Keyword: digital assets

Wyoming, the “Equality State,” Seeks to Level the Playing Field for Digital Assets Businesses

In its continued effort to establish itself as the go-to jurisdiction for digital asset businesses, Wyoming, through its Department of Audit, Division of Banking, recently published a digital asset custody regime for its newly created, special purpose depository institutions (SPDIs). SPDIs are banking institutions authorized to take custody of digital assets. If they function as intended, SPDIs may prove to be a solution to, among other things, digital asset companies’ money transmitter licensing woes.

One major impediment to entering the U.S. market for digital asset companies is the requirement to obtain money transmitter licenses from individual states. Applying for these licenses state by state can be expensive and burdensome, and some states have created additional hurdles for digital asset companies. New York, for example, requires digital asset companies to obtain a “BitLicense,” which is notoriously difficult to obtain, to operate in the state. California may soon follow suit, imposing substantial licensing requirements under Assembly Bill 1489, which has been introduced in the legislature.

Wyoming is trying a different approach. In establishing SPDIs, Wyoming is helping blockchain companies avoid the costs of these burdensome licensing regimes while still protecting customers by taking advantage of a regulatory benefit enjoyed by banking institutions like SPDIs. Per the Bank Secrecy Act, banks are exempt, as a general matter, from needing money transmitter licenses.

Further, advocates argue that the SPDIs will provide a solution for startups seeking to operate in New York without a BitLicense. Federal law, through the Riegle-Neal Amendments Act, protects the parity of national banks and the state-chartered banks of other states. Accordingly, if a state exempts a national bank from a regulation, then other state-chartered banks must be exempt from that regulation as well. Because New York exempts national banks from the requirement to obtain a BitLicense to operate, so the argument goes, Wyoming’s SPDIs – which are state-chartered banks – should be exempted from that requirement as well. This theory remains untested, and New York has not taken a position on whether it will exempt SPDIs from needing a BitLicense to operate there. Perhaps Wyoming’s status as “The Equality State” will prompt New York to provide its state-chartered banks with “equal” treatment.

While the first new SPDIs could become operational by early 2020, which might provide a work-around for the current money transmitter licensing barriers facing digital asset companies, there remain a few obstacles for a company desiring to take advantage of the law, albeit surmountable ones.

First, SPDIs are required to maintain a minimum capital requirement of $5 million – making it prohibitive for most startups to charter their own SPDI. However, multiple companies may partner with one unaffiliated SPDI to pool assets. Assuming cooperation among market players, startups should be able to find enough capital among other SPDIs to satisfy the capital requirement. Second, SPDIs are required to maintain the principal operating headquarters and the primary office of its CEO in Wyoming, but – as we know – the excellent skiing, beautiful vistas and abundant wildlife in Wyoming provide ample justification for setting up shop there.

Wyoming’s creation of SPDIs comes on the heels of other pro-blockchain moves by the state, including authorizing corporations to issue securities via “certificate tokens in lieu of stock certificates,” creating a FinTech sandbox that enables startups to receive waivers from laws or regulations that may unnecessarily burden their ability to test new products and services, and classifying digital assets as property.

Wyoming’s small population and limited infrastructure may make it difficult to attract personnel and capital to create a competitive SPDI market. But with sufficient incentives, and the opportunity to engage in a potentially lucrative and groundbreaking industry, Wyoming is making a bid to become the crypto capital of the U.S.

In Case You Needed A Reminder – AML/CFT Regulations Apply to Transactions in Cryptocurrencies

Earlier this month, the leaders of the U.S. Commodity Futures Trading Commission, the Financial Crimes Enforcement Network, and the U.S. Securities and Exchange Commission released a joint statement reminding individuals engaged in transactions involving digital assets of their obligations under the Bank Secrecy Act (BSA) to guard against money laundering and counter the financing of terrorism.

Anti-Money Laundering/Countering the Financing of Terrorism (AML/CFT) regulations apply to all entities that the BSA defines as “financial institutions,” including futures commission merchants and introducing brokers obligated to register with the CFTC, money services businesses as defined by FinCEN, and broker-dealers and mutual funds obligated to register with the SEC. To comply with AML/CFT regulations, financial institutions are required to, among other things, implement anti-money laundering programs and comply with recording keeping and reporting requirements, including suspicious activity reporting (SAR) requirements.

