SEC Determines Interests in Virtual Organizations Are Subject to U.S. Securities Laws

The SEC determined that tokens sold to investors by a “virtual” organization may be considered securities and, thus, are subject to applicable federal securities laws.

In an Investigative Report, the SEC explained that organizations using blockchain or other distributed ledger technology in capital-raising activities must ensure compliance with securities laws. In the report, the SEC scrutinized an incident involving a “Decentralized Autonomous Organization” (“DAO”). A DAO is described as “a ‘virtual’ organization embodied in computer code and executed on a distributed ledger or blockchain.” In this matter, the DAO offered tokens in exchange for initial cryptocurrency investments and eventually was victimized by a hacker who diverted significant cryptocurrency assets raised by the DAO. The SEC investigated whether the DAO had violated securities law by offering and selling unregistered securities.

The SEC decided not to pursue charges but sounded a warning to issuers:

“[Registration] requirements apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”

In an Investor Bulletin, the SEC cautioned investors about potential risks associated with initial coin offerings. The SEC explained the function of distributed ledger technologies, such as blockchain, as well as virtual currency and how it is traded via the exchanges. The SEC warned investors that virtual currency offerings may be particularly susceptible to fraud and theft, and that tracing these currencies is difficult. The SEC noted that virtual currency offerings are often unregistered and operate unlawfully or overseas. As a result, recovering stolen virtual currency can be particularly difficult. The SEC warned investors to be wary of several signs that may indicate investment fraud, including “guaranteed” high rates of return, unsolicited offers and unlicensed issuers.

Lofchie Comment: Notwithstanding the somewhat exotic nature of the relevant asset (i.e., the virtual currency), the SEC’s finding that an asset that represents an ownership interest in a profit-making venture (or that depends on the management expertise of others) is a completely unsurprising result and well within the bounds of existing law.

Bitcoin Exchanges Targeted in Cyberattacks

At least two prominent bitcoin exchanges were targeted by cyberattacks that interrupted normal operations and trading.

BTC-e and Bitfinex were targeted by distributed denial-of-service (“DDoS”) attacks, a form of cyberattack which typically uses multiple compromised systems to flood a target with message traffic that exceeds its processing capacity.  The attacks temporarily disrupted service for both exchanges but reportedly did not cause a loss of funds or protected information. According to a CNBC report, service interruptions like those caused by the DDoS attacks could allow traders to “manipulate the bitcoin market.”

Both exchanges have resumed normal service.

GAO Reports on FinTech

The Government Accountability Office (“GAO”) issued a report on four types of financial technology (“FinTech”): marketplace lending, mobile payments, digital wealth management (also known as “roboadvisor”), and distributed ledger technologies (“DLTs”) such as blockchain. The GAO addressed functionality, risks and benefits, industry trends, and regulatory oversight.

The GAO did not make specific recommendations concerning oversight, noting that very little commonality exists between the differing types of FinTech. However, the GAO acknowledged the challenges involved in regulating FinTech:

“With respect to virtual currencies, federal and state regulators have taken varied approaches to regulation and oversight. The existing regulatory complexity for virtual currencies indicates that regulatory approaches for future applications for DLT will also be complex.”

Lofchie Comment: The GAO report serves as a good introduction to each of the four FinTech subsectors, and to some of the more significant legal and compliance issues that each business raises.

FRB Governor Powell Describes Challenges to Real Time Payment Systems and Blockchain Technology

Federal Reserve System Governor (“FRB”) Jerome Powell described the challenges and policy objectives behind (i) the creation of a real-time retail payment system, (ii) the use of distributed ledger technology for clearing and settlement services, and (iii) the issuance of digital currencies by central banks.

In an address before the Yale Law School Center for the Study of Corporate Law, Governor Powell criticized the sluggishness of the U.S. payment system. He stated: “our traditional bank-centric payments system, sometimes operating on decades-old infrastructure, has adjusted slowly to the evolving demands for greater speed and safety. Innovators have built new systems and services that ride on top of the old rails but with mixed results, and over time, our system has grown more fragmented.” Arguing that “it will take coordinated action to make fundamental and successful nationwide improvements,” Mr. Powell said that efficiency and safety were the FRB’s primary objectives regarding the development of a faster payment system utilizing real-time payments (see FRB Policy on Payment System Risk). Mr. Powell highlighted some of the work being done by the FRB Faster Payments Task Force, which recently completed reviews of 19 faster payment proposals.

