Featured Expert Contributor—Legal & Regulatory Challenges for Digital Assets
By Daniel S. Alter, a Shareholder in the New York, NY office of Murphy & McGonigle P.C.
*Ed. Note: This is Mr. Alter’s inaugural post as the WLF Legal Pulse’s newest Featured Expert Contributor. Prior to joining Murphy & McGonigle P.C., Mr. Alter was General Counsel for the New York State Department of Financial Services.
In July 2017, the Tezos Foundation—a Swiss non-profit organization—conducted an online initial coin offering (or ICO) that raised more than $230 million in value. The terms of sale purportedly governing the ICO contained a forum selection clause designating Switzerland as the exclusive forum for all ICO-related litigation and choosing Swiss law to govern disputes. Soon after the ICO concluded, however, purchasers of Tezos tokens brought suits in U.S. federal district court against multiple defendants (including American and European individuals and entities) involved in managing the token sale.
The plaintiffs alleged that the defendants had sold unregistered securities in violation of §§ 12 and 15 of the Exchange Act of 1934 (“Exchange Act”). 15 U.S.C. §§ 77l, 77O. Once the cases were consolidated, several defendants moved to dismiss the complaint arguing, among other things, that—because the Exchange Act does not apply to the extraterritorial sale of unregistered securities—a foreign ICO cannot give rise to federal liability.
This past August, the United States District Court for the Northern District of California rejected that defense. Guided by the most recent and controlling precedents, the district court understandably asked where the acquisition of “an unregistered security, purchased on the internet, and recorded ‘on the blockchain,’ actually take[s] place.” Tezos at 14. In a pioneering decision, the district court denied the dismissal motions, holding instead that the plaintiff’s averments “support[ed] an inference that [the] alleged securities purchases occurred in the United States.” Id.
Assuming the facts alleged in the complaint, though, the court’s conclusion is far from obvious. And given the technological paradigm shift that the world is confronting, policymakers may wonder whether the court’s analysis even focuses on the right considerations. In the digital economy, after all, the relevance of geographic location is rapidly shrinking. The decision in Tezos therefore gives us an opportunity to pause and think about the present gap between law and commerce—and how best to bridge it.
The Extraterritoriality Analysis
In Morrison v. National Australia Bank, Ltd., 561 U.S. 247 (2010), the U.S. Supreme Court ruled that § 15 the Exchange Act does not have extraterritorial reach. Especially mindful of the potential “incompatibility” of U.S. securities law “with the applicable laws of other countries,” id. at 269, the Court cabined the application of the Exchange Act to “transactions in securities listed on domestic exchanges and domestic transactions in other securities.” Id. at 267 (emphasis added). Although the first category of covered transactions identified by Morrison is self-defining (i.e., involving securities listed on U.S. exchanges), the Supreme Court did not explain exactly what makes a securities transaction “domestic” and therefore also covered by the Exchange Act.
The U.S. Court of Appeals for Second Circuit was the first federal appellate court to address that open issue, concluding that “a securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.” Absolute Activist Value Master Fund ltd. v. Ficeto, 677 F.3d 60, 69 (2d Cir. 2012). The Ninth Circuit recently adopted the Second Circuit’s “irrevocable liability” test for determining whether a securities transaction is domestic, which makes that test controlling in the Tezos litigation. Stoyas v. Toshiba Corp., 896 F.3d 933, 949 (9th Cir. 2018). The Ninth Circuit further observed that “factual allegations concerning contract formation, placement of purchase orders, passing of title and the exchange of money are directly related to the consummation of a securities transaction.” Id.
Operating within that analytical framework, the district court in Tezos weighed various geographical aspects of the challenged ICO. For instance, the court took note that the lead plaintiff allegedly participated in the online sale of tokens from the United States by using an interactive web site that was hosted in Arizona and operated primarily by a principal of Tezos Foundation located in California. Tezos at 14. The court also considered that the lead plaintiff “presumably learned about the ICO and participated in response to marketing almost exclusively targeted to United States residents.” Id.
Lastly, the court thought relevant that the lead plaintiff’s use of cryptocurrency to buy Tezos tokens “became irrevocable only after it was validated by a network of global ‘nodes’ clustered more densely in the United States than any other country.” Id. Acknowledging that “no single one of these factors is dispositive to the analysis,” the district court concluded that “together they support an inference that [the] alleged securities purchase occurred inside the United States.” Id.
That ruling is vulnerable for at least two reasons. First, on their face, the factors considered by the district court have little if anything to do with incurring irrevocable transaction liability or passing title to digital assets in the United States. The list of considerations cited in the decision reads far more like the familiar elements of a personal jurisdiction analysis, which simply establish a party’s necessary contacts with a litigation forum to satisfy due process requirements.
In fact, the district court’s analysis here resembles one that the Supreme Court expressly rejected in Morrison as an inappropriate measure of extraterritoriality. Parties in Morrison had urged the Court to adopt a “significant and material conduct” test, which would justify the application of the Exchange Act to an international transaction when the sale of securities involves “significant conduct in the United States that is material” to the success of the sale. Morrison, 561 U.S. at 270 (internal quotation marks omitted). The Court declined that invitation because the parties did not “provide any textual support” in the Exchange Act for the proposed test. Id.
