It was a year filled with tantalizing tidbits and many loose ends.
2019 marked the 10th year since blockchain technology was released into the wild by its still unknown inventor, Satoshi Nakamoto, who mined the first bitcoin block in January 2009. In the intervening decade, blockchain technology has catalysed widespread innovation, some of which has garnered the attention (and consternation) of US regulators. One topic in particular has spawned spirited debate: How should token-based economic activity, especially within the sphere of capital raising and value exchange, be treated under existing US regulatory infrastructure?
While US regulators did not provide any specific answers in 2019, the year was notable for providing the crypto space with additional pieces of the burgeoning regulatory puzzle in the form of agency guidance, enforcement actions, no-action letters, and highly publicized governmental concerns regarding private global stablecoins.
Are You My Regulator?
2019 saw one major regulator defer to another where asset classification and jurisdiction are concerned. Some of the confusion over the definition and regulation of digital assets stems from the various regulatory agencies’ different perspectives and mandates. CFTC Chairman Heath Tarbert acknowledged in an interview that the SEC’s determination that a digital asset is a security (or not) is the “initial threshold determination,” and that if digital asset is deemed to be a security, it will not be treated as a commodity.
Guidance Galore …
2019 also featured significant issuances of agency guidance on digital assets, including:
- On April 3, the SEC staff released a framework for assessing whether a digital asset constitutes an investment contract — a type of security under US securities laws. Specifically, the framework called attention to the factual predicates at issue when evaluating “[w]hether a particular digital asset at the time of its offer or sale satisfies the Howey test.” (See “New SEC Token Guidance: This Is Howey Do It.”)
- On May 9, FinCEN issued interpretive guidance expanding on previously issued guidance and rulings regarding the application of the Bank Secrecy Act and FinCEN’s implementing regulations to a variety of business models involving “convertible virtual currency.” Highlights included that peer-to-peer exchangers and hosted wallet providers will generally be deemed “money transmitters” under the Bank Secrecy Act and FinCEN’s implementing regulations, while unhosted wallet providers, decentralized exchanges and miners that mine convertible virtual currencies for their own purposes will not. (See “Stakeholders Welcome New FinCEN Regulatory Guidance for Convertible Virtual Currency.”)
- On October 9, the IRS issued guidance on the tax treatment of cryptocurrencies to supplement its 2014 guidance. The guidance included Revenue Ruling 2019-24 (Ruling) and a set of FAQs for taxpayers who transact in cryptocurrencies and hold them as investments. The Ruling, which addressed whether a taxpayer holding a cryptocurrency has taxable income as a result of a “hard fork” with and without an “airdrop,” concluded that a cryptocurrency investor does not have taxable income if a hard fork occurs and such investor does not receive any new cryptocurrency units. Moreover, the FAQs provided guidance on the calculation of value and of tax basis of virtual currencies in various situations. (See “The Future Ain’t What It Used to Be: New Tax Guidance Issued for Cryptocurrencies.”)
But Still No Federal Statutory Framework
On April 9, federal legislators introduced two bills that sought to provide the digital asset space with regulatory certainty, but which have stalled and are yet to be enacted:
- The Token Taxonomy Act of 2019 (TTA) proposes to amend the Securities Act (among others) to define and exclude certain digital assets from the definition of a security. The TTA would also amend the Securities Act to create an exemption for transactions involving the offer and sale of such digital assets so long as the person offering or selling the digital asset had a “good faith belief” that the digital asset being offered or sold meets the required definition of a digital asset under the TTA. If a digital asset fails to meet the necessary definition, the TTA also provides that the exemption will be revoked if the offeror or seller fails to publicly post notice and “take reasonable efforts to cease all sales and return all proceeds” within 90 days of receiving notice from the SEC.
- The Digital Taxonomy Act of 2019 (DTA) proposes to appropriate US$25 million annually to the FTC between 2020 and 2024 to prevent unfair and deceptive practices in digital asset transactions. Additionally, the DTA would ask the FTC to provide an annual report to Congress outlining any actions it takes in furtherance of its mandate in relation to digital assets along with legislative recommendations. (See “US Digital Asset Bills: Will April Legislation Bring May Flowers?”)
Custody Is Still Problematic
The SEC and FINRA clarified their position on the possible custody of digital assets that are deemed securities by broker-dealers through the following measures:
- The July 8 joint staff statement from the SEC and FINRA (Joint Statement) clarified that broker-dealers that do not seek to custody digital assets, but seek to otherwise engage in brokerage activities with digital assets (e.g., private placements, or if the broker-dealer matches buyers and sellers who conduct settlement between themselves), should be permitted to do so. However, the Joint Statement specified that broker-dealers were not yet permitted to custody digital assets. (See “Can Broker-Dealers HODL? SEC and FINRA Say Keep It Noncustodial for Now.”)
- On September 27, FINRA granted broker-dealer status to a digital asset platform, Harbor Square Investments, a firm that helps issuers of private securities to tokenize their offerings and bring security tokens to market on its blockchain-based platform. In keeping with the Joint Statement from July 2019, the approval is for a limited-purpose private placement broker-dealer, for which custody is not required. (See “Harbor Finds Calmer FINRA Waters Outside the Custody Storm.”)
