Keyword: U.S. law

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.

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

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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.

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

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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.

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.

SEC’s Light Touch: An ICO Settlement Without a Penalty

In another first for the digital token industry, on February 20 the SEC announced a settlement involving a self-reported unregistered initial coin offering (ICO) without imposing a penalty. Like its earlier settlements with AirFox and Paragon, the SEC required Gladius Network LLC to repay investors and register its GLA tokens as securities. This time, however, in a sign that the SEC is willing to work with companies trying to come into compliance, the SEC did not impose a monetary penalty due to the company’s “decision to self-report and its extensive cooperation with the staff’s subsequent investigation.”

Having just completed their freshman year at the University of Maryland College Park in 2017, Max Niebylski, Alex Godwin, and Marcelo McAndrew during their summer break founded Gladius as a cyber security company dedicated to ending Distributed Denial of Service attacks. On September 27, 2017 Gladius released a White Paper, and between October 13, 2017 and December 13, 2017 it raised a total of $12.7 million dollars through the sale of GLA tokens.

In an apparent attempt to maneuver around the securities laws and avail itself of the as-yet-untested utility token defense – which attempts to show that the tokens did not represent an investment contract but rather, like it sounds, something with utility for the purchaser – Gladius required participants in the ICO to warrant that they were purchasing GLA tokens “solely for the purpose of accessing Services . . . [and not for] any investment, speculative or other financial purposes.” Nevertheless, in the summer of 2018 Gladius self-reported the unregistered sale of GLA tokens to the SEC’s Division of Enforcement.

The SEC, in the settlement order, included a one-sentence Howey analysis, finding that the sale of GLA tokens met the factors of Howey because “[a] purchaser in the offering of GLA Tokens would have had a reasonable expectation of obtaining a future profit based upon Gladius’s efforts to create a ‘marketplace’ using the proceeds from the sale of GLA Tokens and to provide investors with liquidity by making GLA Tokens tradeable on secondary markets.”

Although the Company will have to comply with notice and reporting requirements under the federal securities laws, the only ordered monetary relief is the requirement that the Company refund GLA token purchases made between September 2017 and December 2017 pursuant to a claims process similar to what the SEC devised for the AirFox and Paragon settlements. Given the infrequency with which investors actually file claims, it is unlikely that the Company will end up refunding the full $12.7 million-dollar obligation it faces.

In another notable deviation from the AirFox and Paragon settlements, the SEC directed Gladius to provide the Commission advance notice if it planned to file a Form 15 to terminate its registration pursuant to Rule 12g-4 under the Securities Exchange Act of 1934 on the grounds that the GLA Tokens no longer constitute a “class of securities.” This seemingly superfluous requirement could be the SEC’s way of signaling to the industry that token issuances that remain below the monetary and holder threshold requirements of Rule 12g-4 will not run afoul of securities laws.

All told, the Gladius settlement is proof that the SEC continues to show leniency to token issuers who violated the securities laws if they act in good faith and come into compliance.

Appellate Court – Selling Bitcoin in Florida Requires a Money Services Business License

Following a recent opinion by a Florida appellate court, virtual currency dealers who do business in, from, or into Florida – even individuals in the business of selling their own virtual currency for cash – may be required to obtain a “money services business” license from Florida’s Office of Financial Regulation and maintain costly anti-money laundering programs in accordance with Florida and federal law or face criminal penalties.

On January 30, Florida’s Third District Court of Appeal reinstated criminal charges against Florida resident Michell Espinoza for money laundering and “unlawfully engaging in the business of a money transmitter and/or payment instrument seller without being registered with the State of Florida.” State v. Espinoza, No. 3D16-1860, slip op. (Fla. Dist. Ct. App. Jan. 30, 2019). The trial court had previously dismissed the charges against Espinoza, agreeing with his argument that selling Bitcoin does not qualify as “money transmitting” under Florida law because Bitcoin is not “money,” among other reasons. State v. Espinoza, No. F14-2923 (Fl. Cir. Ct. July 22, 2016). The appellate court disagreed and determined that even a person in the business of selling his own Bitcoin for cash is a “money transmitter” and “payment instrument seller” under Florida law and is therefore required to be licensed as a “money services business.”

The charges against Espinoza stem from a sting operation in 2013, in which undercover detectives contacted Espinoza through a Bitcoin exchange site, LocalBitcoins.com. Espinoza posted on that site that he would sell Bitcoins for cash through in-person transactions. Espinoza was not licensed or registered as a “money services business” with Florida or federal regulators. An undercover detective met Espinoza several times and paid him a total of $1500 cash for Bitcoin, earning Espinoza a profit. During those transactions, the undercover detective allegedly made clear his desire to remain anonymous and said he was involved in illicit activity. For example, the undercover detective allegedly told Espinoza that he needed the Bitcoin to buy stolen credit card numbers from Russians.

