Blockchain and Cryptocurrency Legal ‘Disrupting the Disruptors: 2018 – The Year in Review’


Although 2018 did not see a recovery of pricing for cryptocurrency (after the sharp decrease in 2017), it could be considered the year of transformation for the blockchain industry as a whole. The market was emboldened with technological advancements in everything from platform functionality, scalability and security, and smart contracts. This lead to regulators beginning to take key steps in enforcement, attempting to prevent those who seek to exploit the uninitiated and or those engaging in outright fraud.

June 2018 saw a now famous reiteration of opinion by director of Division of Corporation Finance at the Securities and Exchange Commision (SEC), William Hinman, say to participants of the Yahoo! Finance All Markets Summit in San Fransisco, “…the economic substance of the [token] transaction always determines legal analysis, not the labels.” Identifying a token as a ‘utility’ is not a sufficient assessment under U.S. federal and state securities laws. He went on to say a primary driver of securities driver analysis is the role of the third party, and must be thoroughly examined as such. The main point was to repeatedly reassure that the SEC wants to encourage technological advancement, but through proper channels under the law so market integrity can be upheld.

As the first tangible guidance from a U.S. regulator on how to move forward in this industry to legitimize pathways of security for blockchain, Hinman’s remarks not only fueled the industry but set in motion congressional members to push the SEC for clarification on the criteria of what makes a digital asset an investment contract and if it might become a utility asset.

The struggle of regulating this market has gone far beyond the borders of the U.S. Globally, there is concern with imposing regulations on such a new technological field at the risk of thwarting innovation. Singapore and the EU have recently pulled back from an open and inviting attitude towards the industry due to a focus on market risks, as they attempt to figure out regulation plans that will protect without harming. Malta, on the other hand, wants to become a go-to country for the blockchain market, joining a list of blockchain-friendly areas.

Price volatility caused an increased desire to tie digital assets to a fiat currency or a commodity like gold or silver, creating a ‘stable coin,’ while state and local authorities explore using blockchain tech to streamline cataloging and storing information. This could save massive amounts of money and time.

Several trading platforms have received regulatory approval through 2018, facilitating continued interest in token offerings, but more are expected to receive approval in 2019. The SEC has yet to green light any digital securities under regulation A+ due to custody and other issues. More back-office services addressing escrow, settlement, and custody concerns will become available throughout 2019, making the possibility of it more viable than ever.

Broader adoption will continue to be halted until the challenges of the blockchain community and its regulation can be properly addressed. Nonetheless, this has not stopped key players in financial services, public and private infrastructure, supply chain management, and others from actively pursuing the implementation of blockchain tech in business. Our personal lives and future businesses will certainly continue to be disrupted, evolved, and forever changed in ways we have yet to imagine.

The Federal Securities Cases of 2018

There are a number of federal securities cases throughout 2018 but the following are the most noteworthy:

Securities and Exchange Commission v. Blockvest, LLC et al.: SEC’s Request for Preliminary Injuction Denied-

The SEC filed an injunction with the U.S. District Court of Southern California in November but was denied because they did meet burden of proof, showing that the company was a security token and had incorrectly registered themselves as a cryptocurrency. It is unlikely the court’s decision will set much of a precedent, despite the media hype of the case, because it appears it rested mostly on disputed facts from both sides and inconsistencies with statements throughout the SEC’s complaint.

In the Matter of TokenLot, LLC et al: SEC Order Against Unregistered Broken-Dealer-

Back in September 2018, the Securities and Exchange Commission announced that it would begin enforcing the targeting of unregistered activities conducted between brokers and dealers in such a way as to allow them to side-step capital gains tax which their activity would be responsible for paying. This method, which came to be known as The TokenLot Order illustrated just one of the ways in which the SEC began to act in accordance with its ‘functional approach,' considering and weighing up the various facts and issues which would necessitate the assessment of unregistered activities.This allows the SEC to more accurately validate whether the specific criteria for brokers and dealers are adequately met.

In the Matter of Crypto Asset Management, LP: SEC Order Against Unregistered Hedge Fund-

Within the same span of time as the TokenLot Order, the SEC also announced its associated Crypto Order, which took aim against those respondents active within the Crypto Asset Mangement LP., specifically targeting them as the managing member and manager of Crypto Asset Fund LLC. The company itself was found to be violating various segments of the Securities Act which were set out by the SEC; failing to register securities within their hedge fund and failing to register itself as an investment company, as is require (Investment Company Act of 1940). In total, the company managed to raise $3.6 million from individual investors and collective investors. Crypto Order has found and compiled an expansive list of misrepresentation cases but regarding the case of CAM, Crypto Order found respondents had been committing various acts of misrepresentation to potential investors through the use of various marketing materials.

