Blockchain based loyalty programs are still in their infancy, and as is often the case, the law lags behind the pace of technological change. With strong interest and significant sums flowing into the blockchain ecosystem in recent years, as well as the rise of Initial Coin Offerings (ICOs), regulators around the world have been moving to protect consumers (and in some cases investors) from unlicensed security offerings, misleading or deceptive conduct, the risk of money laundering/terrorism financing and of course looking to ensure tax is calculated (and paid) properly.
The Australian approach to loyalty schemes, as well as to tax treatment of cryptocurrencies, is instructive in considering the regulatory risks of blockchain based loyalty programs and the deployment of same. Developments in this area are occurring swiftly, so any project should ensure they engage competent legal counsel to ensure compliance with local laws where the loyalty scheme is to operate.
Fundamentally, all loyalty programs bear a strong similarity to the offer of financial services. In the blockchain context this usually arises in a few ways. Firstly, where a loyalty system permits points/credits or tokens (hereafter we will use ‘points’ for convenience) to be transferred between users or in payment for goods or services, which could be providing a money transmitter service or, in Australia, be a ‘non-cash payment facility’. Where fiat to cryptocurrency conversions occur, requirements to register under anti-money laundering legislation may arise (see commentary on AML/CTF below) and of course running an ICO to pre-sell loyalty points runs the risk of being considered to be the offer of an investment contract/managed investment scheme.
A ‘non-cash payment facility’ occurs where a person permits payments to be made other than by the physical delivery of Australian or foreign currency in notes or coins. Those offering a non-cash payment facility in Australia must either hold an Australian Financial Services Licence (AFSL) or fall within an exemption. Two such exemptions to the Corporations Act 2001 (Cth) are operating a “low-value” non-cash payment facility (if certain reduced disclosures are met) or where a facility is a loyalty scheme.
In order to qualify as a loyalty scheme, an offering must meet the following criteria:
- The dominant purpose of the scheme must be to promote the purchase of goods from, or the use of services of, the party operating the scheme or another business; and
- A person using the scheme must be allocated points (or tokens) as a result of the purchase of goods from, or the use of the services of, the party operating the scheme or another person; and
- The points (or tokens) allocated in the program can be used to make a payment or part payment for goods or services or to obtain some other benefit; and
- The program is not a component of another financial product.
A traditional loyalty system could simply replace their current databasing by using a token driven system, and should have little difficulty complying with the above requirements. The greater challenge arises where a greater element of decentralisation occurs, such as through the use of masternodes or other incentivised users of the platform, or where secondary trading of reward points is offered.
While many airline program loyalty schemes have permitted the transfer and sale of points for a long time, and permit top-up points purchases, selling points as a pre-sale of goods or services may not meet compliance with the second limb of the test in Australia, as the points may not be arising from the ‘purchase of goods or services’ but rather from a transaction to acquire the points themselves with a future purchase of goods or services with the points.
Another important requirement for exclusion from licensing requirements is that the points are not a component of another financial product. The Corporations Act has an expansive definition of what is a ‘financial product’ and many loyalty programs, including blockchain based loyalty programs, could fall within this definition, particularly if the tokens representing points are offered for sale prior to the points being usable within a platform, or if they are seen as a form of fundraising. The offer of a financial product in Australia carries with it specific licensing and disclosure obligations which can be expensive and onerous, and significant penalties apply when these obligations are not met.
Licensing requirements are most likely to arise where the offer of points is made before a loyalty platform is functional. In Australia, ASIC’s INFO225 guidance document suggests that many Initial Coin Offerings would be characterised as managed investment schemes, which are treated as ‘financial products’ and have licensing and disclosure obligations. In the USA, Mr Jay Clayton, Chairman of the Security and Exchanges Commission in the USA has indicated ICOs need to comply with securities laws.
However, the UK in early 2019 has taken a different approach, with a Financial Conduct Authority consultation paper suggesting the FCA will only treat as securities those tokens which provide explicit security like features such as revenue or dividend sharing, or which actually represent ownership of an underlying asset. That paper indicated that the FCA considers so called “utility tokens” akin to crowdfunding outside of regulations, such as that offered by Kickstarter, Indiegogo and others. Loyalty points offered for sale within a loyalty scheme, so long as they don’t provide any ownership of underlying assets or revenue/profit sharing or dividend rights, may have a strong likelihood of being considered “utility tokens” and hence not be regulated in the UK if this line of thinking is adopted at law. It will remain to be seen if the consultation paper becomes a formal guidance in the UK or adopted in other countries, such as Australia. It seems unlikely that the SEC in the USA will follow the UK’s lead on this point given enforcement action by the SEC to date.
