Legal Considerations to Make Before Investing in Digital Assets
A growing number of firms and individuals worldwide use virtual currencies and other digital assets for transactional, operational and investment purposes.
While this relatively new technology is fraught with unknown dangers, it provides users many benefits and incentives.
However, the pseudonymity and anonymity blockchain-based assets provide lends them to abuse, making them worthy of legal and financial oversight.
This article explores some common legal issues associated with crypto assets with focus on cryptocurrencies, Initial Coin Offerings(ICOs)and Smart Contracts.
We will use case studies, images, and stories to ensure you get a clear picture of the matter.
Happy reading😊
In this Article:
∘ What Considerations should firms make before investing in Digital Assets?
∘ The Legal Status of Initial Coin Offerings (ICOs)
∘ The Validity of Smart Contracts
∘ What are Smart Contracts and How do they Operate?
∘ What are the Legal Implications of Smart Contracts?
∘ Do traditional remedies of breach of contract apply to smart contracts?
⚡Highlights
- A growing number of firms accept payment in digital currencies.
- There is sufficient evidence indicating that unscrupulous business people may use crypto currencies to facilitate financial misconduct.
- Crypto enables firms to access new asset classes, capital and liquidity pools via tokenization of assets.
- The regulation of cryptocurrencies remains unsettled in many jurisdictions around the world.
- Central banks, tax authorities, and regulators across the world are anxious to establish legal frameworks to avoid a host of risks associated with new technology.
- The absence of centralized authority exposes consumers to legal and financial risks, like extreme volatility and fraud.
- The US Securities Exchange Commission ( SEC) uses the Howey Test to determine whether an Initial Coin Offering (ICO) is an investment contract.
- The legal validity of smart contracts remains unsettled in jurisdictions across the globe.
The establishment of new channels of commerce causes legal and financial concerns, partly because they enable novel ways of committing financial misconduct.
Their potential to facilitate money laundering, terrorist financing, fraud, and data theft is usually high, especially during their early days.
The collapse of major crypto players, like FTX, Mt. Gox, and BlockFi, paints a picture of incompetence, hubris, and greed within the industry.
What is novel about the collapse of these crypto behemoths is not the causes of their fall, but rather the speed at which they fell.
Granted, crypto did not invent Bankruptcy, fraud, or some of the nasty competitor behaviors we are witnessing in the industry.
Bearing this in mind,
What Considerations should firms make before investing in Digital Assets?
As interest in crypto currencies and other digital assets grows globally, the need to establish legal clarity around virtual currencies and other blockchain-based assets is critical.
Below are common crypto risks:
- Lack of regulations/ regulatory uncertainity
- Lack of consumer protection
- Market volatility and manipulation
- Crypto scams
- Privacy Issues
- Cyber attacks
- Crypto exchange insolvencies
Central banks, tax authorities, and regulators across the world are anxious to establish a legal framework to avoid a host of risks associated with new technology.
Extreme volatility, security, regulatory uncertainity, and fraud are some of the concerns surrounding the proliferation of crypto currency schemes.
Before diving into crypto, consider the following questions:
- What is the legal status of tokens? Are they commodities, securities, or payment methods?
- Are direct sales of tokens regulated or unregualted in your country? What about secondary sales?
- What is your country’s legal position regarding crypto lending, yield farming and staking arrangements?
- What is the legal status of smart contracts?
- Are crypto exchanges permitted to provide services in your country? Are you allowed to engage off-shore exchanges?
- What compliance requirements must you satify to engage in digital assets? What is the cost of compliance?
- Do you need a license to operate a crypto business? If so, how long does it take to get one, and at what cost?
The list above is by no means exhaustive. The crypto industry is rapidly evolving, and regulators find it hard to keep up.
The industry is constantly churning out new products and services, some of which require legal clarification.
Currently, many crypto currency exchanges remain unregistered. This means that firms and individuals who use them are not protected by financial integrity regimes.
