Blockchain and the Law

SEC Responds to Wyoming’s Opinion on Custody of Digital Assets and Qualified Custodian Status

The U.S. Securities and Exchange Commission (“SEC”) issued a statement in response to the Wyoming Division of Banking’s No-Action Letter on Custody of Digital Assets and Qualified Custodian Status.

in October, the Wyoming Division of Banking granted Two Ocean Trust, a Wyoming-chartered public trust company, “no action” relief setting forth the first opinion by a state or federal banking regulator to permit a financial institution to act as a “qualified custodian” under the Advisers Act of 1940 (“Advisers Act”) for digital assets. The no-action letter is Wyoming’s latest move to further establish the state’s position as the digital asset epicenter of the U.S.

The SEC “Custody Rule” (Rule 206(4)-2 under the Advisers Act) requires that registered “advisers that have custody of client funds or securities [maintain] those assets with broker-dealers, banks, or other qualified custodians.” In turn, only financial institutions that are deemed “qualified custodians” under federal law may provide custodial services to the public.

The Wyoming Division of Banking determined that Two Ocean Trust meets the definition of “bank” under the Advisers Act and may serve as a “qualified custodian” for both digital and traditional assets. The Wyoming Division of Banking also stated that it “will not recommend an investigation or enforcement action to the SEC on these issues.” Following the no-action letter, Two Ocean Trust announced its offering of the “first comprehensive digital asset wealth management platform”.

In response to the Wyoming Division of Banking’s opinion, the SEC’s Staff of the Division of Investment Management (the “Staff”), along with the SEC’s Strategic Hub for Innovation and Financial Technology (FinHub), issued a statement to reinforce, as stated by the Wyoming Division of Banking, that the no-action letter “should not be construed to represent the views of the SEC or any other regulatory agency.”

The Staff noted that “[d]etermining who qualifies as a qualified custodian is a complicated, and facts and circumstances based, analysis” and that the SEC “has limited the types of financial institutions that may act as qualified custodians to those institutions that possess key characteristics, including being subject to extensive regulation and oversight, that help to ensure that client assets are adequately safeguarded.”

The Staff solicited comments to inform and support “staff recommendations to amend the Custody Rule”—an opportunity that will play a critical role in the development of the cryptocurrency industry and how it will operate under state and federal law.

Traditional Supply Chain Challenges During COVID-19 Spur Innovation in Blockchain Applications

Before the onset of the COVID-19 pandemic, companies were already exploring the promise of blockchain to modernize certain aspects of their supply chains.  Traditional supply chains can be inefficient, data intensive and costly, often characterized by burdensome paperwork, conflicting records and delays resulting from manual reconciliation processes involving a series of transactions and document exchanges among multiple parties.  Blockchain offers potentially substantial benefits in this context, including the secure and auditable validation of transactions, automated documentation to support legal and customs compliance, improved quality control, enhanced end-to-end transparency (e.g., for verifying sustainability or ethical sourcing standards), and overall improvements in efficiency and cost-control.

Indeed, ever since news reports in 2018-19 that Walmart had successfully tested a blockchain platform for food traceability and accountability to track mangoes and other products through the supply chain, entities have been looking in earnest at, and investing in, blockchain solutions targeting the supply chain. Indeed, Walmart has continued to invest and conduct trials of blockchain solutions, having recently announced in August the promising results of Walmart Canada’s use of blockchain technology to reduce inefficiencies and invoice disputes for freight and trucking payments. Blockchain applications in the supply chain to date have largely been in the testing or pilot phase, however, due to the complex array of necessary considerations.

As a preliminary step, companies seeking to leverage blockchain solutions need to assess blockchain’s potential applications and advantages, the practical aspects of transitioning away from legacy systems, and the legal and operational issues associated with the use of blockchains. Before going live, participants in a private blockchain must first understand and be satisfied with how the blockchain will be implemented and administered, including, for example, which parties will be responsible for maintaining the blockchain, which data will be stored “on-chain” or “off-chain” to achieve the desired functionality without compromising the confidentiality of certain proprietary data, and how cybersecurity and data origin integrity issues will be handled. In many situations, an overarching written legal agreement among the various participants is necessary to ensure clear and robust governance and to address key legal issues. Also, testing a blockchain solution in the supply chain context is necessarily a collaborative affair (e.g., it may involve assembling a consortium) because a working platform that delivers business value in a supply chain will require participation by the various players in the ecosystem. This can raise antitrust compliance considerations, requiring careful structuring.  Thus, while there was optimism in using blockchain to bring the supply chain into a new digital age before the pandemic, many organizations felt that implementation could wait.  However, the COVID-19 outbreak has spurred changes in that mindset. Continue Reading

Kraken Becomes First Digital Asset Company to Receive U.S. Bank Charter

Kraken recently announced that it “is the first digital asset company in U.S. history to receive a bank charter recognized under federal and state law, and will be the first regulated, U.S. bank to provide comprehensive deposit-taking, custody and fiduciary services for digital assets.”

