A Cautionary Tale for Tokens

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As the digital asset community tries to project how the world’s governments and agencies will ultimately regulate the cascade of coins and tokens now being blockchained into existence, we could use a good anecdote. Do we have a relatively recent story that features large quantities of regulatory uncertainty, customer frenzy and start-up obsession? One that might illuminate basic truths that help token investors and issuers navigate the unusual regulatory landscape they find themselves trying to cross? In fact we do. The story of daily fantasy sports companies during the second half of 2015 offers the digital asset community several valuable insights.

The DFS Tale

July 2015. DraftKings raises $300 million. Its investors now include Google, FOX, Time Warner and Major League Baseball. FanDuel raises $275 million. Its investors now include Time Warner, NBC, Google and Comcast. FanDuel, DraftKings and the Fantasy Sports Trade Association contend that, under the federal government's Unlawful Internet Gambling Enforcement Act, DFS is legal because it fits within the Act’s carve-out for fantasy sports. They contend that DFS is legal under the laws of 45 of the 50 states because DFS is not gambling—it’s a game of skill, not a game of chance.

September 2015. During the first week of the NFL season, DraftKings and FanDuel spend more than $27 million on about 8000 television ads.

October 2015. The Nevada Gaming Commission declares that DFS is gambling and DFS companies cannot operate there without licenses. Licenses in Nevada are difficult and costly to obtain. Customers file class action lawsuits against FanDuel and DraftKings in New York, Illinois, Florida and Louisiana.

November 2015. The New York Attorney General orders FanDuel and DraftKings to cease operations in New York because their activities constitute illegal gambling under state law. One week later, the New York Attorney General files a lawsuit seeking an injunction to prohibit FanDuel and DraftKings from operating in New York. New York is reportedly the DFS industry’s largest market. The Massachusetts Attorney General proposes regulations for DFS companies operating in Massachusetts.

December 2015. An Illinois casino helps kill a pro-DFS bill in the Illinois state legislature. The Illinois Attorney General announces that DFS constitutes gambling under Illinois law.

January 2016. Jay Caspian Kang argues in a New York Times Magazine piece that the betting economy created for customers by FanDuel and DraftKings is "highly unstable and corrupt." The New York Attorney General files an amended complaint that seeks an order requiring FanDuel and DraftKings to give back the hundreds of millions of dollars they have made in the state and pay a stiff penalty for running what he argues are illegal gambling operations.

Also in January 2016, Vantiv Entertainment Solutions, a payment processing company, announces plans to cease doing business with DFS clients. What motivated Vantiv's decision? The short answer probably consisted of three points: (a) while the Unlawful Internet Gambling Enforcement Act prohibits any company (including FanDuel and Draft Kings) from accepting a payment related to "unlawful Internet gambling," the Act also requires financial transaction providers (aka payment processors) such as Vantiv to refuse to process such "restricted transactions;" (b) the number of state attorneys general who opine that DFS is illegal seems to grow larger with each week that passes (AGs for Texas, Hawaii, Mississippi and Vermont recently joined the list); and (c) Vantiv--whose business most likely extends far beyond DFS-- does not want to jeopardize that business by being accused of processing "restricted transactions."

Regulatory Truths

What insights can digital asset issuers and investors take from this multi-jurisdictional hailstorm of regulatory bad news and class action fury?

  • Regulators regulate. The chances that DFS companies would continue indefinitely to operate in a 45-state regulatory vacuum were virtually zero. The environment involved too much money, too many people who could be hurt, and too many potential regulators for inaction. For the same reasons, increased regulation is likely on the horizon for the digital asset community.

  • Turbulence happens. The chances that 45 states of regulators would move in DFS-supportive lockstep as they instituted their regulations were also virtually zero. Similarly, no matter how intelligent or desirable uniformity of digital asset and blockchain regulation may seem to some, the chances of that regulation being uniform are also virtually zero. The People’s Bank of China, the California Attorney General, the German Federal Financial Supervisory Authority, and the US Treasury are unlikely, for example, to see the world through the same prism. A regulator with political aspirations could make Eric Schneiderman’s approach look tame. Financial incumbents could build the trade association equivalent of a Maginot Line in front of tokens. What is the worst-case regulatory scenario, and can the issuer or investor function effectively in that scenario? Boards and investors are wise to consider this question in advance.

  • Certainty hurts. Notwithstanding the pro-fantasy provisions of the UIGEA, one would think that Google, Time Warner, MLB, NBC, DraftKings, FanDuel et al. knew when they embarked on their endeavor—given that DFS is at least a cousin of gambling and was prohibited in five states—that multiple battles over significant DFS regulation and perhaps prohibition could arise. Apparently they were buoyed by input like this: “[A]n outside law firm hired by MLB concluded that DraftKings ‘overwhelmingly’ offered games of skill, not chance.” The digital asset community will benefit from remembering that experts are not the regulators.

  • Procrastination bites. Said one DFS investor, “’We thought the regulatory issues were going to have to be flushed out at some point...But no one anticipated the fervor of what happened and the way [the authorities] directed their energies’ against the industry.” To unprepared digital asset investors and directors, regulation will appear to arrive with the flip of a switch. Today is a good day to start considering what regulation might look like.

  • Others count. The moral of Vantiv’s exit from the DFS scene: while understanding how laws may be used by regulators to impact your plans is important, understanding how laws may affect third parties who are crucial to your plans is a less obvious but equally crucial part of building a valuable enterprise.

  • Standard of living matters. DFS companies incurred customer and regulator wrath because those companies allowed their compliance with UIGEA to blind them to the damage they were causing. The digital asset community has an opportunity to do better. Regulators may in fact struggle to regulate token, coin and blockchain innovation effectively, so thinking beyond compliance may be smart. Does this innovation improve our standard of living? A focus on this question will help prevent strategies that would cause a DFS-like backlash against the enterprise and the movement, and promote strategies that help the enterprise and the economy function well, so that the enterprise can continue to do commercially inventive and societally valuable work.

William Devine runs a regulatory law firm in Silicon Valley, and teaches Legal and Societal Issues in Management at Menlo College.