Blockchain and the Law

Smart Contracts: Best Practices

Proskauer authored an in-depth Practice Note published by Practical Law, which details best practices for the use of smart contracts on blockchains. It discusses functional and legal considerations for both standalone smart contracts and smart contracts used in conjunction with traditional written contracts (hybrid smart contracts) and explores the extent to which smart contracts can independently be legally binding.

The full text of our Practice Note is available here: Smart Contracts: Best Practices

 

CFTC, FinCEN, and SEC Warn of Crypto AML Enforcement

Based on a recent regulatory statement, entities involved with cryptocurrency or digital assets should revisit their anti-money laundering and countering the financing of terrorism obligations (AML/CFT) compliance under the Bank Secrecy Act (BSA).

On October 11, the leaders of the Commodity Futures Trading Commission (CFTC), the Financial Crimes Enforcement Network (FinCEN), and the Securities and Exchange Commission (SEC) issued a joint statement (the “Joint Statement”) regarding the application of the BSA to activities involving digital assets. The Joint Statement “reminds” those involved with such activities of their AML/CFT obligations and specifically calls out those entities that would be subject to such obligations: futures commission merchants and introducing brokers (regulated by the CFTC), money services businesses (regulated by FinCEN), and broker-dealers and mutual funds (regulated by the SEC).

Potentially indicating a key concern of the regulators going forward, the Joint Statement notes that the applicability of AML/CFT obligations is not dependent on the terminology surrounding the applicable assets, but rather the nature of the assets themselves: “Regardless of the label or terminology that market participants may use, or the level or type of technology employed, it is the facts and circumstances underlying an asset, activity or service, including its economic reality and use (whether intended or organically developed or repurposed), that determines the general categorization of an asset, the specific regulatory treatment of the activity involving the asset, and whether the persons involved are “financial institutions” for purposes of the BSA.” Thus, while market participants refer to digital assets in many different ways, how assets are referred to should not have a bearing on BSA compliance. By way of example, the Joint Statement offers that “something referred to as an ‘exchange’ in a market for digital assets may or may not also qualify as an ‘exchange’ as that term is used under the federal securities laws.”

Following the general statement, each leader provides additional comments, which should guide entities subject to each applicable regulator’s review. Heath Tarbert (Chairman, CFTC) notes that introducing brokers and futures commission merchants are required to report suspicious activity and implement reasonably-designed AML programs, regardless of whether the digital assets qualify as commodities or are used as derivatives. Kenneth A. Blanco (Director, FinCEN) advises those handling digital assets to review FinCEN’s May 2019 interpretive guidance, under which FinCEN makes clear that many digital asset activities would qualify a person as a money services business subject to AML/CFT obligations (unless the person is registered with and functionally regulated and examined by the SEC or CFTC, whereby they would be subject to the BSA obligations of those regulators).  Jay Clayton (Chairman, SEC) reminds persons engaged in activities involving digital assets as securities that they remain subject to federal securities laws, but certain rules also apply regardless of whether the assets are securities, such as broker-dealer financial responsibility rules.

The Joint Statement is yet another warning to the cryptocurrency markets following each regulator’s recent steps to clarify their positions on digital assets. This follows closely after the SEC’s April 2019 release of its “Framework for ‘Investment Contract’ Analysis of Digital Assets” and July 2019 joint statement on broker-dealer custody of digital asset securities with the Financial Industry Regulatory Authority. Additionally, FinCEN cited their May 2019 guidance which came shortly after FinCEN levied its first civil penalty against a peer-to-peer virtual currency exchanger for failure to meet AML requirements, amongst other violations, in April 2019.

The fact that the Joint Statement was issued jointly by multiple regulators may signal that the regulators intend to bring parallel actions in cases where they share jurisdiction, so entities operating under shared jurisdiction would have to deal with multiple cases at once. Such entities should not assume that if one regulator brings a case then the other regulators will not also do so. If anything, this Joint Statement makes clear that the regulators are most interested in those entities handling digital assets that had previously operated as though the AML/CFT obligations did not apply to them, so those without such programs in place should carefully evaluate their compliance in the near future.

