Gordon Einstein, Managing Partner at CryptoLaw Partners, for The Fintech Times.
Executive Summary / Bottom Line
The US is a regulatory mixed bag when it comes to blockchain, cryptocurrencies, and ICOs. From the ICO perspective, the US has had many negative, and perhaps a few positive, recent developments. However, dealing with US law and the US market is not really a matter of choice for any serious ICO – in the long run the US is simply unavoidable. The US capital markets are too large, and its customer base is simply too numerous and (relatively) wealthy, to ignore. Any supposedly ‘global’ ICO which forever seeks to bypass US law, US markets, and US customers, exposes itself to the risk of being blown out of the water by one which manages to successfully engage the US.
The unique US system of government and law is a fascinating one, with regards to how it creatively balances stability and progress, freedom and duty, centralisation and local liberty. There is no doubt as well, that an effective US is generally good for the entire world. An effect US is one that stays on top of innovation and firmly grasps developments, instead of letting them pass by. Therefore, it is deeply worrying that US is currently not effectively leveraging the national opportunities presented by blockchain, cryptocurrencies, and (regulated and honest) ICOs.
If the US is not careful, then they risk letting these developments (blockchain-related and others) essentially pass them by. All parts of the jurisdictional system, including US lawmakers and regulators, need to get involved and communicate with one another if this situation is to be remedied, and avoiding the worst-case scenario. Thankfully, the US has a uniquely-flavoured constitutional form of federal representative democracy which is specifically designed to be receptive to consensus-building, experimentation, advocacy and change.
Introductory Note
This inaugural article on discussing ICO jurisdictions will focus on the US, and is divided into several parts. This part (part 1) will provide an overview of the US legal system, with part 2 focusing on the very important topic of US securities regulation. There are several interrelated reasons for this special treatment, some of which are listed below. The bottom line is that understanding and working with US law, especially US securities regulation, is both invaluable and beneficial for companies contemplating an ICO.
Firstly, the US regulatory framework for securities provides a useful “reference case” for other national frameworks. US securities regulation has proven itself to be both effective and flexible, but is also undeniably complex, and is fraught with traps for the unwary. The law and practice associated with US securities regulation has been extensively updated and interpreted over its history, and has been used as a model for many other countries’ systems. Thus, an understanding of the history, principles, and policies undergirding the US framework can be leveraged to then understand and appreciate other how other nations approach the regulation of securities. To the extent that the US framework falls short (and it does in some areas – especially now with respect to ICOs), other countries have and will leverage these shortfalls to create their own areas of unique competitive advantage. Understanding the US framework is, therefore, key to spotting, evaluating, and exploiting the advantages offered by these other countries.
Secondly, there is the fact that, rightly or wrongly, US government departments and agencies have an expansive view of their jurisdiction. This shows up in at least two ways. On one hand, US law in general defines the term “security” very broadly, so US regulators see themselves as having broad “subject-matter jurisdiction” over anything that even slightly resembles a true security. On the other hand, the US government also has a very broad view of its “territorial jurisdiction”. If US interests, including those of its citizens, are even potentially affected in a negative way, even from abroad, the US government may take action. Both the reach of US law, and also its memory of past perceived wrongdoing, is very long.
Thirdly, the US is (still) the largest national source of capital in the world that is available for ICOs, and most of this capital is accessible either directly, or indirectly, through its public and private securities markets. This may change if China ever re-enables its ICO market, or if the EU develops a consistent approach to ICO regulation, but for now these remain purely hypothetical propositions. It is true that US regulators currently seem to be mischaracterizing some tokens/ICOs as securities/security offerings when, in truth, they are nothing of the sort if one were to undertake an objective and accurate reading of US statutory and case law. However, the reality is that it will often be necessary for ICO success to gracefully concede to this regulatory mischaracterisation in order to gain access to US capital. In return for this compromise, they will be able to market themselves to wealthy Americans and US-based funds, who are often very eager to participate in ICOs; especially in the seed and pre-ICO rounds.
Overview of the US Legal System and US Constitution – Distributed and Decentralised
A holistic understanding of the US legal system is key to A holistic understanding of the US legal system is key to understanding how the US regulates securities (and everything else).
The entire US governance and legal model is based upon its written constitution (the ‘US Constitution’), which is a beautiful exemplar of English and European Enlightenment thought. The drafters of the US Constitution anticipated Satoshi by over two centuries when they established a governance and legal model for the US which is both distributed and decentralised. This system has survived numerous attempted and hostile hard forks, including most notably during the US Civil War. The US Constitution is the ‘supreme law of the land’, and no other law in the US, or action of any government actor within the US, may operate in violation of it (i.e., such law or government action will be found ‘unconstitutional’, and have no legal power as a result).