The safe guards found in traditional stock markets do not exist here. The collapse of FTX, is instructive.
FTX’s collapse will have serious consequences for crypto investors for decades to come. FTX CEO, Sam Bankman-Fried, together with some celebrities, were accused of orchestrating a fraudulent crypto scheme, which defrauded investors across the globe.
In March 2024, A manhattan Court sentenced Sam Bankman Fried to 25years in prison. Bankman was convicted on seven charges, including one count to commit securities fraud, two counts of consipracy to committe wire fraud, one count to committ money laudering , and one count to commit commodities fraud.
Initially the prosecution sought 50 years!
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There are serious consequences for defrauding customers and investors,” U.S. Attorney General Merrick Garland said in a statement. “Anyone who believes they can hide their financial crimes behind wealth and power, or behind a shiny new thing they claim no one else is smart enough to understand, should think twice.
Many operating companies have been allocating cash to virtual currencies and other digital assets.
For instance, in 2020, MicroStrategy Inc., made more than a billion dollars worth of Bitcoin purchases, despite the volatile nature of the virtual currency space.
According to the company’s president and CEO, Phong Le ‘’global monetary, macro economic, and digital evolutions have converged, making it necessary for forward thinking firms to consider adding alternative asset classes to their balance sheets.’’
The company’s investment seems to be paying out.
As of August 17, 2024, Microstrategy’s Bitcoin holdings were at $13 billion.
Fundraising with cryptocurrencies is booming, but is that a good thing?
The economist
Be as it may, digitally mature firms and savvy investors must consider the following the legal and financial considerations before investing in digital assets:
The Legal Status of Initial Coin Offerings (ICOs)
Token-based assets are gaining rapid popularity and widespread acceptance globally.
The popularity of Initial coin Offerings (ICOs) attest to this. Over the decade, initial coin issuers have raised billions of dollars from investors across the globe.
💡An ICO is comparable to an initial public offering (IPO), which enables firms to raise funds through the issuance of shares. An ICO ( Token Sale) enables companies looking to create new coins to raise funds.
Investors who buy into an offering receive cryptocurrency tokens, which represent their stake in a project. This is why the US SEC, for instance, considers ICOs to be under its jurisdiction.
‘’Every ICO I’ve seen is a security.”
Jay Clayton, Former SEC Chair
💡Food for thought: The Broadway Ticket Anology by Jay Clayton
The former SEC chair used the Broadway Ticket Anology to clarify the connection between digital assets and securities laws.
Clayton compares some tokens to to tickets for Broadway show. If a person buys a ticket to only watch a show, the ticket is just that, a ticket, and not a securities offering.
However, if a person buys a ticket having been promised that it will gain value, it becomes a securities offering, because the value derives from the efforts of another/others.
This analogy demonstrates how crypto assets can implicate securities laws. Jay Clayton used this to show that digital assets may start as non-securities, but may later implicate securities laws on account of how they are used and marketed.
Unfortunately, ICOs are mostly unregulated. Businesses and individuals looking to invest must be extremely cautious and diligent while engaging them.
⚡In March 2023, Michael Allan Stollery, founder and CEO of Titanium Blockchain Infrastructure Services Inc. (TBIS) was found guilty of crypto currency fraud involving the company’s ICO, which raised over 21 million dollars from American and foreign investors.
Stollery falsified aspects of the company’s whitepaper containing information regarding the technology and purpose of the offering ,the virtual currency investment offering, and the uniqueness of the offer compared to others.
Additionally, he failed to register the ICO with the SEC, and failed to secure a valid exemption from the agency’s registration requirements.
Fast Fact⚡
Failing to register an ICO may lead to legal and financial liability, including bans on fundraising activities, disgorgement of profits, among other penalties.
The legality of digital assets, tokens and virtual currencies vary from jurisdiction to jurisdiction.
For instance, the Chinese government first banned ICOs in 2017. Consequently, the People’s Bank of China ordered all Initial Coin issuers to immediately refund investors and cease all activities.
