Blockchain and Due Diligence

Blockchain and Due Diligence

March 31, 2022

In 2009 a new and disruptive technology burst into our lives: Blockchain. One of the biggest advantages of Blockchain is that it enables a direct transactional managing system (P2P) without the need for an institutional middleman, which changes completely the whole transactional world and creates huge advantages but, of‘course, also new challenges. As any new field, this also raises complex legal issues regarding property rights, as well as risks related to this technology – issues that are vital to be acquainted with by any person transacting with a company in the blockchain field.

The blockchain technology allows each entity to distribute the information in its possession on a number of linked “blocks”, each of which holds information. These blocks, together, form a data chain (hence the name “blockchain”) in which the level of security is significantly higher by virtue of being distributed, as it is not possible to break into each particular database and change it because the data is held in many locations simultaneously. However, at the same time, the use of this technology and the creation of new assets based on this technology raise legal issues that are important to review in a due diligence process, not only of a company engaged in the field but also of a company holding assets using this technology.

Thus, for example, there are legal questions that need answering while conducting a due diligence review, such as questions regarding ownership of NFT assets. One of the reason for the rising popularity of NFT assets is the security is the trust of people in their ability to show ownership due to the credibility of the blockchain technology, but one must keep in mind that the blockchain records ensures that there will be no tempering from the moment of recording, but a question arises about the original asset itself. It might well be, that when there are significant assets protected by blockchain technology (or the company uses cryptocurrencies based on this technology) there is a need to examine their storage location, the history of the ledgers associated with such, the ability to prove ownership and unique taxation issues related to crypto assets, as well as compliance locally and globally. A case heard at the Israeli Central District Court in May, 2019, dealt with a person who sold Bitcoin at a profit of about ILS 8 million. The Tax Authority demanded capital gains tax despite his contention that it should be treated as foreign currency. The Court held that cryptocurrency, even if a substitute for money, is not considered an official currency and thus, for tax purposes, is an asset subject to capital gains tax at the time of sale.

When a company holds assets using cryptocurrency wallets, risk management questions also arise, such as whether the company manages the risk regarding loss of the encryption keys of the wallets and its backups or how it is prepared for cases of inability to access the wallet. In addition, there are significant questions regarding the field of money laundering. Is the company conducting a KYC procedure for the entities it operates with, or may it one day find itself involved in money laundering, without intent on its behalf. Moreover, even a proper KYC may not solve the issue of bringing the money into Israel later and a whole fabric of IP, regulation and tax planning. In this regard, it should be noted that banks take the utmost care when it comes to crypto-currency companies. for example, in a case heard at the Tel Aviv District Court in March, 2019, the Court allowed the closing of an account of a crypto company by the bank, after it became clear that the company did not report its actual activities to the bank. The Court noted that banks have extensive identification obligations to prevent money laundering and therefore there is a difficulty for the bank to receive money from a customer who cannot identify the cryptocurrency path sought to be converted to cash (FIAT).

Undoubtedly blockchain, NFT and Web3 are here to stay and they are about to, in one way or another, become an integral part of the activities of many businesses. Blockchain has many benefits of security and efficiency, but as with most new technologies, one needs to adapt the risk review model to the review of companies operating in the field and it is important to be accompanies by lawyers familiar with this field.