Blockchain and the Law

First Securities Lending Transaction Using Blockchain Technology Completed

It was reported this month that ING Groep NV and a major international bank recently completed the first live securities lending transaction settled using distributed ledger technology (“DLT”). The transaction involved the banks swapping baskets of government securities through a collateral lending application from financial technology company HQLAx built using bank consortium R3’s Corda DLT. Securities lending transactions involve the temporary exchange of securities (including legal title), usually for other securities or cash of an equivalent value, with an obligation to redeliver a like quantity of the same securities at a future date.

Currently, securities lending transactions require the transfer of underlying securities between party accounts. For this transaction, the banks agreed to transfer legal title to baskets of government securities on the DLT platform by transferring ownership of HQLAx Digital Collateral Records (“DCRs”), while the underlying securities were held at a third-party custodian. According to HQLAx, DCRs created using Corda allow market participants to exchange legal title ownership of and/or pledge baskets of securities in real-time using standardized legal documentation and “haircuts”. Each DCR is intended to be backed by pre-defined baskets of eligible collateral which are stored for safekeeping in a segregated custody account at a trusted third-party custodian. The creator of each DCR has an obligation to maintain securities in the DCR custody account equal to or greater than the notional value of the DCR.

The lynchpin of the transaction is reliance on DCRs to effect legal title transfer of the underlying securities that comprise the DCRs, thereby facilitating liquidity transfers without the requirement to actually move the underlying securities through the custodian infrastructure. The importance of the transfer of legal title is twofold. First, it allows the borrower to deliver the securities onward, for example to settle a short trade. Second, it means that the lender generally receives value in exchange for the disposition of legal title (whether in cash or securities), which ensures that the loan is collateralized.

While HQLAx noted that this was only a pilot transaction, it represents an important milestone and HQLAx is targeting the end of 2018 for rollout of a production-ready securities lending platform.

New SEC Probe of ICO Issuers and SAFT Structure

The Wall Street Journal recently reported that the SEC has issued dozens of subpoenas and information requests in connection with sales and pre-sales of initial coin offerings. As we have previously noted, the SEC Enforcement Division’s Cyber Unit has been targeting ICOs in recent months, and the SEC has provided a number of public statements raising concerns regarding the ICO and cryptocurrency markets.  It now appears that the SEC’s regulatory efforts in this area may be ramping up.

According to the WSJ, the SEC’s current scrutiny is focused in part on “simple agreements for future tokens,” or SAFTs. SAFTs are one type of offering structure designed to insulate issuers of digital tokens from the risks of non-compliance with the federal securities laws.  A typical SAFT structure will involve the sale of tokens for future delivery, with the sale made at a time when the tokens have either not yet been created or have not yet been issued due to the pre-functional development status of the network. Generally, issuers may treat the SAFT itself as a security, and take steps to structure the SAFT transaction so that it complies with an appropriate registration exemption or safe harbor under the Securities Act (including the filing of a Form D with the SEC in connection with the offering of the SAFT).

Proponents of the SAFT project have argued that the tokens sold pursuant to a SAFT are not securities under the federal securities laws, even if the SAFT itself is a security (although, since the initial SAFT white paper was published, the SEC has more specifically stated its views on when digital tokens will be considered securities). Critics of the SAFT project have argued that bifurcating the purchase of digital tokens through a SAFT may bring additional scrutiny of the transaction, and could, contrary to the purpose of the offering structure, make it more likely that a court would determine that the underlying token is a security. If the WSJ is correct and the SEC is targeting this transaction structure in particular, we may soon get additional clarity.

New York State Department of Financial Services Issues Guidance to Virtual Currency Entities

On February 7, 2018, the New York State Department of Financial Services (“DFS”) issued guidance for all virtual currency entities licensed by New York State regarding the prevention of market manipulation, fraud, and other wrongdoing. According to DFS, New York has granted four licenses and two charters to virtual currency businesses to date.

In its guidance, DFS directed virtual currency entities to adopt measures that include, at a minimum, effective implementation of a written policy that:

  • Identifies and assesses the full range of fraud-related and similar risk areas, including, as applicable, market manipulation;
  • Provides effective procedures and controls to protect against identified risks;
  • Allocates responsibility for monitoring risks; and
  • As part of its procedures and controls to protect against identified risks, virtual currency entities must provide for the effective investigation of fraud and other wrongdoing, whether suspected or actual, including, as applicable, market manipulation.

The guidance also reminds virtual currency entities that, immediately upon discovery of any fraud or wrongdoing, they must submit a report to notify DFS of the pertinent details known at the time.

Legal and compliance professionals involved in digital or virtual currencies should familiarize themselves with the new guidance and review their written policies to ensure compliance. It is not only the SEC and CFTC that are actively regulating cryptocurrencies and cryptocurrency-related assets – state-level regulators are also getting involved. In addition to the CFTC’s and SEC’s positions on their jurisdiction over virtual currencies as commodities or securities, state regulators are also looking for fraud, market manipulation or other wrongdoing in this area.

