This is our eighth monthly bulletin for 2022, aiming to help companies identify important and significant legal developments governing the use and acceptance of blockchain technology, smart contracts and digital assets.
While the use cases for blockchain technology are vast, this bulletin will be primarily on the use of blockchain and or smart contracts in the financial services sector. With respect to digital assets, we have organized our approach to this topic by discussing it in terms of traditional asset type or function (although the types and functions may overlap), that is, digital assets as:
- Virtual currencies
- Deposits, accounts, intangibles
- Negotiable instruments
- Electronic chattel paper
- Digitized assets
In addition to reporting on the law and regulation governing blockchain, smart contracts and digital assets, this bulletin will discuss the legal developments supporting the infrastructure and ecosystems that enable the use and acceptance of these new technologies.
How the Digital Commodities Consumer Protection Act of 2022 would broaden the CFTC’s authority to regulate cryptocurrencies and other digital assets
The total market capitalization of the global cryptocurrency market returned to the $1.1 trillion level, despite a bleak performance in June. It’s estimated that one in five Americans have used or traded digital assets. Given the value of this market and the volume of American participation, legislators continue to introduce bills aimed at regulating cryptocurrency markets. Two such bills introduced in this session are the Responsible Financial Innovation Act (RFIA – see our article immediately below) and the Digital Commodities Consumer Protection Act of 2022 (DCCPA), both of which seek to expand the powers of the Commodity Futures Trading Commission (CFTC) under the Commodities Exchange Act (the Act) to address digitization of commodities. Read more.
How the Responsible Financial Innovation Act proposes to regulate cryptocurrencies and other digital assets – commodities perspective
Institutional clients are estimated to have traded $1.14 trillion worth of cryptocurrencies on Coinbase in 2021. Analysts warn the industry is so large that macroeconomic consequences may occur if these assets are mismanaged. Still, regulating cryptocurrency has been largely piecemeal. Now, the Responsible Financial Innovation Act (RFIA), recently introduced by Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY), aims to change this by, as stated in the Senators’ joint press release, “integrat[ing] digital assets into existing law and to harness[ing] the efficiency and transparency of this asset class while addressing risk.” Read more.
The SEC has begun imposing automatic penalties for failure to comply with a consent order– the case of Bloom Protocol LLC
The SEC has continued to bring a steady stream of crypto asset enforcement actions. On August 9, the agency announced a settled proceeding against Bloom Protocol LLC arising from what the SEC found was an unregistered initial coin offering (ICO) which raised nearly $40 million between mid-November 2017 and early January 2018. However, Bloom Protocol is unique in that the consent order entered in the case imposes penalties on Bloom if it fails to meet its obligations – including registration. Read more.
NFT projects reconsider their licensing strategies
Non-fungible token (NFT) projects are reconsidering their licensing strategies as they develop their business models. A number of major NFT projects, such as Nouns, Goblin Town, Cryptoadz and MFERS, have adopted as their initial approach Creative Commons Zero – no rights reserved (CC0). CC0 is the declaration of abandonment of copyright developed by Creative Commons. Other NFT projects are opting instead for a commercial license. Read more.
- CFTC adds 34 foreign entities to RED list. On July 14, the Commodity Futures Trading Commission (CFTC) announced that it added 34 unregistered foreign entities to its Registration Deficient List (RED List), bringing the current total to 202. Many of these RED List entities are cryptocurrency companies. According to the CFTC, a firm is added to the RED List when the CFTC determines, from investigative leads and public inquiries, that the firm is not registered with the CFTC and appears to be acting in a capacity that requires registration, such as trading binary options, foreign currency or other products.
- FBI issues consumer warning on cryptocurrency fraud. On July 18, the Federal Bureau of Investigation (FBI) released a notification warning financial institutions and investors about fraudulent cryptocurrency investment mobile phone applications. The statement warns of cybercriminals who use the names, logos and identifying information of legitimate investment firms to cause potential investors to download their fake mobile apps which enable the criminals to defraud the investors of their cryptocurrency.
