Keyword: cryptocurrency

2022 Is the Year of Sweeping Changes for Cryptocurrency and Other Digital Asset Transfers

What to look out for in the proposed new Chapter 12 of the Uniform Commercial Code (UCC)

The world of cryptocurrencies and other forms of digital assets (such as non-fungible tokens) is exploding. While Bitcoin is the largest and best-known cryptocurrency in the global economy, it is far from the only one. The combined total value of Bitcoin, Litecoin, Monero, Ethereum, and all the other significant cryptocurrencies exceeds $2.4 trillion. In 2021, El Salvador enacted legislation to recognize Bitcoin as a medium of exchange. Other countries are also considering adopting similar legislation. Some countries even contemplate adopting their own blockchain-based currency as a form of legal tender.

Questions have emerged among regulators and market participants whether Bitcoin and other cryptocurrencies constitute “money” and how to perfect a security interest in such virtual currency (to ensure that it can’t be claimed by another party). Other questions relate to how interests in cryptocurrencies, NFTs, and other digital assets can be transferred or monetized and how purchasers of digital assets can be protected from adverse claims.

2022 will bring major changes to commercial law in a sweeping mission to answer some of these questions and to facilitate transactions in these emerging technologies. The proposed new Chapter 12 of the UCC will govern essentially any transfer (whether intended as a sale or a financing) of virtual currencies, NFTs, and other digital assets. These provisions will affect cryptocurrency startups and companies as they purchase and sell cryptocurrency, as well as financial institutions and fintech companies interested in financing cryptoassets and investment banks underwriting issuances of securities underpinned by crypto assets.

2021 and Earlier

By current definition, Bitcoin is not money because it is not a medium of exchange created, authorized, or adopted by a domestic or foreign government, or by an intergovernmental organization or by an agreement between two or more countries. Moreover, since Bitcoin, NFTs, and other digital assets are intangible and therefore not capable of possession, under the UCC as it is currently in effect, a security interest in them can currently only be perfected (as a general intangible) by the filing of a financing statement describing the digital asset. Under the UCC as it is currently in effect, it is uncertain that control of the digital wallet for a digital asset is sufficient to perfect a security interest.

Nevertheless, some practitioners have proposed a practical “workaround” to perfect a security interest in Bitcoin by “control” if the Bitcoin is held in a “securities account,” and the secured party has control over the financial assets (including the Bitcoin) held in the securities account. In this manner, a secured party will have control if the secured party, the debtor, and a securities intermediary (holding the account in which the Bitcoin is held) enter into an agreement in which the securities intermediary agrees to comply with the instructions originated by the secured party directing disposition of the funds and other property in the account without consent by the debtor. The securities intermediary must be a person, including a financial institution, custodian, or broker that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. The workaround provides the secured party with the amount of control that, as a practical matter, it would need to foreclose upon, and exercise its remedies with regard to the digital asset, but that control itself would not necessarily perfect the secured party’s security interest in the digital asset under the current UCC.

What is New

The proposed new Chapter 12 to the UCC will:

  1. address the transfer of digital assets/virtual currencies and also provide conforming changes to Article 9 of the UCC to address secured transactions in these assets
    • Chapter 12 is designed to govern the transfer (both outright and for security) of interests in some, but not all, electronic records (adopting a new term “controllable electronic records”) (e.g., Bitcoin/NFTs)
  2. facilitate secured lending against digital assets (e.g., virtual currency, NFTs, and electronic fiat money (i.e., central bank digital currency))
  3. provide protections for certain qualifying purchasers to take interests in virtual currency and digital assets free of conflicting property claims
  4. provide rules regarding the assignment of controllable accounts and controllable payment intangibles
  5. provide other changes including updates to the definition of chattel paper and revisions to the requirements for the transfer and perfection of security interest in chattel paper, and revisions to some rules regarding negotiable instruments and payment systems

How Will These Changes Affect Different Players in the Industry

Blockchain and Cryptocurrency Startups

Chapter 12 will impact blockchain and cryptocurrency startups and companies involved in purchasing, selling, and financing virtual currencies, NFTs, and other digital assets. Chapter 12 will govern the transfer of property rights in intangible digital assets (defined as “controllable electronic records”) that can be subjected to control. Control is the functional equivalent of “possession” of the digital asset. Companies are currently using digital assets in exchange for payment, rights to receive services, for goods or interests in personal or real property. Chapter 12 will reduce the risks among claimants to, and specify the rights in, the digital assets that the purchaser acquires and to facilitate these transactions.

