Cryptoventures and the Law

HOW THE LAW WORKSFUQINTRD 697: Innovation and Cryptoventures
Duke University 2021 2
Who are the regulators?
Federal • Securities Exchange Commission (SEC) • Commodity Futures Trading Commission (CFTC) • Treasury Department - Financial Crimes Enforcement Network (FinCEN) • Internal Revenue Service (IRS) • Federal Trade Commission (FTC)
Duke University 2021 3 Prepared with the help of Trevor Kiviat, Sean Semmler, Zeeve Rose.
State • Securities Laws • Commodities Laws • Consumer Protection and Anti-Fraud Laws • State Money Transmitter Regulations (including NY BitLicense)
State • Securities Laws • Commodities Laws • Consumer Protection and Anti-Fraud Laws • State Money Transmitter Regulations (including NY BitLicense)
SEC SEC established in the wake of the Crash of 1929
• Idea to protect uninformed investors from fraud in US markets • Provides guidance on how to comply with laws • Has enforcement power through civil penalties (criminal handled
through Department of Justice) • Jurisdiction: Sale of securities to US persons
SEC The offer or sale of any security must be registered under the Securities Act – unless an exemption is granted
When is a digital asset a “security” 1. Asset just represents a traditional security like a stock or a bond,
e.g., tokens representing shares (or fractions of shares) of securities 2. An “investment contract”
SEC Investment contract derived Securities Act and Howey (1946) • Howey and Co. owned orange groves in Florida • They offered the following deal. An investor could buy the land and lease
it back to Howey who would tend the land, harvest, and market the produce
• It was determined by the Supreme Court this type of leaseback was an “investment contract”
Duke University 2021 8 https://supreme.justia.com/cases/federal/us/328/293/
SEC Howey Test (1946) • “…an investment contract for purposes of the Securities Act means a
contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”
Duke University 2021 9 https://supreme.justia.com/cases/federal/us/328/293/
SEC U.S. Securities laws: • Goal to protect retail investors • Howey only matters if token is not obviously a security (like equity or debt) • Under Howey SEC looks at: manner of sale, promotional material, utility vs.
speculation
Is it a Security? Decentralized Autonomous Organization • Investors deposited ETH into a smart contract in return for DAO tokens • The ETH in the contract was to be used as venture capital • DAO token holders got to vote for various investments • Clear expectation of making profits from the initial investment • SEC rule The DAO was a security
Is it a Security?
Decentralized Autonomous Organization • July 26, 2016 The SEC rules that DAO tokens were “securities” subject to
federal securities laws. • …issuers of distributed ledger or blockchain technology-based securities
must register offers and sales of such securities unless a valid exemption applies. Those participating in unregistered offerings also may be liable for violations of the securities laws. Additionally, securities exchanges providing for trading in these securities must register unless they are exempt. The purpose of the registration provisions of the federal securities laws is to ensure that investors are sold investments that include all the proper disclosures and are subject to regulatory scrutiny for investors' protection.
12Duke University 2021 https://www.sec.gov/news/press-release/2017-131
SEC – Registration and Exemption In a sale of a security in which the security is offered or sold to U.S. persons the issuer must:
1. Register the Securities with the SEC • This is an expensive option that most startups cannot afford
2. Find Registration Exemptions (Safe Harbors) • Regulation D – Private Placement and General Solicitation
• 506(b) – limit of unaccredited (must be sophisticated), unlimited raise, unlimited Accredited Investors, no general solicitation.
• 506(c) – only Accredited Investors, burden on issuer to confirm accreditation status, unlimited raise, general solicitation allowed.
• Regulation S – Offerings outside the US to non-US persons Duke University 2021 13
SEC – Bottom line • The cost to engage a lawyer to determine whether your token is a
security is low
• The cost of not engaging a lawyer and SEC determining you are doing a security offering – is high.
SEC - Other Regulatory Authority
• Investment Advisors • Broker/Dealers • Underwriters
SEC – Statements by Commissioner/SEC
• Cryptocurrencies (coins and tokens) can be Securities (DAO Ruling) • Commissioner believes all ICO that he has seen have been
unregistered security offerings, but has recognized that there is a possibility of a compliant token/coin sale.
