Daniel Nathan

Partner

Washington, D.C.


Read full biography at www.orrick.com

Daniel Nathan uses his deep enforcement and regulatory experience to represent U.S. and international financial institutions and individuals before financial regulators.

With a combined 25 years as a senior enforcement official with the SEC, CFTC and FINRA, three of the country’s leading regulatory and enforcement authorities, Dan is a particularly effective advocate for those facing investigations and/or enforcement action by those regulators. He is also active in advising and representing companies who issue or transact in cryptocurrency and is co-chair of Orrick's Blockchain and Cryptocurrency group.

Daniel’s intimate knowledge of broker-dealer regulation provides clients facing SEC or FINRA examinations and enforcement investigations with experienced counsel related to broker-dealer supervisory procedures, sales practices, anti-money laundering, ETF regulation, product disclosure and supervision, and securities and broker registration. His extensive experience includes the JOBS Act and Dodd-Frank Act, and he has led extensive efforts to help foreign banks establish programs for complying with the Volcker Rule. He also represents individuals and entities facing investigations by the CFTC or derivatives exchanges.

Previously, Daniel served as the Vice President and Regional Enforcement Director of the Financial Industry Regulatory Authority (FINRA), where he oversaw 70 lawyers across 15 offices responsible for bringing up to 900 disciplinary actions annually against broker-dealer firms, registered representatives and associated persons. This included many of FINRA’s most significant nationwide enforcement actions, including actions and sweeps involving mutual fund breakpoints, structured products sales practices and supervision, and private placement due diligence and disclosure.

In his 12 years at the SEC, Daniel served as Assistant Director in the Division of Enforcement, where he supervised federal securities investigations of insider trading (including the investigation that resulted in the seminal case US v. O’Hagan), market manipulation, financial fraud and accounting misconduct. In nine years with the CFTC, he served as Deputy Director of Enforcement, with responsibility for oversight of the agency’s Enforcement Division.  In that role, he supervised significant actions regarding market manipulation, trade practices, commodity trading advisor practices and foreign exchange dealer practices.

An oft-quoted authority on complex financial, legal and business issues, Daniel is frequently sought after to speak and write on the important issues confronting financial institutions, including broker-dealer sales practices and compliance, complex products, ETFs, the Volcker Rule, derivatives, cryptocurrency, cybersecurity, and anti-money laundering. He is Co-chair of the ABA SEC Enforcement Subcommittee and a member of the Editorial Advisory Board of the Journal of Investment Compliance.

Posts by: Daniel Nathan

“But if You Fall, You Fall Alone” – The SEC Goes After Ripple

Seven years after Ripple Labs, Inc. first began to sell its digital asset XRP, the Securities and Exchange Commission on December 22, 2020, filed a Complaint in the Southern District of New York against Ripple and its current and former CEOs, alleging that since it began these sales, Ripple has been engaged in an unregistered securities offering through the sale of its XRP token within the United States and worldwide. In the action, which does not allege fraud, the SEC is seeking injunctive relief, disgorgement with prejudgment interest, and civil penalties.

The SEC applied a legal analysis similar to that in other enforcement actions against offerors of digital assets, such as Kik and Telegram. What separates the Ripple Complaint from others is the years-long history of activity the SEC draws upon to allege that the Defendants created substantial risk to investors through asymmetric information disclosures for their own personal gain—the very thing the securities laws are designed to protect against.

The Howey test is used to determine if a financial instrument is an “investment contract” and thus a security. An investment contract was defined by the Supreme Court in SEC v. W. J. Howey Co., 328 U.S. 293 (1946), as an investment in a common enterprise with a reasonable expectation of profits or returns derived from the entrepreneurial or managerial efforts of others. Applying that test, the SEC alleges that purchases of XRP constituted investments, and the XRP offering constituted a common enterprise because the fortunes of the participants were tied together. In typical cases brought by the SEC to date alleging that a form of cryptocurrency is a security, these two prongs of the Howey test have been easily met.

As to the third prong: the SEC alleges that purchasers of XRP reasonably expected their profits to be derived from the efforts of the Defendants, pointing to their efforts to create, control, and manage secondary markets for XRPs, to develop XRP use cases, and to work with banks and other financial intermediaries to implement said use cases. In contrast, note that SEC officials have declared that Bitcoin is not a security—and at least one former commissioner has stated that, in his view, Ether, in its current decentralized form isn’t either—because those tokens do not meet the “reasonable efforts of others” prong of the test, since there is no single third party the token holders are reliant upon for the their continued management and success. (The SEC has elaborated on this analysis in the Framework for “Investment Contract” Analysis of Digital Assets.) The SEC is arguing that this is not the case with Ripple, because, according to the Complaint, XRP investors are not in any position to undertake “various, complex, expensive and all-encompassing strategies about when or how to sell XRP into the markets to protect XRP’s price, volume, and liquidity. Nor are XRP investors in any position to increase significantly ‘demand’ or ‘value’ for XRP by developing a ‘use’ for the token through entrepreneurial efforts—at least not without Ripple’s support.”

The 71-page, 404-paragraph fact-intensive Complaint appears designed to leave little to doubt about the extensive history of the conduct alleged. (According to the Complaint, the statute of limitations as to possible claims against the company was tolled six times.) The SEC’s efforts to bolster its legal conclusions includes, oddly, a footnote citing to guidance from a sister regulator, FinCEN, for its views on the application of the federal securities laws to convertible virtual currencies. And the lengthy Complaint overpleads the SEC’s case, devoting substantial discussion to facts suggesting manipulative conduct designed to support the price of XRP through artificial means, although the SEC does not go so far as to include a cause of action for manipulation. 

In sum, it is unclear whether the attention given by the SEC’s Complaint to dated facts, and allegations that go well beyond the causes of action, constitutes a litigation strategy; a hint about the future direction of SEC cryptocurrency enforcement efforts; or compensation for the SEC’s inaction with respect to this company until now. But it does beg the question as to why the SEC allowed Ripple to operate for as long as it did before bringing this Complaint, during which the XRP attained widespread distribution and heavy concentration with some investors.

