Keyword: Securities, Derivatives and Financial Institutions

CFPB Makes an Entrance: Crypto Products Targeted

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Ending doubts regarding its interest in the space, the Consumer Financial Protection Bureau (CFPB) has for the first time publicly acknowledged its investigation of a crypto company — and it’s likely a sign of things to come.

The agency hinted at increased enforcement in a summary of consumer crypto complaints in November 2022. The CFPB acknowledged an investigation for the first time that same month, when it published a decision in the case.

Crypto companies with direct-to-consumer products should take note — and consider steps to mitigate risk.

What Happened?

The CFPB sent a Civil Investigative Demand (CID) for testimony in December 2021 to Nexo, a cryptocurrency platform that offers an earned-interest product and lets customers make deposits.

The CID focused on whether Nexo made “false or misleading representations to consumers” about its safeguards used to protect crypto assets. The CFPB also stated that the investigation included potential violations of the Electronic Funds Transfer Act, confirming its view that the law applies to crypto assets.

Nexo filed a petition to set aside or modify the CID. It argued that the SEC views interest-bearing crypto accounts as securities that are subject to SEC regulation and exempt from CFPB jurisdiction.

CFPB Director Rohit Chopra denied the petition. He noted that Nexo had been unwilling to fully concede that its product was a security subject to SEC regulation and that “it [was] too early to tell whether Nexo … was required to be registered with the SEC,” and exempt from the CFPB’s jurisdiction.

Since then, Nexo announced it had made “the regrettable but necessary decision” to phase out its products and services in the U.S. after “inconsistent and changing positions among state and federal regulators.”

What does this mean?

Though this is the first publicly identified CFPB crypto investigation, there are likely more on its docket.

This matter also reveals that CFPB crypto investigations have been ongoing since at least the fourth quarter of 2021. Less than two weeks before issuing the Nexo decision, the CFPB issued a Crypto-asset Complaint Bulletin. The CFPB typically uses these bulletins to notify a market of its plans to address certain types of consumer harm. Three top crypto complaint themes likely to trigger CFPB interest include:

  1. Fraud: 40% of consumer complaints in the bulletin were a result of having been victimized by fraudulent activity or scams in the crypto ecosystem.
  2. Access to Funds: Many consumers reported struggling to access their funds due to issues with crypto platforms and the freezing of funds before filing for bankruptcy protection.
  3. Poor Customer Service: A major issue cited in the complaint bulletin was the inherent lack of customer service provided to consumers in the crypto market. Consumers described company customer service as non-responsive or non-existent. The CFPB launched an initiative to improve customer service this year with Director Chopra’s stated goal “to ensure the legally enshrined right to obtain basic customer service.”

Looking Forward

We expect increased enforcement action aimed at addressing the themes in the Crypto-asset Complaint Bulletin. Crypto companies that have not affirmatively subjected themselves to SEC or CFTC authority may be more vulnerable to CFPB scrutiny. In an environment of increased regulatory risk, we recommend that crypto companies review their products and services from a consumer/end user perspective and pay attention to customer complaints.

Contact Melissa Baal Guidorizzi and Daniel Forester if you have any questions regarding recent regulatory trends and best practices for building compliance programs if your company is subject to the CFPB’s enforcement and examination powers.

SEC Provides Expectations About Public Company Disclosures Regarding Crypto Ecosystem Impact

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What Happened

The Division of Corporation Finance of the Securities and Exchange Commission (“SEC”) issued a sample letter on December 8, 2022, highlighting considerations that public companies that are in, or connected to, the crypto industry should keep in mind as they prepare their public disclosures, spanning the description of business, management’s discussion and analysis (“MD&A”) and risk factor disclosures.

What Public Companies Need to Consider

While the letter highlights additional points for consideration in the business and MD&A sections, the majority of the comments focus on risk factor disclosure, flagging nine key risks, including:

  • any material gaps identified with respect to risk management processes and policies,
  • the “possibility of regulatory developments related to crypto assets and crypto asset markets,” and
  • material risk of reputational harm from recent disruptions.

Additionally, the sample letter also calls for increased disclosure regarding whether any of the crypto assets held or issued by the company serve as collateral for certain activities, as well as any downstream effects experienced by the company as a result of certain bankruptcies in the crypto industry. The sample letter gives insights into general themes of disclosures that the SEC is focused on, including the following: (i) the risk exposure a company has to other actors in the blockchain and cryptocurrency ecosystem (interdependencies within the industry), and (ii) changes to the value of assets held by the company resulting from fluctuations in the larger blockchain market.

