In Conversation with Lewis Cohen & Token Basics

Off the Blocks | Vol 78, July 30, 2019

Mixing things up a bit, today we are in conversation with Lewis Cohen, co-founder of CohenWilson LLP (better known as DLx Law), and a highly respected name in the blockchain securities arena. Lewis is based in the firm’s New York office (DLx Law also have offices in Washington, D.C. and Wilmington, Delaware).

Lewis Cohen has been a pioneer in the application of securities law to the rapidly changing blockchain ecosystem. He recently led a Pocketful of Quarters to the first-ever no-action relief for sales of a ERC-20 token on the public Ethereum chain, creating a pathway for an actual use case for the token in a gaming application.

Read Press Coverage About The Pocketful of Quarters

Follow Lewis Cohen on Twitter - @NYcryptolawyer

This week Abid Azam and I sat down for a conversation with Lewis to understand his perspective on the direction of crypto/blockchain space with recent regulatory news.

Abid is a partner with Unchained.VC. He is actively working with emerging technology companies in crypto/blockchain. He has a broad background in investing in biotech/healthcare and tech startups. He currently serves as an advisor to a number of startups and accelerator programs. His other interest areas are in fin tech, healthcare and AI/ML technologies.

Abid Azam (AA): When I met you through a mutual friend, you were partner at a Big Law firm and decided to leave. What made you decide to start a  practice solely focused on crypto and blockchain?  

Lewis Cohen (LC): So, the first piece was my general view that blockchain and crypto would change the future of just about everything and it was very important to me to be a part of that transformation. And so then my question was: How best to achieve that? I was fortunate to be at a terrific law firm at the time, Hogan Lovells; however, I also recognized that as amazing and awesome as it was to be in Big Law, it was going to be a bit difficult to achieve what I wanted to do in the confines of a traditional large law firm.  I have always been highly entrepreneurial and realized that blockchain was a very fast-moving area.  That meant that there had to be a lot of flexibility ability to make quick decisions and pivot etc. when needed.   Big law firms are definitely not known for that.  Also, I was exceedingly fortunate to meet my co-founder, Angela Angelovska Wilson, one of the most respected names in the blockchain legal community, almost from the very start. The opportunity to practice directly with Angela and combine our complimentary skill sets and geographic locations was a huge part of my decision to form DLx Law.

AA: Was there any particular inflection point that helped to make the decision to jump into crypto and blockchain?

LC: Absolutely - there were a series of inflection points along the way for me.  Very early on I had the opportunity to work with Matt Corva, General Counsel of Consensys and the amazing team there.  This was a big moment for me and allowed me to better understand ConsenSys’ vision of a more decentralized economy based around blockchain and tokenization.  I also did a lot of my own reading, not only about the technological side of blockchain but also looking at how blockchain represented the cross-section of economics, law, mechanism design, game theory, philosophy, governance and other disciplines.

The more I learned the more became clear how as a lawyer this was really very different than just the Internet. The Internet is hugely important but it doesn't interact with what lawyers do in the same way.

Aman Johar (AJ): The industry works at breakneck speed, but the regulators have been methodical even as they are literally reshaping the environment from what it was at the beginning of 2019.  What is your take on the recent uptick in SEC opinions? 

LC: It is perhaps a misimpression many had that regulators in the US weren't working that hard because the general public wasn’t seeing much activity.  It is important to be mindful that it takes a lot of team effort at any regulatory agency to get comfortable with something as new and different as blockchain, and there are always a lot of stakeholders to bring on board.  Different people at a given regulator are going to have different perspectives and different concerns and, generally speaking, I see that as a positive. However, that also means you've got a lot of people to work with and that process simply takes time.  So I would say that we're now starting to see the fruits of a lot of investment that has taken place over the course of the last 12 to 18 months.

The other thing I would note is that the goalposts the regulators are working toward are constantly moving in real-time, meaning they don’t only have to get comfortable with state-1 of blockchain, they also have to understand states-2 through n, because things like the Facebook Libra proposal come out along the way, changing the landscape.  In addition, other jurisdictions are reacting to blockchain and crypto and coming up with their own policy positions.  So it is definitely not a static environment.  The regulators are trying to figure out how they adopt an strategy that protects the wider community in a very fast-moving and unruly ecosystem.  No easy job, that!

AJ: So how does the regulatory environment here in the (US) compare with other jurisdictions?

