This document provides an overview of blockchains, including how they work, smart contracts, issues around ICOs and whether tokens are securities, AML/KYC compliance, and patentability of blockchain technology. It defines key terms and concepts, describes how blockchains use proof of work or proof of stake to validate new blocks of transactions, and how smart contracts can automate various types of agreements and transactions using blockchain. Regulatory issues around jurisdiction, privacy, and securities compliance with ICOs are also summarized.

1. Presented By:
Blockchains
Ian R. Blum
iblum@cozen.com
(212) 297-2679

2. Blockchains
What are they and what issues do they raise?

3. Overview
• What is a Blockchain
• Smart Contracts
• Blockchains, cryptocurrency, and the SEC
• Patentability

4. Glossary
• Bitcoin: A cryptocurrency that replaces background agreements and transactions with
software, a distributed and secure database called a blockchain.
• Blockchain: A shared database that grows only by appending new data, authenticates
users with strong cryptography, and leverages economic incentives to encourage
mistrustful strangers to manage and secure updates.
• Block signers: The actors in a proof-of-stake blockchain that are responsible for
validating transactions and adding them to the blockchain.
• Ethereum: A public blockchain designed to store and execute smart contracts and
other complex software apps. It features its own cryptocurrency, ethers.
• Hash function: An algorithm that digests a chunk of data of arbitrary size and turns it
into a string of numbers and letters of fixed length, called a hash. The function is a one-
way operation used in blockchains to choose which participants update the chain.
• Miners: The individuals that add new blocks to public blockchains that use proof of
work, such as Bitcoin.

5. Glossary
• Oracle: An entity that records data about real-world events on a blockchain.
• Permissioned ledger: A blockchain database that restricts access to reading, writing, or
both to a set of known actors. Opposite of a Public blockchain that is open for anyone to
look at and to add new blocks to.
• Proof of stake: A mechanism for allocating the right to add new blocks of data to a public
blockchain.
• Proof of work: A mechanism for allocating the right to add new blocks of data to a public
blockchain. Participants (miners) gain the right to add new blocks by repeatedly running a
hash function.
• Smart contracts: Software-based agreements deployed in systems capable of automatically
executing and enforcing the terms of the contracts.

6. How Do Blockchains Work
• Determine who will add the next block of data in a blockchain using either (1) proof of
work or (2) proof of stake.
• Bitcoin created a single, universally accessible digital ledger, called a blockchain. It is a
chain because changes can only be made by adding new information to the end of the
chain. Each new addition, or block, contains a set of new transactions that reference
previous transactions in the chain.
• The blockchain is duplicated on networked computers and is accessible to anyone with
a computer and an Internet connection.
• Miners are responsible for detecting transaction requests from users, aggregating them,
validating them, and adding them to the blockchain as new blocks.
• Validation entails verifying ownership and that the bitcoins have not been spent.
Ownership is determined by a pair of cryptographic keys. A public key, associated with
a Bitcoin resides in the blockchain for anyone to see. A private key is maintained by the
owner.

7. • Transactions are signed with private keys and the public key most recently associated with
coins being spent. When the transaction gets processed, those coins get assigned a new
public key.
• The main role of miners is to ensure the irreversibility of new transactions, making them final
and tamperproof using the proof of work scheme.
• To make the Blockchain tamperproof Bitcoin mining software makes it very expensive, in
terms of computing power (electricity) to add new blocks and even more expensive to change
blocks further back in the record.
• To add a new block, a miner must provide a cryptographic proof. To produce the proof, the
miner digests the new block through multiple rounds of a hash function to create an
alphanumeric string with a fixed length, called a hash. The blockchain algorithm requires the
resulting hash start with a certain number of zeroes.

8. • The first miner who finds a satisfactory hash announces the new block to the other miners,
who check it and append it to the full version of the blockchain that they are hosting on their
computers.
• Miners collect newly minted bitcoins and mining fees, which users voluntarily tack onto their
transactions in hopes expediting their transaction.

10. Blockchain Characteristics
• Database maintained by a network of computers and managed via a consensus
protocol. Collectively managed by a peer-to-peer network through software.
• Global and Transnational.
• Resilient and Tamper-Resistant Data.
• Transparent and Non-Repudiateable Records.
• Enables group consensus.
• Highly resilient, authenticated, and tamper-resistant registries.
• The execution of autonomous computational processes (“smart contracts).

11. Smart Contracts
• Code facilitated via a blockchain. Ethereum uses transactions that are miniprograms,
called smart contracts, that can be written with an unlimited amount of complexity. The
miniprograms rely on the blockchain for functionality. Users can then interact with
programs by sending them transactions loaded with instructions, which miners then
process.
• Legal agreements (property sales, employment, …).
• Machine-to-machine interactions (monetary exchanges).
• Document management (access and/or edit rights).
• Rules to govern activity (service providers such as Uber, Spotify).
• Structuring “decentralized” applications (Facebook without censorship).
• Oracles provide “real world” data such as temperature, on-time delivery, win/loss data.