On the use of DLT and blockchain technology, Mr. Powell noted recent developments and collaborations between banks and market infrastructures, including plans to use DLT by a few major U.S. clearing organizations. However, Mr. Powell observed that:

  • the financial industry has focused on the development of systems that require permission for access to ledgers, functions or information, rather than the open access system contemplated by Bitcoin;
  • firms are still trying to determine the business case for upgrading and streamlining payment, clearing, settlement, and other functions related to DLT;
  • technical issues – including issues of reliability, scalability, and security – remain unresolved;
  • governance and risk management will be “critical” to the success of DLT; and
  • the legal foundations supporting DLT, including jurisdictional issues, need more attention.

Mr. Powell also discussed the prospect of central banks issuing digital currencies. He cautioned that major technical and privacy challenges, as well as competition with private-sector products, might “stifle innovation over the long run.”

SEC Chair White Calls for Vigilance of the “Unicorns”

SEC Chair Mary Jo White outlined the opportunities, challenges and risks of “Silicon Valley” technology in the financial markets and urged entrepreneurs and issuers of private companies – particularly of “unicorns” (private start-up firms with valuations that exceed $1 billion) – to focus on investor interests.

Chair White examined the following challenges for new and evolving markets:

  • Pre-IPO Financing: Chair White asserted that despite broad sophisticated investor awareness that the majority of pre-IPO companies fail, venture capital firms, private equity funds, smaller retail investors and the “next . . . student whose great idea needs funding” all equally lose when “participants choose – with eyes wide open – to invest in private companies at valuations that may be ethereal or over-inflated.” She called for vigilance of so called unicorns, by establishing robust internal controls and governance procedures to provide accurate disclosures of financial results.
  • New Models of Capital Formation: Chair White declared that the SEC will hold brokers and funding portals responsible to be “bulwarks of investor protection” in securities-based crowdfunding that was recently introduced by Regulation Crowdfunding. She also emphasized that the SEC is counting on advisers as “gatekeepers” presenting information on the significant risks involved to make secondary market trading work fairly for investors. Although Chair White recognized that many secondary market participants may be “buy and hold” investors seeking exposure to late round pre-IPOs to profit from an eventual IPO or acquisition, she asked for regulators to scrutinize these emerging platforms to ensure they provide a functioning market that operates within the disclosed parameters.
  • Financial Controls and Corporate Governance: Chair White noted a “current slow-down” in IPOs and that unicorns are staying private longer. She called on entrepreneurs and their advisers, venture capital and private equity investors as well as general industry leaders to request that private startups develop enhanced governance structures and internal control environments to match their respective size and impact.
  • Fintech: Chair White highlighted that the SEC is exploring whether: (i) blockchain technology applications require registration under existing SEC regulatory regimes, such as those for transfer agents or clearing agencies; (ii) “robo-advisors” meet Investment Advisers Act obligations and their fiduciary duties when they solely provide automated advice; and (iii) online marketplace lending platforms provide adequate information to investors on offered securities and whether these offerings are registered or made using an exemption.

Chair White concluded by encouraging cooperation between the SEC and Silicon Valley.

Chair White delivered her remarks at the SEC-Rock Center for Corporate Governance speaker series, “The Silicon Valley Initiative: Protecting Investments in Pre-IPO Issuers.”

Lofchie Comment: While it is certainly appropriate for the SEC to concern itself with investment in private issuers, the SEC should also be concerned that the costs of the regulation that it imposes might discourage companies from going public. Put differently, the SEC should consider whether it is selling a “product” (access to the public capital markets and exchange liquidity) that is unattractive in light of its subsequent costs.

Congress should also be concerned about the deterrent costs of needless regulation. When issuers and investors see that the costs of going public include regulatory requirements such as those relating to “conflict minerals” or “compensation ratios” that have no reasonable benefit to either party, they may forsake liquidity for the sake of rationality.