SEC Attempts to Halt Telegram’s Planned Token Distribution

On October 11, 2019, the SEC filed an emergency action to stop Telegram (Telegram Group Inc. and its wholly owned subsidiary TON Issuer Inc.) from continuing its offering of tokens. Telegram raised approximately $1.7 billion in early 2018 through the sale of its tokens, dubbed “Grams”, which it originally committed to deliver to purchasers from the sale by the end of this month. The SEC brought the action to prevent Grams from “flood[ing] the U.S. capital markets.” The company filed a response a few days later and, according to Bloomberg, in a separate email to investors proposed delaying the distribution of Grams until April of next year and requested their approval.

The SEC alleged in its complaint that Grams are securities and that Telegram failed to register the offering in accordance with the Securities Act. The SEC’s analysis followed its previously released framework for determining whether a digital asset is an “investment contract” (and therefore a security), focusing on the main issue of a purchaser’s expectation of profit. The SEC argues that Telegram led purchasers to expect profit because, among other actions, Telegram told purchasers that Grams would be listed on “major cryptocurrency exchanges” and sold Grams at “deeply discounted prices from its own projected secondary market price at launch.”

Telegram reiterated the argument that the 2018 purchase agreements for Grams are securities, but continued to deny that Grams themselves are securities, instead arguing that they are merely a currency or commodity. It also emphasized its previous cooperation with the SEC, including producing documentation, participating in in-person presentations and regular communication with the SEC. It is important to note that, consistent with its position, Telegram has previously filed two Form D filings with the SEC for the purchase agreements, claiming exemptions from registration with the SEC under Rule 506(c) and Regulation S. Form D filings are required by issuers claiming an exemption from registration under U.S. securities laws, while Regulation S is a “safe harbor” for the offshore sales of securities.

Despite Telegram’s efforts and apparent cooperation, the SEC has nonetheless decided to take the step of attempting to enjoin Telegram from issuing Grams. In a press release, Steven Peikin, the Co-Director of the SEC’s Division of Enforcement, stated, “Telegram seeks to obtain the benefits of a public offering without complying with the long-established disclosure responsibilities designed to protect the investing public.” Companies should continue to exercise caution when participating in the offering of digital assets, especially where certain characteristics of the assets or the offering fall under the SEC’s analysis of the assets as securities under its framework. If the digital asset in question is considered a security, offerings are not prohibited, but may need to be registered with the SEC if the facts and circumstances require it.

IRS Answers Some, but Not All, Questions in Long-awaited Cryptocurrency Guidance

The first official guidance on the taxation of cryptocurrency transactions in more than five years has been issued.

The guidance includes both a Revenue Ruling (Rev. Rul. 2019-24, 2019-44 I.R.B. 1) and answers to Frequently Asked Questions on Virtual Currency Transactions (the “FAQs,” together with Revenue Ruling 2019-24, the “Guidance”) was issued on October 9, 2019 by the U.S. Internal Revenue Service (the “IRS”).  The Guidance provides much sought information concerning the tax consequences of cryptocurrency “hard forks” as well as acceptable methods of determining tax basis for cryptocurrency transactions.  The Guidance also reasserts the IRS’s position, announced in Notice 2014-21, 2014-16 I.R.B. 938, that cryptocurrency is “property” for U.S. federal income tax purposes and provides information on how the rules generally applicable to transactions in property apply in the cryptocurrency context.  However, important questions remain unanswered.  It remains to be seen whether more definitive regulatory or administrative guidance is forthcoming.

