Blockchain technology has unfolded a whole new industry and novel opportunities for business. Entrepreneurs constantly launch new start-ups, trying to apply the nascent technology to real-world applications and improve existing corporate-grade operations.
However, this unexplored territory hides numerous traps and obstacles, entrepreneurs often overlook or are unable to identify. Therefore, laying the foundations for a legally compliant blockchain project is essential.
Blokt spoke with Jim Gatto, leader of Sheppard Mullin’s Blockchain Technology and Digital Currency Team, which consists of 30 highly-specialized legal advisors. Gatto has extensive experience in intellectual property and online gambling games.
He talks about the applicants’ most common misconceptions regarding patent applications and the importance of staying updated with the developments of the industry.
Above all, he emphasizes the need for entrepreneurs to consult a legal advisor and highlights that “compliance is not an option.”
Nick Tsakanikas: You highlight the importance of legal consultation on blockchain-based start-ups. How well-prepared do you believe entrepreneurs are prior to launching a new project? Are they fully aware of legal aspects and complications?
Jim Gatto: Startups often are not aware of the relevant legal issues prior to launch. There are many common legal mistakes startups make, not just those in the blockchain space. Those in the blockchain space often make other mistakes as well given the complexity of the legal issues and the evolving regulatory issues.
Nick Tsakanikas: How do lawyers manage to keep pace with this dynamically changing regulatory environment worldwide?
Jim Gatto: I personally read about two hours a day and even then, it is hard for me (or anyone) to keep up. One of the advantages of having a team of more than 30 lawyers focused on blockchain, is that we regularly share information and leverage each other’s investment of time.
Nick Tsakanikas: Do you believe that regulators limit innovation in the crypto and blockchain industry?
Jim Gatto: No. US regulators have taken a balanced approach in encouraging innovation and proceeding carefully with regulation and enforcements. Many agencies have issued guidance before they have engaged enforcements. If they wanted to kill the technology, they likely would have (and could have) long ago.
Nick Tsakanikas: Have you ever seen fraudulent crypto schemes, seemingly legitimate, and therefore legally compliant?
Jim Gatto: Most fraudulent schemes can be detected with a bit of diligence. The issue is many people don’t exercise that diligence.
Nick Tsakanikas: Specializing in Smart Contracts and Intellectual Property, could you please share some insight about the hurdles faced by the entrepreneurs?
Jim Gatto: With smart contracts, many people (including some lawyers) do not really understand what they are, much less how to address the legal issues. One of the problems is that the term is somewhat misdescriptive. It is possible to have a smart contract that is a legal contract.
However, most smart contracts are not and are not intended to be an actual contract. Rather, many are code that implement the operational terms of a contract or other agreement between two or more parties. Often there will be a traditional written contract executed by the parties.
Additional terms need to be added to address the use of smart contracts to implement some of the operational terms. Understanding the facts in each case and knowing how to address each different scenario are critical. With IP, people often have difficulty understanding what is protectable in this space.
We are filing a lot of patents on blockchain technology. We have prepared several papers (e.g., Drafting Effective Blockchain Patents) on the topic. The biggest hurdle for startups is that much of the information published about blockchain patents is inaccurate.
Not everything is patentable. However, startups would be well advised to spend an hour speaking with a patent attorney who focuses in this area and get a proper assessment of their technology.
Nick Tsakanikas: What are the traps and things to think about before applying for a blockchain-based patent?
Jim Gatto: The law has changed and there are a lot of misperceptions about what is and what is not patentable. Merely taking a known set of functionalities and implementing them via a blockchain is not likely to be patentable. But it is also a trap to think that nothing in the space is patentable.
It is important to identify the specifics of the blockchain implementation, such as what is new from a technical perspective; what advantages exist over non-blockchain solutions; and be able to articulate that in a way that a Patent Examiner can understand. This often involves looking at the technology at various levels from high level functionality down to the lower level technical details.