Another area which has attracted early interest from governments around the world is how to manage the taxation of transactions involving cryptotokens. As tokens fundamentally represent some kind of contract when a transaction is entered into, the main analysis when considering whether and how tax will apply is to consider just what a party is contracting for in a transaction and how that transaction is treated under the tax laws of the jurisdiction in which it occurred.
In Australia, an amendment to the the Goods and Services Tax (GST) laws provided an exemption from GST which appears designed to apply to Bitcoin. Specifically, GST was exempted from “digital currency” from 1 July 2017. The tax law defines digital currency as a ‘digital unit of value that has all of the following characteristics’:
- It is fully interchangeable with another unit of the same digital currency for the purpose of payment;
- It can be provided as payment for any types of purchases;
- It is generally available to the public free of any substantial restrictions;
- It is not denominated in any country’s currency;
- The value is not derived from or dependent on anything else; and
- It does not give an entitlement or privileges to receive something else.
The ATO has stated that it will not consider loyalty points issued by retailers that can only be redeemed for products or services specified by a loyalty scheme to be digital currency for GST purposes. Similarly, the ATO has released guidance and a ruling concerning the tax treatment of loyalty schemes which appears well settled. Simply because a loyalty scheme is blockchain is no compelling reason for tax treatment to be different. However, an important distinction may arise where the loyalty points are tradeable, in which case the holders of the points should ensure they are keeping adequate records if their purchase or sale of the tokens is other than in connection with personal or domestic use. It must also be recognised that cryptocurrencies are considered to be a nuanced asset class, which can be utilised and applied in ways that other assets are not able to be applied. Cryptocurrencies also have unique components, such as forks. A fork is a change to the covert protocol in the relevant blockchain, and requires all nodes that are linked to the blockchain, to update to the new protocol software and adopt that new version moving forward. At this moment, there are two available strands of forks; a hard fork and a soft fork. A hard fork changes the protocol code entirely, creating a fresh version of the blockchain, and a soft fork is merely an update to the blockchain protocol. Examples of forks that have occured within the past 2 years include; the “Segwit” fork which occurred in August 2017, the Bitcoin Cash fork, and the Bitcoin Gold fork.
Where new cryptocurrency cash is involved, for example, when Bitcoin holders receive Bitcoin Cash as a result of the hard fork, the ATO states that taxpayers do not derive ordinary income or make a capital gain at that time. However, the capital gain will only come about when the newly made cryptocurrency is disposed of. The ATO stated that it is unlikely that the new cryptocurrency will be stored as a personal use asset, and hence, will not be entitled to the personal use asset exemption. It should be noted however, that the ATO guidance at this time is not legally binding upon the ATO as the law in this area is extremely nuanced, and has not been well established. It is likely that in the future this position will be challenged, as the existing and new assets (Bitcoin and Bitcoin Cash for example) will be classified as the same type and therefore be ascribed as identical within the holder’s statement of financial position.
Obligations in regards to Anti-Money Laundering and Counter-Terrorism Financing (AML/CTF) are in place to ensure that businesses in Australia and around the world do not engage in money laundering and the financing of terrorism. In Australia, the principal legislation is the Anti-Money Laundering/Counter-Terrorism Funding Act 2006 (AML/CTF Act), and its purpose is to “bring Australia into line with international best practice to deter money laundering and terrorism financing.” This is important, as Australian AML/CTF laws must remain comparable to such laws in a foreign country. Effective implementation of AML/CTF laws in Europe such as the Directive (EU) 2015/849 on preventing the use of the financial system for money laundering or terrorist financing, and the Bank Secrecy Act 1970 in America, provide for an efficient and expansive process for reporting entities to combat corruption domestically and overseas.
The AML/CTF Act applies where a person is providing a ‘designated service’. For the most part it is unlikely that a loyalty program operator is providing a ‘designated service’ and the definition of digital currency under that Act should normally not apply to loyalty points. However, where the loyalty points are represented by a form of digital currency, and the platform operator is providing an exchange between fiat currency and that digital currency, in Australia (and likely other countries) a ‘designated service’ will be very likely being provided and compliance with the AML/CTF Act will be required. Such compliance in Australia will include registering with AUSTRAC as a Digital Currency Exchange and developing an AML/CTF Program and appropriate supporting policies, training and guidelines for employees.
