Legal Considerations to Make Before Investing in Digital Assets

Studies show that a growing number of firms and individuals across the world 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 its users many benefits and incentives. It also brings up a myriad of legal and ethical considerations, which beg careful consideration.

Unfortunately, the establishment of novel commercial channels elicits a myriad of legal and financial concerns. For instance, their potential to turn into instruments of money laundering, terrorist financing, financial fraud, and data theft is usually high, especially during their early days. For instance, the collapse of major crypto players, like FTX and BlockFi, paints a picture of incompetence, hubris, and greed within the industry.

Granted, crypto did not invent Bankruptcy, fraud, or some of the competitor behaviors we are witnessing in the industry. What is novel about the collapse of these crypto behemoths is not the causes of their collapse, but rather the speed at which they collapsed.

This article explores some common legal issues associated with the crypto industry with focus on Initial Coin Offerings and Smart Contracts.

As interest in crypto currencies and other digital assets grows globally, the need to establish legal clarity around virtual currencies and their underlying technology ( block chain) is critical for users. 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 and fraud are some of the concerns surrounding the proliferation of crypto currency schemes. Currently, many crypto currency exchanges are unregistered. The safe guards found in traditional stock markets do not exist here. The recent collapse of FTX, is instructive.

Undoubtedly, FTX’s collapse will have serious consequences for crypto investors for decades to come. FTX CEO, Sam Bankman-Fried, together with some celebrities, have been accused of orchestrating a fraudulent crypto scheme aimed at taking advantage of unsophisticated investors across America.

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 all forward thinking firms to consider adding alternative asset classes to their balance sheets.

Be as it may, digitally mature firms and savvy investors must consider the following legal and financial aspects before investing in digital assets:

Token-based assets are gaining rapid popularity and widespread acceptance globally. 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 enables companies looking to create new coins to raise funds.

Investors who buy into an offering receive cryptocurrency tokens, which represents their stake in the firm or project. Unfortunately, ICOs are mostly unregulated. Businesses and individuals looking to invest in them must be extremely cautious and diligent whilst researching and investing in 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, in a bid to entice investors, 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, Stollery failed to register the ICO with the SEC, and failed to secure a valid exemption from the agency’s registration requirements.

The legality of digital assets, tokens, and virtual currencies vary from jurisdiction to jurisdiction. For instance, 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.

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 authorities maintain that most ICOs are pyramid schemes and financial schemes aimed at defrauding the public. Surprisingly, As the Chinese double down their efforts to ban ICOs, South Korea looks to legalize them. There are reports indicating that the nation’s financial regulators want to reexamine their stance on ICOs rather than criminalizing them entirely. In fact, South Korea is working on a Digital Asset Basic Act to regulate the industry.

In 2022, Terra, a crypto company based in South Korea collapsed, costing investors over $60 billion. The collapse of the company behind the crypto currencies Terra USD and Luna accelerated the country’s desire to regulate the crypto industry. Consequently, 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.

In 2015, the Central Bank of Kenya (CBK) published a report detailing the potential risks of investing in crypto products. In its report, the CBK pointed out that the crypto industry was prone to volatility and lacked regulation. And that crypto currencies like Bitcoin and Etherium 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 like Doge coin or Ethereum.

The CBK regulates digital currencies via the Money Remittance Regulations. Like their American counterparts, Kenyan courts apply the Howey Test to determine whether a digital currency is a security. Digital currencies THAT qualify as securities are subject to the Capital Market’s Act ( CMA), which is administered by the Capital Markets Authority.

In the US ICOs must be registered with the SEC and must satisfy the Howey test, which the US Securities and Exchange Commission ( SEC) utilizes to determine whether an offering is an investment contract/instrument. Per Howey’s test, an investment contract exists if:

Generally, the test 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.

Meta, formerly Facebook, and Google had banned all advertising related to crypto products, such as coin offerings, binary options, crypto exchanges, and wallets. According to Scot Spencer, Google’s director of sustainable ads, the company banned adverts on crypto related products, including crypto mining extensions, due to the potential harm they pose to consumers. However, in the recent past both companies have reversed their stand on crypto advertising.

Virtual currencies, such as Bitcoin and Ethereal, are difficult to categorize because they are decentralized, which makes them notoriously hard to regulate. However, 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, due to the Howey Test, most ICOs are off limits to American investors. Indeed, 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 information involves trading using ‘material non-public information.’ This practice threatens the industry critically, 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. The practice 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 Faces up to 40 years imprisonment. This is the first crypto related case the DOJ has pursued.

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 an SEC report, 10–25 percent of all crypto listings are subject to insider trading. The report 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.

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. Likewise, technological advancements have helped overcome, among other things, inefficiencies and distances, which are 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 lubricate friction in today’s markets. Today, 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 our 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.

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:

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:

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?

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 abide by the rules of contract law. These include 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 accommodate 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.

Breach of contract happens when a contracting party fails to perform or when performance is defective. Many legal professionals believe that smart contracts are unlikely 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 but are not limited to the remedies of specific performance, damages, termination, restitution, etc. However, 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, such as when automated payment is followed by an automatic supply of products.

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.