For example, if the invention involves the use of a “smart contract” it may not be enough to just say you are using a smart contract. You may need to recite the functionality of the smart contract, potentially identify the oracles/data sources, any relevant data structures, programming logic, and outputs.
Each case is different and half the battle is knowing the right questions to ask and understanding how an Examiner is likely to evaluate the patent application. Being a former Patent Examiner has been helpful to me in this regard.
Nick Tsakanikas: We saw STOs’ popularity increasing in 2018. Are STOs the evolution of ICOs? How are your views regarding STOs as a legal consultant?
Jim Gatto: ICOs and STOs share many of the same legal issues. Some people use the more generic TGE (token generating event).
Changing the name doesn’t change the facts, and the facts are what the regulators care about. One of the key questions is what does the token represent?
The reality is that most ICOs were originally securities offerings but did not comply with securities laws. Some folks use STO to indicate that they are doing an offering that is compliant with securities law.
The evolution is that more people are realizing that compliance is not an option. Our views have been the same all along. If what you are offering is a security, you need to comply, regardless of what you call the token.
Nick Tsakanikas: Given their partially anonymous nature, do cryptocurrencies pose a real threat for governments? What are your views in respect to the taxation of cryptocurrencies and investors’ liabilities?
Jim Gatto: Crypto can be partially anonymous, but it is still more traceable than cash. Law enforcement has used computer forensics to successfully track down some of the bad guys. The great thing about on-chain transactions is that all of the transactions are recorded and visible there, and it is hard to delete that evidence.
If there is a significant volume of activity involving a particular wallet, that activity is detectable. As far as taxation, the IRS has issued guidance. My view is to comply with the guidance. Many people are not. The IRS has issued subpoenas and I have little doubt we will see enforcement actions.
Nick Tsakanikas: As new blockchain projects are constantly developed, do lawyers need to go through a continuous learning process to remain updated with the emerging blockchain technology?
Jim Gatto: It is hard to properly advise clients if you do not have a sense of what is going on. As a simple example, when it comes to patents, it can be important to understand the range of potential alternatives, so you do not unduly narrow the invention based on a poor choice of words.
For example, describing something as “blockchain” may unnecessarily omit other distributed ledger technologies, cryptocurrency may exclude other digital currencies and/or tokens that have functions that are more than just a currency.
Nick Tsakanikas: Is there a need for law firms merely focused on cryptocurrencies and blockchain businesses?
Jim Gatto: Not necessarily. It is important that lawyers who want to work in this space are focused on cryptocurrencies and blockchain businesses.
But there are so many legal issues, including IP, tech agreements, international trade and finance, financial regulatory issues (SEC, CFTC, FinCEN, FINRA, IRS), all of the industry-specific regulations that apply to the blockchain-based apps and more, that it would be hard for a boutique to effectively field a team that covers all of these issues.
This is one of the reasons why we have a multidisciplinary team focused on blockchain. We combine lawyers with the relevant legal backgrounds and ones with deep industry-specific regulatory experience to be able to offer our clients an unmatched depth and breadth of service.
Nick Tsakanikas: From a legal point of view, could cryptocurrencies like XRP serve as a global remittance system?
Jim Gatto: Cryptocurrencies can and are being used for international remittance.
Nick Tsakanikas: We saw people massively investing in cryptocurrencies in an attempt to profit from the crypto frenzy in 2017. How well-protected is the average investor from the risks associated with cryptocurrencies?
Jim Gatto: Not very well protected. Despite the advice “buyer beware,” most individual buyers do not heed this advice. As mentioned above, many investors have not conducted enough diligence and have paid the price.
Some cryptos have failed due to fraud. Some were just bad ideas. Some due to poor execution. To get a sense of how many “coins” have failed checkout https://deadcoins.com/
Nick Tsakanikas: Which industry do you think can benefit the most from blockchain technology?
Jim Gatto: I believe that blockchain will transform every industry, just as the internet did. It is that transformative.