Chinese investors who raise funds through ICOs are liable to face serious legal consequences, including a ten year jail sentence. In 2022, the Supreme People’s Court of China amended China’s criminal laws to include ICOs as illegal fundraising methods.
Chinese authorities maintain that most ICOs are pyramid schemes, financial schemes aimed at defrauding the public.
Surprisingly, as the Chinese double down their efforts to ban crypto activities, South Korea looks to legalize them. South Korea is on the forefront of bringing legal clarity around these novel finacial products.
There are reports indicating that the nation’s financial regulators want to reexamine their stance on ICOs rather than criminalizing them entirely.
As of October 2024, South Korea has promulgated several crypto-specific laws and continues working on various instruments to regulate the industry.
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As it becomes possible to bring severe penalties against those engaging in unfair trading activities, it is also expected to help establish a sound order in the virtual asset market.
Financial Services Commission, S. Korea’s financial markets regulator
In 2022, Terra, a crypto company based in South Korea collapsed, costing investors over $60 billion. Terra was behind Terra USD and Luna. Its collapse ignited South Korea’s desire to regulate the crypto industry.
Arrest warrants were issued against Do-Hyung Kwon, Terra cofounder, for breaching the country’s financial laws.
The SEC has also filed proceedings against Do Kwon for orchestrating a crypto asset securities fraud worth billions. Do Kwon was arrested in Montenegro in March 2023.
While Kenya is Sub-Saharan techhub, by October 2024, Kenya’s parliament has not promulgated any crypto-related law. This is unlike Kenyan legislators who legislate on the fintech industry actively.
Fintech regulations in Kenya are broad and inclusive. This approach has helped the country adopt fintech friendly regulations. Kenyas legislative approach ensures compliant firms fit
In 2015, the Central Bank of Kenya (CBK) published a report detailing the potential risks of investing in crypto products. The CBK pointed out that the crypto industry was prone to volatility and lacked regulation.
The report further provided that crypto currencies were not legal tender. However, despite cautioning investors against trading crypto, it did not prohibit it.
Today, Kenyans hold more than a billion dollars worth of Bitcoin, not mentioning other crypto currencies.
Despite Kenya’s lack of crypto-specific laws, some crypto activities may be regulated under certain Kenyan financial laws.
The Kenyan crypto industry may be regulated via Kenya’s money remmittance regulations, the Capital Markets Act, the National Payment Sytems Act, and the Kenya Information and Communication Act.
Market participants may also be required to uphold the Proceeds of Crime and Anti-money laundering Act, and the Consumer Protection Act.
In Lipisha Consortium and Another v. Safaricom LTD, the High Court of Kenya upheld Safaricom’s policy to terminate the plaintiffs’ M-PESA services for operating an unlicensed money remmittance firm.
Safaricom expressed fear that it may be held liable for anti-money laundering for allowing the plaintiffs to run crypto transaction through M-PESA. M-PESA is a popular money remittance service in the East African region.
Safaricom urgued that the anonymous/psuedonymous nature of crypto transactions exposed it money laudering risks.
Like their American counterparts, Kenyan courts apply the Howey Test to determine whether a digital currency is a security.
Kenya’s financial watchdog, the CMA, holds the position that most crypto assets are securities. ICOs fall under its jurisdiction.
In Wiseman Talent Ventures Limited v. The Capital Markets Authority( 2019), the plaintif sought to raise funds via an ICO. The court ruled that an ICO was a securities offering, as it satified the Howey Test.
The Capital Markets Authority of Kenya has never sanctioned any ICO in Kenya.
In the US, ICOs must be registered with the SEC if they satisfy the Howey test,
Per Howey’s test, an investment contract exists if:
- There is an investment of money;
- In a common business enterprise
- With reasonable expectation of profits
- To be derived from the efforts of others.