The Florida appellate court’s determination that Bitcoins are “monetary value” and “payment instruments” under Florida law fits within a line of cases finding that Bitcoin qualifies as “money” for the purposes of money laundering and anti-money laundering laws. For example, in 2014 Judge Rakoff, a United States District Judge for the Southern District of New York, found that Bitcoin clearly qualifies as “money” or “funds” for the purposes of the federal money transmitter statute because “Bitcoin can be easily purchased in exchange for ordinary currency, acts as a denominator of value and is used to conduct financial transactions.” United States v. Faiella, 39 F. Supp. 3d 544, 545 (S.D.N.Y. 2014) (citing SEC v. Shavers, 2013 WL 4028182, at *2 (E.D. Tex. Aug. 6, 2013)). Some states have also codified virtual currency into their anti-money laundering regulations. For example, after the trial court determined that Bitcoin was not a “monetary instrument” that could be laundered under Florida’s money laundering statute, the Florida legislature amended the statutory definition of “monetary instruments” to explicitly include the term “virtual currency.” Fla. Stat. § 896.101(2)(f) (2017). Other states, however, have taken a different approach. Pennsylvania’s Department of Banking and Securities (“DoBS”), for example, recently published guidance that virtual currency, including Bitcoin, is not considered money under Pennsylvania law. “Money Transmitter Act Guidance for Virtual Currency Businesses,” Pennsylvania Department of Banking and Securities (Jan. 23, 2019).

The Florida appellate court found that Espinoza was operating as a “money transmitter” and therefore was a “money services business,” simply by engaging in the business of selling his own Bitcoin for cash and not otherwise acting as a middleman between parties. The trial court had applied the more common and narrow understanding that a “money transmitter” operates “like a middleman in a financial transaction, much like how Western Union accepts money from person A, and at the direction of person A, transmits it to person or entity B,” as explained by the appellate court.

To reach its conclusion, the Florida appellate court looked to the text of Florida’s money services business statute – which the court believes is critically different from federal regulations. Under both federal and Florida state law, a “money services business” is defined to include a “money transmitter.” Compare 31 C.F.R. § 1010.100(ff) with Fla. Stat. § 560.103(22). According to the Florida appellate court, the federal definition of “money transmitter” includes a third-party requirement. Under federal regulations, a “money transmitter” means a person engaged in the “acceptance of currency, funds or other value that substitutes currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.” 31 C.F.R. § 1010.100(ff)(5(i)(A) (emphasis added). In comparison, the Florida statute defines a “money transmitter” as an entity “which receives currency, monetary value, or payment instruments for the purpose of transmitting the same by any means.” Fla. Stat. § 560.103(23). The Florida appellate court found that, in contrast to the federal regulations, the Florida statute’s “plain language clearly contains no third party transmission requirement in order for an individual’s conduct to fall under the ‘money transmitter’ definition” and, as such “decline[d] to add any third party or ‘middleman’ requirement.”

The appellate court’s interpretation of the text of Florida’s statute is disputable. From a statutory interpretation perspective, the middleman requirement is arguably inherent in the plain meaning of the word “transmit,” which is defined by Merriam-Webster as “to send or convey from one person or place to another.” (Notably, Pennsylvania’s DoBS recently issued guidance interpreting the word “transmitting” in a comparable state statute to include a third-party requirement. See “Money Transmitter Act Guidance for Virtual Currency Businesses,” Pennsylvania DoBS (Jan. 23, 2019) (interpreting statute that “[n]o person shall engage in the business of transmitting money by means of a transmittal instrument for a fee or other consideration with or on behalf of an individual without first having obtained a license from the [DoBS]” to impose a third-party requirement).) It would, therefore, be reasonable to interpret Florida’s statute as consistent with federal regulations. Moreover, the Florida appellate court’s interpretation of the statute could have broad and troubling consequences. Although dicta in the Florida appellate court’s decision make it seem like the court is making a distinction between “merely selling [one’s] own personal bitcoins” and “marketing a business,” the court’s statutory interpretation leaves open the possibility that the mere act of selling one’s own property – without registering as a “money services business” – could be a crime.

While we watch to see whether Espinoza will appeal this decision to the Florida Supreme Court, virtual currency dealers should be aware that selling virtual currency in, from or into Florida may require a money services business license and the maintenance of an anti-money laundering program.