 

CFTC Commissioner Cautions Global Regulators against Impeding Blockchain Technology Innovation

CFTC Commissioner J. Christopher Giancarlo cautioned global regulators against impeding innovation of blockchain technology. In an interview with Energy Metro Desk Editor-in-Chief John Sodergreen, the CFTC Commissioner reaffirmed remarks delivered at the Energy Metro Desk annual conference.

Mr. Sodergreen reported that Commissioner Giancarlo maintained a “decidedly not-so-grim . . . outlook” and expressed his enthusiasm for the potential of blockchain technology:

[T]he great promise of blockchain technology is in its ability to help market participants manage the enormous operational, transactional and capital complexity brought about by the legion of disparate mandates, regulations and capital requirements promulgated in the wake of the 2008 financial crisis.

Mr. Sodergreen reports that Commissioner Giancarlo stated that global regulators must be cautious not to impede blockchain innovation with “protracted regulatory uncertainty or an uncoordinated regulatory approach,” and instead should establish uniform principles.

Click here to view the article in the latest issue of Energy Metro Desk, which is published biweekly by Scudder Publishing Group, an energy trade news publishing company based in the Washington, D.C. metropolitan area.

IOSCO Addresses Emerging Challenges in Global Securities Markets

The Board of IOSCO met to discuss emerging challenges and recent developments in the global securities market. According to the press release, Board members discussed “the implications for global securities markets of slowing economic growth, declining commodity prices, continuing low or negative interest rates and market volatility.”

The Board:

• “agreed on further research on financial technology subsectors with particular relevance for securities regulators, including blockchain”;

• “supported further work on the use and regulation of automated advice tools in securities markets and understanding the risks arising from the use of cloud technology”;

• “discussed a report on IOSCO’s work addressing the challenges of cyber risk”; and

• “heard updates on the work of the Growth and Emerging Markets Committee on digitization and fintech.”

As to capacity building and co-operation, the Board:

• “approved the framework for a Global Certificate Program to be run in conjunction with the Program of International Financial Systems at Harvard University and designed specifically for market regulators”;

• “welcomed the completion of an Online Toolkit for Regulatory Capacity Building to be launched in March”;

• “progressed work on the enhanced IOSCO Multilateral Memorandum of Understanding on cooperation and the exchange of information, with a view to seeking Presidents’ Committee approval in Lima in May”; and

• “supported further work on regulator powers to compel witness statements on behalf of a foreign securities regulator and another proposal about regulators taking enforcement action based on sanctions in foreign jurisdictions.”

CFTC Chair Discusses Regulatory Oversight and Technological Innovation

CFTC Chair Timothy Massad called on market regulators to consider ways to transform regulatory oversight, both domestically and internationally, in light of technological innovation and market transformation.

Chair Massad began by discussing the future of the swaps market. He stated that the framework being created by the CFTC and other G-20 nations will “provide a basis for further growth of our derivatives markets.” He contemplated the extent to which the regulation of OTC swaps should follow the model that exists in the futures market. Moving forward, he concluded, a framework must be created that can also evolve.

Chair Massad stressed the need for product innovation in the derivatives market. Specifically, he discussed a number of steps that were taken by the CFTC regarding bitcoin, and recognized that bitcoin “raises many important issues” for law enforcement agencies, tax authorities and other regulators. Chair Massad also noted that benchmark integrity has been a “priority issue” in enforcement actions, and that the CFTC must ensure that efforts to safeguard integrity in the administration of benchmarks do not have an adverse effect on innovation.

Additionally, Chair Massad discussed issues raised by the growth of automated trading, and called for regulators to give greater consideration to its impact on liquidity, fairness, volatility and systemic risk. He emphasized that the CFTC currently is focused on the operating risks that arise from the automation of order origination, transmission and execution. It is considering proposing additional standards in order to minimize the potential for disruptions and other problems.

Finally, Chair Massad spoke about recent international progress in achieving consistency in the regulation of OTC swaps, such as the G-20 Leaders’ agreement on basic reforms. Chair Massad acknowledged that there is “no area of financial regulation where rules are harmonized across borders,” but encouraged regulators to keep this in perspective while moving forward with regulation.