Generally, Howey is applicable to all schemes, contracts and transactions. While Bitcoin has never made an ICO, it is important to note that it fails the Howey Test.
In 2017, the SEC applied the Howey’s Test significantly by ruling that the sale of DAO tokens in exchange of Ether, a transactional token, breached federal securities laws.
Today, Ether (ETH)is regarded as a commodity.
Most ICO issuers avoid security laws by offering utility tokens. ICO issuers market utility tokens by ascerting that their value will increase upon the completion of the underlying platform.
⚡Fast Fact!
Financial regulators normally conduct a substance-over-form analysis. During the analysis, regulators look into the circumstances and intent before determining the status of an asset. Despite an asset passing the Howey Test, it is possible for it not to be classified as a security.
💡Case Law: The Paragon Coin Case
The respondent sought streamline the Cannabis industry through blockchain tech. Potential investors were informed that they would use PRG tokens in the future to transact after the creation of the ecosystem.
In the course of creation, no one was able to transact with the token. Users were only allowed to pre-order merchandise. The respondent, on the other hand, touted how the token’s value would increase over time.
The projects whitepaper stated that the value of the token would increase due to the efforts of the ecosystem’s developers. The SEC found the token to be an unregistered security per the Howey Test.
The SEC also found that the respondent was selling unregistered securities invilation of section five of the Securities Act. The respondent did not challenge the charges.
Today, due to the Howey Test, most ICOs are off limits to American investors. Before making an investment in an ICO an investor must confirm that THEY are neither US citizens nor Green Card holders.
In January 2023, the Bidden administration published the Roadmap to Mitigate Crypto risks, encouraging regulators to intensify their enforcement efforts and for Congress to expand their powers.
Following this, the Federal Reserve and the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corp. (FDIC) issued a joint statement warning banks against the risks crypto assets pose to them.
As interest and market capitalization of the crypto industry increases, concerns about market players engaging in financial misconduct are bound to arise.
⚡Insider trading is one of the risks that investors must be weary of before investing in coin offerings. Insider trading involves trading using ‘material non-public information.’
The practise threatens crypto seriously, as there are over 300 million crypto users, including institutional investors, who have made significant investments therein.
According to Moish Peltz, a web 3 lawyer, investors should have faith that a market works effectively and it is not rigged against them. Insider trading is an illegal practice that has plagued traditional financial markets for decades.
Insider trading was unheard of in the crypto industry until recently when the US Department of Justice ( DOJ) filed a lawsuit against Nathaniel Chastain for NFT insider trading. Nathaniel Chastain is a former product manager at OpenSea, an NFT marketplace.
Nathaniel faces one count of money laundering and one count of wire fraud. If found guilty, Nathaniel Faced up to two years imprisonment. This is the first crypto related case the DOJ has pursued.
In August 2023, Nathaniel was found guilty of money laundering and fraud charges and sentenced to three months imprisonment. The court attributed the three month sentence to Nathaniel’s modest earnings from the trades.
While digital assets and currencies have the potential to enhance business networks tremendously, misconduct in the crypto industry threatens to inhibit their adoption into traditional finance.
According to reports, 25–51% of all crypto listings are subject to insider trading. The reports purports that insider trading is more pervasive in the crypto industry compared to traditional financial markets. Like any other form of financial misconduct, insider trading hurts investors and undermines market integrity.
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Also Read: Security Tokens and STOs: A New Frontier for Block Chain and Securities Law
The Validity of Smart Contracts
An Overview of the Disruptive Potential of Smart Contracts
We all agree that the single greatest creator of wealth across human history is trade. While the greatest inhibitor of trade, across millennia, is market friction.
Market friction is anything that impedes trade, including delays in executing contracts, involvement of intermediaries, bureaucracy, among many other things. Market frictions impact different sectors differently, and they continue to inhibit local and international trade tremendously.
Over the centuries, businesses and governments have overcome numerous sources of friction by creating various instruments and institutions of trust to mitigate risks in transactions.