Blockvest II: Court Reverses Itself and Grants the SEC a Preliminary Injunction in the Face of Manifest Fraud

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As we previously discussed, the SEC suffered a rare defeat in Securities and Exchange Commission v. Blockvest, LLC et al. on November 27, when Judge Curiel of the U.S. District Court for the Southern District of California issued a denial (the “November Order”) of its motion for a preliminary injunction against Defendants’ future violations of Section 17(a) of the Securities Act of 1933 (“Section 17(a)”), despite manifest evidence of fraudulent representations in the Defendants’ website postings. The November Order attracted intense scrutiny and on December 17, the SEC moved for partial reconsideration of the November Order. Last week, on February 14, the court granted, in part, the SEC’s motion for reconsideration (the “February Order” and, together with the November Order, the “Orders”), relying on purported new evidence and an argument that the court apparently had overlooked. It is fair to ask whether the new evidence motivated the reversal.

As Judge Curiel recited, under the Federal Rules of Civil Procedure, a motion for reconsideration is appropriate, among other reasons, if the district court is “presented with newly discovered evidence.” Judge Curiel stated that the standard for granting a preliminary injunction requires the SEC to show: “(1) a prima facie case of previous violations of federal securities laws, and (2) a reasonable likelihood that the wrong will be repeated.” Based upon these standards, the court concluded that reconsideration in this case was warranted “based upon a prima facie showing of Defendants’ past securities violation and newly developed evidence which support the conclusion that there is a reasonable likelihood of future violations.” However, it is not clear what “newly developed evidence” formed the basis for this conclusion.

In applying the Howey test to the tokens offered by Blockvest, the court agreed with the SEC that “the Howey test is unquestionably an objective one.” The court disputed the SEC’s assertion that in the November Order the court had applied a “subjective test” by relying solely on the beliefs of some individual investors. Rather, the court stated that it had “objectively inquire[d] into the ‘terms of promotional materials, information, economic inducements or oral representations at the seminars, or in other words, an inquiry into the ‘character of the instrument or transaction offered’ to the ‘purchasers.’”

The court emphasized that in the November Order it had denied the motion for a preliminary injunction “because there were disputed factual issues as to the nature of the investment offered to alleged investors.” Nonetheless, the court acknowledged that in denying the SEC’s motion for a preliminary injunction, it did not “directly address” an alternate theory originally presented by the SEC that the promotional materials presented on Defendants’ website, in the whitepaper posted online, and on social media accounts concerning the ICO of the token constituted an offer of unregistered securities that contained materially false statements and therefore violated Section 17(a). The court again applied the Howey test to find that the tokens being offered were securities. The court also rejected the defendants’ arguments that applied state law to interpret “offer” narrowly to require a manifestation of an intent to be bound, finding that “offer” is broadly defined under the securities laws.

The court also found that the SEC had satisfied the required showing that there is a reasonable likelihood of future violations, one of the elements of injunctive relief. In support of its ruling, the court cited the misrepresentations in Defendants’ website postings that had been detailed in the November Order and which were manifestly fraudulent. Based upon this information, addressed by the SEC in supplemental briefing, the court granted partial reconsideration of the November Order.

Also factored into the February Order were the findings that defense counsel had moved to withdraw as counsel because “the firm found it necessary to terminate representation due to, inter alia, Defendants instructing counsel to file certain documents that counsel could not certify under Rules of Civil Procedures 11… and Defendants have yet to find substitute counsel.” The court stated its concerns that Defendants would resume their prior alleged fraudulent conduct, in light of its order allowing defense counsel to withdraw.

Given the severity of the fraudulent representations as alleged in the SEC’s action, which included false claims of approval by federal regulators and a wholly fabricated federal agency, it was surprising that the court had originally denied the SEC’s request for a preliminary injunction; the need to shut down ongoing fraud and protect investors often drives a court’s rulings on requests for interim relief in these cases. It appears that in reversing itself, the court rethought its reasoning based on the information and arguments that the SEC had originally presented. In one telling ruling in the new decision, the court declined to accept new arguments raised by defendants in opposition to the motion for reconsideration because they had not previously raised them. It appears that the SEC can shrug off its original loss and continue to seek to shut down this alleged fraud with all the power of the federal securities laws.

The Token Taxonomy Act: A Fatal Drafting Ambiguity

As we’ve previously written, the Token Taxonomy Act (TTA) is an ambitious and potentially impactful piece of legislation that, by exempting digital tokens from the securities laws, might remove regulatory inhibitions from the maturing digital token industry. The bill is not without fault, however. As it stands, the language of the bill requiring that a digital token’s consensus be inalterable is ambiguously written and the SEC could use a strict interpretation to preclude many digital assets from qualifying as digital tokens.