Word on the Street Is That Virtual Currency Is the “New Gold,” and it’s Swiftly Moving Up the IRS Watchlist

The IRS has been increasingly active in its effort to ensure that virtual currency does not become a tool for tax evasion. This is not surprising, given that—as we started the last month of 2020—the value of Bitcoin, by far the most well-known cryptocurrency in the world, reached its highest level since 2017. Between June 2019 and July 2020, about 3.1 million active accounts were estimated to use bitcoin in the U.S.

Guidance

The IRS first started publishing guidance and notices on the federal income tax treatment of virtual currency in 2014. The first one among many was Notice 2014-21, which concluded that convertible virtual currency (virtual currencies that can be used to make purchases in the real economy and can be converted into government-issued currencies) should be treated as property for tax purposes. The next Notice, Rev. Rul. 2019-24, addressed the tax treatment of more specific types of virtual currency transactions, “hard fork” and “airdrop.” The IRS has also posted answers to frequently asked questions about virtual-currency transactions on its website. Starting with taxable year 2019, the IRS revised Schedule 1 to Form 1040 to require taxpayers to identify whether they engaged in any transaction involving virtual currency. The IRS plans on going even further as shown in a released draft of the revised Form 1040 for 2020, where it proposed placing the question about cryptocurrencies in a very prominent location—immediately below the taxpayer’s name and address.

More guidance might be forthcoming. One issue is whether the rules for broker reporting should apply to cryptocurrency transactions in the same way that they apply to trades in stocks and securities. The IRS believes that increased reporting leads to greater compliance. Earlier this year, the Chamber of Digital Commerce (the “Chamber”) submitted a comment letter to the IRS and the Department of Treasury to provide its views on potential forthcoming guidance on the reporting issue. The letter pointed out there is still some lack of clarity on the tax information reporting requirement for digital asset transactions, and that further instruction is needed for taxpayers to accurately interpret existing tax rules in the digital currency context. Some of the key areas on which the Chamber had requested clarification are: how “broker” is defined in the virtual currency context—which is critical for analyzing basis reporting requirements and certain information return filing obligations—and what factors are relevant for determining the location transactions take place, which can be a critical factor for cross-border transactions.

Enforcement Efforts

At the same time that it has been providing such guidance, the IRS has begun efforts to investigate possible tax evasion using virtual currency. The agency started its enforcement efforts in as early as 2016 when it served a “John Doe” Summons on one of the largest cryptocurrency exchanges in the country. The IRS demanded that the exchange produce a wide range of taxpayer identifying information and historical transaction records, and when the exchange refused to comply, the U.S. District Court for the Northern District of California ordered the exchange to turn over taxpayer information for those who conducted transactions worth more than $20,000 on its platform for the 2013 – 2015 period.

As part of its virtual currency compliance campaign announced in 2018 to address tax noncompliance related to virtual currency, in 2019 and again in 2020, the IRS sent thousands of warning letters to cryptocurrency holders whose tax returns did not match their virtual currency transaction records. While the IRS has not made it clear where it obtained the information about taxpayers’ transactions, one possible source of data could be Form 1099 reports from virtual currency exchanges. The IRS sent three different types of letters, varying in severity. The first type, Letter 6173, raised the possibility of an examination or enforcement activity if the taxpayer didn’t respond by a specific date and noncompliance persists. The other two, Letters 6174 and 6174-A, reminded taxpayers of their obligation to report.

According to the Internal Revenue Manual (IRM 5.1.18.20.3 (7-17-19)), the IRS uses normal investigative techniques to identify virtual currency including interviews, bank or credit card analysis, summonses of exchanges and financial institutions, review of Forms 1099-K, review of FinCEN Query reports, tracking and internet searches. While this set of instructions may appear relatively old-fashioned, the IRS’ latest moves demonstrate that it is upgrading its crypto-investigation toolbox. According to published reports, in September 2020, the IRS spent approximately $250,000 on a contract with Blockchain Analytics and Tax Services LLC, which will give the IRS access to blockchain analysis tools to track cryptocurrency transactions. Earlier in the summer, the IRS also signed a deal to purchase access to certain blockchain-tracing software for a year.

Despite the industrywide complaint that the IRS’s expectations with regards to holders of virtual currency are vague and unclear, this year, the IRS and the Department of Justice have started taking more proactive actions to prosecute taxpayers who allegedly committed a greater scale of tax evasion related to the use and trade of virtual currency. In October 2020, the Department of Justice charged software pioneer John McAfee with alleged evasion of tax by using cryptocurrency. In addition, on December 9, 2020, the SEC charged Amir Bruno Elmaani, founder of cryptocurrency called Oyster Pearl, with tax evasion. Elmaani allegedly evaded tax on millions of dollars of profits from cryptocurrency transactions and using shell companies and pseudonyms to conceal his income.

Increasing Regulation and Enforcement

All indications are that regulation and enforcement of the law with respect to virtual currency is increasing. On the regulatory side, earlier this month, a new U.S. congressional bill called the “Stablecoin Tethering and Bank Licensing Enforcement Act” was introduced that aims to regulate digital currencies by requiring certain digital currency issuers to obtain a banking charter and obtain approval from the Federal Reserve. Different government agencies are working in parallel to clarify tax payment and reporting obligations with respect to cryptocurrency, and the latest movements indicate that the enforcement actions are continuing.