Chair Massad delivered his keynote address before the World Federation of Exchanges’ Annual Meeting in Doha, Qatar.

Lofchie Comment: It is difficult to know what to make of this speech. Chair Massad seems to be calling for more innovation as well as more regulation. While these goals weren’t always inherently inconsistent with one another, the markets have reached the point over the past several years at which the goals have become incompatible. Now Chair Massad must decide if he wants to acknowledge that over-regulation is damaging to the markets, and to determine if he is open to the genuine reconsideration of any material part of the CFTC’s post-Dodd-Frank rulemaking. Of course, the easier and less ambitious path is to continue to “fine tune” without taking on the real task of reexamination.

NY Department of Financial Services Grants Charter to Bitcoin Exchange

The New York Department of Financial Services (“NYDFS”) granted a charter under New York banking law (“Banking Law”) to Gemini Trust Company, LLC (“Gemini”), a Bitcoin exchange based in New York City. The NYDFS stated that it conducted a rigorous review of Gemini’s July 2015 application to operate as a trust for virtual currency exchanges in which it examined the company’s anti-money laundering, capitalization, consumer protection and cybersecurity standards. The NYDFS stipulated that as a chartered limited purpose trust company with fiduciary powers under the Banking Law, Gemini can begin operating immediately and is subject to ongoing supervision by the NYDFS.

Lofchie Comment: Gemini made an interesting legal/strategic decision to be regulated under “banking” law rather than under the new bitcoin regulatory framework.

NY Department of Financial Services Releases Final Rules for Licensing Virtual Currency Businesses in New York

The New York Department of Financial Services (“NYDFS”) released a final “BitLicense” framework that establishes a licensing and regulatory regime for New York businesses engaged in activities related to Bitcoin and other virtual currencies.

According to NYDFS, the rules will apply to persons located in New York that engage in activities related to virtual currency, as well as persons outside of New York that engage in activities related to virtual currency with persons located in New York. The rules define a “person” as an individual, partnership, corporation, association, joint stock association, trust or other entity, however organized. While the final rules have been issued by the NYDFS, the effective date has not yet been announced.

The rules, which seem to be largely modeled after those that apply to broker-dealers, are divided into 13 sections, covering areas include (i) the process for obtaining and maintaining licenses, both for the firm and for its personnel, (ii) capital, (iii) custody, (iv) record keeping, (v) the development of an AML program, (vi) the establishment of a cybersecurity program and (vii) general compliance procedures. In addition, the rules contain a significant amount of detail with respect to any “change” in a firm’s business. Change refers to a change in ownership or a “material change” to a firm’s business (see Section 200.10 of the rules). Material change is a term defined to include, in effect, anything new about a firm’s business or any change that could result in something going wrong in a firm’s business.

Lofchie Comment: In a statement accompanying the new set of rules, Benjamin Lawsky, the Superintendent of the New York Department of Financial Services, stated that he had resisted pressure to “ban Bitcoin” (a view that he said was “Luddite”), and had instead attempted to develop regulations that would contribute to the “long-term health of the virtual currency industry.”

The new rules are fairly significant in scope and thus, add to the expense of the compliance burden. They provide a significant degree of power to regulators (essentially enabling the review and approval of any aspect of a firm’s business plan). Further, the rules are inherently ambiguous, insofar as the rule requirements are drafted in broad terms and there is no precedent to indicate how those requirements will be interpreted. It also remains to be seen how able the NYDFS will be to review and approve changes to a regulated firm’s business within a reasonable time period, particularly in the absence of any standards for approving or denying requests for such changes.

The rules seem like a heavy lift for a newly regulated firm. One wonders if it would not have been better to phase in the regulations over time. Whether the regulations are workable will likely depend on the manner in which they are enforced, given the great latitude given to the regulators. The two big dangers are (i) that the scope of the regulations discourage smaller firms, and (ii) that the time required for regulatory approvals of business changes makes it impractical to do business.

See: NYDFS Final BitLicense Rules; NYDFS Superintendent Benjamin Lawsky’s Remarks.