- Senators introduce legislation to simplify use of virtual currency for daily purchases. On July 26, US Senate Banking Committee Ranking Member Pat Toomey (R-PA) and US Senator Krysten Sinema (D-AZ) announced the introduction of the Virtual Currency Tax Fairness Act. The intent of the act is to exempt from taxation personal transactions of less than $50 that use virtual currencies to purchase goods and services. The Act seeks to modify current law which establishes that the use of a digital asset triggers a taxable event which may include capital gains. The Act has received positive reactions from the cryptocurrency industry, and reportedly includes an aggregation rule that identifies related sales and exchanges as a single transaction in an effort to prevent potential tax evasion.
- Congresspersons ask SEC to withdraw crypto staff accounting bulletin. On July 15, four members of Congress sent a letter to the Securities and Exchange Commission (SEC) requesting that it retract Staff Accounting Bulletin 121 (SAB 121) which provides staff guidance regarding the accounting of, and disclosures relating to, entities holding digital assets on behalf of consumers. Specifically, SAB 121 advises that entities, including banks, adjust the accounting treatment of digital assets from off-balance sheet to on-balance sheet – requiring the reporting of crypto assets as liabilities and the provision of additional disclosures regarding the value of those assets. The congressmen warn that the change runs contrary to guidance provided by the Office of the Comptroller of the Currency (OCC) and would make bank “custody of digital assets economically infeasible.” The letter recommends that the SEC instead address this issue through a formal notice of proposed rulemaking, including providing a public comment period. For more information on SAB 121, see our April 2022 issue.
- USPTO and Copyright Office to study intellectual property rights in NFTs. The US Patent and Trademark Office (USPTO) and the US Copyright Office have reportedly confirmed that they will launch a joint study to examine intellectual property rights issues related to non-fungible tokens (NFTs). According to reports, the study will consider potential intellectual property challenges with NFTs, the rights associated with transferring ownership of an NFT, licensing rights and infringements, and the potential IP rights given to NFT creators. The study is being conducted in response to a June 9 letter by Senators Patrick Leahy (D-VT) and Thom Tillis (R-NC), the Chair and Ranking Member of the Judiciary Subcommittee on Intellectual Property, respectively, requesting that the USPTO and the Copyright Office conduct such a joint study to help the subcommittee understand “how NFTs fit into the world of intellectual property rights.” The letter proposed study questions which include, for current and potential future applications of NFTs:
- How do transfers of rights apply? How does the transfer of an NFT impact the IP rights in the associated asset?
- How do licensing rights apply? Can and how can IP rights in the associated asset be licensed in an NFT context?
- In what way does infringement apply? What is the potential infringement analysis where an NFT is associated with an asset covered by third party IP? Or where the underlying asset associated with an NFT is owned by the NFT creator and infringed by another?
- What intellectual property protection can be afforded? What IP protection can be afforded to the NFT creator? What if the NFT creator is a different person or entity from the creator of the associated asset?
- How else does 17 USC 106 apply?
- Arizona allocates $500,000 in blockchain funding: On June 23, 2022, Arizona enacted HB 2862, which allocates $500,000 for distribution by the Arizona Commerce Authority to applied research centers that specialize in blockchain technology, subject to available funding. The funds may be distributed in amounts of up to $250,000 to applied research centers that have matching out-of-state funds, that collaborate with universities, nonprofit business associations, health science research centers, institutes or other technology businesses that do business in Arizona, and the recipient must submit annual reports. Funds must be used by September 1, 2026 or else must be returned.
- Iowa and New Hampshire enact Article 12 of the UCC. On June 13, the governor of Iowa signed HF 2445, and on June 28, New Hampshire enacted HB1503. Each new law enacts a new provision of the Uniform Commercial Code that governs “controllable electronic records.” The Uniform Law Commission (ULC) and the American Law Institute (ALI), as the joint sponsors of the Uniform Commercial Code (UCC), established a committee that began work in 2019 on drafting proposed amendments to the UCC, including drafting the new Article 12, that serves as the basis for Iowa’s law. See here for our initial thoughts on the new Article 12. In short, the new laws of Iowa and New Hampshire extend the concept of control, as set forth in the UCC, to “controllable electronic records,” thus expanding the types of digital assets for which a party can establish control.