We expect to see more enforcement actions in the upcoming administration. In November, the president-elect Joe Biden appointed Gary Gensler, a former Commodity Futures Trading Commission Chair under the Obama administration, to its presidential transition team. Gensler has testified before Congress about virtual currency and blockchain on several occasions, and while little information is known about Biden’s stance on cryptocurrency, Gensler called blockchain technology a “change catalyst” in a 2019 CoinDesk opinion and is generally considered to be “Bitcoin-friendly.” While it is generally unclear what Gensler’s long-term official position under the Biden administration will be, he is also on top of a list of potential picks for the SEC chair. Another clue that may provide some insight with regards to Gensler’s attitude towards cryptocurrency is his 2019 statement that Facebook’s proposed digital token, Libra, should be treated as a “security,” which establishes the basis for increasing regulatory oversight. (Cryptocurrency’s uncertain status as a security for tax purposes raises other tax issues.) The general industry consensus is that, while there is a growing acceptance of the legitimacy of cryptocurrency, it is likely that more regulatory and enforcement actions will continue by the SEC against issuers and intermediaries, and by the IRS against taxpayers. More regulation is not necessarily negative—it can create clearer guidelines and landscape for exchanges and virtual currency holders and enable them to better understand the regulatory and tax authorities’ expectations. That being said, it will be important for exchanges and taxpayers to closely follow the latest government guidelines with respect to virtual currency and ensure they comply with reporting and tax payment obligations.

CFTC: Virtual Currency Creates Real Segregation Risks

Virtual currency presents risks to futures commission merchants (FCMs) when deposited by futures customers or cleared swaps customers to margin futures, options on futures, or cleared swap transactions, according to an Advisory issued last week by the Director of the CFTC’s Division of Swap Dealer and Intermediary Oversight (DSIO). The CFTC staff Advisory is intended to provide guidance to FCMs on developing risk management programs for holding virtual currency as futures customer funds.

One of the most important principles underlying commodity futures regulation is the “segregation” requirement, that is, the requirement that all customer funds for trading must be treated as belonging to the futures customer and kept apart from the FCM’s own funds. These funds include cash deposits and any securities or other property deposited by customers to margin or guarantee futures trading. FCMs must hold sufficient funds in segregated accounts to be able to meet all of their customer obligations. The segregation requirement also applies to funds of customers engaged in swap transaction that are cleared through a registered derivatives clearing organization. (These requirements can be found in Sections 4d(a)(2) and 4d(f) of the Commodity Exchange Act.)

The Advisory reports DSIO’s determination that receiving virtual currency from a customer and holding that currency as segregated funds creates additional risks for the other customers in the same origin. This is because custodians of virtual currencies are “typically not subject to a system of comprehensive federal or state regulation and oversight.” Examples of such risks include: the owner or custodian’s failure to effectively safeguard virtual assets or digital keys or loss of digital keys; misappropriation of those key, hacking of systems designed to hold virtual currencies; and the limited commercial insurance to cover virtual currency losses.

To address these risks, the Advisory “reminds” FCMs to adhere to certain requirements when holding virtual currency as customer funds, including the following:

  • FCMs must deposit such virtual currency only with a bank, trust company, another FCM, or with a clearing organization that clears virtual currency futures, options on futures, or cleared swap contracts;
  • The virtual currency must be held under an account name that clearly identifies the funds as customer funds and shows that the funds are segregated;
  • FCMs must report virtual currency on their daily and month-end segregation statements at fair market value, in U.S. dollars, and reflect the FCM’s reasoned judgment based on spot market or other appropriate market transactions;
  • In their daily calculation of segregated funds, FCMs may not use the value of a customer’s virtual currency to offset a deficit in a future customer’s account, since they are not considered “readily marketable securities;”
  • FCMs may not invest any segregated futures customer or segregated cleared swap customer funds in virtual currency to be held on behalf of customers.

Further, when designing and maintaining its risk management program (required under CFTC Regulation 1.11), an FCM that accepts virtual currency as customer funds should limit its acceptance of virtual currency into segregated accounts to particular types of virtual currency that relate solely to trading of futures or options on futures or cleared swaps contracts that provide for physical delivery of those virtual currencies. The Advisory mentions bitcoin and ether as examples. Moreover, the virtual currency accepted by an FCM should only provide margin value to futures and options contracts related to virtual currency (although the FCM could use virtual currency to cover a customer default from losses on any types of futures or cleared swap transactions).

In a further recognition of these risks, the Advisory specifies that before an FCM even begins to accept any virtual currency into segregation, it should provide 45 days written notice to all futures and cleared swaps customers of the practice.

The Advisory concludes chillingly by stating that, notwithstanding the guidance, the DSIO is free to refer to the Division of Enforcement “the FCM’s practices involving virtual currencies, specific transactions involving virtual currencies or related contracts, or for any other reason.”

Our Takeaway

The DSIO’s Advisory highlights the implications for an FCM of dealing in virtual currency and, specifically, whether to accept virtual currency as futures customer funds. Virtual currency cannot be treated in the same was as fiat currency or other more traditional and stable sources of value, such as securities. A firm that decides to accept virtual currency needs to adopt policies and procedures that go beyond typical segregation funds and which, among other things, limit which types of virtual currency it can accept, how to value the virtual currency for margin purposes, and how to protect the currency against hacks and loss of keys.

The SEC Gets its Kiks out of a Successful Application of the Howey Test

In a closely-watched cryptocurrency case, on September 30, the Southern District of New York ruled in favor of the SEC in SEC v. Kik Interactive, Inc., holding that the Kin tokens Kik had offered and sold through a pre-sale and ICO were securities under the Howey test. The case illustrates the difficulties cryptocurrency companies face when they try to avoid having their tokens classified as securities; even though Kik intended to create a decentralized ecosystem for their Kin tokens on which third parties would supply products and services, the Court reasoned that Kik’s essential role in driving that ecosystem meant that token holders were reliant on Kik’s efforts to realize a profit on their Kin holdings.

Kin tokens were issued on the Ethereum blockchain, and Kik planned to develop an ecosystem of products and services that accepted Kin as currency. Kik stated in its white paper that Kin purchasers would profit through an appreciation of the value of Kin – as more products and services became available within the Kik ecosystem there would be a greater demand for Kin, but the supply of tokens would remain fixed. This increased demand against a fixed supply would drive up the price, which Kin holders could realize by selling their Kin on secondary markets. Kik would not be the sole developer of products and services in the ecosystem – third party participation was expected.

