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SEC announces first settlement with a digital currency exchange
On November 8, the SEC announced its first enforcement action settlement with a digital currency platform for allegedly operating as an unregistered national securities exchange. According to the cease-and-desist order, the founder of the digital currency exchange, who has since sold the exchange to foreign buyers, allegedly violated federal securities laws by providing an online platform for secondary market trading of digital assets, including ERC20 tokens, without registering with the Commission or operating pursuant to a registration exemption. ERC20 tokens are digital assets issued and distributed on the Ethereum Blockchain using the ERC20 protocol, which, according to the SEC, is the standard coding protocol currently used by a significant majority of issuers in initial coin offerings. The order emphasizes that 92 percent of the trades on the exchange took place after the SEC released its Report of Investigation Pursuant To Section 21(a) Of The Securities Exchange Act of 1934: The DAO (the DAO Report) in July 2017, advising that non-exempt digital currency exchanges must register with the Commission. Without admitting or denying the findings, the founder agreed to pay $300,000 in disgorgement plus interest and a $75,000 penalty.
NYDFS adds check cashing and virtual currency businesses to nationwide licensing system
On October 1, NYDFS announced the commencement of the final phase of its initiative to manage the license application and regulation of all non-depository financial institutions operating in the state through the Nationwide Multistate Licensing System and Registry (NMLS). As such, NYDFS now allows financial services companies holding check casher and virtual currency business activity licenses to transition those licenses to NMLS. Additionally, companies applying for new licenses may now submit applications through NMLS. As previously covered in InfoBytes, licensed budget planners, sales finance agencies, money transmitter licensees, and mortgage providers have already made the transition to NMLS.
District Court concludes a small virtual currency is a “commodity” under the Commodities Exchange Act
On September 26, the U.S. District Court for the District of Massachusetts denied a virtual currency trading company’s motion to dismiss, concluding that smaller virtual currencies are commodities that may be regulated by the CFTC. In January, the CFTC bought an action alleging the company violated the Commodities Exchange Act (CEA) and CFTC Regulation 180.1(a) by making false or misleading statements and omitting material facts when offering the sale of their company’s virtual currency. For example, the complaint alleges that the company falsely stated that its virtual currency was backed by gold, could be used anywhere Mastercard was accepted, and was being actively traded on several currency exchanges. Moreover, while consumers who purchased the virtual currency could view their accounts, they were unable to trade it or withdraw funds from their accounts with the company. The company moved to dismiss the case, arguing that the conduct did not involve a “commodity,” specifically one that underlies a futures contract, under the CEA. In denying the motion to dismiss, the court determined that Congress intended for the CEA to cover a certain “class” of items and specific items within that class are then “dealt in.” Because the company offered a type of “virtual currency” and it is “undisputed that there is futures trading in virtual currencies (specifically involving Bitcoin),” the court held that the CFTC sufficiently alleged the company’s product is a “commodity” under the CEA. The court also rejected the company’s other arguments, determining Regulation 180.1(a) was meant to combat the fraud alleged by the CFTC, notwithstanding its use of the term “market manipulation,” and the CFTC adequately pleaded the fraudulent claim under the regulation.
Colorado regulator exempts certain cryptocurrency exchanges from money transmitter licensing requirements
On September 20, the Colorado Department of Regulatory Agencies Division of Banking (Division) issued interim guidance exempting certain types of cryptocurrency exchanges from the state’s money transmitter licensing requirements. Under the interim guidance—which outlines the Division’s interpretation of Colorado’s existing Money Transmitters Act (the Act)— the Division determined that the Act regulates the transmission of money, meaning legal tender, and that cryptocurrencies are not legal tender under the Act. As a result, virtual currency exchanges operating in Colorado do not require a license if transmitting only cryptocurrencies without any legal tender issued and backed by a government (fiat currency) involved in the transaction. However, if fiat currency is present in a transaction, then a virtual currency exchange may require a license. Additionally, a virtual currency exchange must obtain a license when it performs all of the following: (i) it engages in the business of selling and buying cryptocurrencies for fiat currency; (ii) it allows a Colorado customer to transfer cryptocurrency to another customer within the exchange; and (iii) it allows the transfer of fiat currency through the medium of cryptocurrency within the exchange. If a virtual currency exchange offers the ability to transfer fiat currency through the medium of cryptocurrency, the Division encourages the exchange to contact the Division to determine whether it must obtain a license.
New York Attorney General issues Virtual Markets Integrity Report, following cryptocurrency integrity initiative
On September 18, the New York Attorney General’s office announced the results of its Virtual Markets Integrity Initiative, a fact-finding inquiry into the policies and practices of platforms used by consumers to trade virtual or “crypto” currencies. As previously covered in InfoBytes, last April questionnaires were sent to 13 virtual asset trading platforms to solicit information on their operations, policies, internal controls, and safeguards to protect consumer assets. The resulting Virtual Markets Integrity Report finds that virtual asset trading platforms vary significantly in the comprehensiveness of their response to the risks facing the virtual markets, and presents three broad areas of concern: (i) the potential for conflicts of interest due to platforms engaging in various overlapping business lines that are not restricted or monitored in the same way as traditional trading environments; (ii) a lack of protection from abusive trading platforms and practices; and (iii) limited protections for customer funds, such as the insufficient availability of insurance for virtual asset losses and platforms that do not conduct any type of independent auditing of virtual assets. According to the report, the Attorney General’s office also referred three platforms to the New York Department of Financial Services for potential violations of the state’s virtual currency regulations.