• Commissioner’s critique of market professionals (lawyers) using sematic argument to try and claim tokens/coins are not securities
SEC – The Simple Agreement for Future Tokens (SAFT) and Semantics
• The SAFT framework and idea of Utility Token • SAFT Whitepaper*
• Argument • Pre-functionality sale using SAFT – SAFT as a security with eventual
token/coin not being a security • Token sale post-functionality (utility token)
*https://saftproject.com/
SEC –Enforcement Authority: Actions and Penalties
• Recent Actions • DAO, Munchee, AriseBank • Manner of Sale is key! • Bad-Actors – fraud or misleading information high targets
• Criminal and Civil Penalties • Private Right of Actions – individuals/class actions
Commodity Futures Trading Commission (CFTC) – Intro
• What is the CFTC? • The CFTC is the regulatory body that “aims to protect market users and their funds, consumers, and
the public from[:] fraud, manipulation, and abusive practices related to derivatives and other products that are subject to the Commodity Exchange Act (CEA).
• Broad Definition of a Commodity: “A commodity…includes…agricultural commodities…and all other goods and articles… (except onions)… and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in; (2) A physical commodity such as an agricultural product or a natural resource as opposed to a financial instrument such as a currency or interest rate.”
• Cryptocurrencies are commodities* • Securities are not commodities
*http://www.cftc.gov/idc/groups/public/documents/file/labcftc_primercurrencies100417.pdf. Duke University 2021 19
• Commodity Derivative Markets • Require approval from CFTC
• LedgerX only exchange that has ability to hold customers Bitcoin • Open question on what holding Bitcoin means?
• Requires certain data reporting
• SAFTs as Future Contracts?
CFTC – Enforcement Authority
• Market Manipulation • Can subpoena and enforce civil and criminal penalties • Market manipulation in underlying commodity (spot) markets and derivative
markets
CFTC – Statements by Commissioner and Actions by CFTC
• More positive then SEC • Chairman J. Christopher Giancarlo - “[y]et, while [decentralized ledger technologies]
promises enormous benefits to commercial firms and charities, it also promises assistance to financial market regulators in meeting their mission to oversee healthy markets and mitigate financial risk. What a difference it would have made on the eve of the financial crisis in 2008 if regulators had access to the real-time trading ledgers of large Wall Street banks, rather than trying to assemble piecemeal data to recreate complex, individual trading portfolios. I have previously speculated that, if regulators in 2008 could have viewed a real-time distributed ledger (or a series of aggregated ledgers across asset classes) and, perhaps, been able to utilize modern cognitive computing capabilities, they may have been able to recognize anomalies in market-wide trading activity and diverging counterparty exposures indicating heightened risk of bank failure. Such transparency may not, by itself, have saved Lehman Brothers from bankruptcy, but it certainly would have allowed for far prompter, better-informed, and more calibrated regulatory intervention instead of the disorganized response that unfortunately ensued.”
Treasury Department - Financial Crimes Enforcement Network (FinCen – Intro)
• Bank Secrecy Act • Money Services Businesses and Crypto-exchanges
• Businesses engaged “in the exchange of virtual currency for real currency, funds, or other virtual currency” (“exchangers”) or businesses engaged “in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency” (“administrators”) are deemed money transmitters and are therein Money Services Businesses. Users, defined as “a person [or business] that obtains virtual currency to purchase goods or services” are not a Money Services Business.
FinCen – Money Services Businesses
• Money Services Businesses Must Comply with Bank Secrecy Act: • Anti-Money Laundering Laws – be able to trace money received back to root
(some trusted institution). • Know Your Customer Laws – verify and maintain the identities of the
customers. • What does this look like?