Courts use the Howey test to analyze whether a cryptocurrency is an “investment contract,” which is a type of security. The Howey test is comprised of three prongs: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit derived from the managerial or entrepreneurial efforts of others.

Kik’s critical role to the development of the Kin ecosystem was enough for the Court to find that Kin holders expected to derive their profit from Kik’s efforts, thereby making Kin a security (the other two prongs of the Howey test were more clearly met). The Court found that “the economic reality is that Kik, as it said it would, pooled proceeds from its sales of Kin in an effort to create an infrastructure for Kin, and thus boost the value of the investment,” and that, while Kik planned for Kins to have a “consumptive use,” those uses were not available at the time of the Kin distribution and would “materialize only if the enterprise advertised by Kik turned out to be successful.” Growth of the company “would rely heavily on Kik’s entrepreneurial and managerial efforts,” the Court found, because Kik would play an “essential role…in establishing the market” and “Kik had to be the primary driver of [the] ecosystem”; Kik planned to provide significant resources to develop the Kin ecosystem, to integrate Kin into their Kik messenger product, and to provide incentives for developers to create new uses for Kin. Furthermore, if Kik did not follow through with the aforementioned efforts and no ecosystem developed, “Kin would be worthless.”

This reasoning around the “efforts of others” prong is similar to what the Southern District of New York said in SEC v. Telegram, where the Court applied a “Bahamas Test,” reasoning that were the Telegram team to immediately decamp to a tropical island after launching their blockchain, the TON Blockchain project and Grams would “likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits.” Telegram, like Kik, also had plans to integrate their token into their proprietary messaging product.

A determination of whether a financial instrument is a security based upon the Howey test depends of course upon the facts and circumstances of the particular matter. The Court ruled against Kik Interactive principally because the company disclosed that the value of tokens purchased could increase based upon the company’s efforts, and because at the time of the token sales the tokens did not yet have an immediate utility. A different result might have been reached if the company already had established a working infrastructure in which the tokens had a use independent of investment value. It is not clear that would be enough in all cases to defeat application of the securities laws, but it is at least one helpful argument.

A “Key” OCC Interpretation – National Banks Can Provide Cryptocurrency Custody Services

Banking regulators took a significant step toward the mainstreaming of cryptocurrency recently when the Office of the Comptroller of the Currency (OCC) provided guidance about how a bank can provide custody services for cryptocurrency. In Interpretive Letter #1170, published on July 22, the OCC concludes that “a national bank may provide these cryptocurrency custody services on behalf of customers, including by holding the unique cryptographic keys associated with cryptocurrency.”

The OCC’s Letter arrives at an opportune time, when, according to CipherTrace’s recently published findings, the majority of cryptocurrency transactions are cross-border and, on average, each of the top ten U.S. retail banks unknowingly processes an average of $2 billion in crypto-related transactions per year. Providing custody services might help bring more of these transactions in to the open.

The OCC Interpretive Letter

The Interpretive Letter—which was issued just a few short months after the former Coinbase chief legal officer Brian Brooks became the Acting Comptroller of the Currency—is a breakthrough in terms of bringing cryptocurrency within a regulated environment. The OCC outlined three sources of market demand for banks to provide cryptocurrency custody services: (1) cryptocurrency owners who hold private keys want to store them securely because private keys are irreplaceable if lost—misplacement can mean the loss of a significant amount of value; (2) banks may offer more secure storage services than existing options; and (3) investment advisors may wish to manage cryptocurrencies on behalf of customers and use national banks as custodians.

The OCC recognized that, as the financial markets become increasingly technological, there will likely be increasing need for banks and other service providers to leverage new technology and innovative ways to provide traditional services on behalf of customers. The OCC pointed out that cryptocurrency custody services fit neatly into the long-authorized safekeeping and custody services national banks provide for both physical and digital assets.

With respect to cryptocurrency, the Letter states that national banks may provide fiduciary and non-fiduciary custody services. Non-fiduciary custodial services typically entail providing safekeeping services for electronic keys, which, as discussed above, fit neatly into the types of activities national banks have historically performed. Specifically, the OCC explains that a bank that provides custody for cryptocurrency in a non-fiduciary capacity typically would not involve physical possession of the cryptocurrency but rather “essentially provide safekeeping for the cryptographic key that allows for control and transfer of the customer’s cryptocurrency.” Fiduciary cryptocurrency custody services (such as those where the service provider acts as trustee, administrator, transfer agent, or receiver, or receives a fee for providing investment advice) are permissible if conducted in compliance with the National Bank Act and other applicable laws and regulations (such as 12 CFR Part 9 and 12 U.S.C. Ch. 2). Banks are authorized to manage cryptocurrency assets in a fiduciary capacity just as they manage other types of assets in a fiduciary capacity.

Banks that provide cryptocurrency custody services have to comply with existing policies, laws, and regulations, and conduct its custody services in a safe and sound manner, including having adequate systems in place to identify, measure, monitor, and control the risks of its custody services. In particular, banks should ensure they assess the anti-money laundering (AML) risk of any cryptocurrency custodial services and update their AML programs to address that risk. It would be advisable for AML compliance personnel to be well-integrated in the development of cryptocurrency custodial services. Banks must also implement effective risk management programs and legal and regulatory reporting practices for these services. Cryptocurrency custody services may raise unique issues identified by the OCC, including the treatment of blockchain forks, and consideration of whether technical differences between cryptocurrencies (for example, those backed by commodities, those backed by fiat, or those designed to execute smart contracts) may require different risk management practices.