The proposed additional language of Section 2(a)(20)(B) of the Securities Act of 1933 reads that to qualify for the exemption, a digital token:

(i) must be recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and

(ii) after consensus is reached, cannot be materially altered by a single person or group of persons under common control.

In other words, a digital token must use an inalterable and objectively verifiable process. This language is designed to include in the definition only those digital tokens that are or will be in widespread enough use so that no one single party can influence the nature of the outstanding tokens in a way that adversely affects digital token holders.

The proposed language creates the possibility that the SEC could strictly apply the requirement that a token “cannot” be materially altered. As it stands, proof-of-work and even proof-of-stake digital assets are susceptible to a 51% attack, which could alter the digital token’s consensus. “Proof-of-work” and “proof-of-stake” refer to different systems used to verify and process transactions on a blockchain.

A “51% attack” is an event in which a party takes control of the requisite computer power underlying a token’s blockchain such that the party can control the token platform’s operation. Typically, a party seeking such control needs to possess 51% of the outstanding tokens, but the threshold amount can be lower for individual digital assets. A party that has successfully executed a 51% attack can change the ledger history so that it can, for example, double-spend tokens.

The SEC could negate the potential application of the TTA because the recent 51% attack against Ethereum Classic shows that the risk of attack against proof-of-work digital assets, especially those with a low market capitalization, is real. And although the proof-of-stake system makes a 51% attack prohibitively expensive, the SEC could justifiably claim that it is theoretically possible. An irrational, non-economic actor could still stage a 51% attack against a proof-of-stake digital asset with an intent to destroy it rather than to make profit.

In the end, the ambiguity in the bill’s language might not have a deleterious effect. It is hoped that a regulator would not strictly interpret the bill’s language to exclude the intended beneficiaries because of a hypothetical possibility of a 51% attack. So, too, the digital asset industry will likely continue to innovate new and more secure protocols that could potentially eliminate the threat of 51% attacks, making potential exclusion from the bill’s benefits a moot point. Nonetheless, as the TTA undergoes revision, the potential ambiguity in the proposed language should be remedied.

Transactors in Digital Tokens – New Bill Offers Hope

On December 20, 2018, Representatives Warren Davidson (R-Ohio) and Darren Soto (D-Fla) offered some early holiday hope to digital token issuers by introducing the “Token Taxonomy Act” (the TTA). If passed, the TTA would exclude “digital tokens” from the federal securities laws and would undoubtedly have profound effects for the U.S. digital token economy. The TTA is an ambitious piece of legislation that faces an uncertain future. Nevertheless, Representatives Davidson and Soto should be commended for attempting to provide some regulatory relief and certainty to an industry that has been yearning for it.

In addition to exempting digital tokens from the securities laws, the TTA would amend the Internal Revenue Code and classify the exchange of digital tokens as like-kind exchanges under Section 1031, and allow digital tokens to be held by retirement accounts.

The TTA would also amend language in the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that state-regulated trust companies, which include broker dealers, investment advisors and investment companies, would be able to hold digital assets for customers.

According to the TTA’s authors, the intention behind the bill is to provide much-needed regulatory certainty to digital token issuers and to ensure the U.S. remains competitive against other countries like Switzerland, where blockchain startups are thriving.

However, the TTA’s benefits are hypothetical at this point, since it is likely to be opposed by the SEC. On November 30, 2018, SEC Chairman Jay Clayton opined at a New York Times-hosted event that SEC rules were made by “geniuses” and “have stood the test of time.” He stated that he did not foresee changing rules “just to fit a technology.” While he was not referring specifically to the TTA, these comments indicate an unwillingness by the SEC to change its longstanding rules to accommodate a nascent technology.

Even if the bill is passed, it would permit the SEC to determine whether a particular digital unit qualifies as a security and therefore is subject to the SEC’s regulation. The SEC thus would have the power to halt an offering and force compliance with the applicable securities laws. The TTA would spare issuers from any penalties if they have acted in good faith and take reasonable steps to cease sales. But with an unclear, and a potentially costly or lengthy, appeals process, the SEC could discourage issuers from taking the risk of attempting to qualify and sell digital tokens from the start. This provision would blunt the intended deregulatory impact of the TTA.

Although its future is uncertain, the TTA shows that there are government leaders that are listening to the concerns of the digital token issuers. If the TTA is introduced in the 116th Congress, it will be a piece of legislation worth tracking. Even if this particular bill is not enacted, it might point the way to other legislation whose passage might provide some regulatory relief to those who transact in digital tokens.