- NY issues investor alert on crypto platforms. On August 1, the New York attorney general issued an investor alert urging any New Yorker deceived or affected by the cryptocurrency crash to contact the Office of the Attorney General (OAG). New Yorkers who have been locked out of their crypto accounts, who are unable to access their digital investments, or who have been deceived about their cryptocurrency investments are encouraged to report the events to the OAG. Additionally, employees in the cryptocurrency industry who have witnessed misconduct or fraud are also encouraged to file a whistleblower complaint with the OAG.
ENFORCEMENT ACTIONS AND LITIGATION
- FDIC and Federal Reserve demand Voyager cease and desist representations of deposit insurance. On July 28, the Federal Deposit Insurance Corporation (FDIC) and the Federal Reserve Board announced the issuance of a joint letter demanding that the crypto brokerage firm Voyager Digital cease and desist from making false and misleading statements regarding its FDIC deposit insurance status and to take immediate action to correct any such prior misstatements. According to the agencies, Voyager make false statements or falsely suggested that Voyager was FDIC-insured, that customers who invested with Voyager would receive FDIC insurance coverage for all funds provided to, and held by, Voyager, and the FDIC would insure customers against any failure of Voyager. For more information on Voyager Digital, see our July 2022 and April 2022 issues.
- FDIC provides advice regarding dealings with crypto companies. On July 29, the FDIC issued letter FIL-35-2022 announcing the issuance of an Advisory to FDIC-insured institutions and a Fact Sheet to the public “to address certain misrepresentations about FDIC insurance by some crypto companies.” The Advisory and Fact Sheet are intended to protect institutions and the public against fraud by crypto companies misrepresenting that their products are eligible for FDIC deposit insurance coverage.
- SEC charges 11 individuals in $300 million crypto pyramid scheme. On August 1, the SEC announced charges against 11 individuals for their roles in creating and promoting Forsage, a fraudulent crypto pyramid and Ponzi scheme that raised more than $300 million from millions of retail investors worldwide. Those charged include the four founders of Forsage, who were last known to be living in Russia, the Republic of Georgia, and Indonesia, as well as three US-based promoters engaged by the founders to endorse Forsage on its website and social media platforms, and several members of the Crypto Crusaders – a promotional group that operated in the United States from at least five different states. According to the SEC’s complaint, in January 2020, Vladimir Okhotnikov, Jane Doe a/k/a Lola Ferrari, Mikhail Sergeev, and Sergey Maslakov launched Forsage.io, a website that allowed retail investors to enter into transactions via smart contracts that operated on the Ethereum, Tron, and Binance blockchains. Forsage allegedly operated as a pyramid scheme in which investors earned profits by recruiting others, and allegedly as a Ponzi scheme, using assets from new investors to pay earlier investors. The charges include violating the registration and anti-fraud provisions of the federal securities laws. The SEC’s complaint seeks injunctive relief, disgorgement, and civil penalties.
- SEC charges former Coinbase manager and others in crypto asset insider trading action. On July 21, the SEC announced the filing of insider trading charges against Ishan Wahi, a former Coinbase product manager, his brother Nikhil Wahi, and his friend Sameer Ramani, for perpetrating a scheme to trade ahead of multiple announcements regarding certain crypto assets that would be made available for trading on the Coinbase platform. The SEC’s complaint charges Ishan and Nikhil Wahi and Ramani with violating the antifraud provisions of the securities laws and seeks permanent injunctive relief, disgorgement with prejudgment interest, and civil penalties. The Department of Justice (DOJ) also separately charged the same individuals with conspiracy and wire fraud in connection with the alleged insider trading. The SEC’s complaint alleges that Wahi helped to coordinate the Coinbase platform’s public listing announcements that included what crypto assets or tokens would be made available for trading. Further, Coinbase is asserted to have treated such information as confidential and warned its employees not to trade on the basis of, or tip others with, that information. However, Ishan repeatedly tipped the timing and content of upcoming listing announcements to his brother and his friend. Ahead of those announcements, Nikhil Wahi and Ramani allegedly purchased at least 25 crypto assets, at least nine of which the SEC alleges were securities, and then typically sold them shortly after the announcements for profit. The long-running insider trading scheme generated illicit profits totaling more than $1.1 million.