The OCC Letter points out that different cryptocurrencies may be subject to different regulations and guidance. For example, some cryptocurrencies are deemed securities and therefore are subject to federal securities laws and regulations. In addition, because crypto assets are thought of as offering a greater level of anonymity or as falling beyond the ken of centralized banking systems, they have been associated with illicit activity including money laundering. Consequently, banks must ensure that their AML programs are appropriately tailored to effectively assess customer risk and monitor crypto-related transactions. Just yesterday, the Financial Crimes Enforcement Network published an advisory warning that “[f]inancial institutions dealing in [cryptocurrency] should be especially alert to the potential use of their institutions to launder proceeds affiliated with cybercrime, illicit darknet marketplace activity, and other [cryptocurrency]-related schemes and take appropriate risk mitigating steps consistent with their BSA obligations.”

While there has been limited enforcement of federal law against banks for crypto-currency related activity, earlier this year, the OCC brought its first crypto-related enforcement action, against M.Y. Safra Bank for deficient AML processes for digital asset customers. The OCC concluded that the Bank’s deficiencies included its failure to: (1) appropriately assess and monitor customer activity flowing to or from high-risk jurisdictions; (2) conduct ongoing testing of its due diligence processes; (3) implement sufficient controls for its digital assets customers, including cryptocurrency money service businesses (MSBs); (4) address the risk created by the significant increase in wire and clearing transactions created by the cryptocurrency MSB customers; and (5) notify the OCC of its significant deviation from its previous business plan. In the Matter of M.Y. Safra Bank, SFB, AA-NE-2020-5, Consent Order (Jan. 30, 2020).

The OCC’s Letter should give comfort to many banks that have been bystanders to the growth of the cryptocurrency market. Now banks can offer more cryptocurrency-based financial services with more certainty, although many questions will likely be answered through greater participation. More marketplace involvement by traditional banks will in turn have a beneficial effect. Smaller businesses wishing to engage in cryptocurrency-based transactions now may do so by interacting with large, stable, and well-regulated banking institutions.

OCC’s Consideration of an MSB Regime

OCC’s Interpretive Letter may be part of a broader movement by the OCC to promote greater integration of cryptocurrencies into mainstream financial services. Acting Comptroller of the Currency Brooks announced on a podcast on June 25 that the OCC intends to unveil a new bank charter including a national payments charter that will pave the way for nationwide participation by cryptocurrency payments companies. As contemplated, that charter would be equivalent to FinCEN’s MSB registration process and stand in (under the doctrine of preemption) for individual state-level MSB licensing requirements. It also should answer questions like how the Community Reinvestment Act might apply to banks that do not take deposits and how the OCC will impose capital standards on companies that do not bear credit risk.

New York Looks Like it Might Loosen Up on Its Virtual Currency Regulation

On June 25, the New York State Department of Financial Services (NYDFS) published a “Conditional BitLicense” proposal for reforming its licensing framework that would make it easier for virtual currency businesses to obtain permission to operate in New York. The proposal was developed as part of a broader effort to respond to industry changes and concerns that NYDFS identified in its five-year review of its cryptocurrency licensing regime (which originally took effect in June 2015) under which more than two dozen cryptocurrency companies have been approved to do business in New York. Under the proposed regulations, a virtual currency firm will be authorized to operate in New York even if it does not have a full BitLicense from the state if it obtains a “conditional BitLicense” and partners with a firm that does have a full license. (To note, the conditional BitLicense has always existed, but this is the first time that the NYDFS has announced clear rules to help companies access the license.)

The NYDFS’s proposal is likely a welcome development. New York’s process for obtaining a full BitLicense is considered one of the toughest in the country and has long been unpopular with blockchain startups. Among the complaints: steep paperwork requirements and lengthy approval times. Under the proposed conditional licensing regulation, a cryptocurrency firm that wishes to operate in New York can bypass the difficulties of applying for a full license and instead apply for a conditional BitLicense, which would grant it operational privileges so long as it partners with another cryptocurrency firm that is fully licensed. Currently, the NYDFS envisions that under such a partnership, the licensed firm can assist in providing various services and support, including “those relating to structure, capital, systems, personnel, or any other support needed.”

The proposed application process is simple: In order to apply for such a license, the unlicensed cryptocurrency firm would need to inform the NYDFS of its intention to apply and provide a copy of the service agreement between the unlicensed cryptocurrency firm and the licensed cryptocurrency firm, as well as additional documentation. It is clear, however, that the NYDFS views this licensing framework as a temporary stepping stone; the NYDFS stated that it expects firms who obtain such conditional licenses to then apply for a full license within 2 years.

It is not entirely clear how the conditional license will operate in practice. It does not appear that any other state makes conditional licenses available. To that end, the NYDFS is inviting comments on its proposed regulation, including:

  1. What type of cryptocurrency firms would benefit the most from such a conditional license?
  2. What type of licensed firms would be best and most effectively able to partner with unlicensed firms under the terms of a conditional license?
  3. What types of services and support should a licensed firm provide for the firm with the conditional license?
  4. Should there be limits placed on the types of services that a licensed firm can provide?
  5. Should there be caps and limits on the total number of conditional arrangements that a licensed firm can enter? What other checks should be in place?
  6. Should the licensed firm be held accountable for initial due diligence of the firm wishing to obtain a conditional license and to what extent?
  7. Should ongoing due diligence be required?
  8. How should the licensed firm and firm with the conditional license divide responsibilities and obligations for ensuring compliance with legal and regulatory requirements?
  9. What is the best way to check for and resolve conflicts of interest between the two firms involved?
  10. What is the best way to structure such collaboration to limit any potential adverse effect on the markets?
  11. Are there other methods besides a conditional license that the NYDFS should consider?

NYDFS requests that all comments by submitted by August 10, 2020. Given that cryptocurrency regulation is generally uncharted territory, virtual currency firms should consider submitting comment to the NYDFS to assist it in developing this regulation further so that it is effective and workable.

