We examined the key legal issues that need consideration when launching a blockchain or smart contract project.
Legal systems and jurisdictions’ approaches to emerging technologies have often been uncertain. For example, a few years ago, the legal validity and enforceability of “Electronic Contracts” were still under debate, yet today, most governments worldwide recognize and utilize such contracts. Similarly, blockchain projects are not exempt from legal uncertainties and face some ambiguity.
Although regulating blockchain technology and cryptocurrencies has begun in most countries and jurisdictions, and various proposals have been put forward, a comprehensive and all-encompassing framework has yet to be established. This field still faces questions concerning legal and judicial matters. This article examines issues that must be legally considered when launching a blockchain-based project. Furthermore, in future editions of this monthly publication, we aim to address the adaptation of the legal issues discussed in this article to Iran’s legal framework.
Nature of Blockchain and Blockchain-Based Systems
As you may know, blockchain refers to a decentralized and distributed ledger technology (DLT) for recording and storing data digitally across various connected computer systems in a peer-to-peer network. What distinguishes blockchain-based storage from other traditional electronic storage methods is its immutability (data cannot be altered or deleted), high transparency, robust security, quicker settlement times, and decentralized nature. Given these advantages, many startups and modern businesses are eager to adopt this new technology.
While blockchain can potentially transform businesses, it also presents unique challenges. Familiarity with all aspects of creating and using a blockchain-based system—especially legal—is critical. If you plan to launch a blockchain-based startup or project, read this article carefully to understand the related legal issues.
Legal Issues for Companies in the Blockchain Industry
The advent of blockchain and smart contracts represents a revolution in technology and commerce. However, this major innovation also brings numerous legal challenges that must be addressed to ensure a secure and efficient transition to this emerging space. Below are 12 legal issues to be aware of in blockchain and smart contract technology:
1. Legal and Regulatory Issues in Different Jurisdictions
Given blockchain’s structure, nodes within a blockchain network can be located in any geographical location worldwide. This means that each transaction stored on a blockchain network may be subject to the laws of multiple jurisdictions. Thus, the network must comply with all relevant legal and regulatory requirements across different regions.
Legal and regulatory requirements vary by jurisdiction. What may validate a contract or transaction in one jurisdiction could be considered void or fraudulent in another. Consequently, determining the legal status of a transaction that may be deemed fraudulent or erroneous under one or more jurisdictions is challenging.
To avoid this confusion, a blockchain network may operate under a predefined internal governance system, allowing users to define contracts and rights under these internal rules.
“Blockchain is the greatest set of opportunities we can think of for the next decade or more.” –Bob Greifeld, Former Chairman of NASDAQ
2. Security Issues and Their Legal Consequences
While blockchain is considered a highly secure and “tamper-proof” technology, any compromise of stored data at the outset of launching a blockchain-based network negates this advantage. Criminals and hackers often bypass the ledger itself, targeting entry points and thereby leading to false or misleading data being stored and creating fraudulent transactions for personal gain.
There are various ways to attack a blockchain network and steal user assets. For example, in most blockchain-based systems, processing is handled by a subset of nodes. The entire network is compromised if a cyber attack can identify and target these nodes. This type of attack is known as a “Brute Force” attack. Other types, including “Sybil Attack” and “Eclipse Attack,” can increase the vulnerability of blockchain-based services, such as cryptocurrency exchanges.
3. Emergency Situations or Force Majeure
In traditional contracts and agreements, unexpected events like wars, pandemics, natural disasters, and fires are typically accounted for. These events, or any other circumstances beyond control that prevent the fulfillment of contractual obligations between parties are often specified as force majeure conditions.
These situations may have unique implications in blockchain-based systems, requiring distinct legal considerations. Issues like the execution of smart contracts, the transfer of cryptocurrencies, transaction completion, and access to the blockchain network should be addressed under force majeure scenarios.
It must also be clarified whether such events qualify as force majeure. Can parties rely on the system to defer or avoid their obligations in similar circumstances? Additionally, it might be necessary to state that parties to a blockchain agreement cannot attribute the consequences of failing to take appropriate protective measures to force majeure, thus preventing misuse of emergency provisions.
4. Intellectual Property
Every blockchain project inherently carries certain values and intellectual property. Developers and users may emphasize these considerations and enforce them, opting to issue a usage license for an agreed period or permanently (as long as it’s not limited to that specific network). Intellectual property in blockchain systems can be limited by time, type of users, or the method of use.
Notably, most blockchain and cryptocurrency-related projects are open-source, generally non-commercial and royalty-free, imposing specific restrictions on users. For developers, understanding the limitations of open-source licenses and the potential liabilities from license violations is critical.
Additionally, advancements in this industry, like mining algorithms, encryption methods, payment modes, and scalability solutions, should be patented to protect the IP rights of the company and development team. Blockchain startups should actively file patent applications to safeguard the essential components of their technology.
“No matter how revolutionary (this technology) seems, blockchain is a mechanism that brings everyone to the highest level of accountability.” –Ian Khan, Technology Futurist at Forbes and CNN Consultant
5. Decentralized Autonomous Organizations (DAOs) and Legal Accountability
A key question for regulators regarding decentralized systems has been: who is accountable for legal violations? Decentralized Autonomous Organizations (DAOs) operate independently and are governed by predefined, coded rules. This setup enables minimal or no human intervention and facilitates smart contract execution, which is recorded and stored on the blockchain. Such arrangements introduce numerous legal challenges for blockchain companies, including:
How should the legal status of these entities be defined?
Are they simply automated legal contracts, software, or a legal entity like a corporation?
In case of a violation of set rules, who is responsible?