In light of the heightened scrutiny faced by companies with exposure to the crypto industry, careful consideration should be given to any public disclosures regarding their operations in order to address the SEC’s concerns of providing adequate information to make a company’s public disclosures not misleading.

Contact Alice Hsu, Daniel Forester, Joseph Perkins or Soo Hwang for guidance on whether your company could be impacted or if you have any questions about navigating this evolving regulatory landscape.

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

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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.

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

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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.

Blockchain in Banking: OCC Seeks Public Comment

For the first time in a dozen years, the Office of the Comptroller of the Currency (OCC) is seeking to update its regulations on digital activities to consider banks’ use of blockchain and distributed ledger technology (DLT), as part of a larger effort regarding banks’ use of technology. On June 4, 2020, the OCC released an Advance Notice of Proposed Rulemaking (ANPR) seeking public comment on the digital activities of banks, including with respect to DLT. The ANPR states that “[the OCC] is interested in making sure it is aware of and understands the evolution of financial services, so it ensures the federal banking system continues to serve consumers, businesses, and communities effectively[, and] is reviewing its regulations on bank digital activities to ensure that its regulations continue to evolve with developments in the industry. [The ANPR] solicits public input as part of this review.” Public comments on are due by August 3, 2020.

Under the existing regulatory framework, OCC regulations specifically addressing national banks’ digital activities are generally set forth in 12 C.F.R. part 7, subpart E, which was originally promulgated in 2002 and updated in 2008. Since then, the OCC has generally responded on a case-by-case basis to industry requests for approval to engage in “innovative, technology-driven banking activities.” Now, the OCC is undertaking a comprehensive review of 12 CFR part 7, subpart E (as well as related part 155), and the ANPR was issued in connection with such review.

The ANPR lists and solicits public comment for 11 specific technology-related questions. Of those 11, the question related to DLT states:

“5. How is distributed ledger technology used, or potentially used, in banking activities (e.g., identity verification, credit underwriting or monitoring, payments processing, trade finance, and records management)? Are there specific matters on this topic that should be clarified in regulatory guidance, including regulations?”

Other questions concern artificial intelligence, “regtech,” and similar topics that may potentially overlap with DLT. In recent years, the OCC has established certain innovation-friendly programs, including a dedicated Office of Innovation, and the ANPR seems to fit that pattern. As financial institutions increasingly implement DLT-based systems and products, OCC regulation may focus on that area and become a critical facet of its development.

In response to the ANPR, financial institutions and other interested parties may wish to consider submitting comments. Regulation works best when it is informed by industry practices, and in the time since OCC last updated its framework, blockchain technology has become an important part of the financial industry. Revised regulations will help provide certainty to financial institutions that use or are considering using such technology.

The SEC Sends a Telegram to European Token Offerings: Avoid the U.S.

On March 24, the United States District Court for the Southern District of New York granted the U.S. Securities and Exchange Commission (SEC) a preliminary injunction preventing Telegram from distributing $1.7 billion of its “Gram” digital tokens to investors. By way of background: According to Court filings, during the first quarter of 2018, Telegram sold purchase contracts to 175 initial purchasers entitling them to receive Grams when Telegram launched its proprietary blockchain platform. Telegram claimed an exemption from SEC registration as a U.S. private placement (i.e., transactions not involving security sales to the public). Some initial purchasers were locked up from reselling the Grams for brief periods following receipt, but otherwise were unrestricted in their ability to resell Grams to anyone on Telegram’s blockchain platform.

It’s premature to cite the Court’s grant of a preliminary injunction as gospel, as the Court’s findings are, by their nature, preliminary and subject to appeal. In granting an injunction, the Court accepted the SEC’s argument that the SEC was likely to succeed in demonstrating a securities laws violation following a trial, and that, if the Gram distribution was not paused now, unwinding that distribution (i.e., curing the violation) years later would be impractical. Since a Gram distribution today would, effectively, moot the SEC’s case, the Court’s grant of an injunction is not surprising. The appellate courts, or the trial court, may still take a different view, and in another situation with different facts, a court may view the outcome differently, as well.