In or Out? – The CFTC Explains When Virtual Currencies Come Within Its Jurisdiction

On March 24, the Commodity Futures Trading Commission (CFTC) issued final interpretive guidance (the Guidance) regarding retail commodity transactions involving virtual currency. In short, this Guidance clarifies when “actual delivery” of virtual currency (such as bitcoin and ether) occurs under the test determining whether a leveraged arrangement is exempt from regulation by the CFTC as, effectively, a futures contract. This important Guidance demonstrates the proactive and leading role that the CFTC has taken in connection with understanding and addressing developments in the fintech sector. In the Guidance, the CFTC explains the exemption clearly and places it in the context of the CFTC’s regulatory mandate, its somewhat tortured history in obtaining jurisdiction over leveraged retail transactions in commodities, and its interest in preventing abusive practices. As part of its commitment to assisting the industry in adjusting to the evolving interpretations, the CFTC also announced that it would impose a 90-day moratorium on initiating enforcement actions that address aspects of the Guidance that, according to Chairman Tarbert’s accompanying statement, “were not plainly evident from prior CFTC guidance, enforcement actions, and case law.”

The Guidance in effect enables those transacting in leveraged virtual currency (often referred to as “cryptocurrency”) to understand whether they are subject to CFTC jurisdiction. As noted in the release, the CFTC has exclusive jurisdiction over commodity futures, options and swaps – which encompasses a broad range of derivatives – and has broad anti-fraud and anti-manipulation authority over any contract of sale of any commodity in interstate commerce, as well as swaps and futures. This jurisdiction includes certain speculative commodity transactions involving leverage or margin, which are also treated by the CFTC as futures. The CFTC’s jurisdiction over leveraged retail transactions remained uncertain until passage of the Dodd-Frank Act in 2010.

Before the Dodd-Frank Act, it was possible that a retail transaction in a commodity entered on a leveraged or margined basis, or financed by the counterparty, could avoid regulation by the CFTC even though it was economically indistinguishable from a futures contract. In his statement, Chairman Tarbert offers this example: suppose that someone decides to purchase a commodity with some money down, with delivery and final payment to be made at some future date, but is also able to trade out of the position at any time to lock in any gains or losses incurred to date; “that starts to look an awful lot like a futures contract—with identical economics but without any regulation.” The Dodd-Frank Act addressed this regulatory gap, with a particular application to abusive sales practices involving foreign currency and precious metals, and now the Guidance provides interpretation to apply the same principles to virtual currency.

The important exception to the CFTC’s jurisdiction over leveraged retail commodity transactions is for a contract of sale that “results in actual delivery within 28 days…” The determinative factor as to whether a transaction in virtual currency is subject to CFTC jurisdiction is whether actual delivery occurs within 28 days of trade execution. (Note that, for retail foreign currency transactions, the delivery period is only two days.) In its 2015 Coinflip Order, the CFTC clarified that virtual currency constitutes a “commodity” under the Commodity Exchange Act. Although virtual currency is an intangible commodity, the CFTC has jurisdiction over other types of intangible commodities, including rate indices and renewable energy credits. Multiple federal courts have also held that virtual currencies are commodities under the Commodity Exchange Act. The CFTC broadly defines virtual currencies as follows:

a digital asset that encompasses any digital representation of value or unit of account that is or can be used as a form of currency (i.e., transferred from one party to another as a medium of exchange); may be manifested through units, tokens, or coins, among other things; and may be distributed by way of digital “smart contracts,” among other structures.

In the Guidance, the Commission interprets “actual delivery” in the context of virtual currency as taking place when (a) a customer (i) secures possession and control of the entire quantity of the commodity – whether it was purchased on margin, or using leverage, or any other financing arrangement – and (ii) has ability to use the entire quantity of the commodity freely in commerce, no later than 28 days from the date of the transaction; and (b) the offeror and counterparty seller do not retain any interest in, legal right, or control over any of the purchased commodity after 28 days from the date of the transaction. While this interpretation is carefully drafted to avoid permitting any “sham delivery” to qualify, the Guidance states that the simplest definition of actual delivery is the ability of a purchaser to use the virtual currency immediately as a unit of exchange. And while the 28-day period is provided as the outside time limit to constitute actual delivery, as a practical matter, it typically takes much fewer than 28 days for a virtual currency transfer to complete. To determine whether the seller no longer retains any interest in the virtual currency, the CFTC may look to whether the seller retains any ability to access or withdraw any quantity of the virtual currency from the purchaser’s account or virtual wallet. The Guidance essentially reaffirms guidance that the CFTC provided in 2013, in a non-virtual currency context, as to the “functional approach” that the CFTC would apply in determining whether actual delivery had occurred.

In the Guidance, the CFTC emphasizes the importance of virtual currencies and their underlying blockchain technologies, and highlights its efforts to take a “deliberative and measured approach” in this area, to avoid stifling technological innovation. The CFTC points to its efforts in this area, including the LabCFTC initiative, which seeks to promote market-enhancing innovation. It also notes that several derivatives contracts based on virtual currency are listed on CFTC registered entities. The Guidance also reports that the CFTC continues to follow the evolution of the cash market for virtual currencies, since cash markets affect related derivatives markets. It is because the technology, market structures and law are evolving so quickly that, as discussed by several Commissioners in their accompanying statements, issuing interpretive guidance is more appropriate than rulemaking at this time. We encourage readers to refer to the CFTC’s full Guidance, which is clearly written with helpful examples.

At Your Service: First-Ever On the Chain Survey Reflects a Steady Rise in Blockchain Awareness, Acceptance and Adoption

The results are in! Responses to Orrick’s first survey of the dedicated followers of On the Chain, our blockchain blog, revealed at least two things: (1) that blockchain technology is continuing to gain acceptance in and figure into plans of businesses across numerous industries, and (2) that during the holiday season people will take the time to respond to a survey if there is a prospect of receiving an Amazon gift card. Message received.

