Blockchain and the Law

Three Critical Questions That Will (Hopefully) be Answered by the SEC’s Lawsuit against Ripple

Late last year, the SEC filed a litigated action in the U.S. District Court for the Southern District of New York against Ripple Labs Inc. and two of its executive officers (collectively, “Ripple”), alleging that Ripple raised over $1.3 billion in unregistered offerings of the digital asset known as XRP. Ripple opted not to file a motion to dismiss the complaint, and based on recent filings it appears that the parties do not believe a pre-trial settlement is likely.

The Ripple case raises three very important questions regarding digital assets, and may provide a vehicle for the SEC or the court to offer answers to those questions.

Read the full post on our The Capital Commitment blog.

SEC Brings Charges against Individuals Behind Allegedly Fraudulent Unregistered Digital Asset Securities Offering

On February 1, 2021, the U.S. Securities and Exchange Commission (SEC) announced that it had brought charges against several individuals involved in an alleged scheme to induce investors to transfer more than $11 million to buy into an unregistered initial coin offering (ICO) of B2G tokens, which the SEC claimed was merely an elaborate sham. (SEC v. Krstic, No. 21-0529 (E.D.N.Y. Filed Feb. 1, 2021)). The complaint, filed in the Eastern District of New York, alleged that Kristijan Krstic (“Krstic”), John DeMarr (“DeMarr”), and Robin Enos (“Enos”) (collectively, “Defendants”) conspired, in violation of securities laws, to defraud over 460 investors of $11.4 million with promises of large returns on investments from its offerings, including for B2G tokens that the defendants claimed were genuine digital assets for a mining and trading platform. Continue Reading

Crypto Asset Regulation: Is the US or UK Keeping Up Best With This Emerging Market?

One driver for the first widely adopted cryptocurrency Bitcoin was to create a store of value that existed outside of government control. It is therefore no surprise that attempts to regulate the rapidly developing crypto asset market have required great efforts from regulators and legislators around the world to keep apace.

In this blog, we compare key drivers and results of the regulatory approach being taken in the US and UK. While the U.S. is leading the way on the enforcement of crypto regulations, the UK has taken greater steps in relation to banking approvals. With regard to tax treatment, the position is becoming much clearer in both jurisdictions.

First though, is there even “an” approach within each country? Continue Reading

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.

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