• Establish effective BSA compliance programs • Establish effective customer due diligence systems and monitoring programs • Screen against Office of Foreign Assets Control (OFAC) and other government
lists • Establish an effective suspicious activity monitoring and reporting process • Develop risk-based anti-money laundering programs
• Bit-e – AML violation* • $110,003,314 civil penalty • One of operators arrested and personally penalized $12,000,000
*https://www.fincen.gov/news/news-releases/fincen-fines-btc-e-virtual-currency-exchange-110-million-facilitating-ransomware*
Internal Revenue Service (IRS) - Intro
• What does the IRS do? • Collect taxes and enforce tax laws
IRS – Cryptocurrency as Property • Taxed as property – Income subject to capital gains tax* • Capital Gains (Price Sold – Basis)
• Short term (held less then 1 year) • ordinary income – bracket same as other income
• Long term (held longer then 1 year) • Lowest 2 tax brackets – 0% • Middle tax brackets – 15% • Highest tax bracket – 20%
• Problem for using crypto as medium of exchange • Have to calculate and pay capital gains taxes when spending on goods or services • What about trading for another cryptocurrency?
• 83(b) election likely needed (if subject to vesting schedule)
*https://www.irs.gov/irb/2014-16_IRB#NOT-2014-21 Good Article - https://www.forbes.com/sites/greatspeculations/2018/01/03/what-you-should-know-about-taxation-of- cryptocurrencies/#1bf3f6cc1346
• Investment in foreign securities • Can still be subject to IRS
IRS – Enforcement
• Low likelihood of audit – 1% random audits a year • Be careful if high net worth or famous
• Reporting from Coinbase (20K owned automatically reported to IRS) • Difficulty in Calculating?
Future – Regulatory Gap
• Spot-market Gap • Currently, no federal agency has claimed authority to regulate the “Spot Markets” (aka exchanges
• No government agency has the power to “conduct regulatory oversight over spot virtual currency platforms or other cash commodities, including imposing registration requirements, surveillance and monitoring, transaction reporting, compliance with personnel conduct standards, customer education, capital adequacy, trading system safeguards, cyber security examinations or other requirements” (See Page 4 of J. Christopher Giancarlo Written Testimony).
• CFTC is collecting some data via data collection of spot markets
• Future Legislation? - https://www.reuters.com/article/us-crypto-currencies- congress/congress-sets-sights-on-federal-cryptocurrency-rules-idUSKCN1G31AG
• Fedcoin • Identity • Taxes
NEW YORK & BITLICENSE
• First of its kind • Most virtual currency (e.g. Bitcoin) businesses will have to be licensed to
engage in business with NY customers (retail or institutional) • Exclusion for businesses engaging in transactions for non-financial
purposes and involve only a nominal amount of digital currency • Mere consumers who use Bitcoin or merchants that accept Bitcoin will not
have to register • Some effects of BitLicense:
• UNBELIEVABLY ONEROUS • Create barriers to entry (e.g. impose significant application & compliance costs) • Companies will likely find it easier to establish banking relationships • May promote both investment in the industry and consumer trust
oversight, etc. • Capital Requirements
• Licensees can hold virtual currency as capital • AML / KYC Requirements
• Licensee must obtain information for counterparties to its customers’ transactions only to the extent practicable • Records must be kept for 7 years • Licensee subject to federal Suspicious Activity Reporting (“SAR”) need not file SARs with NYDFS • Currency Transaction Reports for NYDFS needed only for > $10,000 virtual currency to virtual currency transactions (and only if
not federally reportable) • Clarification of Scope of Virtual Currency / Business Activities
• Mere software developers / end-users not covered • Mere miners / mining pools likely not covered • Non-financial uses of virtual currency technologies no longer covered • Companies that merely “secure” virtual currency on behalf of a person not covered (potentially intended for “multi-sig”
applications) • Digital units used for customer affinity or rewards program / pre-paid cards not covered • Merchants / consumers using virtual currency solely for investment purposes not covered
NEW YORK & BITLICENSE
• BitLicense applies to business activities involving a “Virtual Currency” • Virtual Currency - any type of digital unit that is used as a medium of exchange or form of digitally stored
value • Broadly construed to include digital units of exchange that (i) have a centralized repository or