BitConnect Promoters Targeted in Class Action Suits, Twice in One Week

BitConnect International, PLC had a somewhat unique business model, even for an industry known for its unconventional nature.  On its face, BitConnect functioned as an exchange. However, the real purpose of the platform, and what led to its ultimate downfall, was its lending program. BitConnect “borrowed” the crypto investments of its customers in exchange for an equal value of its own native coin, BitConnect Coin or BCC, along with promises of astronomical returns on those BCC holdings. These promises were often made by well-known social media personalities that received significant compensation. However, after BitConnect was hit with two cease-and-desist orders from the Texas and North Carolina state securities regulatory bodies in the lead-up to the launch of a new coin, dubbed BitConnectx, the company closed its exchange and the price of BCC dropped by over 90%. This drop caused investors to lose millions of dollars, as they had traded other cryptocurrency and fiat currency for BCC, which rapidly devalued and became largely functionless cryptocurrency.

This spurred two class action lawsuits. The first suit, filed in federal court in Florida, alleges that BitConnect operated like a Ponzi scheme, taking the investments of new investors to pay returns to earlier investors before it ultimately folded. The suit stands out as it names not only BitConnect’s affiliated business entities and insiders, but also five individuals paid to promote the exchange through social media outlets, primarily YouTube and Facebook. The second suit filed in federal court in Kentucky, includes similar allegations but only names BitConnect, along with one promoter, Ryan Maasen, as defendants. These promoter-targeted suits may have been spurred by two statements released by the U.S. Securities and Exchange Commission in November and December of last year, which clarified the SEC’s position that promoters of initial coin offerings and other cryptocurrencies which fall under the SEC’s definition of a “security” must comply with federal securities laws. Both cases are still in the preliminary stages pending initial hearings.

These cases and the SEC’s statements send a warning to ICO runners and promoters: Federal regulators are paying close attention to the crypto space and are treating many actions no differently than if they happened in more traditional financial markets, and class action lawsuits may be waiting in the wings for those who push unlawful ICOs or fraudulent schemes. We will be continuing to follow and blog about notable developments in this area.

State-Level Legislation Anticipates Wide-Spread Business Use of Blockchain

On a daily basis, companies are announcing new developments on the adoption of blockchain in core business operations.  However, many of these use cases present unique legal issues.  In order to provide some clarity on some of these issues, and perhaps to offer a blockchain-friendly environment for the operation of blockchain companies, state legislatures around the country are rushing to adopt blockchain-friendly laws.  Among the latest states to join are Florida and Nebraska. Continue Reading

Alleging Fraud, SEC Shuts Down AriseBank’s Celebrity-Endorsed ICO of Purported “Decentralized Bank”

In its latest effort to combat scams in the initial coin offering (ICO) space, the SEC announced today that it has obtained a court order cutting off AriseBank’s ICO of “AriseCoin” tokens, appointing a receiver over AriseBank and freezing AriseBank’s and its co-founders’ digital and other assets. The SEC’s complaint against AriseBank and its co-founders alleges that the ICO, which AriseBank claimed had raised over $600 million and would fund what it touted as the first “decentralized bank,” was an illegal, fraudulent and unregistered offering of securities that violated multiple federal securities laws.

This court order follows a cease-and-desist order issued by the Texas Department of Banking earlier this month in response to regulatory violations by the Texas-based company. That order barred AriseBank from continuing to falsely imply that it engages in the business of banking in Texas and offering services to Texas residents.

The AriseBank ICO was officially endorsed by boxing champion Evander Holyfield. Although Holyfield was not named in the SEC’s complaint, a statement issued by the SEC in November of 2017 cautioned celebrities and other promoters of ICOs that if they promote a virtual token or coin that is a security, then their promoting may be unlawful if they fail to disclose the nature, source and amount of any compensation paid in exchange for their endorsement, and they could also potentially be liable for violations of the anti-fraud provisions of the federal securities laws or for offering unregistered securities.

Supply Chain Adoption of Blockchain Continues to Gain Steam and Generates Many Legal Issues

While there has been a great deal of attention being paid lately to the use of blockchain for the issuance and investment (or speculation) in cryptocurrencies, other enterprise-based applications of blockchain continue to be deployed with increasing frequency but less fanfare.

One of the more recent deployments of blockchain – viewed as a milestone in the world of supply chain logistics – is based on Easy Trading Connect (“ETC”), a blockchain-based system developed by a consortium of companies led by Dutch financial institution ING. The system was initially designed to manage commodity trading funds transactions. The most recent transaction, involving a shipment of soybean cargo, is believed to be the first agricultural commodity sale processed completely “on chain” (e.g., on a blockchain-based system). The ETC was used to process all steps of the transaction, and reportedly no paper contracts, certificates or other similar documents changed hands. According to ING, the system reduced what is traditionally a process of 11-14 days to only four days.

This is not the first deployment of ETC – in 2017, it was used to handle the sale of an oil consignment. The shipment at issue was resold three times through the system before it actually left its departure point. The banks involved reportedly reduced the cost typically associated with these types of transactions by thirty percent. Continue Reading