Financial Institutions

Financial institutions, banks, and other lenders who finance virtual currencies and other digital assets will find it easier to arrange secured lending transactions under Chapter 12 (and conforming changes under UCC Chapter 9). A lender will have a perfected security interest if the lender has “control” over the digital asset (or the system on which the digital asset is recorded). In addition, financial institutions, lenders, and other secured parties should consider amending existing security documents. Many existing revolving credit facilities are secured by blanket or broad liens on substantially all assets of the debtor, including its general intangibles. Lenders may want to amend their security documents to provide for a security interest in virtual currencies and other digital assets to provide (a) an express grant of a security interest in “controllable electronic records”, “controllable accounts” and “controllable payment intangibles” and (b) for the lenders to obtain control over controllable electronic records, controllable accounts, and controllable payment intangibles. The amendment will mitigate the risk that the lender will lose its priority position if another party obtains control over the controllable electronic records, controllable accounts and controllable payment intangibles, and the lender has only perfected by filing a financing statement.

Investment Banks

Many securities are issued secured by rights to payment arising from the sale of amounts due under credit cards, accounts, instruments, student loans, and other lines of credit. Underwriters and investors in structured finance and securitization transactions involved in assignment of accounts and payment intangibles will want to review the Chapter 12 provisions regarding the payment obligations and conditions for discharge of obligors on digital assets (controllable accounts and controllable payment obligations). Underwriters and investors should also review the ability under Chapter 12 of a purchaser to acquire special protection as a good faith purchaser for value (a qualifying purchaser) of a controllable electronic record, controllable account and controllable payment intangible.

Parties in Equipment Finance/Lease Transactions

Parties involved in equipment finance/lease finance transactions, underwriters and investors (such as auto finance and auto securitization transactions) will want to review the other proposed changes to UCC Article 9, including the proposed changes to chattel paper. For example, the definition has been amended to provide that chattel paper is a monetary obligation that is either secured by specific goods (such as a car or furniture) or arises in connection with a lease of specific goods (such as a car or furniture). The rule regarding perfection of a security interest in chattel paper has also been revised. Under the old rule—if you had tangible chattel paper (evidenced by writing), the secured party was required to have possession of the writing, and there was confusion if there were multiple copies or what constituted a writing. If electronic chattel paper, the secured party was required to have control of the single authoritative copy, and there was confusion of what it meant to have a single authoritative copy. Under the new rule, the secured party:

  1. Can perfect its security interest by taking possession of all tangible authoritative copies and obtaining control of all electronic authoritative copies.
  2. The secured party can produce the copies in its possession and provide evidence that these are the authoritative copies.
    • Need not prove that no other tangible authoritative copies exist.
  3. For electronic chattel paper, the secured party must:
    • be able to identify each electronic copy of electronic chattel paper as authoritative or nonauthoritative,
    • identify the secured party as the assignee of each authoritative copy,
    • have the exclusive power to prevent others from adding or changing an identified assignee and to transfer control of the authoritative copies.

What’s Excluded

UCC Chapter 12 is limited in scope—it only applies to controllable electronic records (i.e., a virtual currency and other digital asset) and payment rights that are evidenced by a controllable electronic record. Chapter 12 does not address a number of federal, state, and local laws and regulatory issues that will undoubtedly interplay with these emerging technologies, including anticipated new regulations from regulators like the SEC, OCC, and the IRS. These laws and regulations are rapidly changing. We will be providing periodic updates.