administrator; (ii) are decentralized and have no centralized repository or administrator; or (iii) may be created or obtained by computing or manufacturing effort
• Does NOT include digital unites (e.g. World of Warcraft Gold, Airline Miles, etc.) • Types of business activities subject to Bitlicense are those that:
• Receive virtual currency for transmission or transmitting it • Hold virtual currency for others • Buy and sell virtual currency as a customer business • Exchange services as a customer business • Control, administer, or issue virtual currency
• Exempt from BitLicense: • Certain entities chartered under New York Banking Law • Mere merchants, consumers, investors • Mere software developers/distributors
DELAWARE BLOCKCHAIN INITIATIVE
• This matters because Delaware matters – really the corporate capital of the world
• Companies incorporated in Delaware are now expressly allowed to keep track of their stockholders and outstanding stock by using blockchain (also known as distributed ledger) technology
• Used to be tracked on an Excel spreadsheet – so if there was a transfer of shares the corporation’s stock ledger had to be updated (subject to human error)
• Old system of tracking the stock of a company was based on the issuance of shares on paper - processes for authenticating and authorizing the ownership and transfer of shares were complex and costly
• New Delaware law is enabling, rather than prescriptive - no specific technology is required
STATE REGULATIONS • Bitcoin Friendly States:
• Texas – Memorandum 1037 - no money transmitters license is required to sell Bitcoin. Bitcoin companies that reside in Texas can even run a custodial exchange without a money transmitters license (a license is required for custodial services outside of Texas)
• Kansas – based off Texas but has lower cost of entity organization than in Texas • Tennessee – also based off Texas’s crypto regulations • SC & Montana - no money transmission laws nor bitcoin regulation – HOWEVER -in June of 2018 SC’s money
transmission laws go into effect (includes cryptocurrencies) • Nevada - prohibits taxing the use of a blockchain & says blockchains satisfy requirement of a written record – follows
Arizona • However, requires a permit for blockchains
• Vermont • Senate Bill 135 - calls for any "fact or record" verified through the use of a blockchain to be "authentic.”
• gives Blockchain-notarized documents, including those on the Bitcoin blockchain, added legal bearing in a court of law. • Can introduce evidence on a blockchain
• Arizona • House Bill 2417 - the legislation defines both blockchains and smart contracts, while declaring that all data tied to a blockchain is
"considered to be in an electronic format and to be an electronic record," which is acceptable for use by the state • Smart contracts are given legally-binding status
• However, also makes it a felony to subject citizens to having their guns tracked on a blockchain
• Bitcoin Unfriendly States: • Wisconsin - refuse to issue a money transmitters license to any company that desires one and will require
an agreement if a company deals in virtual currency stating that they will not use virtual currency to transmit money
• Both CoinX and Circle financial have agreements in place with Wisconsin • NC - has money transmission laws and laws restricting the transacting of virtual currency – Bitcoin sellers
allowed to operate so long as they are registered federally with the Financial Crimes Enforcement Network ("FinCEN")
• California – no real regulation yet (though that is coming) - sent a cease-and-desist letter to the Bitcoin foundation a few years ago and also called out Coinbase stating that they were not regulated in California
• New Hampshire and Pennsylvania – have bills proposed that will make Bitcoin and other virtual currencies monetary value and thus require a money transmitters license to sell
• Connecticut - new regulation prohibits selling Bitcoin or storing bitcoin for others without a license and the bond will be set by the banking commissioner on a case-by-case basis with no clear understanding of how that is going to be calculated
• Hawaii - recently re-classified cryptocurrency-using businesses as Money Transmitters, forcing Coinbase to stop doing business within the state
• House Bill 1481 - tourism focused bill - “A large portion of Hawaii's tourism market comes from Asia where the use of bitcoin as a virtual currency is expanding. Hawaii has the unique opportunity to explore the use of blockchain technology to make it easier for visitors to consume local goods and services and to drive the tourism economy.”
