Blockchain and the Law

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.

SEC Qualifies Blockstack and YouNow Regulation A Offerings

Blockstack

On July 10, the Securities and Exchange Commission (the “SEC”) qualified Blockstack PBC’s (“Blockstack’s”) offering circular, enabling Blockstack to commence sales and distribution of up to $40 million worth of its Stacks Tokens (“Stacks”) under Regulation A. This marks the first time in history that the SEC has qualified a Regulation A offering of blockchain-native digital assets.

We previously covered the initial public filing of Blockstack’s April 11, 2019 preliminary offering circular (which was originally filed by Blockstack’s subsidiary, Blockstack Token LLC) here. Blockstack Token LLC subsequently filed an amended preliminary offering circular on May 16; then Blockstack filed a further-amended version on July 10.

The SEC’s decision to qualify Blockstack’s offering circular represents a milestone for Blockstack, as well as the blockchain industry as a whole. It is a key step down what may be a viable pathway for companies to raise capital to develop open, cryptographically secured networks powered by digital assets.

Much, however, remains to be determined from a regulatory standpoint, including:

  • At what point, if at all, can Blockstack realize its stated ambition to no longer treat Stacks as securities under the federal securities laws? While Blockstack’s stated ambition is theoretically consistent with recent SEC staff guidance, which stated that the analysis of whether a digital asset represents an investment contract (and thus, a security) may change over time, the SEC’s guidance only provides a litany of factors that may be relevant to this determination; there is no bright line.
  • Will Blockstack need to register the Stacks as a class of equity securities under Section 12(g) of the Securities Exchange Act, and thereby become a fully-fledged public reporting company? Conspicuously, the final offering circular removes disclosure contained in the May 16 version stating Blockstack’s determination that Stacks should be classified as “debt” (as opposed to “equity”) securities, thereby taking them outside the purview of Section 12(g). And while Regulation A contains a conditional exemption from Section 12(g) for Tier 2 offerings such as Blockstack’s, the exemption requires (among other things) that the issuer utilize a SEC-registered transfer agent, which Blockstack is not doing.
  • Are persons who run validator nodes on the Blockstack network required to register as broker-dealers under the federal securities laws? Are these persons, or Blockstack, required to register as a clearing agency or transfer agent under the federal securities laws? Must Blockstack register with FinCEN as a money services business, or obtain a BitLicense from the New York State Department of Financial Services? The offering circular (along with exhibits thereto) sets forth Blockstack’s reasoning for why, in their belief, no such registration or licensing is required. However, this does not mean that applicable federal and state regulators will agree.

These uncertainties – among others – should be carefully considered by market participants moving forward with similar offering structures. Nevertheless, the value in the precedent that Blockstack has now set is undeniable.

YouNow

Indeed, other companies are already moving forward with similar approaches. Most notably, yesterday, the SEC also qualified the Regulation A offering circular of YouNow, Inc. (“YouNow”), for up to $50 million worth of Props Tokens (“Props”). Rather than solicit cash (or cryptocurrency) consideration for the sale of Props, YouNow and its affiliate, The Props Foundation Public Benefit Corporation, will use YouNow’s Regulation A program solely to distribute Props as rewards and grants to users, developers and other contributors within YouNow’s network of consumer-facing digital media applications.

Who’s next?

As Bitcoin’s Price Moves Dramatically, ETF Proposals Remain at a Standstill

On June 26, the price of bitcoin surged to a 12-month high of nearly $13,900 (up about 35% on the month) before losing more than $1,700 in a span of 15 minutes, then rebounding slightly and closing the day at around $12,800. All the while, retail and institutional investors seeking to gain exposure to this volatile asset class through an exchange traded product continued their wait. The Securities and Exchange Commission’s (“SEC”) evaluation of the listing proposals filed by CBOE BZX Exchange, Inc. (“CBOE”) and NYSE Arca, Inc. (“NYSE Arca”) – first covered here – remains ongoing and could continue through September.

Initially, the SEC had 45 days from each proposals’ publication in the Federal Register to issue a decision or request an extension. The agency may extend this deadline up to a total of 240 days.