The joint statement emphasized that AML/CFT regulations apply to financial institutions engaged in activities involving “digital assets,” including instruments that may qualify under applicable U.S. laws as securities, commodities, and security- or commodity-based instruments such as futures or swaps. Because digital assets and financial transactions in digital assets are referred to by many names – including “cryptocurrencies,” “digital tokens,” “virtual assets” and “initial coin offerings” – the regulators issuing the joint statement reminded financial institutions that commonly used labels may not necessarily align with how an asset, activity or service is defined under the BSA or under laws and rules administered by the CFTC and the SEC. The nature of the digital asset, activity or service, including underlying “facts and circumstances” and the asset’s “economic reality and use,” determines how it is regulated under federal laws and regulations.

By reminding industry participants that the nature of a digital asset and the manner in which it is used – and not industry lingo – determines how the digital asset is regulated, the CFTC, FinCEN and the SEC signaled that they are adopting the same framework courts already use to determine how to classify other types of assets under the federal securities laws. The joint statement indicates that regulators are continuing to take steps toward applying existing federal securities laws and regulations to digital currencies.

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.

SEC/FINRA Joint Statement on Digital Asset Securities Does Not Address Regulatory Log Jam

Last week, the Staffs of the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) (collectively, the Staffs) released a Joint Statement concerning the application of the SEC’s Customer Protection Rule and other federal laws and regulations to transactions in digital asset securities. The Joint Statement is the result of months of dialogue among the Staffs and industry participants regarding the practical application of the federal securities laws to emerging digital technologies. Nonetheless, it gives no indication as to when FINRA expects to begin working down its backlog of applications from broker-dealers seeking to facilitate markets in digital asset securities.

The Customer Protection Rule

The Joint Statement primarily addresses the application of SEC Rule 15c3-3, the Customer Protection Rule, to federally registered broker-dealers taking custody over their customers’ digital asset securities. The Customer Protection Rule requires broker-dealers to segregate customer assets in specially protected accounts, thereby increasing the likelihood that customers will be able to withdraw their assets even if the broker-dealer becomes insolvent. To comply with the rule, broker-dealers must either physically hold customers’ fully paid and excess margin securities or deposit them at the Depository Trust Company, a clearing bank, or other “good control location” free of any liens or encumberments. This infrastructure additionally protects customers by allowing mistaken or unauthorized transactions to be reversed or canceled.

While the Customer Protection Rule applies to both traditional and digital asset securities, the Staffs advised that broker-dealers taking custody over digital asset securities may need to take additional precautions to respond to unique risks presented by these emerging technologies. For instance, there may be greater risk that a broker-dealer maintaining custody of digital asset securities could become the victim of fraud or theft or could lose the “private key” required to transfer a client’s digital asset securities. Further, another party could hold a copy of the private key without the broker-dealer’s knowledge and transfer the digital asset security without the broker-dealer’s consent. The Staffs noted that an estimated $1.7 billion worth of digital assets was stolen in 2018, of which approximately $950 million resulted from cyberattacks on bitcoin trading platforms. These risks could cause customers to suffer losses and create liabilities for the broker-dealer and its creditors.

The Staffs noted that broker-dealer activities that do not involve custody functions do not trigger the Customer Protection Rule. Examples of such activities include the facilitation of bilateral transactions between buyers and sellers similar to traditional private placements or “over the counter” secondary market transactions. These transactions do not “raise the same level of concern among the Staffs” as do transactions in which the broker-dealer assumes custody over the securities.

Other Federal Regulations

The Staffs advised broker-dealers to consider how distributed ledger technology may impact their ability to comply with broker-dealer recordkeeping and reporting rules. Because transactions in digital asset securities are recorded on distributed ledgers such as blockchains rather than traditional ledgers, broker-dealers may find it more difficult to evidence the existence of these digital asset securities on financial statements and to provide sufficient detail about these assets to independent auditors.