Do they have powers similar to traditional companies, such as the right to sue?
Determining individual accountability for a corporation’s infractions can be challenging, yet this issue has been somewhat addressed through legal doctrines that identify real persons responsible for corporate misconduct. It may be necessary to examine if similar doctrines are required to determine the accountability of a DAO or its creators.
Only time will answer these questions. Regulatory bodies and courts face difficulties in resolving such disputes and remain uncertain about supporting widespread adoption of these technologies without comprehensive laws.
6. Database Ownership
While companies typically do not hold ownership rights over individual pieces of information provided to them, a collection of data forms a database that may fall under IP protection. Due to the decentralized nature of blockchain networks, data ownership may span multiple jurisdictions with varying laws. For instance, in some countries, databases are protected under copyright law as a form of literary work.
Companies often share such data with other entities, like data processors, marketing agencies, and service providers, to enhance services. If a party with access to this data wishes to use it for different purposes, they must obtain permission from the original IP owner. Otherwise, they may breach data protection laws, which are prevalent across jurisdictions. Consequently, data ownership considerations within blockchain platforms should be carefully examined.
7. Data Privacy Protection
Although immutability is one of blockchain’s key benefits, it is also a double-edged sword. Since data stored in a distributed ledger cannot be altered or deleted, blockchain often conflicts with data protection laws in many countries, including the European Union and certain U.S. states. In these jurisdictions, consumer protection regulations grant consumers the right to request modifications or deletions of their data.
It’s also important to note that while parties in blockchain transactions are pseudonymous (meaning that transactions cannot directly be traced to an individual), in many cases, it’s possible to identify the actual person behind a blockchain transaction through indirect tracking methods, especially if the transaction involves centralized exchanges. Once a transaction is linked to a specific person, all their pseudonymous transactions throughout their lifetime may be at risk of exposure. The persistent record of transactions on the blockchain heightens this risk over time.
8. The Automated Nature of Smart Contracts
As mentioned earlier, smart contracts are pre-coded computer scripts that execute automatically. These blockchain-based contracts execute transactions without third-party approval when certain conditions are met.
This raises questions about the legal enforceability of such contracts; since everything is automated, there is no room for negotiation, review, or reconsideration. Additionally, developers may lack expertise, potentially leading to flawed code or unforeseen situations not accounted for by either party.
Moreover, public blockchains like those used by DAOs can be vulnerable to hacks. For instance, in 2016, a hack targeted smart contracts on the blockchain, transferring nearly $50 million into a subsidiary contract controlled by the attacker.
In light of these issues, it’s crucial to establish whether the developer or DAO can be held accountable for such incidents.
“The internet is programmable information. But blockchain is programmable scarcity.” –Balaji Srinivasan, Former CTO at Coinbase
9. Acceptance of Products
In smart contract transactions, the buyer initially completes a payment for the asset, which is held securely until the seller releases the asset or digital currency. Upon the seller’s full release, the payment is automatically transferred to the seller. This raises the issue of asset or product acceptance.
Traditional contracts often include provisions for inspecting the quality and standard of purchased assets. Buyers generally have a reasonable timeframe to assess and verify the asset, with the right to reject it if it does not meet agreed-upon standards. However, blockchain-based systems and smart contracts lack this option, making accepting the product (under any circumstances) mandatory unless future developments enable such flexibility.
10. Compliance with Financial and Tax Regulations
Taxation is a complex area, as tax laws vary significantly across jurisdictions. Most of these regulations apply to custodians of financial products or their agents. However, many blockchain-based systems, especially in decentralized finance (DeFi), have a non-custodial structure, raising questions and ambiguities about the applicability of these regulations.
In general, the current tax framework is inadequate for a blockchain-based economy, presenting challenges in its application. Consequently, separate tax regulations may be needed for cryptocurrencies, tokenized assets, blockchain network management platforms, and more.
11. Antitrust and Confidentiality Considerations
In collaboration or joint investment on a blockchain platform, there is a risk of sensitive information exchange between competitors, which may lead to anti-competitive practices and complicated partnerships.
Businesses should use safeguards to prevent the exchange of confidential data. For example, they may employ licenses that limit recipients to specific data blocks. Additionally, aggregating or anonymizing sensitive data stored on the blockchain can help prevent competitors from misusing that data.
In “Multi-Party Blockchain Systems,” considerable data is exchanged across various system parts. These systems should clearly specify whether adding confidential information to the network constitutes authorized disclosure. Given blockchain’s immutability, it’s also important to consider how to handle the return or deletion of confidential information after a contract expires and whether any solutions are available.
12. Comprehensive Awareness and Due Diligence
When analyzing legal matters related to blockchain investment platforms, all traditional legal review methods should be adapted. Attorneys and decision-makers involved in such matters must be thoroughly informed about new technology and industry-specific issues like data ownership, intellectual property, and the limitations of open-source blockchain projects.
The Future of Blockchain-Based Businesses Amid Legal Challenges
Given the legal and regulatory challenges, it’s evident that any company looking to adopt blockchain technology will need to manage certain obstacles. However, it’s worth noting that similar challenges and risks accompanied previous innovations such as the internet, e-commerce, and electronic records. The key to managing risks posed by these challenges is identifying and, where possible, effectively mitigating legal issues.
Blockchain companies might leverage insurance coverage to manage these legal risks. Since digital currencies are roughly equivalent to traditional assets like securities and money, traditional insurers may eventually cover some risks. Several companies and leading insurers in this space, such as Binance, have developed specialized insurance products for the cryptocurrency and blockchain market. In summary, the advantages of blockchain technology outweigh its potential risks.