Kraken obtained a charter from the State of Wyoming to operate the world’s first special purpose depository institution (SPDI). In 2019, Wyoming enacted a law to authorize the chartering of SPDIs as a new form of bank, to facilitate the establishment of financial institutions with the requisite expertise to provide banking services to blockchain innovators.

Kraken currently operates one of the largest cryptocurrency exchanges, and it noted that its SPDI’s banking services “will be seamlessly integrated into the existing exchange services, providing clients better funding infrastructure, a better experience and enhanced regulatory clarity.”

According to Kraken’s blog post, during its first year of operations, the SPDI’s services will include digital asset custody, demand/deposit accounts, and wire transfer and funding services. Kraken noted, over the next few years, it plans to support additional services such as enhanced digital asset custody offerings, services specific to individual accounts and corporate clients, including, with respect to the former, a debit card to spend crypto funds and a complete online and mobile banking suite of products, as well as additional retail, wealth management and treasury services.

Kraken will operate its bank via an online and mobile-first banking model, initially offering accounts to only U.S. residents, with plans to expand globally—as stated in its announcement, “Kraken’s vision is to become the world’s trusted bridge between the crypto economy of the future and today’s existing financial ecosystem.”

New York Proposes Conditional BitLicense Framework

The New York State Department of Financial Services (the “NYDFS”), as a part of a series of virtual currency initiatives, proposed in June a framework for applying for and obtaining a virtual currency Conditional BitLicense. The framework is aimed at easing the process for businesses to enter the New York virtual currency marketplace and providing further clarity in a complex area of regulation.

In 2015, the NYDFS issued its first comprehensive rules for regulating firms dealing in virtual currency, 23 NYCRR Part 200. That regulatory regime outlined the NYDFS’s authority to grant licenses to operate a virtual currency business in New York (“BitLicenses”) and a conditional version of that license (“Conditional BitLicenses”). The NYDFS had not, however, established clear rules for applicants to obtain a Conditional BitLicense. As a result, New York virtual currency businesses have, as a practical matter, relied on the BitLicense path, despite its high bar (for example, see here and here).

The NYDFS’s regulatory approach to virtual currency businesses had received criticism from industry players, particularly with respect to the BitLicense’s challenging application process. The NYDFS, in its request for comments on the proposed framework, “recognize[d] that some firms may face actual or perceived hurdles in obtaining a BitLicense. These include a rigorous application process, which can involve a significant expenditure of time and resources for applicants fulfilling the regulatory requirements for strong governance, operational and compliance controls, and capital, among others.” To provide firms an alternative to the BitLicense application process not only in regulation, but also in practice, the NYDFS has proposed a framework to guide applicants to obtain and utilize a Conditional BitLicense.

The proposed framework would permit a firm to engage in virtual currency business activity under a Conditional BitLicense, provided that the firm collaborates with an authorized BitLicensee (i.e., a firm that holds a BitLicense or a New York limited purpose trust charter) for “various services and support, such as those relating to structure, capital, systems, personnel, or any other support needed.”

According to the NYDFS, “the framework can be utilized by a variety of entities, such as startups, growth-stage companies, established New York companies not yet conducting any virtual currency business activity, and established virtual currency companies now operating outside of New York.” While the framework permits a new entrant to initially skip the full BitLicense application process, the NYDFS’s intent is for firms to only temporarily operate under a Conditional BitLicense and eventually apply for a full BitLicense.

The NYDFS provided a general overview of the proposed process a business would follow to obtain a Conditional BitLicense. Among other requirements, an applicant firm must first provide the NYDFS a draft service level (or similar) agreement between it and a fully licensed entity governing the proposed collaboration, and later enter into a supervisory agreement with the NYDFS, which would outline, for example, the allocation of responsibilities and liabilities between the applicant firm and the fully licensed entity, the activities the applicant firm will be permitted to engage in, and the NYDFS’s continued oversight of the applicant firm.

Interested parties and the general public have until August 10, 2020 to submit comments to the NYDFS with respect to the proposed framework, an opportunity for the blockchain and virtual currency industry to help calibrate regulations in this evolving area of law.