Dragged to the U.S. Courts (Part 3): The Importance of a Valid Forum-Selection Clause

We have said it in both part 1 and part 2 of this series: for a U.S. court to exercise its powers over a foreign defendant, it must have personal jurisdiction. But even if the court finds that it has jurisdiction, the defendant can request the court to transfer the case to an alternative forum, even to a different country, under the common law doctrine forum non conveniens. In In re Tezos Securities Litigation, the Swiss defendant Tezos Foundation failed in its attempt to transfer the action to Switzerland because of the operation of its forum-selection clause. In this final part of our series discussing jurisdictional questions for blockchain and cryptocurrency companies, we address two crucial factors that non-U.S. companies should consider when crafting a forum-selection clause.

Once a defendant moves to transfer the case by implicating forum non conveniens, the court will undertake a fact-intensive balancing of private and public factors, such as the location of witnesses and evidence, the enforceability of any judgment, avoidance of unnecessary conflicts of law, and administrative congestion. Generally, courts give great deference to the plaintiff’s choice of forum and transfer the case only if the balance of factors “strongly favors” the defendant. But this analysis changes when the parties have agreed to a valid forum-selection clause. As many courts have noted, and Judge Seeborg repeated in In re Tezos, “Because a valid forum-selection clause is bargained for by the parties and embodies their expectations as to where disputes will be solved, it should be given controlling weight in all but the most exceptional cases.”

In the Tezos case, the Swiss defendant argued that there were no exceptional circumstances preventing the court from giving controlling weight to its forum-selection clause, which stated that “[t]he applicable law is Swiss law [and] any dispute . . . shall be exclusively and finally settled in the courts of Zug, Switzerland.” This forum non conveniens motion, however, failed because the court found that the plaintiff had not been put on notice of the forum-selection clause and thus could not have consented to it.

While forum selection is a complex subject, the Tezos decision demonstrates one necessary requirement for any binding forum-selection clause, dispute-resolution clause, or indeed even contract – consent. Below are two factors from In re Tezos and other cases relating to online businesses that blockchain and cryptocurrency companies should consider if they want their forum-selection clauses to bind their website users:

  1. Choose clickwrap over browsewrap: A clickwrap or clickthrough agreement requires the user to engage with the website, usually by checking an “I agree” or “I accept” box. A browsewrap agreement attempts to bind users of the website by inferring assent to the terms and conditions. Generally, it is easier to prove notice and consent where a clickwrap agreement has been used, since the user is required to take affirmative action to show agreement to the terms and conditions. A browsewrap agreement may also bind the user, but this requires either (i) a showing that the plaintiff had actual knowledge of the agreement, or (ii) the website putting a reasonably prudent user on “inquiry notice” of the terms. The Contribution Terms of the Tezos ICO did not include a clickwrap agreement for the forum-selection clause. And, as discussed next, the browsewrap agreement itself was poorly executed.
  2. When using a browsewrap agreement, make the forum-selection clause visible: The question of whether a user has notice of the terms is likely to depend on the design and content of the website. If a link to a website’s terms of use (which includes the forum-selection clause) is “buried at the bottom of the page or tucked away in obscure corners of the website where users are unlikely to see it,” the courts are likely to refuse to enforce the browsewrap agreement (see Nguyen v. Barnes & Noble Inc., 763 F.3d 1171 (9th Cir. 2014)). Similarly, some courts have found that browsewrap agreements were not enforceable where the link to the terms and conditions was not visible without scrolling down to the bottom of the page, which was not necessary to do to complete the purchase (see Specht v. Netscape Commun’ns Corp, 306 F.3d 17 (2d Cir. 2002)).

A fundamental problem with the Tezos ICO Contribution agreement was that it did not actually include the forum-selection clause but instead had a single sentence, on page ten of the twenty-page agreement, directing users to “refer to the legal document that will be issued by the Foundation for more details.” Adding to the problems, the court noted that the relevant website did not even hyperlink to this legal contract with the forum-selection clause. Finally, Judge Seeborg added that even if Tezos Foundation had added hyperlinks and some language indicating a user’s “purported agreement,” the browsewrap agreement might still be held unenforceable, particularly against individual consumers.

After finding that the terms of the ICO did not provide sufficient notice that the plaintiff had agreed to Switzerland as the forum, the court applied the traditional forum non conveniens analysis and dismissed the transfer motion. Judge Seeborg added, however, that if discovery later shows that the plaintiff was, in fact, aware of the forum-selection clause, then he may consider dismissal or transfer of the case to the courts of Switzerland.