The 60+ survey responses came largely from senior personnel in a broad range of industries and regions, mostly working in technology, media, telecommunications, professional services, fintech and financial services, and mostly located in North America, Asia and Europe. Overall, almost all responders considered themselves moderately or very familiar with blockchain technology, which is not surprising given the nature of the blog’s steadily increasing readership. It is also not surprising, since one-third of the responders stated they work for companies that currently employ blockchain technology, including smart contracts. These uses include: payment processing and investments; buying, selling and exchanging digital currencies; data management and storage; maintaining data privacy; and gaming. For those companies not currently employing blockchain technology, about a third view it as a high priority or important to the organization; and about one-half of those view it as relevant to the company’s strategy but not a priority.

The overwhelming majority of responders believe that blockchain will achieve mainstream adoption in the next five years. This matches the observation of Orrick’s Blockchain Group, whose members from week to week seem to be working on or learning about a new or expanded application of blockchain technology in an existing industry. The greatest advantage to the adoption of blockchain technology, according to responders, is improved business efficiencies, while reduction of costs is viewed as a lesser benefit. The most significant barriers to mainstream adoption of blockchain technology are considered to be technological challenges to implementation, regulatory issues and the uncertain financial return on the investment. We received fewer responses that security threats, failure of companies to treat it as a priority, and unproven technology are barriers to adoption.

In sum, the survey results provide a snapshot – albeit unscientific – of how companies view blockchain technology at this point in time, and where they think it is going. The results help Orrick to focus its blockchain practice on the sectors where our advice and representation will most likely be useful. And, lastly, the results help us deliver our observations and analyses about “the state of blockchain” to our clients and other members of our audience. Survey responders expressed a preference for hearing from us through our electronic newsletter and our On the Chain blog, and we will continue to deliver content in those forms. Many responders also indicated that they would appreciate reading posts regarding success stories and practical uses of blockchain technology. We intend to start publishing regular pieces, so stay tuned for that. And many responders also sought human interaction with the charming and knowledgeable members of Orrick’s Blockchain Group – seminars and networking receptions – and we hope to announce such opportunities in the near future. Finally, we are grateful to those responders who provided ideas about the content for future blog posts (and those who appreciate the topics we have already offered). Look for content that is responsive to those requests.

Thanks again to all our survey respondents for taking the time to provide such useful information, and congratulations to our lucky prizewinner!

They Did It for the Gram: SEC and Telegram File Dueling Expert Reports

The battle in federal court between the SEC and Telegram continues to progress at breakneck speed. The SEC commenced its action less than four months ago, on October 11, 2019, by seeking a temporary restraining order against Telegram Group Inc. and TON Issuer Inc. (collectively, “Telegram”). That same day, Judge Castel in the Southern District of New York granted the SEC’s TRO request and ordered expedited discovery. Months of intensive discovery ensued that culminated with both parties filing cross motions for summary judgment on January 15, 2020.

At the center of the dispute is whether issuers of digital tokens can avoid registering their sale with the SEC by issuing them pursuant to “SAFTs,” or Simple Agreements for Future Delivery. SAFTs are commercial instruments used to convey rights to digital tokens to sophisticated investors prior to the development of the functionality of the platform on which the tokens are designed to operate. Issuers usually treat SAFTs as securities and offer and sell them pursuant to the exemption from registration in Rule 506(c) of Regulation D under the Securities Act of 1933. The digital tokens are later issued pursuant to the SAFTs once the platform for which the tokens were designed to use is “fully functional.” The theory is that once use-cases exist for the tokens, they no longer constitute securities, but rather utility tokens that can be distributed as commodities or currency without being subject to regulation as securities by the SEC. The SEC action against Telegram based upon its SAFTs and intended issuance of Grams is the first litigated case to contest that theory.

According to the SEC, from January 2018 to March 2018 Telegram entered into SAFTs with sophisticated investors for the future delivery of Grams. Grams have not yet been delivered. In its TRO motion, the SEC argued that the Grams were securities at the time the SAFTs were executed and the temporal separation between the signing of the SAFTs and delivery of the Grams upon the launch of the fully functional Telegram platform (the “TON Blockchain”) is immaterial and does not change the nature of the Grams themselves. The SEC further argued that upon delivery of the Grams to the SAFT investors, those investors will be able to resell the Grams without restrictions. “Once these resales occur, Telegram will have completed its unregistered offering” for which no exemption from registration exists.

In opposition, Telegram argued that the Grams must be separately analyzed from the SAFTs under the federal securities laws. Telegram contended that the Grams are not securities because they “do not exist and may never exist.” Rather, under the SAFTs, Telegram represented that it will create and distribute Grams only upon the launch of a “fully functional TON Blockchain,” which will provide Gram’s use-cases; that is, once the TON Blockchain is launched, Grams will be able to be used for, among other things, payment for physical and digital products and services, commission paid to TON validators for processing transactions and smart contracts, voting on parameters of the protocol, and payment for services provided by third-party applications on the TON Blockchain.

The SEC is expending significant resources in this case. It recently submitted to the Court expert opinions to support its position that token sales are offerings of securities subject to its regulation. Together, these opinions are intended to buttress the SEC’s argument that Telegram’s offering satisfied the Howey test and qualified for no exemption from registration:

  • A financial economist at the SEC’s Division of Economic and Risk Analysis, Carmen A. Taveras, Ph.D., provided an opinion that the price at which Grams are sold increases exponentially over time and is a function of the total number of Grams in circulation. As a result, the price at which purchasers who bought Grams pursuant to the SAFTs is significantly discounted to the price at which Grams will be available for purchase by subsequent buyers. The opinion also disputed Telegram’s representation in promotional materials that it will maintain price stability following the launch of the TON Blockchain by setting up a “TON Reserve” to strategically buy and sell Grams. Taveras concluded that the TON Reserve’s ability to buy and sell Grams would likely have a limited effect on curbing sudden spikes and dips in the price of Grams.
  • A blockchain data scientist in private practice, Patrick B. Doody, opined that while it is reasonable for private placement purchasers to buy Grams expecting to profit by selling them in the secondary market, Grams are unlikely to attract investors seeking a “realistic currency option to buy goods and services.” Telegram’s promotional materials appealed to potential investors seeking to profit through resales, while providing short shrift to factors that would enhance Grams’ viability as a currency, including fraud prevention, theft, integration with existing banking relationships, compliance with financial regulations, and price stability such as that which can be achieved by pegging the price of Grams to a fiat currency.
  • An expert in the field of computer science at Brown University, Maurice P. Herlihy, Ph.D., opined that the publicly released version of the TON Blockchain code lacks critical components that would be required in a fully developed and running system, and users cannot evaluate the security and effectiveness of the TON Blockchain in its current state. Moreover, the TON Blockchain is not yet mature enough to support the suite of services described in TON public documents.