- CEO of Titanium Blockchain pleads guilty in $21 million ICO fraud scheme. On July 25, the DOJ announced that Michael Alan Stollery, the CEO of Titanium Blockchain Infrastructure Services Inc. (TBIS) pleaded guilty in the Central district of California in connection with charges resulting from the company’s initial coin offering of the BARs token without registering the offering with the SEC or having a valid exemption from registration. The ICO raised $21 million from investors. Stollery pleaded guilty to one count of securities fraud. He is scheduled to be sentenced on November 18 and faces up to 20 years in prison.
- OFAC sanctions virtual currency mixer. On August 8, the US Department of the Treasury’s Office of Foreign Assets Control (OFAC) announced sanctions against virtual currency mixer Tornado Cash, which had been used to launder more than $7 billion in virtual currency since its creation in 2019. Tornado, along with 38 cryptocurrency addresses, has been added to the Specially Designated Nationals List. According to the press release, “Those in the virtual currency industry … should take a risk-based approach to assess the risk associated with different virtual currency services, implement measures to mitigate risks, and address the challenges anonymizing features can present to compliance with AML/CFT obligations … mixers should in general be considered as high-risk by virtual currency firms, which should only process transactions if they have appropriate controls in place to prevent mixers from being used to launder illicit proceeds.” Certain members of the cryptocurrency industry have argued that OFAC may have exceeded its authority in making this designation at least with respect to those cryptocurrency addresses for the Tornado mixer smart contract. Reasons for this include that the smart contract software operates automatically, allegedly not under the control of Tornado, and it is does not constitute property in which Tornado has an interest.
- Alleged Russian cryptocurrency money launderer extradited to US. On August 5, the DOJ announced that Alexander Vinnik, alleged operator of the cryptocurrency exchange BTC-e, was extradited to the US to face charges in a 21-count superseding indictment. The charges include operation of an unlicensed money service business, conspiracy to commit money laundering, money laundering and engaging in unlawful monetary transactions. The indictment alleges BTC-e facilitated transactions for cybercriminals worldwide and received more than $4 billion in bitcoin over the course of its operation. Despite doing substantial business in the United States, the indictment alleges that BTC-e was not registered as a money services business with the US Department of Treasury, had no anti-money laundering process, no system for appropriate know your customer or KYC verification, and no anti-money laundering program as required by federal law.
- My Big Coin founder convicted of cryptocurrency fraud scheme. On July 21, the DOJ announced that a federal jury convicted Randall Crater of New York in connection with a scheme to defraud investors by marketing and selling fraudulent virtual currency. According to evidence presented at trial, Crater founded My Big Coin Pay Inc., a purported cryptocurrency and virtual payment services company, and offered virtual payment services through “My Big Coins,” a digital currency which he marketed to investors. Crater and his associates falsely claimed that Coins was a fully functioning cryptocurrency backed by $300 million in gold, oil and other valuable assets. Crater also falsely told investors that My Big Coin had a partnership with MasterCard and that Coins could readily be exchanged for government-backed paper currency or other virtual currencies. Over the course of the scheme, Crater misappropriated over $6 million of investor funds for his own personal gain. Crater was convicted of four counts of wire fraud, which carries a maximum statutory penalty of up to 20 years in prison for each count, and three counts of money laundering, which carries a maximum statutory penalty of up to 10 years in prison for each count. He is scheduled to be sentenced on October 27.