District court rules U.S. securities law may cover initial coin offering in criminal case
On September 11, the U.S. District Court for the Eastern District of New York issued a ruling that the U.S. government can proceed with a case for purposes of federal criminal law against a New York-based businessman who allegedly made “materially false and fraudulent representations and omissions” connected to virtual currencies/digital tokens backed by investments in real estate and diamonds sold through associated initial coin offerings (ICOs). The defendant—who was charged with conspiracy and two counts of securities fraud for his role in allegedly defrauding investors in two ICOs—claimed that the ICOs at issue were not securities but rather currencies, and that U.S. securities law was unconstitutionally vague as applied to ICOs. However, the U.S. government asserted that the investments made in the tokens were “investment contracts” and thereby “securities” as defined by the Securities Exchange Act. The U.S. government further argued that the jury should apply the central test used by the U.S. Supreme Court in SEC v. W.J. Howey Co. to determine if a financial instrument “constitutes an ‘investment contract’ under the federal securities laws.” The judge commented that “simply labeling an investment opportunity as ‘virtual currency’ or ‘cryptocurrency’ does not transform an investment contract—a security—into a currency.” Moreover, while the judge cautioned that it was too early to determine whether the virtual currencies sold in the ICOs were covered by U.S. securities law, he concluded that a “reasonable jury” may find that the allegations in the indictment support such a finding.
CFTC wins $1.1 million judgment in cryptocurrency fraud action
On August 23, the U.S. District Court for the Eastern District of New York entered final judgment in favor of the Commodity Futures Trading Commission (CFTC) in its suit against a cryptocurrency trading advice company and its owner (defendants) for allegedly misappropriating investor money through a cryptocurrency trading scam. As previously covered by InfoBytes in March, the court granted the CFTC’s request for a preliminary injunction, holding that the CFTC has the authority to regulate virtual currency as a “commodity” within the meaning of the Commodity Exchange Act and that the CFTC has jurisdiction to pursue fraudulent activities involving virtual currency even if the fraud does not directly involve the sale of futures or derivative contracts. The final judgment orders the defendants to pay over $1.1 million in restitution and civil money penalties and permanently enjoins them from engaging in future activities related to commodity interests and virtual currencies.
FinCEN director discusses approach to virtual currency and emerging technology
On August 9, Financial Crimes Enforcement Network (FinCEN) Director Kenneth A. Blanco delivered remarks at the 2018 Chicago-Kent Block (Legal) Tech Conference to discuss, among other things, the agency’s approach to virtual currency and its efforts to protect financial institutions from being exploited for illicit financing purposes as new financial technologies evolve and are adopted. Blanco commented that while innovation provides customers with greater access to financial services, it can also create opportunities for criminals or serve as a vehicle for fraud. Blanco discussed several areas of focus, such as (i) the regulation of virtual currency and initial coin offerings (ICOs), along with coordinated policy development and regulatory approaches done in conjunction with the SEC and CFTC; (ii) examination and supervision efforts designed to “proactively mitigate potential illicit finance risks associated with virtual currency”; (iii) anti-money laundering/countering the financing of terrorism (AML/CFT) regulatory compliance expectations for companies involved in ICOs or virtual currency transmissions; (iv) enforcement actions taken against companies that fail to implement effective programs; (v) the rise and importance of virtual currency suspicious activity report filings which help the agency identify and investigate illicit activity; and (vi) the development of an information sharing virtual currency-focused FinCEN Exchange program. Blanco emphasized that “individuals and entities engaged in the business of accepting and transmitting physical currency or convertible virtual currency from one person to another or to another location are money transmitters subject to the requirements” of the Bank Secrecy Act.
Ohio governor enacts legislation recognizing blockchain transactions as enforceable electronic transactions
On August 3, the governor of Ohio signed into law SB 220, which codifies that records or contracts and signatures secured through blockchain technology are enforceable electronic transactions. Specifically, SB 220 amends Ohio’s Uniform Electronic Transactions Act to state that “a record or contract that is secured through blockchain technology is considered to be in an electronic form and to be an electronic signature” and that a “signature that is secured through blockchain technology is considered to be in an electronic form and to be an electronic signature.” The amendments also create an affirmative defense or “safe harbor” to tort actions against businesses alleged to have failed to implement reasonable information security controls leading to a data breach of personal or restricted information. To qualify for the safe harbor, a business must implement and comply with a written cybersecurity program that contains specific safeguards for either the protection of personal information or the protection of both personal and restricted information.
CFTC advisory warns customers to research digital coins and tokens before purchasing
On July 16, the CFTC issued an advisory to alert customers to exercise caution and conduct thorough research prior to purchasing virtual/digital coins or tokens. Specifically, customers are reminded (i) to conduct extensive due diligence on all “individuals and entities listed as affiliates of a digital coin or token offering”; (ii) to confirm whether the digital coins or tokens are securities and, if so, verify that the offering is registered with the SEC before investing in an Initial Coin Offering (ICO); (iii) to verify how the money will be utilized, if they can get it back, and what rights the digital coin or token provides; and (iv) that many ICOs are frauds.