For now, though, the Court’s order provides some helpful clarifications and reminders for European companies considering token offerings (whether cryptocurrency, digital assets or digital tokens). First and foremost is that your safest best is to just avoid U.S. jurisdiction by carefully adhering to the restrictions provided in Regulation S under the U.S. Securities Act of 1933. Complying with Regulation S allows a security offering, and subsequent resales, to be excluded from SEC registration if the entire transaction – offers, sales and delivery – is conducted entirely outside the U.S., to non-U.S. persons, with restrictions in place to prevent flow-back of securities into the U.S. In practice, complying with Regulation S means you must have a closed pool of offerees, you must know the details of your initial purchasers, and you must have a closed resale/transfer system to effectively prevent resales to the U.S. or token distributions to U.S. persons (which the SEC refers to as “flow-back” to the U.S.). While there are exceptions and caveats to these general principles, the Court made clear its sympathy to the SEC’s view that the U.S. private placement and Regulation S rules broadly prohibit back-door public token distributions, regardless of whether the tokens themselves are “securities” under the SEC’s rules (which define “security” broadly, a discussion for another day), following a “securities” offering that is not registered with the SEC.

Another key lesson for European companies is that, if the SEC believes your token offering has violated the U.S. securities laws, the SEC may come after you, even if your U.S. contacts are minimal. Telegram argued (unsuccessfully) that its non-U.S. transactions should be exempted from SEC jurisdiction because the issuer was not a U.S. company, its control persons were not in the U.S., some of the contracts were not entered into in the U.S., some of the purchasers were not in the U.S., and some of the securities were not delivered in the U.S. Crucially, however, Telegram did not demonstrate in its court filings that it took the appropriate steps at the time of the offering, sale and intended distribution of the Grams to separate the U.S. private placement transactions from the Regulation S (non-U.S.) transactions. If you, and your proposed transaction, are wholly outside the U.S., but you determine to include some U.S. purchasers in your token offering, you risk bringing the entire transaction within the SEC’s jurisdiction if you do not carefully ensure that your U.S. private placement is separate and distinct from your Regulation S (non-U.S.) offering when you make an offer, confirm a sale, and deliver any tokens, and that the Regulation S transaction has sufficient safeguards in place to avoid flow-back of the tokens into the U.S. by subsequent resales. Structuring a token transaction to comply with Regulation S can be complicated and requires careful attention to current and future token offers, sales, distributions and transfers.

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

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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.

Orrick Hosts Fireside Chat with SEC Commissioner Hester Peirce

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On March 2, Orrick had the pleasure of hosting SEC Commissioner Hester Peirce for a fireside chat discussion at our San Francisco office on the state of blockchain and cryptocurrency, the emerging regulatory landscape and her safe harbor proposal. Commissioner Peirce was joined by Orrick partner Ken Herzinger and CipherTrace CEO David Jevans, and moderated by Mark Friedler.[1] To view a recording of the full discussion, please click here. Read on for key takeaways from the panel discussion.

Providing Clarity to the Crypto Community

Commissioner Peirce sees signs of progress at the SEC and believes that her colleagues have the best intentions. She’s hopeful and optimistic that the SEC can continue to make progress and both protect investors and allow innovation to move forward.

Commissioner Peirce believes that regulators have provided more clarity regarding blockchain and cryptocurrency regulation, but there’s a long way to go. Regulators struggle because there’s great variation across digital assets, so it’s hard to lump them together and produce a regulatory framework that works for everything. Furthermore, she acknowledged the fact that often the clarity that comes from the SEC is provided in the format of a facts-and-circumstances discussion, which can be frustrating for people who want to be given straightforward bright line rules. However, she says, U.S. securities laws just typically don’t work that way.

While she is hopeful that the SEC can provide more clarity, she does not know if we will ever get to a point where people feel there are no questions that they need to hire lawyers to help them figure out.

Insights into Commissioner Peirce’s Token Safe Harbor Proposal

Commissioner Peirce said her February 6, 2020 Token Safe Harbor Proposal is solely her own, and her colleagues at the SEC need to be convinced to put it forward as a formal proposed SEC rule pursuant to the SEC’s normal rulemaking process. The theory behind the safe harbor is that the regulatory framework, as currently applied, serves as an obstacle to launching token networks and giving them the time to mature into decentralized networks. Token project creators are afraid that if they launch their network it will be treated as a securities offering. The purpose of the safe harbor proposal is to find a way for people to feel comfortable releasing tokens under an exemption that works for tokens specifically.

Commissioner Peirce explained that one reason you would want securities laws to cover token offerings would be so that the people who are purchasing tokens are receiving the information they need to make good purchasing decisions, so the disclosure requirement was tailored to meet the needs of token purchasers.

Commissioner Peirce published the proposal because she wants to solicit feedback to refine it, and encourages people to contact her with thoughts and ideas to improve upon it.