Finally, the Staffs discussed the application of the Securities Investor Protection Act (SIPA) to broker-dealers exercising custody over digital assets. In the event a broker-dealer is liquidated, SIPA gives securities customers first-priority claims to securities and cash deposited with the broker-dealer. However, the Joint Statement notes that SIPA’s definition of “security” is different than the federal securities laws definitions. For example, the definition in SIPA of “security” excludes an investment contract or interest that is not the subject of a registration statement with the Commission pursuant to the provisions of the Securities Act of 1933. Consequently, customers whose digital assets are subject to the Customer Protection Rule and other federal regulations may only have an unsecured general creditor claim against their broker-dealer’s estate in the event their broker-dealer fails. The Staffs found that such outcomes are likely inconsistent with the expectations of investors in digital assets that do not qualify for SIPA protection.

Waiting Game

Absent from the Joint Statement is a clear answer to the question at the forefront of many industry participants’ minds: When will FINRA begin approving the dozens of applications of existing broker-dealers and new registrants seeking authority to offer a variety of custodial and non-custodial services with respect to digital assets? Applicants seeking to engage only in non-custodial activities, such as market-making, may be encouraged that the Staffs have indicated that those activities pose the least concern to federal regulators, and, presumptively, may be more readily approved. Nonetheless, the Staffs have given no indication that FINRA will prioritize processing applications seeking authority to provide only non-custodial services currently in its backlog, or when such applications will once again be approved.

Meanwhile, the Joint Statement underscores that considerable uncertainty remains regarding the application of existing laws and regulations to broker-dealer activities involving the custody of digital assets. While the Staffs invite broker-dealers and other industry participants to continue to engage with federal regulators to develop workable methodologies for securely carrying customers’ digital assets, industry participants hoping to get a firm answer as to when secondary market trading in digital asset securities will gain federal regulators’ seal of approval will have to keep waiting.

 

Three Yards and a Cloud of Dust: SEC Staff Provides Its “Plain English” Framework to Guide Future Discussions

The SEC chose a week that saw the price of Bitcoin spike by over $700 in an hour, kicking off a rally reminiscent of the go-go days of 2017, to issue its long-awaited “plain English” guidance for determining whether a digital asset constitutes a “security” under the federal securities laws.

The SEC also unexpectedly released its first no-action letter to a company planning to issue a digital asset without registering the transaction under Section 5 of the Securities Act of 1933 and Section 12(g) of the Securities and Exchange Act of 1934.

Now that the dust has settled, we can start to analyze what all this means for the digital asset industry. Upon review, the Bitcoin rally might have been the more impactful event.

On April 3, a statement entitled “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”) was issued by Bill Hinman, Director of Division of Corporation Finance, and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation; and the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service.

The Framework goes out of its way to caution that it represents the views of the Strategic HUB for Innovation and Financial Technology of the Commission and is not a rule, regulation or statement of the Commission: that the Commission has neither approved nor disapproved its content; and that it is not binding on the Divisions of the Commission. The Framework further emphasizes its limited scope: “Even if no registration is required, activities involving digital assets that are securities may still be subject to the Commission’s regulation and oversight,” for example buying, selling, or trading; facilitating exchanges; and holding or storing digital assets. Thus, the Framework has limited utility from a factual, legal or precedential standpoint. Nevertheless, we expect it to be a significant source document that will be cited by the Commission, practitioners, and courts alike.

On the same day, the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service (the “No-Action Letter”). The No-Action Letter is not binding on the Commission and only applies to the very specific, and restrictive, set of conditions presented in the No-Action Letter request and, therefore, it does not have broad implications for the industry in general. Like the Framework, the No-Action Letter provides little guidance to the industry, but it should be touted as a step in the right direction, albeit a small step.

Though the Framework and No-Action Letter are not as helpful as some might have hoped, both are key developments that shed light on the Staff’s current views regarding the regulation of digital assets and the activities of industry participants under the federal securities laws.

The Framework

The Framework, which the Staff emphasized does not “replace or supersede existing case law, legal requirements or statements or guidance” from the SEC, largely relies on the 73-year-old Howey test for determining whether a digital asset is a security in the form of an “investment contract.” The Howey test is composed of four prongs: (i) an investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profit; (iv) derived from the efforts of others.

The Framework succinctly analyzes the applicability of the first two prongs to an offer and sale of a digital asset in three sentences and reserves the other nine pages for the latter two prongs. It is reasonable to ask whether the existence of a common enterprise in an offer and sale of a digital asset is as foregone a conclusion as the SEC evidently believes.