The Guidance comes amidst an ongoing campaign by the IRS to increase taxpayer compliance with tax and information reporting obligations in connection with cryptocurrency transactions.  In 2017, a U.S. district court ordered a prominent cryptocurrency exchange platform to turn over information pertaining to thousands of account holders and millions of transactions to the IRS as part of its investigation into suspected widespread underreporting of income related to cryptocurrency transactions.  Earlier this year, the IRS sent more than 10,000 “educational letters” to taxpayers identified as having virtual currency accounts, alerting them to their tax and information reporting obligations and, in certain cases, instructing them to respond with appropriate information or face possible examination.  Schedule 1 of the draft Form 1040 for 2019, released by the IRS shortly after publishing the Guidance, would require taxpayers to indicate whether they received, sold, sent, exchanged, or otherwise acquired virtual currency at any time during 2019.[1]

Taxpayers who own or transact in cryptocurrency or other virtual currency should consider carefully any tax and information reporting obligations they might have.  Please contact the authors of this post or your usual Proskauer tax contact to discuss any aspect of the Guidance.  Read the following post for background and a detailed discussion of the Guidance.

Except where the context indicates otherwise, the tax consequences discussed in this post generally apply to transactions involving cryptocurrency held by a taxpayer as a capital asset.  This post does not consider tax consequences other than U.S. federal income tax consequences.

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CFTC Chairman States Ether is a Commodity

In remarks made at the Yahoo! All Markets Summit in New York, Heath Tarbert, Chairman of the U.S. Commodity Futures Trading Commission (CFTC), said that he believed the Ether cryptocurrency was a “commodity” and should be regulated under the Commodity Exchange Act (CEA). This statement follows the agency’s December 2018 announcement that it was seeking public comment to better understand the technology, mechanics and markets for virtual currencies beyond Bitcoin, namely Ether and the Ethereum network. The “commodity” issue has come up previously in court proceedings regarding virtual currency offerings, with some courts finding that the virtual currencies at issue were commodities subject to CFTC jurisdiction.  However, this was the first announcement by the CFTC Chairman regarding Ether’s characterization as a commodity.

“A commodity has a very broad definition. […] We’ve been very clear on Bitcoin. Bitcoin is a commodity under the CEA. We haven’t said anything about Ether…until now. It is my view as Chairman of the CFTC that Ether is a commodity and therefore it will be regulated under the CEA. And my guess is that you will see in the near future Ether-related futures contracts and other derivatives potentially traded.”

The Chairman also responded to what the interviewer characterized as “murky” regulation surrounding cryptocurrency (and related securities law issues) and explained how the nature of a virtual asset might even change over time:

“The analysis can be somewhat challenging, but ultimately the question is: Is it a security, first and foremost? And if it’s not a security, it is most likely a commodity.  So that is the initial test. Unlike other kinds of investment contracts, a digital asset can transform itself throughout time.  You can have a situation where something in an initial coin offering is a security, but over time, the system becomes more and more decentralized, the enterprise that originally sponsored the currency is no longer in the fore and there’s an intangible value there, so you can have things that switch back and forth.  [One could imagine another potential scenario] where something is decentralized but then all of a sudden, the company gets more involved in it, it starts to look more like a common enterprise, where profits are derived from the activities of others, thereby meeting the Howey test.”

The CFTC Chairman also offered an opinion on forked digital assets, such as Bitcoin Gold, that have “spun off” from the original cryptocurrency, and how such forked currencies might be treated by the agency:

“It stands to reason that similar assets should be treated similarly. If the underlying asset, the original digital asset, hasn’t been determined to be a security and is therefore a commodity, most likely the forked asset will be the same. Unless the fork itself raises some securities law issues under that classic Howey Test.”

While the remarks by the CFTC Chairman are not officially binding as a regulatory matter, they are important to understanding the evolving regulatory environment (note, last year’s statement by SEC Director William Hinman at the All Markets Summit regarding offers and sales of Ether not being securities transactions). We will continue to follow the regulatory developments surrounding cryptocurrencies, including Libra, the stablecoin being developed by Facebook, which Chairman Tarbert commented the agency was still studying.

New York State Department of Financial Services Establishes New Research and Innovation Division

On July 23, the New York State Department of Financial Services (the “DFS”) issued a press release announcing the establishment of a new Research and Innovation Division (the “Division”) within the DFS.