Also Excluded:

  • Who has title to or rights in the digital assets
  • Federal and state securities, data privacy, cybersecurity, and other regulation
  • Banking laws
  • Taxation of digital assets
  • Anti-money laundering laws
  • Transferable records under UETA or E-SIGN

Schedule for Approval of Changes

Date Event
January 2022 Drafting committee submits draft proposed recommendations to ALI counsel
May 2022 ALI approval of draft proposed recommendations
July 2022 Uniform Law Commission approves proposed recommendations
Post-July 2022 Submission to states for adoption of proposed recommendations

Industry Comments

The drafting committee of Chapter 12 and the conforming changes to the other changes to the UCC are in the process of meeting with industry groups and other stakeholders to continue advising industry leaders and other stakeholders regarding these proposed changes. The drafting committee is continuing to work on finalizing the proposed recommendations prior to the May 2022 meeting. We would be happy to meet with you to discuss any comments or concerns that you may have with the proposed changes.

Cryptocurrency Transactions and Taxes: 5 Things to Know

The $1.2 trillion Infrastructure Investment and Jobs Act – also called the Bipartisan Infrastructure Law –garnered attention with its promise to tackle an array of projects, from rebuilding roads and bridges to broadening high-speed internet access.

Provisions in the law that relate to taxing cryptocurrency transactions, however, received less notice. Those measures seek to ensure that taxpayers properly report and pay tax on crypto-related income.

Here’s what you need to know:

1. The law redefines “broker” and views digital assets as “specified securities”

The Infrastructure Act makes two significant changes to Section 6045 of the Internal Revenue Code (IRC). That section requires brokers to report gross proceeds from transactions to the taxpayer and to the IRS. If the item subject to reporting is a “covered security,” the broker must report the customer’s adjusted basis in the security and say whether a gain or loss is long- or short-term. Covered securities are further defined to include “specified securities,” such as stocks, bonds, commodities and other financial instruments.

The Infrastructure Act:

  • Includes digital assets in a list of specified securities. The law defines “digital asset” as “any digital representation of value which is recorded on a cryptographically secured distributed ledger” or similar technology. The definition of digital asset is significant as that term is used in a number of other provisions in the Internal Revenue Code.
  • The provision covers a broad category of digital assets, including traditional cryptocurrencies like bitcoin as well as non-fungible tokens. The Treasury Secretary has authority to exempt types of transactions.
  • Modifies the definition of “broker” to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”
    • The use of “on behalf another person” is perplexing because the broker already includes a “middleman” concept. On its face, the updated provision would require miners, software developers, transaction validators and node operators to provide information because they provide services in connection with crypto transactions on behalf of users of the software.

2. The law expands reporting requirements to encompass “broker-to-non-broker” transactions

IRC Section 6045A deals with reporting transactions between brokers. It requires every “applicable person” who transfers a covered security (including the “specified securities” discussed above) to a broker to furnish information so the transferee can provide required gain or loss and basis reporting information. The Infrastructure Act expands reporting to cover “broker-to-non-broker” transactions.

3. People receiving more than $10K in digital assets now need to report

IRC Section 6050I requires anyone receiving more than $10,000 in cash in a “trade or business” to report it to the IRS via Form 8300, and to provide a written statement to the payer. It also covers “to the extent provided in regulations” any monetary instrument (whether or not in bearer form) with a face amount of not more than $10,000. Failure to report cash transactions can trigger steep penalties.

The Infrastructure Act amends the Code so that the reporting requirement also applies to people receiving digital assets.

4. It’s not always easy to identify someone who buys a digital asset

Broadening IRC Section 6050I to apply to people receiving digital assets is consistent with the changes described above to Section 6045: viewing digital assets as a specified security and requiring brokers to report information on certain digital transactions.

On the surface, the law’s reporting requirement would apply to people receiving digital assets for validating transactions or other services relating to crypto transactions.

One of the problems this introduces in the world of decentralized finance transactions is the difficulty of identifying the purchaser if the transaction is made through a smart contract rather than from an identifiable person.  Often times these transactions are entered into on an “open” and “trust-less” basis (meaning that there are no limits as to who can participate in the transaction) making it difficult or impossible to report on who the counterparty is (other than by identifying the blockchain wallet address involved in the transaction).