LC: I think it is important again to point out the Libra proposal because it was very much a wake-up call to policy makers.  We saw that clearly during the recent Congressional hearings.  Numerous Congressmen asked Facebook why they based the Libra Foundation in Switzerland.  Why couldn't they base it in the U.S.?  It was difficult for them to understand that it was at least in part because of inquisitions like those they were undertaking that companies or organizations in the blockchain space look to be based in other locales.

There was also a recognition at the hearings that the Libra project potentially represents a fundamental challenge to the hegemony of the U.S. dollar. And if a third party private currency could potentially become a widely accepted medium of exchange around the world, then that really does change the dynamic of how the U.S. not only regulates but also interacts with other economies.  It is a scary thought that it may be beyond the power of Congress to prevent this.

But the reality is that at some point crypto-based decentralized systems may not need the U.S. to be viable.  Other jurisdictions may be much more friendly and so US policy makers and regulators have to balance on the one hand appropriate protections for U.S.-based investors and other market participants with the risk of our country being left behind by other jurisdictions that are more pioneering.

So I think that, when you're looking at the regulatory landscape, you have to appreciate how dynamic an environment it really is.

AJ: Do you think the current regulatory environment is conducive to doing something on a global scale. Does the regulatory environment itself need to be rewritten for this industry?

LC: Yeah - that’s a great question. There are a lot of things that don't work well with crypto. My personal view is that we shouldn't be too quick to blame the regulators. There's a cart and a horse problem and I think that the starting point for crypto and blockchain always has to be a utility for real-world problems.  If we start to see products that are used or could be used by real people in real situations, I think the regulatory impediments will find a way of being resolved through interpretation or amendments to rules or even amendments to statutes.

I think what the industry needs to do is create usable products or at least show that there are blockchain-based products that real people would use.  When regulators look at a lot of the activity that has occurred to date, they see products that are really just - trading.  Much of the industry spends its time simply creating new products to be traded.

An analogy I use sometimes is people playing poker and after a while they get bored with playing cards they are using and get obsessed with designs on the back. They want a different design of the back but they're still just playing poker. And most of the tokens out there - that's all they are: the same as all the others but with small differences in design to keep traders interested.

AA: I wanted to actually discuss the recent and the first  SEC approval of Reg A+ offering of Blockstack. What's your take on that decision by the SEC and Blockstack.Would you say beneficial or were there any drawbacks to that approach?  

LC: Blockstack took their own decision to treat their token as a “security” - one assumes in consultation with their counsel and as a result of discussions with the SEC.  I respect that approach and that it was determined to be the best available solution for Blockstack.  However, this does not mean that it will prove to be the best long-term solution for most crypto projects.  I believe that it will be challenging - I mean really challenging - to create a decentralized marketplace when your token is treated as a security.

Blockstack did a great service for the industry, but I think that their approach needs to be looked at not so much as an end-state but rather as the beginning of a much longer discussion of when blockchain tokens should properly be treated as “securities”.

One point I really struggle with, though, in the Blockstack approach is the idea that, without any change to its underlying terms, a token can go from being a “security” to not a security.   That is, the idea that a transformation in the nature of an asset can occur based only on external factors (rather than being based on something that fundamentally changes in the asset itself).   Going forward, I think we will have a more elegant solution to the legitimate concerns about balancing disclosure on the part of someone raising funds and transferability of a software product that is not in and of itself a “security”.

AA: So do you have a position on security tokens in or that if they're issued more like equities vs Utility Tokens. 

LC: First off, I really don’t like the term “utility token“.  It was much misused during the ICO boom and really doesn’t mean what most people think it means.  

The fact that any object (token or otherwise) has some “utility“ does not mean that it’s offer and sale would not constitute a “securities offering“, which is what most people care about.  So I urge folks just to drop that term like a hot potato.

Regarding “security tokens”, it is important when we use that term that we clarify what we mean.  When I use the term “security token”, I mean something that is intended to be security at all times by the issuer.  This means that the token is or represents either a debt instrument or an equity instrument, some variant of those, or combination of their features.  I don’t use the term “security token” for a digital asset that was not intended to be a security but somehow “missed“.

Moreover, it can become confusing when you have both utility (functionality) and traditional  security (debt/equity) elements combined.   Among other things, it can result in very adverse tax consequences where your instrument has all the disadvantages of being an equity security and yet is treated as the taxable sale of a product.   Not a good look.

AA: I was thinking a potential way that the crypto market would evolve where you would have a security token aspect and a utility token aspect and the security aspect could be the equity portion, as opposed to utility component of the project. I was just wanting your perspective and comments on that. 