GIBRALTAR
• World’s First DLT Regulatory Framework • Since 1st January 2018, any firm carrying out by way of business, in or from Gibraltar, the use
of distributed ledger technology (DLT) for storing or transmitting value belonging to others (DLT activities), needs to be authorized by the Gibraltar Financial Services Commission (GFSC) as a DLT Provider
• Principles for DLT Providers : • should have: honesty, integrity, a good reputation, skill, competence, strong financial position, and
experience • must protect their customers with information disclosures, risk management, adequate compliance
policies, etc. • need adequate financial and non-financial resources • need effective corporate governance arrangements • need proper security and prevention mechanisms in the event of an attack OR detection mechanism
for money laundering/crime (e.g anti-money laundering & terrorist financing) • Application Fees – 2,000 pounds (nonrefundable) + an additional 10,000-30,000 pounds
depending on the complexity of the business + 10,000-30,000 pounds annually thereafter • Generally ICOs and Token Sales will NOT fall under this DLT framework
SWITZERLAND • Zug, Switzerland – Crypto Valley • Assessing whether an ICO will be regulated:
• Each case is decided on its individual merits • FINMA will focus on the economic function and purpose of the tokens • money laundering and securities regulation are the most relevant to ICOs (Banking Act and Collective Investment Schemes Act are
less typical) • Anti-Money Laundering Act - the need to establish the identity of beneficial owners • Securities regulation – protects market participants and makes sure trading is fair and based on reliable information
• 3 Types of ICOs: • Payment ICOs - ICOs where the token is intended to function as a means of payment and can already be transferred
• FINMA will require compliance with anti-money laundering regulations - FINMA will not, however, treat such tokens as securities • Utility ICOs - These tokens do not qualify as securities only if their sole purpose is to confer digital access rights to an application
or service and if the utility token can already be used in this way at the point of issue. • if a utility token functions solely or partially as an investment in economic terms, FINMA will treat such tokens as securities (like asset tokens)
• Asset ICOs - FINMA regards asset tokens as securities, which means that there are securities law requirements for trading in such tokens, as well as civil law requirements under the Swiss Code of Obligations (e.g. prospectus requirements)
• FINMA categorizes tokens into 3 types: • Payment tokens (cryptocurrencies) - have no further functions / links to other development projects • Utility tokens - tokens which are intended to provide digital access to an application or service • Asset tokens - represent assets such as participation in real physical underlyings, companies, or earnings streams, or an
entitlement to dividends or interest payments (and are analogous to equities, bonds or derivatives)
• ICO Code of Conduct Duke University 2021 41
ESTONIA • Already have their medical records on a blockchain platform • Has announced plans for a national cryptocurrency (estcoin) – it would be to support the e-Residency
program • 3 proclaimed uses of estcoin:
• community token - structured to support the objective of growing the new digital nation by incentivizing more people around the world to apply for and make greater use of e-Residency
• identity estcoin – allow members of e-Residency to digitally sign documents or log onto services safely and securely (can’t be sold / traded)
• euro estcoin (controversial) - have a value linked to that of the euro, the fiat currency used in Estonia (not a replacement of the Euro)
• e-Residency (digital ID/digital governance) - a government-issued digital ID available to anyone in the world
• primary benefit at present is the ability to establish and manage a trusted location-independent company entirely online
• To gain e-Residency, applicants must undergo background checks by the Estonian Police and Border Guard board before they are issued with their e-Residency kit
• contains an ID card, a card reader that plugs into a computer’s USB slot and a set of pin codes for both authenticating themselves online and digitally signing documents
• ( https://e-resident.gov.ee/become-an-e-resident/ )
• September saw the second exchange shutdown of 2017 – became a permanent moratorium on crypto-to-fiat platforms
• Chinese lawmakers seeking to end “centralized” exchange activities altogether
• Report from the People’s Bank of China stated that no individual or organization may longer raise funds through ICOs
• China has also clamped down on mining operations – mining operations are moving elsewhere
• China is currently working to implement a massive firewall to block trading on a foreign platform
• China, at the same time, with its state-owned social media and search engines is wiping clean any trace of cryptocurrency and ICO advertising
• Why is it doing this? And does it even matter?