The Office of the Comptroller of the Currency Solicits Public Comments on the “Digital Activities” of Banks

On June 3, 2020, the Office of the Comptroller of the Currency (OCC) published an advance notice of proposed rulemaking (ANPR) to solicit public input on the “digital activities” of banks and the impact of emerging technologies on the banking industry. Among other technologies, the ANPR includes questions focused on distributed ledgers, cryptocurrencies and cryptoassets. The OCC, which is an independent bureau of the U.S. Department of the Treasury that regulates and supervises all national banks and federal savings associations, may use public comments received in response to the ANPR to inform its rulemaking activities – an opportunity for the blockchain industry to potentially influence regulations. The OCC’s recent hiring of its new Acting Comptroller of the Currency, Brian Brooks, who was formerly the Chief Legal Officer at a major digital currency exchange, could signal increased attention of the OCC to the future of blockchain technology and cryptocurrency in banking.

Banks, regulators, companies and other organizations that are involved in money transfers or deposits, trading and hedging or the use of digital assets should carefully consider this ANPR, as the ANPR will likely lead to regulations that directly impact their respective businesses. Generally, anyone submitting comments should suggest changes in regulations to appropriately address the new considerations that the deployment of blockchain technology in banking raise and identify regulations that would undesirably stifle technological developments or inadequately protect participants.

The subject matter of the ANPR can be broadly categorized into two groups – questions about future regulations and questions about current regulations.

Regarding future regulations, the OCC seeks to understand technological advancements in areas related to banking, with a goal of better meeting customers’ evolving needs and ensuring that regulations “continue to evolve with developments in the industry.” Some questions that the ANPR invites comments on are geared towards the OCC gaining deeper insight into how the public uses new technologies. For example, one question asks what type of “cryptocurrencies or cryptoassets” an individual is engaged with as well as what distributed ledger technology the individual is using in, or believes could be used in, banking activities. Other questions encourage the public to conceptualize future regulations in light of digital activities. For example, the ANPR invites comments on crypto-related activities that “should be addressed in regulatory guidance.”

Aside from future regulations, the OCC is also evaluating current regulations to determine if they are sufficiently “flexible and clear” or “create unnecessary hurdles” to technological advances in banking. For example, the public will be able to comment on the assessment the OCC uses to determine whether an activity is “convenient or useful,” the threshold test that the OCC employs to determine whether a national bank’s investment activity is sufficiently necessary to the business of banking that it falls within banks’ incidental powers. (Under the current regulations, an activity is convenient and useful if it improves the efficiency, production, or delivery of the bank’s products or services and increases capacity for other bank activities – a broad definition.) Technological advances relevant to various areas of regulations promulgated by the OCC, such as advances in the areas of cryptomining and “layer 2 protocols” may, for example, draw public comments on areas of regulation such as the sale of excess electronic capacity and data processing.

Any potential revisions must satisfy three OCC principles. Any regulation adopted: (1) needs to be technology-neutral so that products, services, and processes can evolve regardless of the enabling technology; (2) should facilitate appropriate levels of consumer protection and privacy; and (3) should be principle-based rather than prescriptive, to manage evolving risks and guard against regulations quickly becoming outdated.

Any comments submitted in response to the ANPR are due by August 3, 2020 and may be used by the OCC to propose revisions or additions to the OCC’s rules. Public input will improve the ability of the OCC to tailor its rulemaking to the needs of different stakeholders and develop a more coherent set of regulations that is in line with technological developments.

Since 2000, the OCC has solicited public comments to calibrate the regulation of national banks’ digital activities. In the rapidly evolving areas of blockchain technology and cryptocurrency, where new implementations, applications and variations are continuously being developed and deployed, the ANPR provides a timely opportunity for the OCC to obtain a more thorough understanding of which changes in regulations may be desirable in continuing to further its mission of fostering the safe, sound and fair operation of national banks and federal savings associations.

Another Blockchain Supply Chain Shipping Consortium Files for Federal Antitrust Exemption

In late May, the Global Shipping Business Network (GSBN), a consortium of ocean carriers and terminal operators, filed a petition with the Federal Maritime Commission (FMC) to obtain an antitrust exemption under the U.S. Shipping Act of 1984. The Act seeks to promote efficient ocean commerce and industry response to international shipping practices by, among other things, providing for antitrust immunity for ocean common carrier agreements filed with the FMC that concern activities outlined in the Act. The FMC is the independent agency charged with regulating oceanborne transportation related to foreign commerce and monitoring agreements among carriers for anti-competitive effects. If the FMC takes no action on a submitted agreement, that agreement becomes effective and federal antitrust laws do not apply to activities undertaken pursuant to the agreement.