In re Tomahawk Exploration: SEC Deems Token Airdrop as Sale of Securities-

Another instance of this active approach took place August 14th, 2018, when the Commission issued an immediate and permanent cease and desist order to Tomahawk Exploration LLC, as well as David Thompson Laurence, in light of growing evidence showing the company was fraudulently selling Tomahawkcoins (TOMs), the company's digital asset. Tomahawk underwent these sales through its associated Initial Coin Offering (ICO), as well as free token ‘airdrops' to its community, flagging the SEC’s attention for operating in violation of the Securities Act as well as the Exchange Act (a common struggle for digital asset companies).

The GT Advisory that took place in May, 2018, concluded the process of ‘airdropping' digital assets does not exempt them under the Securities Act because airdrops of this nature promote the assets and company in question, raising awareness and potentially raising its prospective value.

The SEC found its associated ‘bounty program' (which is commonly used for finding faults within a platforms underlying code) also acted in violation of the same subsections of the Securities act:

“The lack of monetary consideration for ‘free’ shares does not mean there was not a sale or offer for sale for purposes of Section 5 of the Securities Act … a ‘gift’ of a security is a ‘sale’ within the meaning of the Securities Act when the donor receives some real benefit.”

Munchee had similar violations with the SEC and both became the subject of fees and terms in deals with the SEC, proving a need to engage with adequate legal counsel before undergoing such a new strategy as digital asset sales, airdrops, or bounty programs.

State Regulatory Overview

The state-level saw both new legislation addressing blockchain and cryptocurrency, as well enforcement actions grow increasing interest, with the most notable from 2018 being:

Operation Cryptosweep Spearheaded by NASAA-

In a collaborative effort between regulatory bodies within the United States and Canada, May 2018 saw an international operation which focused on various promotors and issuing parties involved in the illegal publication and advertising of cryptocurrencies as well as the promotion of fraudulent Initial Coin Offerings (ICOs). Known only as ‘Operation CryptoSweep,' it was headed up by the North American Securities Administrators Association (NASAA) in conjunction with more than 40 other agencies, ending with 47 enforcement actions involving ICOs and investment products which were linked with some form of cryptocurrency.

Regulators submitted these actions under Securities Violations, finding a wide range of potential violations over regional and state lines regarding securities laws including failure to operate and register appropriately. As a somewhat back-handed 10 year anniversary gift for Bitcoin, the NASAA released a series of instructional videos intended to raise greater awareness on the subject of crypto offerings, summed up in what has come to be known as the three ‘U's of cryptocurrency investments:

Untraceable (Cryptocurrency investments operate entirely in cyberspace, and companies can establish themselves anywhere in the world, rendering them nigh impossible to trace).

Uninsured (Unlike their stock, security, bond, etc, counterparts, withdrawals and deposits to digital wallets and on coin exchanges are uninsured).

Unregulated (While these crypto exchanges offer anonymity to traders, they offer nothing in the way of legal or financial protection to any party).

ICO Enforcement State by State-

2018 also saw state regulatory enforcement agencies hard at work, with a large number of local cease and desist orders being placed against Initial Coin Offering projects within their local remits. Wherever ICOs and Cryptocurrency related products conformed to the legal definition of an ‘investment contract' with the Howey test for securities, local agencies became involved.

From a state by state basis, the following states had seen a much more extensive range of activities with regards to violations of state and federal securities legislation, as well as other laws pertaining to investment contracts:

  • Colorado – 18
  • Texas – 9
  • Alabama – 7
  • North Dakota – 7
  • North Carolina – 1
  • Massachusetts – 5
  • New Jersey – 1
  • South Carolina – 1

According to each states regulatory agencies, substantiated legal actions took place based on the following:

The ICO in question offered a kind of referral or other kind of bonus commission with associated interest rates to prospective investors. Potential investors would have purchased these securities with the promise of profit and some form of dividend yields.

Through issuing these security tokens, it alluded to being sold under the auspices of utilizing an existing blockchain to allow them to have an underlying utility and value.

A broad range of social media outlets were used as a means of advertising of products, ranging from sub-reddits via the similarly named Reddit, Twitter, and YouTube, as well as on more professional outlets such as PRNewswire and web-pages for various television stations.

The underlying goal of these companies was to pool the funds accrued from the various kinds of sales of its security tokens, constituting investment contracts as well as profit sharing agreements, thereby violating the Securities Act.

The company itself, along with its range of promoters, were not otherwise registered within the securities industry or with the larger SEC. This resulted in trading with broker-dealers with no claim of exemption from the requirement to be registered as securities.