LC: Yeah. That's a perfect segue to looking at the Quarters structure.  Pocketful of Quarters started out separating the economics of their business from the underlying functionality of the token.  As designed, the token has no reason to go up or down in value.  It is used for the purpose of allowing gamers to have a better experience playing online video games. The separate Q2 token which was used to help fundraise for the project is an investment token and it provides a revenue stream which, if the Quarters platform becomes successful, could be quite valuable.

AJ: What are the kind of different issues when you look at it from a securities framework and what are the prime considerations that they should have when they are figuring out their strategy?

LC: The critical questions to my mind are: 

  1. Are you seeking to create a decentralized marketplace for something?  

  2. Are you what I would call a “catalyst entrepreneur” - someone who puts a platform into motion but then is ready to step away from it?

  3. If you want to have a “company” and have a token, you need to think - what's my equity structure versus my token structure?

There is an important dichotomy here.  Either you are trying to create a decentralized network that can stand on its own without a traditional management team making decisions and you are planning on capturing the value of that network through the ownership of the blockchain tokens used to engage with the network (as per the “fat protocol” thesis first popularized by Union Square Ventures) or you’re not.  If you are creating a decentralized system, you may set up a legal entity to hold a portion of those tokens, but that is very different then being the management team that runs and operates the network and makes decisions as to its ultimate direction.

On the other hand, if your goal is to create an ongoing business that happens to use tokens, which business you intend to run more or less in perpetuity - that’s not decentralized.  So if you are creating an ongoing business you want to run and own, and you want to have a token as part of that business, I would recommend looking at the Quarters model.

As a sidenote, above I used the term “catalyst entrepreneur”, which I really like.  I first saw the term used in the book “The Starfish and the Spider”, which ai would highly recommend to anyone interested in these topics.  In short, a catalyst entrepreneur sets a network in motion and then walks away.  In theory, in a decentralized system whoever sponsored it isn't necessary to keep it going because if they are, it's not really decentralized.

Read | The Starfish and the Spider

AJ: What else is on the near-term horizon? How do you expect Libra to navigate these waters as you're looking at the SEC opinions? 

AA: I was going to add a slight piece to it. Is there a certain regulatory organization or agency  that you should focus on more or more than the other - SEC, CFTC, FinCEN,Treasury/IRS, etc

Facebook’s Libra complicated things being a global project and effort.

LC: I would say in answer to your last point first that the biggest concern from a regulatory point of view is what you just put your finger on - money transmission regulation, which is relevant both at the federal level and at the state level in the US.  My expectation is we're going to see a lot more enforcement activity in that area in the near future.  And that will get definitely people in blockchain much more focused.

To my mind one of the biggest challenges regulators have to find a way to motivate compliant behavior because this is an area where non-compliant behavior is, unfortunately, an option.

It seems like there are some in the US government (though not yet many) who would like to believe that they can put up a “great firewall” to keep all crypto activity out of the States.  But in the same way that the great firewall around China is ineffective at fully preventing such activity, I believe attempting the same here in the U.S. would also be ineffective, particularly where other jurisdictions are not necessarily supporting that approach.

So what I'd like to see are more affirmative steps like the Quarters no-action letter and the Blockstack Reg A+ qualification where different paths toward regulatorily compliant activity are being developed.  Otherwise,  we run the risk of seeing more and more activity migrate outside of United States.

AJ: Yeah, that conversation can be so fascinating as it rakes up all kinds of geopolitical issues. 

LC: Absolutely!  So that let’s us wrap up where we started - Why did I decide to go into this space?  Answer:  simply put, it's the most interesting work I think you can do right now as a lawyer.   When people ask me why we started  DLx Law, I ask “How could you not want to do this?”  That's my question.

AA & AA: Yes, It is the most interesting work you can do.

The Final Word | Differences Between Tokens, Coins and Virtual Currencies, Explained

Differences Between Tokens, Coins and Virtual Currencies, Explained
Image Credit: Cointelegraph

There are indeed differences between all of these terms, both major and minor. For instance, when JPMorgan Chase released its JPM Coin, it presented it as a “digital coin,” while Facebook’s Libra was introduced as a solid “cryptocurrency” — and, ironically, that could be part of the reason why regulators around the world got so worked up about the latter. 

Nevertheless, while JPM Coin and Libra are different by design, in both cases, decentralization pundits were quick to discard them as not “cryptocurrencies,” but “virtual money” or “digital currencies” — basically because they are run by corporations and hence are centralized. Unfortunately, it’s not quite as simple: While decentralization is a core ideology behind cryptocurrencies, some of them can be centralized, at least to a certain degree. [… Read More on CoinTelegraph]

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