Section (f) and the Application of the Safe Harbor to Tokens that Have Already Been Distributed

Section (f) of the Safe Harbor provides for how the safe harbor would apply to digital assets previously sold pursuant to an exemption. Commissioner Peirce said those who have already launched and distributed tokens have to think about whether the token sales were done pursuant to an exemption – i.e., tokens sold pursuant to an exemption could rely on the safe harbor to then do a future token distribution. Projects would have to consider on a case-by-case basis if they could take advantage of the safe harbor and if it would be meaningful. For example, if a promoter used the Reg A exemption (which applies to public offerings that do not exceed $50 million in any one-year period), the safe harbor may still be useful for having a wider distribution and allowing the tokens to trade more freely.

Tokens Wrapped in Investment Contracts

Commissioner Peirce highlighted the unique problem that arises with certain token launches, where tokens wrapped in investment contracts are sold, thus creating what looks like a traditional offering, but then when the tokens start being used in the network they no longer look like securities. At that point, it is a stretch to argue the securities laws should still apply.

Interestingly, in the SEC v. Telegraph case currently pending before Judge Kevin Castel in the U.S. District Court for the Southern District of New York, the SEC Enforcement Staff is arguing that the Judge should conflate the investment contract and proposed token launch and view the sale of an investment contract and subsequent token distribution as “one transaction.” Enforcement and Commissioner Peirce do not appear to be on the same page regarding this issue.

“Network Maturity” and the Meaning of “Decentralized” and “Functional”

Commissioner Peirce acknowledged that she needed to do more work defining what it means to be “decentralized.” She thinks it will be easier to tell if a network meets that definition after having been in existence for three years.

She also noted that the functionality test is there because the safe harbor is also trying to protect networks that are intended to remain centralized. There are companies that have created token-based economies that exist on centralized networks. She pointed to the “no action” letters issued to Pocketful of Quarters and TurnKey Jet. In her view, issuing no action letters about things that are clearly not securities is not helpful, because the letters contain conditions, thereby placing constraints on the ability of the companies to run their networks in certain ways.

Section (a)(4) and the Liquidity Requirement

Commissioner Peirce noted that some had suggested that it may be premature to assume that a secondary market would enable trading of a nascent token, and that, initially, the liquidity may need to be found elsewhere. She indicated that some liquidity could be found through non-U.S. decentralized exchanges which could also play a role in creating liquidity in the beginning stages of a token network. Only, later would the token be traded on an exchange with an intermediary that could then conduct the AML/KYC requirements. The issuer could also find ways to create liquidity in the beginning, which is something she has seen centralized projects do. That said, there are clearly unanswered mechanical questions about how a token promoter would generate liquidity.

Section (b)(6) Disclosures Regarding the Initial Development Team and Certain Token Holders

Commissioner Peirce indicated that the type of person covered in Section (b)(6) of the safe harbor is similar to those individuals who fall under Section 16 of the Securities Exchange Act of 1934. Project teams should ask themselves, when they talk about their project, who do they say is working on the project? The people that are being advertised are likely to be the ones who should be disclosed. She wants to be sure that project teams are not intentionally hiding a team member who has been previously arrested for securities fraud, for example.

Stablecoins

Commissioner Peirce said stablecoins are a unique category of tokens, but there is enough variation among them that they may not all fall into a single previously established category. Each one should be judged on its own facts, and there are potential implications for the securities laws depending on how they are set up. They could function like securities or they could function like money market funds. Commissioner Peirce encouraged people interested in launching a stablecoin to think through the implications and reach out to the SEC and other regulators.

Educating Lawmakers and Regulators

Commissioner Peirce said lawmakers and regulators are extremely busy and they have to deal with a wide variety of different issues. The crypto community should try to educate regulators and help them understand the basics of the technology; creating familiarity amongst regulators will generate better regulation. Technologists should not expect regulators to know as much as them, but they can help regulators get to a place of understanding, where the technology does not seem as scary as it might otherwise.

Changing the Accredited Investor Regime

Commissioner Peirce noted that the SEC has issued proposed amendments to expand the definition of “accredited investor” in Rule 501(a) of Regulation D and soliciting comments on whether the accredited investor regime should change. [The formal rule proposal amending Regulation D was published on March 4 which followed the publication of the Commission’s concept release in June]. While the amendments propose modest changes, they raise questions about broader changes that would open up accredited investor status to a wider range of individuals. Personally, she agrees that the correlation currently in use today – i.e., the use of wealth and income as a rough proxy for sophistication – is not perfect. There are also liberty concerns with the regime: people work very hard to earn their money and then the government places constraints on how they can spend it; however, she recognized that issue runs throughout our securities laws. Improving upon the accredited investor regime will help the problem, but Commissioner Peirce is doubtful we will see a radical shift in the accredited investor regulations.