The Division will take on the responsibility of licensing and supervising entities engaged in “virtual currency business activity” that fall within the scope of New York’s BitLicense regime, in addition to supporting market innovation within the state’s financial services industry more generally.

Newly appointed DFS Superintendent Linda Lacewell stated that the establishment of the Division “positions DFS as the regulator of the future, allowing the Department to better protect consumers, develop best practices, and analyze market data to strengthen New York’s standing as the center of financial innovation.”

For market participants in the blockchain and digital assets industry, this development should indicate progress. Among the complaints most frequently levied against New York State’s beleaguered BitLicense regime, inadequate efficiency in processing applications and a perceived lack of technological expertise within the DFS are often near the top of the list. The establishment of the Division should theoretically help to mitigate these concerns.

Nevertheless, some will certainly take the position that short of re-tooling the rules of the BitLicense itself, New York State will remain an undesirable location for operating certain blockchain and digital asset businesses. Perhaps the New York State Digital Currency and Blockchain Task Force, established earlier this year with a mandate to review and make recommendations concerning the impact of the BitLicense regime, will provide an impetus for such change.

Utah Passes the Third State-Run “Sandbox” for Innovative Financial Products and Services

Utah’s governor recently signed into law H.B. 378, which created a sandbox program for companies providing “innovative financial products or services” in the state. The program, run by Utah’s Department of Commerce, requires companies to apply and meet certain requirements in order to participate in the sandbox. Importantly, H.B. 378 specifically includes “blockchain technology” within its scope.

The Utah Sandbox

Companies accepted into Utah’s sandbox are permitted to test their business models without any state license or authorization that might otherwise be required, including any federal law requiring state licensure, on a limited basis (i.e., up to 24 months).

In order to participate in Utah’s program, an applicant must have a physical location in Utah where testing of the product or service takes place, and the product or service may only be tested with Utah residents. Applicants must also provide information describing how the product or service will benefit consumers and is different from existing products or services, what risks consumers may face, and how the applicant plans to test the product or service.

Comparable Programs

Utah is the third U.S. state to pass legislation establishing a sandbox for Fintech companies. Arizona passed its sandbox legislation in March 2018 and Wyoming enacted sandbox legislation in February of this year (see our post regarding Wyoming here).

At the federal level, regulatory sandboxes has been considered, though none have been implemented thus far. For example, Rep. Patrick McHenry (R-NC) introduced H.R. 6118, the Financial Services Innovation Act of 2016, which would have allowed innovative financial product and service companies to apply to federal agencies for exemptions from statutory or regulatory requirements, subject to terms approved by the applicable agencies. Last year, the Consumer Financial Protection Bureau created its Office of Innovation to identify certain areas, such as no-action letters and product sandboxes, that could help foster innovation.

There are also headwinds against the adoption of sandboxes, however. Securities and Exchange Commissioner Hester M. Peirce (who has been referred to as “crypto mom” for her support of innovation in the blockchain and digital asset space), spoke in May last year about regulatory sandboxes at a conference in Los Angeles, CA. In her speech, entitled “Beaches and Bitcoin,” Commissioner Peirce expressed skepticism about the effectiveness of regulatory sandbox programs:

“My fear that regulators will grab hold of the shovels and buckets is why I am often wary of so-called regulatory sandboxes. I am entirely in favor of finding ways to make appropriate regulatory allowances that clear the way for innovation to flourish. What troubles me about sandboxes, however, is that the regulator is typically sitting right there next to the entrepreneurs. The regulator is facilitating and hosting the sandbox.”

In light of such concerns, companies operating in the blockchain and digital asset industry may opt to continue holding on to their own “shovels and buckets” rather than participating in a state-sanctioned sandbox, unless and until the advantages of participation become more clear. Others, however, may find that these sandboxes offer a period of light touch regulatory oversight, which enables them to build out proofs-of-concept without incurring impractical compliance costs at the start-up stage.

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