5. Information-gathering starts Jan. 1, 2023

The changes take effect for returns that must be filed and statements that must be furnished after Dec. 31, 2023. Gathering information for that, though, should start Jan. 1, 2023.

“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.

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.

Playing Catch-Up: Commissioner Peirce Proposes a Safe Harbor for Certain Token Offerings

SEC Commissioner Hester Peirce has once again earned her title as “Crypto Mom” by expressing support for building a “non-exclusive safe harbor” for the offer and sale of certain cryptocurrency tokens. Peirce explained that the concept of a safe harbor is still in its infancy and did not propose a timeline for the project. Nevertheless, her support is welcome news for the industry, which can hope that her well-stated views will influence the rest of the Commission to move to adopting a separate securities regulatory framework for cryptocurrency.

We expect that the SEC will take its time in moving forward with the development and implementation of a safe harbor for token offerings. Peirce previously defended the SEC’s slow approach to crypto regulation, indicating that delays in establishing crypto regulations “may actually allow more freedom for the technology to come into its own.” Peirce is cognizant of the repercussions of moving too slowly and seems to be trying to balance the need for regulatory certainty with the need to get the regulatory framework right.

Peirce explained that in developing its crypto regulatory regime, the SEC can learn from other countries that have taken the lead in developing a regulatory framework for token offerings. For example, Peirce explained that the “nebulous” definition of a security in the U.S., coupled with the difficulty of determining the precise nature of a digital asset – is it a currency, commodity, security or derivative? – has slowed our regulatory progress. Peirce suggests looking at the approach taken by Singapore for the classification of offerings as non-securities, since Singapore does not treat every token offering as a securities offering. Similarly, earlier this month the SEC and FINRA issued a joint statement explaining that there are still unanswered questions regarding custody of digital assets that have led to delays in approving ATS applications. Peirce recommends reviewing Bermuda’s guidance on the subject because “Bermuda is one of the only jurisdictions to address the custody question in detail.”

With so many countries so far ahead of the U.S. in developing regulatory regimes for token offerings, the SEC has an abundance of approaches to review. Ideally this will speed up the development and implementation of the safe harbor. If, however, the SEC continues to drag its feet, token projects that would otherwise prefer to launch in the U.S. might be expected to continue to choose jurisdictions with clearer regulatory regimes.

NY AG Accuses Bitfinex and Tether of Covering Up $851 Million Loss in Investor Funds

On April 25, 2019, New York’s Attorney General secured a preliminary injunction against Bitfinex, a cryptocurrency trading platform, and Tether, the company behind tether (USDT), one of the world’s most popular cryptocurrencies. In papers filed with the court last Wednesday, the state AG accused the companies of misleading investors about their financial well-being while using Tether’s bank account to prop up Bitfinex with $700 million in undisclosed loans. The injunction requires Bitfinex and Tether to temporarily cease drawing down Tether’s cash reserves and to turn over detailed information about their finances and client accounts to the state AG as it investigates them for financial fraud.

As we have discussed in previous blog posts, courts and regulators have determined that some virtual currencies are securities or commodities that are subject to state and federal laws and regulations. Last week’s developments serve as a reminder to cryptocurrency exchanges and token distributors alike that they may be subject to the laws and regulations of any jurisdiction in which they operate. In this case, although Bitfinex purportedly no longer permits U.S. traders to use its platform and is not a licensed exchange in New York, the state AG’s office argued that it and Tether are subject to New York law because some New York residents still use the platform, just as some New York residents own USDT. The companies’ connections to New York subject them to scrutiny under the Martin Act, New York’s powerful “blue sky” securities law that gives the state AG the authority to investigate and prosecute securities fraud regardless of fraudulent intent.