The SEC has extended its deadline twice since the proposals were filed in January, citing the need for further analysis of the proposals’ conformity with the anti-fraud and anti-manipulation provisions of Section 6(b)(5) of the Securities Exchange Act of 1934. In March, the SEC requested public comment on several additional policy questions under consideration for what, if approved, would be the first bitcoin exchange traded product. So far, the SEC has received 49 comment letters for the NYSE Arca proposal and 35 for the CBOE proposal.

On May 1, 2019, NYSE Arca amended its proposal in response to SEC concerns. Such information includes evidence regarding the maturation of the bitcoin market in recent years, the product’s resistance to market manipulation, and how the structure and operation of the proposed Bitwise Bitcoin ETF Trust would protect investors.

A registered bitcoin exchange traded product would open up bitcoin investing to a broader segment of the population by making it possible for investors to get exposure to bitcoin without the sometimes perilous processes of purchasing bitcoin on the open market and managing the public-private key pairs associated with direct bitcoin ownership. It remains unclear if or when exchange traded products will be available. For now, all we know for certain is that the SEC will continue their evaluation, and that bitcoin’s price will continue to move.

Cover Article: Practical Law – The Journal, June/July Issue | “Supply Chain Management – Implementing Blockchain Technology”

We are happy to report that our recent in-depth Practice Note on Blockchain as applied to Supply Chain Management was selected to appear as the cover story for the June/July issue of Practical Law – The Journal. Read the full text here.

SEC Sues Kik for ICO

On June 4, 2019, the U.S. Securities and Exchange Commission (the “SEC”) filed a complaint in the Southern District of New York against Kik Interactive Inc. (“Kik”) alleging violations of Section 5 of the Securities Act of 1933 (the “Securities Act”).

The complaint arises from Kik’s offer and sale of $100 million worth of blockchain-based digital assets known as “Kin Tokens” from May to September 2017.

In that time period, Kik sold Kin Tokens both (1) to accredited investors pursuant to Simple Agreements for Future Tokens (or “SAFTs”) and (2) in a general public sale to purchasers in select jurisdictions, including the United States.

The SEC claims that Kik thereby offered and sold unregistered, non-exempt “investment contracts” – a form of securities – in violation of Sections 5(a) and 5(c) of the Securities Act.

(According to the SEC, although Kik attempted to sell discounted Kin Tokens under the SAFTs in satisfaction of the exemption from registration provided by Rule 506(c) under Regulation D, the subsequent delivery of Kin Tokens to SAFT purchasers in September 2017 constituted an offer and sale of securities that was either part of the same offering as the general public sale or alternatively, should be integrated with that offering. And, because Kik did not take reasonable (i.e., any) measures to verify that purchasers in the general public sale were accredited investors, the offering as a whole failed to satisfy the requirements of Rule 506(c) and thus was required to be registered with the SEC.)

Kik has been vocal in their opposition to the enforcement action and commitment to litigate.

In January 2019, Kik made its Wells Response publically available in a blog post entitled, “Four Commissioners at the SEC are About to Vote on the Future of Crypto in the U.S. You Need to Know Why We’re Fighting Back.”

More recently, Kik teamed up with other market participants to launch Defend Crypto, a donation platform that has raised over $4.4 million worth of digital assets to fund Kik’s litigation war chest.

Finally, in response to the SEC’s complaint, Kik’s General Counsel reportedly stated that:

For the reasons set forth in our Wells Submission, the SEC’s complaint against Kik is based on a flawed legal theory. Among other things, the complaint assumes, incorrectly, that any discussion of a potential increase in value of an asset is the same as offering or promising profits solely from the efforts of another; that having aligned incentives is the same as creating a “common enterprise”; and that any contributions by a seller or promoter are necessarily the “essential” managerial or entrepreneurial efforts required to create an investment contract. These legal assumptions stretch the Howey test [the four-pronged test for determining whether a transaction, contract or scheme constitutes an investment contract] well beyond its definition, and we do not believe they will withstand judicial scrutiny.

If Kik does indeed proceed to trial, its outcome will, one way or the other, reverberate throughout the industry. Stay tuned.

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