Second, the court’s discussion of the one factor related to the irrevocable transfer of anything betrays a misunderstanding of the technology at issue. The court speaks of the irrevocable transfer of cryptocurrency on a “network of global nodes clustered [most] densely in the United States” as an important factor in determining whether the sale of Tezos tokens occurred domestically. Tezos at 14.
But one of the most lauded aspects of blockchain technology is that transactional validation occurs redundantly and incorruptibly on every node of a distributed ledger. In other words, every node on the blockchain irrevocably records every transaction (e.g. the transfer of Ethereum tokens between parties), such that the number of domestic nodes versus foreign nodes is not relevant in determining where irrevocable transactional liability attaches or where title passes. When either of those events occur on the blockchain they occur simultaneously and irrevocably on domestic and foreign nodes alike.
Matters for Future Consideration
These observations are not meant as unsympathetic criticism of the Tezos court’s logic. The controlling authority gave the district court little room to maneuver. The Exchange Act, Morrison, and Morrison’s progeny regulate an analog world. They address tangible financial instruments that are physically traded in readily identifiable locations.
ICOs, on the other hand, operate wholly within the digital realm—a place where legal interests cannot easily be defined by territorial borders. The challenge that they present under present law therefore lies in distilling those attributes of a blockchain-based securities transaction—apart from the parties’ physical location—that reasonably support classifying the sale as domestic. That’s a real challenge.
In a practical sense, the problem may be largely temporal. As the transactional medium for securities trading inevitably shifts to digital tokens, such tokens will surely be listed on U.S. exchanges. The trade in domestically listed tokens will fall squarely into Morrison’s first category of covered transactions, and thus be subject to federal securities law.
As for Morrison’s second category of covered transactions—“domestic” sales of unlisted securities – the law could evolve along two paths. One road follows the traditional common-law approach. “In a world of easy and rapid transnational communication and financial innovation,” the Second Circuit has cautioned, “transactions in novel financial instruments—which market participants can freely invent to serve the market’s needs of the moment—can come in innumerable forms of which [courts] are unaware and which [courts] cannot possibly foresee.” Parkcentral Global Hub Ltd. v. Porsche Auto. Holdings SE, 763 F.3d 198, 217 (2d Cir. 2014).
Such circumstances require judges to “make their way with careful attention to the facts of each case and to combinations of facts that have proved determinative in prior cases, so as eventually to develop a reasonable and consistent governing body of law.” Id.
Although familiar to our legal system, that process has structural limitations—especially in a period of technological boom. Case-by-case adjudication may take substantial time to mark the Exchange Act’s online extraterritorial boundaries. As a result, fledgling global markets in digital securities could remain unnecessarily risk-laden and possibly stunted while courts struggle to domesticate innovation.
A second route—legislative in nature—could be more expeditious. I’m not suggesting a 21st century overhaul of the entire Exchange Act. At this time, that level of congressional intervention is neither warranted nor even desirable. A targeted fix, however, that measures anew the appropriate reach of U.S. securities law against the interests of foreign sovereigns to govern their own financial markets and the press of technological development, is certainly worth considering.
There is analogous precedent for such action. In 1998, Congress enacted the Digital Millennium Copyright Act, 17 U.S.C. § 1201 et seq. (“DMCA”), which, in part, implemented specific measures against the unlawful copying and uncontrolled global dissemination of protected works in digital format. The DMCA did not rewrite fundamental principles of federal copyright law in response to advances in digital technology and the rise of the internet. Instead, Congress grappled with the functionality of a new expressive medium (the instantaneous and unlimited production of digital copies) by prohibiting the use of decryption programs that circumvented coded security measures employed by copyright owners to protect their digital works. Id. at § 1201(a).
The functionality of blockchain technology—with its irrevocable and redundant digital ledger—similarly disrupts the efficacy of traditional securities law enforcement mechanisms. Innovation need not derail regulation, though. Congress has both the authority and institutional wherewithal to put the Exchange Act on some new rails fairly quickly. Indeed, a solution could be as simple as Congress requiring a standard forum selection and choice of law provision in every ICO purchase agreement, the absence of which would deem the transaction “domestic.”
Tezos is just one of many cases in a growing pipeline of securities litigation in which U.S. courts will have to grapple with the application of federal law to international blockchain transactions. It’s a significant challenge, and how that challenge is met will have serious consequences for international financial markets. We live in interesting times.
1. See In re Tezos Securities Litigation, Order on Defendants’ Motions to Dismiss, Case No. 17-cv-06779-RS (N.D. Ca. Aug. 7, 2018) (“Tezos”).
2. In certain circumstances, the location of computer hardware may be determinative. For example, in Myun-Uk Choi v. Tower Research Capital LLC, 890 F.3d 60 (2d Cir. 2018), the Second Circuit held that an international commodities trade was a “domestic transaction” under the “irrevocable liability” test because the buyer’s bid was matched with the seller’s offer on a computer server located in Illinois, see id. at 67. Under the rules governing the electronic trading system at issue, however, irrevocable liability arose “in the classic contractual sense” because the parties were bound to complete their trade “at the moment of matching.” Id. (internal quotation marks omitted).