[1] Commissioner Peirce prefaced her remarks by stating that the views she expressed were her own and do not necessarily represent those of the Securities and Exchange Commission or her fellow Commissioners.

Power of the Peirce: SEC Commissioner Spends Some of Her Influence on Trying to Help Crypto Network Developers

SEC Commissioner Hester Peirce continues to be one of the most vocal persons in leadership positions at federal regulators who are promoting innovation in digital currency and the blockchain. On February 6th, she unveiled Proposed Securities Act Rule 195 – Time-limited Exemption for Tokens, a rule proposal for a safe harbor that would provide regulatory relief under the federal securities laws for developers attempting to build functioning token networks. Her proposal is a step in the right direction to address one of the greatest challenges token network projects face.

As explained by the Commissioner, in the course of building a functioning network, developers must get tokens into the hands of other persons. These efforts run the risk of violating the U.S. securities laws regulating offers and sales, and the trading of, investment contract securities under the Howey test. Thus, she stated, the SEC has created a “regulatory Catch 22.” The Proposed Rule addresses this issue head-on by providing a three-year period during which an Initial Development Team can build their network and distribute tokens to persons who will use the network without concern that these efforts will be deemed by the SEC to violate the securities laws.

Of course, the Proposed Rule, as conceded by Commissioner Peirce and as discussed below, is a work in progress, and a great deal of work is necessary to address outstanding issues. One overarching issue is the degree to which the Proposed Rule should be prescriptive and thereby decrease the need for development teams to seek no-action relief. However, if overly prescriptive, the Proposed Rule would not be flexible enough to accommodate evolving technological developments and the complex facts that will arise in each case.

The Proposed Rule Would Provide Subjective and Prescriptive Requirements

The Proposed Rule provides Initial Development Teams with a three-year safe harbor from the application of the securities laws, with the exception of its anti-fraud provisions. In order to be covered by the safe harbor, five conditions would have to be met:

  1. The Initial Development Team must intend for the network to reach “Network Maturity,” defined as either decentralization or token functionality – within three years of the first offer and sale of tokens and undertake good faith and reasonable efforts to achieve that goal;
  2. Detailed disclosures pertaining to the token project and the Initial Development Team must be made to the public;
  3. The token must be offered or sold for the purpose of facilitating access to, participation on, or the development of the network;
  4. The Initial Development Team must intend to and undertake good faith and reasonable efforts to create liquidity for users; and
  5. The Initial Development Team must file a Notice of Reliance with the SEC.

The safe harbor conditions incorporate elements that are both subjective and prescriptive. The first and third conditions are principle-based and highly subjective, and without further regulatory guidance or authoritative precedent, it is unclear how the SEC would determine if they are being complied with. Additional guidance regarding the definition of “Network Maturity,” particularly in the form of hypotheticals and Q&A’s, would help provide clarity. Thus far, there are few concrete examples, beyond Bitcoin and Ethereum – which appear to have passed the SEC’s muster – to which developers can refer to understand the considerations relied upon by the SEC in determining whether a token is not deemed to be a security.

The second and fifth requirements are prescriptive. The disclosure requirements are intended to address information asymmetries between token issuers and purchasers. However, given that the anti-fraud provisions of the securities laws remain in place, it is not self-evident that an overlay of specific disclosure requirements is necessary.

As proposed, the notice requirement presents potential challenges to Initial Development Teams, particularly in the case of its applicability to tokens previously sold in compliance with the securities laws. It is uncertain as to the remedial actions that would be required, and what fines or penalties might be imposed, if the requirements of the Proposed Rule are not satisfied in whole or in part. Also, what would happen at the end of the three-year period if a network has not reached Network Maturity, e.g., the Proposed Rule does not provide a mechanism whereby the development team can request an extension of the safe harbor period and how such a request would be processed.

Until it is Enacted, the Rule Will Not Provide Industry Relief

Since the Proposed Rule is not binding on the Commission, SEC enforcement actions can and will continue to be prosecuted without regard to the Proposed Rule; attempted compliance with the Proposed Rule will not serve as a defense to an enforcement action. At the same time, the elements of the Proposed Rule can and should inform discussions between the Staff and development teams. In this regard, the specific disclosure requirements of the second condition may, in the short term, have the greatest impact, as they might serve as a ready checklist for statements by development teams and counterparties in connection with the development of their networks.

As positive a development as is the Proposed Rule Proposal, it is only the preliminary proposal of one Commissioner and the adoption of a proposal such as this one is subject to a rigorous vetting process by the SEC. Therefore, its future is uncertain.