There are substantial fines and custodial penalties for failing to comply with the AML/CTF Act and it is expected in future that the Financial Action Task Force (FATF) will be seeking to extend AML/CTF compliance to include digital currency to digital currency conversions, which may render current crypto-centric loyalty schemes the subject of more onerous compliance. The best strategy at present is to have a comprehensive Know Your Customer system in place, which may also assist in gathering data for a loyalty program by ensuring that a customer is properly identified when they are interacting with the loyalty program. Dovetailing into this is a need to have a comprehensive privacy consent and disclosure to address compliance with the Privacy Act (in Australia) and the General Data Protection Regulation (in Europe) which goes beyond the scope of this chapter.
Misleading or deceptive conduct considerations
Regulators across different jurisdictions have been heavily focused on the nature of the token offerings, in particular, the contents of whitepapers and advertising material published and discussed on social media platforms such as Telegram, Twitter and Medium. Regardless of the jurisdiction that loyalty tokens are issued in, unfair or deceptive conduct and representations are strongly condemned by regulators.
Australia has one of the strongest consumer protection laws globally to stop people (individuals and corporations) from exploiting vulnerable users. These protections include prohibiting people from making misleading or deceptive statements, ensuring the goods or services are of merchantable quality and fit for the intended purpose, and preventing unconscionable conduct. While these provisions apply broadly to every transaction, they are particularly important in the provision of new products or services, such as a blockchain loyalty program, where the user may not have any prior experience or knowledge and the product may not be fully developed and tested at the time of the transaction.
The relevant sections in the Australian Consumer Law (ACL) are:
- Misleading or deceptive conduct – ‘a person must not, in trade or commerce, engage in conduct that is misleading or deceptive or is likely to mislead or deceive’ (s.18 ACL)
- False or misleading representations about goods or services: as to the value, standard or quality of goods, or that the person making the representation has a sponsorship, approval or affiliation; or with respect to the price of the goods and services.(s.29(1)(a))
- Unconscionable conduct in connection with goods and services (s.21)
Misleading representations with respect to future matters: if the person does not have reasonable grounds for making the representation it will be taken to be misleading. (s.4)
The above provisions were sculpted to reflect that of the Consumer Protection from Unfair Trading Regulations in the United Kingdom, which provides a general ban on conduct below a level which harm, or are likely to harm the economic interests of the average consumer. It is worth noting that, in Australia, the Australian Competition and Consumer Commission’s jurisdiction around Initial Coin Offerings and the ACL has been delegated to ASIC, permitting ASIC to exercise jurisdiction around token offerings where there is a concern that a breach of the ACL has occurred. Australia is considered to have very pro-consumer laws, and the regulatory framework provides a useful guide for loyalty program operators to consider their system design as well as terms and conditions of the program.
Generally, Australian contract law has endeavoured to follow in the footsteps of jurisdictions around the world in their response terms which can be considered by a Court or Tribunal to be unfair contract terms. Legislation such as the Unfair Contract Terms Act 1977 in the United Kingdom, and the European Commission Unfair Contract terms directive, have used notion of “good faith” to regulate imbalances between the rights and obligations of the consumer, and that of the sellers and suppliers. In America, the threshold to determine whether a contract term is unfair is significantly higher, as a term will only be unfair if it can shown to be ‘unconscionable’, which means that a term is so terribly unfair that the contract simply cannot be allowed to stand as is.
Accordingly, in Australia, enforcement bodies such as the ACCC and NSW Fair Trading have moulded their approach to regulating unfair contract terms in a similar vein to that of the above countries, primarily the United Kingdom. In particular, the ACCC has prioritised ensuring consumer contracts are fair and transparent regarding the rights of both parties involved. In recent years, the ACCC have emphasised their focus on holding both big and small businesses accountable for knowingly inserting unfair contract terms, and stepped up enforcement against businesses to ensure that their standard contracts do not contain such terms. Key provisions within the ACL are examples of such incentives.
Part 2-3 of the ACL, set out in Schedule 2 to the Competition and Consumer Act 2010 (Cth) (CCA) contains the first Australia-wide prohibition of unfair contract terms, in certain circumstances. Part 2-3 of chapter 2 of the ACL renders a contract term void if:
- the contract in question is a ‘consumer contract’; and
- the contract in question is a ‘standard form contract’; and
- the impugned contract term is unfair.