- Coinbase confirms SEC investigation. Publicly traded crypto exchange Coinbase Global (COIN) is under investigation by the US regulators over its token listing processes as well as its staking programs and yield-generating products, the company disclosed in its most recent form 10-Q quarterly report for the period ended June 20, 2022. Specifically, COIN disclosed that it had received investigative subpoenas from the SEC seeking “documents and information about certain customer programs, operations, and existing and intended future products, including the Company’s processes for listing assets, the classification of certain listed assets, its staking programs, and its stablecoin and yield-generating products.” The filing indicates that COIN “believes the ultimate resolution of existing legal and regulatory investigation matters will not have a material adverse effect on the financial condition, results of operations, or cash flows of the Company.” Additionally, the filing discloses that COIN subsidiary Coinbase, Inc. is currently subject to an investigation by the New York Department of Financial Services (DFS) in relation to “its compliance program including compliance with the Bank Secrecy Act and sanctions laws, cybersecurity, and customer support.” Coinbase indicated that it “is cooperating fully and has undertaken initial remedial measures and may face additional remedial and other measures [related to maintaining its Bit-license with DFS].”
- California men sentenced for fraud in $1.9 million cryptocurrency offering. On August 1, the DOJ announced that Jeremy David McAlpine and Zachary Michael Matar, the founders of Dropil Inc., were each sentenced to thirty or more months in federal prison on one count of securities fraud for “conning more than 2,000 investors into purchasing a cryptocurrency [known as DROPS] that purportedly provided exclusive access to a profitable trading program.” According to the release, Dropil launched an unregistered ICO for the sale of DROPS and raised $1.9 million which was disbursed to McAlpine, Matar and their associates.
- North Carolina man pleads guilty to operating unlicensed cryptocurrency business. On July 12, the DOJ announced that Jayton Gill pleaded guilty to operating an unlicensed money transmitting business and willful failure to file a tax return. Gill operated a money transmitting business from 2015 to 2022 involving the exchange of millions of dollars in cash for cryptocurrencies. Gill was released on bond following his plea. The charge carries a maximum penalty for five years in prison and a $250,000 fine.
- CFTC charges Ohio man in $12 million digital asset trading scheme. On August 12, the CFTC announced the filing of a civil enforcement action in the US District Court for the Southern District of Ohio against Rathnakishore Giri and his companies NBD Eidetic Capital, LLC and SR Private Equity, LLC. The complaint alleges that Giri and his companies fraudulently solicited over $12 million and at least 10 bitcoins from more than 150 customers and that Giri and his companies misappropriated customer funds intended for digital asset trading. The CFTC seeks restitution to defrauded customers, disgorgement of ill-gotten gains, civil monetary penalties, permanent trading and registration bans, and a permanent injunction against further violations of the Commodity Exchange Act (CEA) and CFTC regulations. CFTC Commissioner Kristin N. Johnson issued a statement regarding the case, “While the CFTC rigorously surveils markets and enforces regulations in accordance with its mandate to protect customers, novel financial products may create new challenges. Identifying and policing fraud in these emerging markets may be difficult or delayed in light of the agency’s limited visibility in these markets.”
- Alabama consent order with bitcoin ATM provider. On August 12, the Alabama Securities Commission (ASC) approved entry of a Consent Order with Digital Access, LLC dba Cash2Bitcoin, a money service business, in which Digital Access conceded that it operated bitcoin ATMs in the state prior to obtaining registration as a money transmitter. The order requires Digital Access to pay the state a total of $13,500 and allows Digital Access to continue pursuit of its application for registration as a money transmitter.
- Alabama enters cease and desist order against online crypto trading company. On August 5, the ASC entered a Cease and Desist Order against Bybitexcoin.com, an online entity that purported to be a cryptocurrency trading company. Pursuant to the order, an individual claiming to work with Bybitex solicited state residents to invest in Bybitex although Bybitex was not registered in the state to offer or sell securities and was not exempt from registration. If Bybitex fails to timely respond to the order, the AES stated it intends to impose administrative sanctions and issue a permanent order barring Bybitex from soliciting or issuing securities in the state.
- NY announces consent order with Robinhood. On August 2, the New York State DFS announced the issuance of a consent order imposing a $30 million penalty on Robinhood Crypto, LLC, a cryptocurrency exchange and trading platform, for allegedly failing to comply with state bank secrecy act/anti-money laundering and cybersecurity laws and regulations. Robinhood is also required under the consent order to retain an independent consultant to perform a comprehensive evaluation of its compliance with DFS regulations and its remediation efforts. The case marks the DFS’s first enforcement action in the cryptocurrency sector.