In papers submitted to the court, New York’s AG alleged that Bitfinex dipped into Tether’s cash holdings to prop itself up after $851 million was seized from one of its bank accounts. Bitfinex had deposited the cash with an entity called Crypto Capital Corp., who was engaged by Bitfinex to process its clients’ withdrawals. In late 2018, Crypto Capital reported to Bitfinex that it could no longer process withdrawals or return Bitfinex’s funds to it because they had been seized by authorities in Portugal, Poland, and the U.S. To cover up the loss, Bitfinex allegedly caused Tether to extend it a $900 million line of credit, of which Bitfinex has accessed approximately $700 million. Neither Bitfinex nor Tether publicly disclosed these transactions. The state AG alleges that Bitfinex was able to borrow the funds from Tether because the two companies are operated by the same individuals and share the same parent company.

The New York AG has accused Bitfinex and Tether of misleading investors about the security of their investments and of engaging in self-dealing by causing Tether to transfer hundreds of millions of dollars to Bitfinex, taking on enormous amounts of risk without receiving anything of value in return. Tether has long represented that it holds one U.S. dollar in reserve for each of the 2.6 billion outstanding USDT, and that holders of USDT can redeem them at any time for U.S. dollars at a rate of one USDT to one U.S. dollar. Although Tether has recently disclosed that outstanding USDT may be backed by “other assets and receivables” in addition to U.S. dollars, the state AG is investigating, among other questions, whether Tether’s transactions with Bitfinex have rendered Tether’s public statements misleading. The New York AG has also accused the companies of misleading state investigators by purporting to cooperate in the AG’s investigation while secretly transferring funds from Tether to Bitfinex.

Bitfinex responded on Friday with a forcefully worded denial of the allegations brought against it and Tether and reiterated that the companies “are financially strong – full stop.”

Although the New York AG has stated that it does not want its investigation to harm Tether investors or Bitfinex clients, it’s possible that information revealed during the investigation could affect confidence in the companies or in cryptocurrency markets generally. Bitcoin’s price fell seven percent immediately following the announcement of the AG’s investigation on Thursday, perhaps providing a window into the volatility that will come if Bitfinex’s assurances that it and Tether are financially sound are found to be misleading.

FinCEN Shows a Little Bite to Go with Its Bark

Last week, the Financial Crimes Enforcement Network (FinCEN) backed up its strong public statements about enforcing the anti-money laundering (AML) laws with respect to cryptocurrency by bringing an enforcement action against an individual for violating the Bank Secrecy Act (BSA).

FinCEN, a bureau within the U.S. Department of Treasury tasked with safeguarding the financial system from illicit use and combating money laundering, has not been shy about expressing interest in blockchain and cryptocurrency issues. In a recent speech, Director Kenneth A. Blanco explained that “FinCEN has been at the forefront of ensuring that companies doing business in virtual currency meet their AML/CFT obligations regardless of the manner in which they do business.” He added that FinCEN “will continue to work with the SEC and CFTC to ensure compliance in this space and will not hesitate to take action when we see disregard for obligations under the BSA.” But FinCEN enforcement actions involving cryptocurrency activities have been infrequent. Since its landmark action against Ripple Labs in 2015, FinCEN’s only enforcement proceeding in this area was brought in 2017 against virtual currency exchanger BTC-e and its owner.

That changed last week when FinCEN assessed a civil penalty against Eric Powers, a “peer-to-peer exchanger” of virtual currency, for violations of the BSA. In agreeing to pay a $35,350 penalty, Powers admitted that he willfully violated the BSA by failing to (i) register as a money services business (MSB), (ii) implement written policies and procedures for ensuring BSA compliance, and (iii) report suspicious transactions and currency transactions.

The Powers action does not provide much insight into one of the more difficult questions a company whose business involves virtual currency faces: whether it qualifies as an MSB that is subject to the BSA. FinCEN guidance from 2013 indicates that the BSA generally will apply to “exchangers” and “administrators” of convertible virtual currencies. Unlike many virtual currency companies, Powers seems to have clearly fit within FinCEN’s definition of an exchanger – through online postings he advertised his intention to purchase and sell bitcoin for others, and he completed purchases and sales by delivering or receiving currency in person, through the mail, or via wire transfer. But in establishing that the BSA applied to Powers, FinCEN leans heavily on the 2013 guidance. That guidance in many ways is imprecise or unclear and it continues to create uncertainty as blockchain technology and virtual currency business models continue to evolve. But the Powers assessment confirms that other entities operating in the cryptocurrency space nevertheless should continue to evaluate their BSA obligations through the lens of that guidance to the extent possible.

