Walmart’s U.S. patent application involving blockchain technology is one of many blockchain-based patent applications that have been filed by large companies smitten with blockchain technology.  Published May 17, 2018, but filed November 16, 2017, the application is based on a provisional patent filing in November 2016.  In its application, Walmart seeks to patent a blockchain-based marketplace where buyers and resellers of products can leverage blockchain technology’s immutability and security to record characteristics of retail goods and the transactions involving those goods.  The application has not yet been examined, and must undergo prosecution which is highly likely to change the scope of any patent ultimately granted, if at all. Until allowed, it is difficult to predict the impact any patent granted from this application may have on competitors and industries seeking to similarly leverage blockchain-based marketplaces.

The blockchain technology originally used to code the Bitcoin blockchain is not patentable because it is not actually “new.”  However, customized variations of the original Bitcoin code and other decentralized systems that employ similar technologies may be patentable.  General ledger methods and hardware to record and track characteristics and transactions relating to good and services are ancient.  Even computer-aided ledger methods and hardware (e.g., centralized databases) are decades old.   Blockchains, although more recently developed, have generally been known and practiced since the inception of the Bitcoin blockchain’s open, albeit pseudonymous, ledger in 2009.  Accordingly, the maturity of blockchain technology generally renders the basic Bitcoin blockchain unable to pass the novelty and nonobviousness requirements for patentability.  Nonetheless, blockchain technology is being increasingly customized to specific uses, some of which may qualify for patent protection.

Blockchains are digital databases that use cryptography to secure records, or “blocks,” of information.  Each block is timestamped and includes a record of the blocks that preceded it.  The database is decentralized over a network of computers and the information in each block, including the historical information, may only be tampered with if an actor gains control of 51% of the computers in the network.  This ensures the integrity of information on blockchains by making hacking economically inefficient and extremely difficult.  Blockchains can not only store basic information, such as a record of transactions of digital money like Bitcoin, but can also use the information to function as a computer and perform tasks.  These automated processes are commonly known as “smart contracts.”  Smart contracts and the security and immutability of blockchains facilitate large-scale automation and remove the need for trusted third parties to verify transfers and ownership of goods and information.

Blockchain technology is promising.  Corporations like Walmart are racing to file patents covering specific blockchain structures and applications to secure competitive advantages going forward.  Additionally, corporations may file blockchain patents as marketing ploys to create buzz for their business, especially because blockchain infrastructures are difficult to scale for commercial operability.  Amid the hype and hysteria, it is important to understand what a blockchain patent covers and how to protect your company’s proprietary rights.

On June 14, 2018, the SEC’s Division of Corporation Finance Director, William Hinman, gave a speech titled “Digital Asset Transactions: When Howey Met Gary (Plastic).”  This speech provides additional insight into the SEC’s view as to whether cryptocurrencies and initial coin offerings (“ICOs”) are securities.  Here is a summary:

In his speech, Hinman explains that ICOs typically involve passive investors who purchase tokens in hopes that a promoter builds a successful network.  He posits that the networks involved are rarely functional, and that the token purchase “looks a lot more like a bet on the success of the enterprise and not a purchase of something used to exchange for goods or services on the network.”  These circumstances, combined with token marketing efforts that “are rarely narrowly targeted to token users,” are indicators that an ICO is a securities transaction.

ICO issuers have recently tried to avoid their tokens being classified as securities by labeling them “utility tokens” and arguing that the tokens are for consumptive use.  Hinman directly addresses this practice, stating that labeling something a “utility token” does not prevent it from being a security. While he conceded that tokens by themselves and tokens purchased for consumption only are likely not securities, he emphasized that the “economic substance of the transaction” determines whether a token sale is a securities transaction.  Specifically, the speech focused on the “investment strategy” used, and states that “virtually any assets” can be securities “provided the investor is reasonably expecting profits from the promoter’s efforts.”

To support the above concept that securities can be broadly defined to include an “investment strategy,”  Hinman explains that, as outlined in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., the Howey test “is not static and does not strictly inhere to the instrument.”  The non-static interpretation of Howey is critical because it indicates that tokens which start as securities can lose that designation over time as a token’s network becomes “sufficiently decentralized.”  Hinman clarified that a security-token loses its status as a security when it becomes decentralized enough that purchasers “no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,”  noting that, as a system becomes increasingly decentralized, “material information asymmetries recede” and the “ability to identity an issuer or promoter to make the requisite disclosure [required in securities offerings] becomes difficult, and less meaningful.”  This interpretation rewards systems that prioritize decentralization with a shield from securities laws, but creates ambiguity regarding the requirements for a network to become “sufficiently decentralized.”

In light of the above, Hinman finds that Bitcoin and Ethereum’s native token, Ether, are not securities because they are decentralized enough that the efforts of others are not a “key determining factor” in whether an investment in Bitcoin or Ether is successful.  The speech adds that applying the disclosure regime of the federal securities laws to Bitcoin and Ethereum transactions would “add little value”, and that, “[o]ver time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.”