Taken together, the SEC’s experts took the position that (1) Telegram SAFT investors reasonably expected to profit from Telegram’s efforts to develop the TON Network, and (2) that the current state of the TON Network reveals it is not yet mature enough to support the suite of services promised by TON’s public documents.

Telegram also retained its own expert, Stephen McKeon, who holds a Ph.D. in management with a finance focus and a master’s degree in economics. McKeon’s expert report rebuts the SEC’s experts by opining that (1) the profit expectations of SAFT investors is independent from, and not relevant to, the expectations of purchasers following the TON Blockchain launch, and (2) that most TON Network “components are complete or nearing their completion and will be fully available to the TON blockchain users at the launch of the mainnet.”

As further evidenced by the filing of amicus briefs by the Chamber of Digital Commerce and the Blockchain Association, the stakes for the industry in this case are high.

Fraud is Fraud – Sales of Unregistered Digital Securities Resemble Classic Microcap Fraud

A Complaint filed by the SEC in the Southern District of New York last week reminds us that in the area of securities law violations there is not much new under the sun. Even though the action against Eran Eyal and UnitedData, Inc. d/b/a “Shopin” involves the sale of digital assets, and the business of the issuer of those digital assets purportedly involves a blockchain application, the alleged wrongful conduct bears the hallmarks of a traditional securities offering scheme; one can substitute “unregistered securities” for the tokens offered, “private placement” for the token pre-sale, and a speculative venture – such as the “self-cooling can” that was the subject of an SEC offering fraud case years ago – for the blockchain applications touted by the issuer, and the Complaint is one that could have been drafted thirty years ago. To the extent that certain recent cases involving offerings of cryptocurrencies have presented novel applications of the securities laws and the Howey test of whether a digital currency is a security, this case isn’t one of them.

A description of the alleged misconduct makes the parallels clear. The SEC alleges that the issuer, Shopin, and its CEO, Mr. Eyal, conducted a fraudulent and unregistered offering of digital securities. The company’s business plan involved the creation of personal online shopping profiles that would track customers’ purchase histories across numerous online retailers, and link those profiles to the blockchain. However, Shopin allegedly never had a functioning product. The company’s pivot to the blockchain and rebranding resulted from its struggles to stay in business as a non-blockchain business.

The company apparently commenced its digital securities offering with a “pre-sale” of tokens through an unregistered offering, not unlike the private placement of securities that is often alleged as the first step in an offering fraud. Shopin’s initial sales of investment interests were made pursuant to a SAFT – a simple agreement for future tokens – in which initial investors paid bitcoin or ether in exchange for an interest in tokens at a discount that would be delivered once Shopin created the tokens at the completion of the public ICO. The proceeds of this pre-sale purportedly would be used to develop, launch and market the Shopin network, similar to the types of promises made in microcap or blind pool offerings. Unsold tokens in the pre-sale would go to insiders at Shopin and its advisors. The SEC determined that the Shopin tokes were investment contracts under the Howey test, because the purchasers invested money in the form of digital currency, the investors’ funds would be pooled in a common enterprise, and the defendants led the token purchasers to expect profits from their purchases because of the defendants’ efforts.

In its complaint, the SEC treated the token sale – which, again, was not registered under the securities laws – as a private placement subject to Regulation D, and alleged that the defendants failed to ensure that the purchasers of the tokens were accredited investors. Indeed, the SEC alleged that certain investors tried to satisfy the minimum investment requirements by pooling their investments in syndicates. This is a variant of the artifices employed by microcap issuers to artificially achieve a minimum offering level by making nominee purchases. The defendants also, in another resemblance to a microcap scheme, allegedly told investors they intended to have the Shopin tokens listed on digital-asset trading platforms – analogous to a promise to list penny stocks on an exchange – which purportedly would enable investors to realize profits on their positions by selling the tokens at a premium.

Having established that the ICO had the elements of a securities offering, the SEC described the material misrepresentations that the defendants made to investors: that the company had participated in successful pilot programs with prominent retailers; that the defendants had partnerships with numerous retailers; and that it was advised by a prominent individual in the digital asset field, who in fact had asked the company to remove his name as an advisor. Finally, and most serious, the SEC alleged that the defendants had misused portions of the offering proceeds, including for personal expenses, such as an individual’s rent, shopping and entertainment and – the type of salacious detail the SEC likes to include – to pay for a dating service.

Securities schemes tend to fall into certain patterns that involve the use of unregistered securities and misrepresentations to separate investors from their money, and schemes involving digital currency that resembles a security often fall into the same patterns. Perhaps recognizing that those patterns are recognizable to triers of fact and the public, the SEC alleges violations involving digital currency in similar terms. SEC Chairman Jay Clayton has repeatedly emphasized that the regulator will use its traditional tools and standards in treating sales of digital assets that conform to the definition of a security: for example, as he stated last year, “A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’ that is a security and we regulate that. We [the SEC] regulate the offering of that security and regulate the trading of that security.” Legitimate sales and offerings of digital currency might use a different vocabulary and analysis but, as the allegations in the case discussed here show, fraud is fraud.