Unlike those assessed against Ripple and BTC-e, the financial penalty assessed against Powers was relatively small. This might be because Powers was a natural person (potentially with a lesser “ability to pay” than larger incorporated entities), conducted a fairly small-scale operation, and paid larger sums as part of an earlier civil forfeiture action brought by the Maryland U.S. Attorney. While those considerations warranted a lesser penalty in Powers’s case, FinCEN very well could apply the same law, guidance, and reasoning underlying the assessment to more extensive cryptocurrency operations. Director Blanco’s recent comments regarding FinCEN’s priorities and this latest enforcement action suggest that FinCEN likely will do just that. In other words, we wouldn’t be surprised if FinCEN brings more enforcement actions – levying more severe penalties – to enforce the BSA in the cryptocurrency industry. Persons and entities operating in this industry thus should focus on assessing their potential BSA obligations early and take affirmative steps to comply if required.

The 2019 Token Taxonomy Act: A Path to Consumer Protection and Innovation Takes Shape

We’ve previously written that the Token Taxonomy Act first introduced to Congress by Representatives Warren Davidson (R-OH) and Darren Soto (D-FL) on December 20, 2018, was a welcome legislative initiative designed to provide a regulatory “light touch” to the burgeoning digital asset industry. The bill expired, however, with the termination of the 115th Congress, leaving open the question of what any future blockchain regulatory proposals, would look like. The industry’s questions were answered on April 9, 2019 when Representatives Davidson and Soto introduced the Digital Taxonomy Act of 2019 (DTA) and the Token Taxonomy Act of 2019 (TTA) to the 116th Congress. The DTA and TTA represent expanded efforts to clarify regulation and spur blockchain innovation in the United States.

According to Representatives Davidson and Soto, the DTA is meant to add jurisdictional certainty to efforts to combat fraudulent behavior in the digital asset industry. As such, the DTA grants the FTC $25,000,000 and orders it to prepare reports on its efforts to combat fraud and deceptive behavior. The DTA also specifically carves out from its purview the authority of the CFTC to regulate digital assets as commodities subject to the Commodities Exchange Act.

The 2019 TTA, with the backing of four bipartisan representatives in addition to Davidson and Soto, is similar to last year’s model. Besides defining digital assets and exempting them from certain securities law requirements, the 2019 TTA maintains proposals to amend the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that certain regulated entities can hold digital assets. Like the 2018 version of the TTA, the 2019 TTA would also allow the sale of digital assets to qualify for the benefits of Internal Revenue Code Section 1031 like-kind exchange provisions and for the first $600 dollars of profit from digital asset sales to be tax-free.

The TTA also has important updates. The most prominent change is the definition of a “digital asset.” As we’ve previously discussed, the 2018 version of the TTA required that a digital asset’s transaction history could not be “materially altered by a single person or group of persons under common control” to qualify for exemption from securities laws. Because of the unavoidable possibility of a 51% attack, which would alter a token’s transaction history, the language created the possibility that proof of work- and proof of stake-based tokens would not be eligible for regulatory relief, thus limiting the bill’s benefits.

In the re-proposed TTA, however, the newly proposed language of Section 2(a)(20)(B)(ii) requires that the transaction history, still recorded in a mathematically verifiable process, “resist modification or tampering by any single person or group of persons under common control.” Thus, any digital asset, even those subject to 51% attacks, may be exempt from certain securities law requirements, although the language appears to require that a governance or security system underline the token’s consensus system.

Another important update is the TTA’s proposed preemption of state regulation of the digital asset industry by federal authorities. While the TTA would still permit states to retain antifraud regulatory authority, it largely strips states’ rights to regulate digital assets as securities. Representative Davidson’s press release on the bill specifically cites the “onerous” requirements of the New York BitLicense regulatory regime as a reason for the inclusion of this provision.