New York-

It was found that over the course of April 2018, the Office of the Attorney General within the State of New York had begun a fact-finding mission referred to as the ‘Virtual Markets Integrity Initiative,' which involved the submission of letters to 13 major crypto trading platforms commonly used by consumers in order to buy, sell, and otherwise trade virtual currencies as well as cryptocurrencies. It involved a raft of requests for key information on their various operations within the state, internal controls, and a report on the kind of safeguard measures they make use of in order to protect the assets of their customers.

The Virtual Markets Integrity Initiative published its findings in September 2018, highlighting three major areas for concern –

  1. An overall lack of protection for customers with regards to abusive practices from trading platforms, including a complete lack of customer verification, anti-money laundering regulations, and a complete absence of ‘Know Your Customer' (KYC) guidelines.
  2. A very high likelihood for subsequent cases of conflict of interest due in large part to many of these platforms engaging in such a way as to overlap with other businesses that are not otherwise bound by the same regulations as more conventional trading environments.
  3. A very limited amount of protection and safeguarding measures for customer funds, including an insufficient availability of insurance policies in the event of the loss of virtual asset investments.

Currently, the way that digital asset exchanges operate, they offer nothing in the way of safeguards to protect users and often lack any kind of appropriate cybersecurity protections, leaving them exceptionally vulnerable to attack.

New York BitLicense: Launching In November 2018, the 14th charter was created and subsequently granted by the New York State Department of Financial Services (NYDFS). This charter has since become known as the Virtual Currency License (BitLicense), which allows companies to engage in virtual and cryptocurrency businesses of any kind, so long as it is active within New York or is founded by a resident of New York.

NYDIG Execution, LLC, was one of the recipients of this BitLicense, while its subsidiary company NYDIG Trust Company LLC was only authorized to operate as a trust company of more limited purpose. NYDIG Trust Company was fully authorized to serve as a custodial service for digital currencies such as Bitcoin, Bitcoin Cash, as well as ETH, XRP, and Litecoin.

Texas-

Legal activity within Texas has spiraled from a simple Cease and Desist Order to a cause celebre (something that’s gained popular attention among cryptocurrency traders) when on January 4, 2018, the Securities Commissioner for Texas issued it against the since meme-ified cryptocurrency exchange BitConnect.

Failing to place a request for a hearing in order to modify or have the order vacated, BitConnect was able to quickly morph into meme status and resulted in the Cease and Desist to come into full force. Its issuance was a result of the exchange making a false claim to the State's Securities Board, stating that investors would be eligible for partial refunds for their initial investment in the company. Investors could fulfil this by completing a refund form and forwarding an appeal fee of $250. The Order itself was unable to provide for the payment to the affected BitConnect investors.

Another emergency Cease and Desist order was issued by the state's Securities Commissioner, Travis J. Iles, against the cryptocurrency exchange USI-Tech. This order was the very first time that the state had taken legal action against a company accused of fraudulently promoting investments allegedly tied to cryptocurrencies.

Texas' State Securities Board has since taken a total of 11 enforcement actions against a range of crypto promoters, allowing for the immediate cessation of schemes which involved a collected total of billions of dollars’ worth of funds from various investors.

Among those issued by the commissioner were a number of promoters of investment opportunities for cryptocurrency mining projects, many of which made use of social media pages, as well as sales agents through channels such as Facebook, LinkedIn, and Twitter in order to further promote their investments.

In December, the Texas State’s Securities Division provided a revised edition of its Investor Guide, updating it with new information for investors seeking to learn the basics of investing and helping to educate them on fraudulent behaviors from investment offerings, along with a section dedicated to cryptocurrency related investments.

The guide itself is completely free to members of the public and its Securities Division continues to commit to investigations of the marketplace, obtaining evidence and instigating enforcement actions against those which it believes to be violating regulations.

Wyoming-

Considering Wyoming was the very first state to legally define ‘utility tokens' as a whole new asset class, proving unable to be fully defined as a security or commodity, it’s unsurprising that they have been involved with their own legal trappings with the cryptocurrency world. With a more open-minded approach to crypto than many other states, the governor of Wyoming signed the following four blockchain regulations in 2018:

  1. Regulations HB 19 & HB 70, which serve to provide amendments to the already existing Wyoming Money Transmitter Act. This also included special amendments within sub-sections 40-22-102 and 40-22-104, and Wyoming Statutes. These being sub-sections 17-4-206, 17-4-102, 40-22-1094 and 40-22-126.
  2. HB 19 offers digital currency transactions a special exemption within Wyoming State law. This was signed into effect by the Governor of Wyoming as of March 7th, 2018.
  3. HB 70 offers cryptocurrencies a further legal exemption from laws pertaining to money transmission laws, and securities legislation. This came into effect as of July 1st, 2019.
  4. SB 111 provides exemptions for digital currencies from other taxes such as property taxation. This is only in effect so long as a virtual currency does not adhere to the legal characteristics of a ‘property.' This was signed into law by the governor on March 12th, 2018.