The Framework introduces a term to identify the principal actor or actors in the development or maintenance of a digital asset network, an “Active Participant” or “AP,” broadly defined to include a “promoter, sponsor, or other third party (or affiliated group of third parties).” The activities of the Active Participants are emphasized as critical factors for determining whether a purchaser has a reasonable expectation of profits (or other financial return) to be derived from the efforts of others. This is an expansive reading of the Howey test. For example, under the Framework the following are indicative of reliance by the purchaser of a digital asset on the “efforts of others”: (i) when an AP promises “further developmental efforts in order for the digital asset to attain or grow in value”; (ii) when the purchaser expects that the AP will be “performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality”; (iii) an AP creates or supports a market for the digital asset; (iv) an AP maintains a managerial role in the project; and (v) when a purchaser would reasonably expect the AP to “undertake efforts to promote its own interests and enhance the value of the network or digital asset.” As an aside, introducing the concept of “Active Participant” suggests that the SEC might be in the early stages of promulgating a refined regulatory scheme for digital currency that focuses on the role of actors whose efforts help maintain or enhance the value of existing currency.

In the section entitled “Other Relevant Considerations,” the Framework spells out how a digital asset can be structured to avoid being considered a security. As a general matter, the stronger the presence of certain identified characteristics, the less likely a digital asset would constitute a security under the Howey test. These characteristics include (i) the network is fully developed and operational; (ii) holders of the digital asset are immediately able to use it for its intended functionality; (iii) the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network; and (iv) the digital asset is marketed in a manner that emphasizes the functionality of the digital asset. However, some of the other characteristics cited would pose challenges for “traditional” digital asset issuances, including: (i) prospects for appreciation in the value of the digital asset are limited, e.g. the design of the digital asset provides that its value will remain constant or even degrade over time; and (ii) if the AP facilitates the creation of a secondary market, transfer of the digital asset may be made only by and among users of the platform.

The Framework briefly discusses when a digital asset “previously sold as a security” should be reevaluated at the time of later offer or sale. Relevant considerations in that reevaluation include whether purchasers “no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset.” The broad definition of AP is especially troubling when coupled with the Framework’s broad list of examples of continued involvement by the AP in the development or management of the network or digital asset because it arguably could apply to almost any project in the industry.

This discussion is largely a restatement of Director Hinman’s oft-cited speech “When Howey Met Gary (Plastic),” and is generally not helpful in addressing the great leap required to transition from a product developed by a group of identifiable individuals to a “de-centralized” organization. Note that the Framework does not address, among other things, the status of SAFTs and the issuance of tokens thereunder. It also says nothing about projects where sale of tokens are restricted to non-U.S. buyers, and U.S. residents later wish to use the tokens.

No-Action Letter

In the No-Action Letter, the Division of Corporation Finance indicated that, subject to specified conditions, it would not recommend enforcement action to the Commission if TurnKey Jet offers and sells its tokens without registration under the Securities Act and the Exchange Act. The No-Action Letter is instructive because it provides an example of the narrow range of activities that, under the Framework, would exclude a digital currency from treatment as a security. Some of the key features of the digital asset represented in the No-Action Letter request include:

  • TurnKey will not use any funds from the token sale to develop its platform, network, or application, and “[e]ach of these will be fully developed and operational at the time any tokens are sold.”
  • TurnKey’s tokens will be immediately usable for their intended functionality when they are sold.
  • The seller must restrict transfers of the tokens to its proprietary wallet.
  • The token’s marketing focuses on the functionality of the token and not its investment value.
  • The tokens will be priced at US$1 per token “through the life of the program” with each token essentially functioning as a prepaid coupon for TurnKey’s air charter services.

While TurnKey can celebrate being the recipient of the first no-action letter regarding the registration requirements of the Securities Act and the Exchange Act applicable to digital assets, the highly restrictive covenants it must abide by to avoid registration are in conflict with the characteristics of most ICOs and, therefore, the No-Action Letter provides little relief to the typical industry participant.


Although the Framework and the No-Action Letter largely reiterated what digital asset market participants already knew, taken together they have opened the door to further constructive discussions with the Staff that, hopefully, will produce more clear-cut guidance based upon the analysis of specific cases.