Critics have been quick to point out that the bills, while well intentioned, leave many unanswered questions and therefore may not provide the regulatory certainty the bills’ authors hope to effect. And even a perfect bill would face an uphill battle in getting enacted these days. But the digital asset industry should nonetheless take comfort in the growing contingent of legislators who take seriously the imperative to balance consumer protection and blockchain innovation.

The Beat Goes On: Division of Investment Management Seeks Input on the Impact of the Custody Rule on Digital Currency – and Vice Versa

As part of its ongoing examination of the Custody Rule, the SEC’s Division of Investment Management is seeking views from the securities industry members and the public on two issues regarding the Custody Rule: (1) the application of that rule to trading that is not handled on a delivery versus payment basis, and (2) the application of the rule to digital assets. In a March 12, 2019 letter to the President and CEO of the Investment Adviser Association published on the SEC’s website (“the Custody Release”), the Division seeks input to expand on its Guidance Update from early 2017. Both issues are important in view of the increasing complexity of types of securities that registered investment advisers are purchasing on behalf of their customers and, as discussed below, the issues overlap in a way that might predict an important use case for blockchain technology.

The Custody Rule

The Custody Rule under the Investment Advisers Act of 1940 provides that it is a fraudulent, deceptive or manipulative act, practice or course of business for a registered investment adviser to have “custody” of client funds or securities unless they are maintained in accordance with the requirements of the Custody Rule. The definition of custody includes arrangements where the adviser has authority over and access to client securities and funds.

By way of context, we note that although the Custody Rule applies only to registered investment advisers, its concepts are relevant for non-registered advisers and other intermediaries as well, since their clients or customers have a practical interest in assuring that: managed assets are appropriately safeguarded; and the absence of appropriate custody arrangements may preclude a client from investing with a particular adviser.

Also, as the Custody Release notes, the Division previously issued a letter inviting engagement on questions relating to the application of the Investment Company Act of 1940, including the custody provisions of that Act, to cryptocurrencies and related products.

The Custody Rule and DVP Arrangements

The Custody Release points out that when an investment adviser manages funds pursuant to delivery versus payment arrangements – that is, when transfers of funds or securities can only be conducted together with a corresponding transfer of securities or funds – then it provides certain protections to customers from misappropriation by the adviser. The Release seeks to assist the Division in gathering information on payment practices that do not involve delivery versus payment, seeking input on, among other things: the variety of instruments that trade on that basis; the risk of misappropriation or loss associated with such trading; and how such trades appear on client accounts statements.

The Custody Rule and Digital Assets

The Custody Release also asks about the extent to which evolving technologies, such as blockchain/distributed ledger technology, provide enhanced client protection in the context of non-delivery versus payment trading. That question presents a good lead-in to the second part of the Custody Release, which seeks to learn “whether and how characteristics particular to digital assets affect compliance with the Custody Rule.” These characteristics include:

– the use of distributed ledger technology to record ownership;

– the use of public and private cryptographic keys to transfer digital assets;

– the “immutability” of blockchains;

– the inability to restore or recover digital assets once lost;

– the generally anonymous nature of DLT transactions; and

– the challenges posed to auditors in examining DLT and digital assets.

With these characteristics in mind, the Division asks are fairly open-ended about the challenges faced by investment advisers in complying with the Custody Rule with respect to digital assets, including:

– to what extent are investment advisers construing digital assets as funds or securities?

– are investment advisers including digital assets in calculating regulatory assets under management in considering with they need to register with the SEC?

– how can concerns about misappropriation of digital assets be addressed?

– what is the process for settlement of digital asset transactions, either with or without an intermediary?

The most forward-looking question asked in the Release is whether digital ledger technology can be used for evidencing ownership of securities. The answer to this question – which could represent a direct application of the blockchain’s ability to record ownership and its immutability – could pave the way to resolving custody concerns with respect to any asset class transacted in by investment advisers on behalf of their clients. It certainly points the way to an important possible use of blockchain technology – to demonstrate custody in a way that is immutable, anonymous and auditable. Technologists, get to work!

The Custody Release’s questions are a significant next step in drawing digital assets into the embrace of investment adviser regulation, but a positive step nonetheless.