SF 34, which is codified within the Wyoming Statute. sub-sections 2-3-1001 to 2-3-1017 allows for the regulation of fiduciary management as related to digital assets, which includes various digital currencies traded within the state of Wyoming. This was signed into law as of July 1st 2018.

Compared to other states, Wyoming is far-in-a-way at the forefront when it comes to progressive regulatory policy for cryptocurrencies. This is exemplified by the introduction and passage of new pro-crypto legislation in January 2019.

Pending their effectiveness is proven, House Bill HB0185 will allow companies to issue virtual/digital tokens in the place of ordinary stock certificates for investors. Along with this, Senate File No. SF0125 allows for any bank to provide a range of services, along with custodial services for customers with digital assets.

Other State Developments-

While Wyoming provides an interesting exception to a thoroughly proven rule with regards to the SEC and State agencies, there are a number of other states that have provided some authorization to companies and other institutions for leveraging blockchain technology, but this mostly focuses on record-keeping for businesses (as is the case with the states of California, Delaware, Illinois, and Vermont), and paying of taxes (Ohio).

Over the course of 2018, a number of states have allowed for the legislation of money transmission and business licensing, examples of states and their positions on licensing of this kind:

A total of 20 states require some kind of money transmission or licensing requirements.

Only Alaska, Georgia, and Wisconsin operate with no requirement for authorization.

If a specific transaction does not involve the movement of sovereign currency then users do not incur additional charges (cash or ‘legal tender' on hand, through a digital wallet or form of mobile device): For the state of Illinois, this involves both the movement of digital and sovereign currencies.

The following states specify that there is no specific license required for the aforementioned actions – Florida, Maryland, Montana, Pennsylvania, and Wyoming.

The Application of Existing Federal Income Tax

Existing tax law has had a difficult time coping with, and adapting to, the complexities of blockchain technology and cryptocurrency (in transactions, salary, and exchanging). Notice 2014-21 is the only notable guidance the IRS has ever issued on how to tax crypto income, stating cryptocurrency is property for federal income tax purposes. The rule is basic in that it treats cryptocurrency transactions as taxable income much like capital gains, resulting in taxing during gain or loss, with exemptions only as they apply under the International Revenue Code (transfer to corporations for stock in a Section 351 transaction, corporate reorganization, or exchange for partnership interest).

The biggest issue with Notice 2014-21 is its lack of differentiation between the types of cryptocurrency; equity/security tokens for ownership rights, utility tokens for accessing specific services in a closed system, intrinsic tokens used in exchange for goods and services transactions, and asset-backed tokens for tracking the value of assets such as real estate or gold/silver.

Unraveling intricate tax implications for cryptocurrency transactions would require a detailed knowledge of its underlying technology before even considering more normal factors like tax basis, holding period, purpose, source of income, and fair market value (something that has yet to have a formula accurately pinpointing it). Even with that, it may be difficult to make tax code that is cookie cutter for cryptocurrency transactions when even an ICO structure is not universal between entities. Adding to that considerations of offshore and onshore structure, you then delve into labeling with correct jurisdictions and entity types to determine tax implications of intercompany transactions, the transfer of IP, and IP development activities. Plus, a tax-free transaction for an issuer may not be so for the purchaser.

Lack of proper tax planning can quickly become a trap for a technology that is supposed to make transactions faster, cheaper, more efficient, more transparent, and reliable in everything for day-to-day business to government operations.

FinCen Update

The United States Department of the Treasury questioned in 2018 whether or not ICO activities by businesses should be subject to anti-money laundering (AML) obligations. A letter by the Treasury on February 13, 2018, to Sen. Ron Wyden, ranking member of the U.S. Senate Committee on Finance, stated the SEC and Commodities Futures Trading Commission (CFTC) is being closely worked with by Financial Crimes Enforcement Network (FinCen) on clarifying and enforcing AML obligations.

According to Treasury, virtual currency exchangers and administrators have been subject to the Bank Secrecy Act (BSA) since 2011. FinCen published guidelines delving into the finer points of how and why virtual currency exchanges and their administrators are money transmitters that must comply with BSA requirements in 2013.

A developer selling convertible virtual currency (ICO coins or tokens included) for another value substitute for currency is deemed a money transmitter and an exchange selling ICOs or tokens, or that exchanges them for virtual currency, fiat currency, and/or substitute currency are also typically money transmitters. As such, both must comply with AML requirements.

The Letter to Sen. Ron Wyden also recognizes there are variations in ICO arrangements where some involve offerings or sales of securities or derivatives that could put it under the jurisdiction of either the SEC or the CFTC with AML requirements and regulations applying to the ICO participants either way.

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