RUSSIA • Russian Federal Law on Digital Financial Assets:
• Outlines both requirements for projects that launch ICOs, as well as for investors who wish to participate in the token sales
• No investment limit for investors who are licensed professionals in accordance with Russia's securities law • However, there’d be a 50,000 ruble (around $900) cap would be imposed for investors without qualification for each token
issuance • Disclosure requirements (full name of the token issuer, the project's website &network provider, permanent
operating bodies of the organizer) • No promotional activities prior to the token sale
• There may be criminal penalties for mining in the near future – miners must register with a central authority (apparently the government is worried about tax evasion, among other things)
• Also, Despite Putin’s public negativity towards cryptocurrencies, regulations affecting the trade of these cryptocurrencies may be legal soon in Russia
• Talk of developing Russia’s own cryptocurrency, the CryptoRuble (government controlled) • Also, there have been rumors that Russia is investigating blockchain technology for its voting
systems
UNITED ARAB EMIRATES
• Intention to turn itself into the first blockchain-powered government in the world by 2020
• Dubai aims to be at the forefront of the technology and to be the first city built on blockchains (called Smart Dubai)
• workshops to educate the public and private sectors about the technology’s potential • meet with government and private organizations to identify and prioritize the industries and
services which can benefit the most from this technology • implement pilot projects to be conducted this year
• Crypto & ICO Regulations • Companies wishing to organize an ICO are now mandated to approach the Financial Services
Regulatory Authority (FSRA) where the authority will determine if the token offering is to be regulated as a security
• Cryptocurrencies = commodities (virtual currencies aren’t legal tender with characteristics more common with physical commodities)
Category of Instruments Regulatory Approach
Virtual tokens that have the features and characteristics of a Security under the FSMR (e.g. Shares, Debentures, Units in a Collective Investment Fund)
Deemed to be Securities
Market intermediaries and market operators dealing in such tokens or their Derivatives will need to be licensed / approved by FSRA as FSP holders, Recognized Investment Exchanges or Recognised Clearing Houses
Other virtual tokens that do not exhibit the features and characteristics of a regulated investment / instrument under the FSMR
Treated as commodities and hence not regulated a Specified Investments under the FSMR
Spot transactions will not constitute Regulated Activities or activities envisaged under a Recognition Order (i.e. those of a Recognized Investment Exchange or Recognized Clearing House)
However, a regulated firm under the FSMR (i.e. an FSP holder or Recognized Body) that is involved in the use or transaction of such tokens will have to demonstrate that it is fit and proper in carrying on such transactions, and to comply with all applicable regulatory obligations as a regulated firm (e.g. in relation AML/CFT controls, fit and proper management team, etc.)
Virtual currencies
Derivatives of virtual currencies and Security Tokens
Regulated as Specified Investments under the FSMR
Market intermediaries and market operators dealing in such Derivatives will need to be licensed/approved by FSRA as FSP holders, Recognized Investment Exchanges or Recognized Clearing Houses.
OTHER RELEVANT INTERNATIONAL PLAYERS
• Denmark • at the forefront of the push towards eliminating cash in favor of 100% digital
currency • Danish Central Bank declared Bitcoin not a currency, stating that it will not regulate
its use in the country • Sweden
• Swedish Financial Supervisory Authority (Finansinspektionen) have legitimized the fast growing industry in the country by publicly declaring Bitcoin (and other cryptocurrencies) as a means of payment
• Also trying to get rid of fiat currency • Finland
• Members of Finland’s central bank authored a paper arguing that there is in fact no need for governments to regulate bitcoin due to its decentralized infrastructure
OTHER RELEVANT INTERNATIONAL PLAYERS
• Japan • Virtual Currency Act - described and identified what a virtual currency is, clarified
that Bitcoin is considered an asset, and that Bitcoin can be considered a payment method
• did not declare bitcoin as a legal currency • Japan Financial Services Authority was granted ability to both regulate and issue licenses to
virtual currency exchanges in Japan • cemented Bitcoin as an established market in Japan (the rules are clear and consumers can be
protected) • There are certain favorable tax regulations concerning Bitcoin as well, to encourage
international investors • South Korea
• South Korean ministry is planning a bill to ban cryptocurrency trading through exchanges (but it could take years for their Parliament to pass)
Cryptoventures and the Law
SEC – The Simple Agreement for Future Tokens (SAFT) and Semantics
SEC –Enforcement Authority: Actions and Penalties
Commodity Futures Trading Commission(CFTC) – Intro
CFTC – Regulatory Authority
CFTC – Enforcement Authority
FinCen – Money Services Businesses
IRS – Cryptocurrency as Property

Documents

Cryptoventures and the Law