Technological advancements have helped overcome, among other things, inefficiencies and distances, some of the greatest challenges of trade. However, despite all these, many transactions remain expensive, vulnerable and inefficient.
Smart contracts are one of the solutions block chain technology offers in an effort to elliminate friction in today’s markets. A growing number of businesses use smart contracts to digitize their transactions.
While this is the case, there are several legal questions that firms must ask before utilizing this technology. For instance:
How do smart contracts hold up in court? Do smart contracts have the same remedies traditional contracts have? Are smart contracts valid in your jurisdiction?
Technological value alone is not enough to realize this technology’s full potential. The validity of smart contracts should be backed by national and global legal frameworks to ensure smooth operation.
For example, since the US lacks a federal contract law instrument, contract laws differ from one state to the other.
Most states have not clarified their legal standing in regards to smart contracts and block chain technology. However, states like Arizona, Wyoming, Vermont, Nevada, and Tennessee recognize smart contracts and block chain technology.
Subject to judicial interpretation, the E-Sign Act(2000) provides limited validity to smart contracts.
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Further Reading: Unravelling Traditional Contracts v. Smart Contracts: Exploring Legal Frontiers
What are Smart Contracts and How do they Operate?
Simply put, smart contracts are self-executing programs contained in a block chain. They can also be defined as agreements whose execution is automated.
Vending machines are simple models of smart contracts: if you insert a dollar and press B5, the vending machine dispenses the packet of biscuits held in the B5 slot. If the vending machine works properly, and a person inserts money in it, a contract of sale executes automatically.
Generally, smart contracts operate by following simple ‘’if/when..then’’ statements written into code on a block chain. For example:
If Manchester United wins the Champions League, then send 0.06 BTC from Joyner to Nancy.
A smart contract contains as many stipulations as the participants of a transaction require to satisfy it.
Before a developer programs a smart contract, the parties must agree on how transactions and data are to be represented on the block chain, and the contract’s ‘’ if/when…then’’ rules.
Additionally, they could also define a dispute resolution framework, like traditional contracts.
As previously stated, smart contracts are computer programs stored in a block chain. A common use of smart contracts is to allow firms and individuals to automatically exchange things of value when a triggering event occurs.
Consider these examples of smart contracts:
- If Jeff works 50 hours from August 4th through August 9th, then pay him his wages.
- If Jeff wins East Africa Got Talent, then send O.7 ETH from Daisy to Rocky.
You may be wondering, how does a smart contract know if Jeff loses East Africa got Talent or works 50 hours from August 4th through August 9th? Simple, oracles tell them. Oracles supply an unknown bit of information.
In ancient Greece, people consulted the Oracle at Delphi to ascertain the will of the gods or the outcome of an event. Oracles were the link between the spiritual realm and the physical world.
In the cryptosphere, oracles link the digtial world to the real world. They are code that connects block chain to the real world. They provide the necessary information smart contracts need to successfully execute.
Ironically, oracles are intermediaries in a system that looks to eliminate intermediaries.
Contracting parties tell oracles in advance exactly how they should determine the truth. Later, when the oracle supplies the unknown bit of information, it must describe, precisely, how it determined the truth, and all participants of a transaction can verify the information .
Thus, oracles ensure transparency, and any corruption is readily apparent.
Smart contracts guarantee certainty of self-execution. The problem with smart contracts is that the possibility of remedying potential breaches is non existent.
The terms of a smart contract are absolute until the contract is performed. People are not cut-and-dry as machines. So, how will drafters of smart contracts address this matter?
- Smart contracts must be drafted carefully to ensure the code matches the agreements of the parties.
- Lawyers must work with developers to ensure their clients have a firm understanding of the instrument’s implications.
- The code ought to execute in accordance with the prose translation.
What are the Legal Implications of Smart Contracts?
Block chain technology attracts companies and people because of its cost savings, time savings and security features. Smart contracts have the potential to reduce enforcement and transaction costs drastically.