One Federal Government and Many US State Governments
The US Constitution establishes a federal system of governance for the US. There is a single national government (often referred to as the ‘federal government’), with its seat in Washington DC, the US capital city. The federal government has legal, but constitutionally limited, jurisdiction over the entire territory of the US. Within that territory, there are also 50 US states (and some territories and other entities), defined by their geographies, each with a representative form of elected government. These US states are not mere provinces, departments, oblasts, or other administrative ‘units of convenience’ established by some all-powerful central government. Rather, they are truly ‘States’ in the traditional meaning of the term. Thus, US states have a form of limited, but very real, sovereignty within the framework of the US Constitution, and therefore have the associated power to make and enforce their own laws within their own respective boundaries (so long as such laws comply with the US Constitution).
As a consequence, in almost every place in the US, you will find that, at all times, at least two distinct sets of law are potentially applicable: federal law and (the applicable) state law. If a transaction crosses state lines, then even more jurisdictions can be involved. Depending upon the situation, this can make legal compliance extremely complicated. For example, each US state (except Montana) has its own money transmitter licensing scheme. So, a money transmitter seeking to operate in the entire territory of the US must comply with the laws of 49 US states, in addition to federal law. On one hand, the US is uniquely amazing in that it successfully balances federal and state sovereignty within a beautifully crafted constitutional order which has survived and thrived for over 200 years. On the other hand, the practical details of working with such a system can be painful beyond description. In fact, the diversity of overlapping US state and federal legal systems often has the effect of nullifying what should be the US’ major competitive advantage – a unified national market operating on continental scale.
Federal Law Jurisdiction vs. US State Law Jurisdiction
The US Constitution provides that the federal government may only make and enforce laws which relate to those powers directly or indirectly granted to it under the US Constitution, with all other powers being reserved to the US states, or to the people (hence, the idea that the federal government has only ‘limited jurisdiction’). In other words, in the absence of a constitutional grant of power, the federal government will not have ‘subject-matter jurisdiction’, and only US states may make law. In practical reality, because the US Constitution provides that the federal government may regulate ‘interstate commerce’, and because that term is now very broadly interpreted by the US courts, federal power is quite expansive (but not unlimited).
In some situations, where the federal government has the right to legislate based upon a constitutional mandate, and because it is deemed to be in the national interest, the federal government may ‘seize the field’ and forbid US state law from applying in a certain area, or at least from operating in contradiction to federal law. One such national interest might be establishing a consistent scheme of national regulation, with no local variations permitted, in an area considered economically critical to the country as a whole. Relating to a prior example, this has not (yet) been the case with money transmitter law – this is still primarily a US state law issue (with an overlay of federal banking and other law). However, starting in 1933 and especially since 1996, US securities regulation is primarily a federal law issue, with US state law blocked from having any effect except in some specific and narrow areas (e.g., intrastate-only sales of securities and certain fraud actions). As a result, the US market for securities is properly viewed as a national one, which one of the reasons why it is so massive and successful.
The Federal Government’s Three Branches and Their Roles
In addition to sharing power with the various US states, the federal government is divided into 3 distinct branches, each with their own roles and functions. These 3 federal branches of government are the legislative, the judicial, and the executive. The division of federal power between these branches provides ‘checks and balances’ such that no one federal branch can achieve dominance and impose its will on the other two branches. Speaking very broadly:
- The Legislative Branch – the US Congress – makes federal law and also oversees the operation of the federal government via its various committees and its spending (budgeting) powers. The US Congress is itself divided into two separate entities which balance and compliment each other – the US House of Representatives and the US Senate.
- The Judicial Branch – he US Supreme Court and the subordinate US federal courts established by it – interprets and decides matters (federal court cases) related to the US Constitution and federal law. It also has jurisdiction over certain disputes depending upon the identities of the parties involved (e.g., federal branch vs. federal branch cases (such as US Congress vs. US President in a case relevant to an impeachment proceeding), federal vs. state cases, state vs. state cases, state resident vs. other state resident cases, etc.). Recall that no law or government action within the US, whether federal, state, or other, may violate the US Constitution. The US Supreme Court is the ultimate arbiter of constitutionality, and there is no further appeal from a final US Supreme Court decision (though the court itself may change its mind about a point of law in a later case).
- The Executive Branch – the US President and the various departments and agencies of the federal government – implement and enforce federal law and federal programs. Most of the day-to-day operations of the federal government are carried out by the executive branch, subject to congressional oversight and budgeting, with the federal courts, up to and including the US Supreme Court, having the ultimate power to resolve any disputes.
Next Up
Of course, most readers are interested in the US legal system and regulation in terms of how it relates ICO and cryptocurrencies. Both of these areas operates completely within the context of the overall US legal framework, which should now be clear. As an example, a core issue with ICOs is whether the related tokens are securities – which is almost exclusively determined by US federal law, as administered by a US federal agency – the Securities and Exchange Commission. By way of contrast, if crypto or a token is treated as a currency or means of exchanging value, then is subject to overlapping US state and federal jurisdiction. We will explore the specifics in the next article.