12. Smart Contracts
• Contracts are not new. Typically written in some natural language and mostly on paper.
• Electronic Data Interchange (EDI) began a shift to electronic contracts.
• Smart contracts model all or parts of commercial arrangements using software.
• Facilitate micropayments (payments less than one cent).
• Are hard to terminate when reliant on autonomous code.
• Can be adjusted dynamically using data from “oracles”.
• Are less ambiguous, in certain instances (if/then).
• Require less monitoring.
• Can be modular, legal agreements could be assembled using building blocks and
operate without the need for third-party intermediary.
• Asset transfers, token asset sales.
• Problems: Dispute resolution, best efforts, commercially reasonable…

13. Are Smart Contracts Legally Enforceable?
• Bibb v. Allen, 149 U.S. 481 (1893). Case dealt with telegraphed orders for the sale of
bales of cotton. The court did not look at the technology used to communicate, just
whether a contract was formed. Smart contracts should be treated in a similar manner.
• Common law statute of fraud cases
• Uniform Electronic Transaction Act
• E-Sign Act

14. Questions
• Due to the distributed nature of blockchains, which courts will have subject matter and
personal jurisdiction over disputes?
• Which national laws/state laws will apply?
• Where are smart contracts deemed to be transacted?
• Who has jurisdiction over a DAO (Decentralized Autonomous Organization) - an
organization that is run through rules encoded in smart contracts.
• Data privacy is a unique problem. Blockchain nodes can be located in many jurisdictions
and updating the chain could involve moving personal information between nodes
located in different countries. Given the different Privacy rules can a violation occur
because a node is in a specific country?
• There are no decisions that have expressly address this issue. However, for
transactions where the locations of the parties are known, the fact that the transactions
utilized blockchain should not alter the typical jurisdictional analysis. The bigger
challenge will occur with public blockchains where users are anonymous.

15. ICOs
• A funding mechanism for blockchain-based businesses is an initial coin offering (ICO,
after initial public offering, or IPO).
• Groups using ICOs design smart contracts such that a user must own an app-specific
coin (token) in order to use the app. These groups then create coins before their launch
and sell them on the open market to raise capital.
• In July, the Securities and Exchange Commission issued a warning that many of the
ICOs reviewed by the department fell into the category of securities and would therefore
be bound by its rules.
• “These [registration] requirements apply to those who offer and sell securities in the
United States, regardless whether the issuing entity is a traditional company or a
decentralized autonomous organization, regardless whether those securities are
purchased using U.S. dollars or virtual currencies, and regardless whether they are
distributed in certificated form or through distributed ledger technology.”

16. Is a Token a Security?
• Tokens issued in ICOs are being classified by issuers as either securities or utility
tokens (i.e. tokens that allow access to a service or have other consumptive use).
• SEC v. W. J. Howey Co., 328 US 293 (1946) provides a four part test for what is a
security:
1. an investment of money
2. in a common enterprise
3. with an expectation of profits
4. predominantly from the efforts of others.
• Many tokens issued via sales or ICOs arguably meet these criteria

17. Consequences of Being a Security
• Under the Securities Act, securities offered to the public must
be registered with the SEC
• There are several exemptions to the registration requirement
(Section 4(a)(2), Reg D, or Reg A+), however qualification for
these exemptions will limit the amount that can be raised, the
potential purchasers of the tokens (i.e. accredited investors),
and/or place significant restrictions on the resale of the tokens.

18. ICO Guidance
• Canada
• UK
• Hong Kong
• Thailand
• Switzerland
• Australia
• Gibraltar
• Lithuania

19. Where are ICOs Banned
• China
• South Korea
• Macau

20. AML/KYC Issues
• Anti-money laundering (AML) and Know-Your Customer (KYC) regulations in many
countries require financial institutions to prevent, detect, and report money laundering
activities and to verify the identity of their customers to prevent money laundering and
other corruption.
• The Financial Crimes Enforcement Network ("FinCEN") is part of the Department of
Treasury. FinCEN has issued a statement clarifying the applicability of the regulations
implementing the Bank Secrecy Act ("BSA") to persons creating, obtaining, distributing,
exchanging, accepting, or transmitting virtual currencies.
• Blockchains can centralize user data used to verify customers and transaction data in
ways that support AML and KYC compliance. However, the “original” Bitcoin model is
anonymous, token holders can be pseudonymous, their identity reflected only in a public
key.
• Financial firms have limited their blockchain networks to clients who clearly identify
themselves through digital keys (permissioned ledgers).

21. Patentability
• To date, there are 16 patents and 162 applications that
claim blockchains.
• Blockchain patents should comply with 35 U.S.C. §101
because they can improve system functionality by
verifying data, ensuring reliability of the data, and
prevent data tampering. Alternatively, a claim can be
limited to a practical application.