With smart contracts, computer codes handle contract execution, and since parties do not need to rely on themselves or third parties for the validation of contractual terms, costs associated with counterparty diligence and duplication of effort are minimized significantly, or even eliminated.
Contracts are legally enforceable agreements. The novel issue that smart contracts pose to legal systems is what happens when agreements are enforced through computer codes instead of public legal enforcers, like lawyers and judges? Courts around the world continue to grapple with this issue.
Legal recognition of smart contracts and block chain related technologies is critical on multiple counts. It not only facilitates the enforcement of smart contracts, but also spurs innovation by demonstrating that a country’s regulatory environment looks at block chain technology favorably.
Wyoming, for instance, looks to establish itself as a leading block chain innovation hub in the US and the world by legislating laws that recognize block chain technology and smart contracts.
Digital assets, tokens, and virtual currencies are not recognized in all jurisdictions. For instance, initially, India’s Information Technology Act, 2000 was silent on the status of block chain produced signatures until the Act was amended.
In the US, smart contracts are enforceable as long as they uphold contract law. These includes offer, acceptance, consideration, and capacity.
The UK is not known to be a crypto-friendly jurisdiction. However, recent legal developments have demonstrated the UK’s potential in the development of block chain-based financial services.
Since English laws recognize and accommodates smart contracts, investors have nothing to worry if their contracts are governed by UK laws. Unlike the UK, countries like Russia, Italy, Germany, and Belarus have not made provisions for smart contracts in their laws.
Do traditional remedies of breach of contract apply to smart contracts?
Breach of contract happens when a contracting party fails to perform or when performance is defective.
Many legal professionals believe that smart contracts are likely to require formulation of new causes of action, as they give rise to novel fact patterns, which demand careful consideration and in some instances increase the possibilities of defective performance.
For instance, what happens when the code malfunctions due to human error?
The remedies available for breach of a smart contract remain the same as those that apply to traditional contracts.
These remedies include:
1. specific performance
2. payment of damages
3. termination of contract
4. restitution.
It is important to note that the practical application of these remedies may differ from traditional contracts.
For example, while it is expected that the remedy of termination should be applied in the same way as it is done in traditional contracts, it will be extremely difficult to terminate a partially executed , automated code, like when automated payment is followed by an automatic supply of products.
Also Read: 6 Ways Smart Contracts are Revolutionizing Copyright Protection
Final Thoughts
Over the past decade, digital assets, like block chain and virtual currencies have risen to great prominence among many institutional and retail investors.
Despite their meteoric rise to prominence, legal and financial professionals continue to caution investors regarding the legal and financial risks arising from such investments. Digital assets are not recognized in all jurisdictions.
Chinese investors who raise funds through ICOs are set to face serious legal consequences, including imprisonment. In an ICO, Investors who buy into an offering receive cryptocurrency tokens, which represents a stake in the firm or project.
Unfortunately, ICOs are mostly unregulated. Businesses and individuals looking to invest in them must exercise an abundance of caution whilst investing and researching them. The FTX debacle is testimony to this.
Smart contracts are one of the solutions block chain technology offers in an effort to lubricate friction in today’s markets. The remedies available for breach of a smart contract remain the same as those that apply to traditional contracts.
These remedies include but are not limited to the remedies of specific performance, damages, termination, etc. Savvy investors must ensure that their investments in digital assets are recognized in their respective jurisdiction to avert legal and financial risk.
The legal issues mentioned above are bound to intensify due to a myriad of reasons. The absence of a central authority with exclusive jurisdiction to adjudicate crypto related matters poses a serious threat to investors.
Victims of fraudulent crypto currency schemes have a hard time recovering their investments due to the lack of legal avenues. Unlike traditional financial assets, digital assets like crypto currencies are not backed by intrinsic goods, like silver and gold, or a central issuing authority. This is a serious risk factor that investors should analyze.