First of all, a consumer contract is a contract for the supply of goods or services to an individual consumer, who buys the good or service wholly or predominantly for personal, domestic or household use or consumption. Section 23(1)(b) of the ACL confines the prohibition of unfair contract terms to those in a ‘standard form contract’, which is defined as a contract that is pre-prepared for its customers, and not open to negotiation by the consumer. In accordance with section 24 of the ACL, a term of a standard form consumer contract is unfair if; it would cause a significant imbalance in the rights and obligations of the parties under the contract, it is not reasonably necessary to protect the legitimate interests of the party advantaged by the term, or it would cause detriment to a party if it is applied or relied on. Section 25 of the ACL goes on to set out various examples of contract terms which may be unfair.
To the extent that tokens within a blockchain loyalty scheme are considered a good being provided wholly or predominantly to the requisite users for personal or domestic use, the unfair contracts regime will apply. Accordingly, if any pre-sale of loyalty tokens fail to meet the test of transparency pursuant to s 24(3) of the CCA, and are subsequently challenged and found to be unfair, they can be rendered void, and therefore not form part of the agreement including whether or not they are embodied in a smart contract. As such, terms that may be declared unfair within the commencement of any pre-sale, and limit the company’s liability or obligations under the token loyalty scheme, are of the kind which the ACCC and the ACL identify as terms which:
- permits one party, but not another party, to avoid or limit its performance of its obligations under the contract
- penalises one party, but not the other party, for a breach or termination of the contract
- permits one party, but not another party, to terminate, vary or renew the contract
- permits one party to vary the upfront price under the contract without the right of the other party to terminate the contract
Further, a court may decide that a particular term is unfair, if the court determines that the clause leads to a significant imbalance in the parties rights and obligations, or is not reasonably necessary to protect the legitimate interests of the party who benefits from the term in the context of the whole agreement. On 12 November 2016, there were significant amendments introduced to the unfair contract term provisions of the ACL, extending the operation of the unfair contract terms regime to small businesses. A small business is defined as a business who employ fewer than 20 employees. Since the amendments were introduced, the ACCC has demonstrated that it is willing to litigate to enforce the unfair contract provisions of the ACL.
Notably, one of the first enforcement actions taken by the ACCC was against JJ Richard in the case of ACCC v JJ Richards & Sons Pty Ltd (2017), where the ACCC alleged that JJ Richard’s standard form contract contained eight unfair contract terms. The offending terms included clauses which purported to; bind customers to commit to subsequent contracts unless they cancel the contract within 30 days, allowing JJ Richards to unilaterally increase its prices, and remove any liability where its performance is “prevented or hindered in any way.” Following the JJ Richards case, a host of other firms were investigated, including; Servcorp, where it was held that businesses can no longer impose contract terms that create a significant power imbalance between parties; Equifax, whereby the ACCC alleged that Equifax’s renewal term for its credit report service was deemed void under the ACL, and Cardronics, where several unfair terms including an automatic renewal and a unilateral increase of fees were all deemed void and invalid.
Although the above cases reinforce the ACCC’s investigative powers in identifying unfair contract terms, it must be noted however, that the unfairness of each term is evaluated upon the circumstances of the usage of the term. As such, it cannot be guaranteed at this stage, that the ACL offers a requisite barrier to the inclusion of such terms in consumer contracts.
Critically, at this stage the ACL does not provide for penalties for breaches of the unfair contract provisions. If a term is determined by a court to be an unenforceable unfair contract term, then the clause is merely voided. There is no mechanism for the party which imposed the unfair term to be penalised. Historically, the ACCC has merely accepted court-enforceable undertakings to amend offending contracts to remove unfair terms. However, there are currently proposals before the federal Government to amend the ACL to allow the ACCC to seek civil financial penalties when a contract term is declared unfair and void. It remains to be seen whether these proposals will come to be incorporated into the ACL.
The use of blockchain technology is constantly evolving and developing and the law will always be catching up. Smart contracts offer great automation and efficiency but are still largely untested in the courts and unregulated, but as can be seen throughout this chapter, various existing regulatory systems interact with loyalty schemes using blockchain.
As such, the design and operation of any loyalty scheme should take place with considered legal advice, and a blockchain loyalty scheme is no different, but needs additional care at the earliest stages to manage the new risks that come with this new technology.
This is an excerpt from Blockchain Loyalty: Disrupting loyalty and reinventing marketing using cryptocurrencies (2nd Edition) by Philip Shelper with contributions by Piper Alderman.
Blockchain Loyalty is available at all good book stores. Buy it now.