In this instance, the requested exemption would allow the members of the GSBN to participate in the operation of a “blockchain-enabled, global trade digitized process” that will enable shippers, authorities and others within the consortium to exchange supply chain-related event data and documents and collaborate with the software provider, CargoSmart. According to the filed Cooperative Working Agreement, the GSBN platform will: (1) provide APIs to the parties for publication of event data with respect to cargo moving through the supply chain; (2) allow for storing and sharing of documents on the platform; and (3) display a user interface for viewing event data, documents and access permissions. Additionally, the agreement places limitations on the handling and internal disclosure of confidential information exchanged among the parties, and also prohibits the parties from sharing intimate details about particular customer agreements or practices or confidential pricing. The GSBN petition was filed on May 26, 2020 (and opened to public comment), and will become effective on July 10, 2020, unless the FMC moves to block the exemption.

This petition comes on the heels of the FMC’s granting of a similar antitrust exemption to another blockchain based shipping consortium, TradeLens, in February 2020. The popularity of blockchain-based shipping consortia is no surprise given the potential for cost savings and efficiencies in a space which is ripe for modernization. However, as one can see, it’s not just technology that is required to establish a blockchain platform for supply chain – parties to a blockchain consortium must ensure all of the appropriate governance is in place as well, which might include operating agreements, antitrust and regulatory approvals, and other related agreements. For deeper insight into the legal and practical issues in this area, please see our Practice Note, Blockchain and Supply Chain Management.

Issuers of Digital Securities May Benefit from Proposed Changes to Regulation A

In March, the Securities and Exchange Commission (SEC) announced proposed rule amendments to “harmonize, simplify, and improve the exempt offering framework to promote capital formation and expand investment opportunities while preserving and enhancing important investor protections,” which may increase the viability of conducting issuances of digital securities. Under the Securities Act of 1933, every offer and sale of securities must either be registered with the SEC or qualify for an exemption from the SEC’s registration requirements. Where appropriate, an offering conducted pursuant to the exempt offering framework may be more efficient and less expensive than a registered offering. The SEC’s proposed amendments aim to facilitate such efficiency, by “[addressing] gaps and complexities in the exempt offering framework that may impede access to investment opportunities for investors and access to capital for issuers.”

In the proposed rule are certain amendments to Regulation A, which the SEC updated in 2015 with “Regulation A+” amendments pursuant to the Jumpstart Our Business Startups Act of 2012. The “Regulation A+” amendments were intended to offer an exemption for small issuances, providing startups and small firms an easier way to raise funds from investors, and established a two-tiered framework for Regulation A offerings. Under Tier 1, issuers may offer and sell up to $20 million of securities over twelve months. Under Tier 2, issuers may offer and sell up to $50 million of securities over twelve months, subject to ongoing reporting obligations.

Last year, the SEC qualified the first Regulation A offering of blockchain-native digital assets: Blockstack PBC raised more than $23 million through its qualified offering under Regulation A and its offering to non-U.S. investors under Regulation S. Offering digital assets pursuant to Regulation A provides certain benefits to issuers. For example:

  • Securities offered and sold under the exemption are not “restricted securities.” Therefore, digital assets purchased in a Regulation A offering generally can be freely transferred by investors after purchase, subject to restrictions on the resale of such securities by affiliates of the issuer.
  • Issuers are permitted to offer and sell securities to a broad U.S. investor base, subject to certain limits on the amount of securities non-accredited investors may purchase under Tier 2 of Regulation A when the offered securities will not be listed on a national exchange.
  • Issuers may “test the waters” using general solicitation before and after the offering circular is filed with the SEC. Any solicitation materials used prior to the public filing of an offering circular that has been qualified must be included as exhibits to the circular – and, in all cases, materials are subject to the SEC’s solicitation rules regarding fraud.

The proposed amendments aim to further the SEC’s initiative to expand and facilitate capital raising opportunities to meet evolving market needs, while also balancing investor protections. SEC Chairman Jay Clayton stated, “[e]merging companies—from early-stage start-ups seeking seed capital to companies that are on a path to become a public reporting company—use the exempt offering rules to access critical capital needed to create jobs and scale their businesses… [t]hese proposals are intended to create a more rational framework that better allows entrepreneurs to access capital.”

The proposed amendments, among other things:

  • Raise the maximum offering amount from $50 to $75 million under Tier 2 of Regulation A and raise the maximum offering amount from $15 to $22.5 million for secondary sales under Tier 2 of Regulation A.
  • Simplify disclosure requirements of Regulation A to establish greater consistency with the requirements for registered offerings.
  • Expand and harmonize certain issuer eligibility qualifications and bad actor disqualification provisions in Regulation A with other sections of the federal securities laws.

The blockchain industry continues to navigate compliance with federal securities laws. Recently, the SEC has taken action against blockchain startups for engaging in initial coin offerings to raise significant amounts of money allegedly without complying with the requirements of the Securities Act. The SEC’s proposed amendments to Regulation A may provide digital asset issuers a more viable alternative for legally raising funds.

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