable reputational risk to directors.
2. The choice of jurisdiction where the issuer is domiciled is likely to impact the decision to issue either a utility token (nonregistered with any securities regulatory authority) or a security token (which requires registration with a local securities regulator), or hybrid of both. The sale, distribution, and solicitation of a utility token in a jurisdiction such as the United States, for example, is likely to carry significant enforcement fines, penalties, litigation risk, and potential criminal breaches under federal statutes. This has significant financial and reputational risk exposures for directors.
3. The jurisdiction of choice of where the issuer is domiciled is also likely to influence the countries in which investors are solicited to buy and sell the token during the distribution of the offering. This can include both an STO or an IEO on a given digital asset exchange. Although the issuer may be domiciled in the United States and distribute its token in Estonia to non-U.S. investors through an IEO, it still may be captured under U.S. SEC rules and regulations due its domicile status. Directors of issuers must have competent and expert counsel in understanding the various forms of digital currency structures and their regulatory implications.
4. Depending on where the issuer is domiciled and conducting business will determine the scope and type of regulatory licenses required. For example, a digital asset exchange registered in Malta, domiciled in Canada, and looking to attract U.S. customers or investors on its platform may have to secure an ATS (Alternative Trading System) license and file registration statements with the SEC if it wishes to trade as an STO. Similarly, if the digital currency platform involves the movement or transfer of fiat and/or digital currency, it may be required to register as an MSB (Money Service Business) with the local AML regulator. This has separate and distinct regulatory compliance implications for directors.
5. The principle of issuing a digital currency in a borderless world implies that capital is perfectly mobile across borders. The transmission of capital across borders is not without costs and regulatory burden as issuers need to ensure compliance with local securities rules and regulations of where their token is sold, issued, and distributed. Directors need to ensure the extent of regulatory capture and how regulatory arbitrage costs can be effectively mitigated.

Board Inquiries of Management About Blockchain

Given the nascency of blockchain technology, boards must understand the risks and opportunities associated in using blockchain as part of their corporate strategy. The following are questions that boards should be asking management in using blockchain.

1. Competition: What are our direct and indirect competitors using as it relates to blockchain for their business?
2. Cost-Benefit Analysis: Has management considered the advantages and disadvantages of using blockchain?
3. Risk Management: What are the cybersecurity and privacy risks and other mitigating factors, in using blockchain? Do we have a business continuity plan (BCP) or disaster recovery plan (DRP) if the blockchain goes down or is temporarily disrupted?
4. Protocols: Would the company deploy a permissioned or permissionless blockchain protocol? Which vendor (if any) would be used and its cost?³
5. Infrastructure: Do we have the systems and technology to support the blockchain technology? What internal controls are there to manage and mitigate such infrastructure risks?
6. Strategic Integration: How does blockchain fit into our data protection strategy?
7. Auditing: How can we independently audit the technology to ensure it can be trusted? This is especially pervasive in the financial services sector and supply chain management, two leading use cases of blockchain.
8. Regulatory Compliance: What are the regulatory compliance issues to satisfy if blockchain was deployed?
9. Accounting: What accounting issues should we consider in using blockchain?
10. Taxation: Where a digital currency applies, what tax issues should we consider in using blockchain?