Action by No-Action
According to SEC Chairman Clayton, in 2019 the SEC took a measured, yet proactive regulatory approach with respect to digital assets that was intended to foster innovation and capital formation while protecting investors and investment markets. As a result, the SEC released several no-action letters, a promising sign that the agency is willing to engage with companies making good-faith efforts to bring innovative blockchain-based products and services to the marketplace. Notable instances of the SEC’s measured approach include:
- TurnKey Jet, Inc. (April 3): The no-action letter stated that TurnKey’s proposed digital asset, designed to pay for charter flights, would not constitute a security. While the market buzzed about the letter being a first of its kind for digital asset offerings, the SEC’s conclusion that Turnkey’s token is not a security directly followed prior guidance finding that prepaid redeemable credits, such as gift certificates, are not securities. (See “New SEC Token Guidance: This Is Howey Do It.”)
- Pocketful of Quarters, Inc. (July 25): The no-action letter cleared the way for the issuance of “Quarters,” one of two digital assets released by Pocketful on the Ethereum blockchain, provided that Pocketful complied with various conditions intended to ensure Quarters maintain non-security status. For the most part, the stipulations mirror the same requirements enumerated by the SEC in its no-action relief granted to TurnKey. (See “Meet Me at the Arcade: SEC Provides No-Action Relief for Ethereum-Based Gaming Token.”)
- Paxos Trust Company (October 28): No-action relief was granted to Paxos to conduct a two-year “feasibility study” of a securities settlement service using distributed ledger technology. During this period, Paxos will be permitted to operate as a clearing agency under Section 3(a)(23) of the Securities Exchange Act without needing to register as a clearing agency under Section 17A(b)(1) of the same act. The no-action relief for the Paxos Settlement Service is limited to clearing a volume-restricted number of trades per day of highly liquid publicly traded equities, for at most seven eligible broker-dealers. (See “The SEC Greenlights a Blockchain Settlement Service for Public Shares.”)
Beware the Crypto Cops
The SEC’s attempts to provide regulatory clarity for the crypto space did not detract from its mission to also deter and punish actors that it deemed to be in violation of securities laws. As a result, 2019 saw the agency take a number enforcement actions, which raised renewed calls for the SEC to publish clear and up-front guidance rather than to regulate through post-hoc enforcement. Notable actions included:
- Kik Interactive Inc. (June 4): The SEC alleged in a judicial complaint that Kik conducted an illegal securities offering when it raised US$100 million in its Kin token offering in September 2017. The SEC is seeking a permanent injunction, disgorgement plus interest, and a penalty. The litigation is ongoing and contentious, as Kik has challenged the constitutionality of the Howey Test as a way of judging whether a token constitutes a security. (See “What the SEC’s Lawsuit Against Kik Teaches Us About Token Presale Agreements.”)
- SimplyVital Health, Inc. (August 12): The SEC concluded that SimplyVital violated the Securities Act by failing to register an initial coin offering (ICO) presale. In the enforcement order, the SEC found that SimplyVital’s ICO presale (an acknowledged securities offering) did not qualify for an exemption from registration because certain ICO presale participants had pooled their funds in order to participate in the presale and SimplyVital had “failed to take reasonable steps to verify that purchasers of securities sold in its presale offering were accredited investors.” The enforcement order reinforces that private placements of securities must adhere to all requirements of the exemption, and that Securities Act violators who seek to remediate investor losses (such as SimplyVital did in returning nearly all presale proceeds) may be shown leniency by the SEC. (See “SEC’s Crypto Summer Continues.”)
- ICO Rating (August 20): The SEC fined ICO Rating US$268,998 for failing to disclose (as required by securities laws) that the content published on its website was paid promotion content rather than independent research and ratings of tokens offered in ICOs. (See “SEC’s Crypto Summer Continues.”)
- Block.one (September 30): In its order, the SEC alleged that Block.one conducted an unregistered ICO in which participants paid more than US$4 billion worth of Ether to purchase more than 900 million of Block.one’s ERC-20 tokens (Block Tokens). The SEC concluded that the Block Token ICO was a securities offering requiring registration in part because it was conducted to raise capital for the development of Block.one’s blockchain platform, and US persons participated despite Block.one’s apparent efforts (including notices of prohibition on sales, sales agreement disclosures, and geoblocking). The company agreed to pay a modest civil penalty of US$24 million to settle the charges, which some commenters believe is proportional with the amount of total proceeds raised from US participants. Compared with earlier enforcement actions, the sanctions imposed on Block.one appear relatively light as Block.one was not required to register the Block Tokens as securities or offer refunds to ICO participants. (See “The SEC Continues Its Enforcement Streak Against Unregistered Token Offerings.”)
- Nebulous, Inc. (September 30): Nebulous was fined US$225,000 for failing to register the offering of two types of tokens that it had issued. The order alleged that in May 2014, Nebulous raised approximately US$120,000 from the public offer and sale of SiaNotes. When Nebulous launched its decentralized cloud storage network in April 2015, it publicly offered to exchange SiaNotes for another token, SiaFunds, that entitled investors to a share of Nebulous’ future revenue. The SEC found both SiaNotes and SiaFunds to be securities. (See “The SEC Continues Its Enforcement Streak Against Unregistered Token Offerings.”)
- Telegram Group Inc. (October 11): The SEC filed an emergency judicial complaint in federal court against Telegram for alleged violations of the registration provisions of the Securities Act. The SEC obtained a temporary restraining order and a preliminary injunction against Telegram to prohibit the messaging app creator from participating in any offering of unregistered securities, including distributing its Gram tokens to any person. The case is expected to delve into a number of issues central to the determination of how securities laws apply to digital assets. The next hearing is set for early 2020. (See “The SEC Continues Its Enforcement Streak Against Unregistered Token Offerings.”)
- Blockchain of Things, Inc. (December 18): The SEC concluded that Blockchain of Things, Inc. (BCOT), violated the Securities Act between December 2017 and June 2018, when it raised US$13 million through an unregistered token offering without an applicable exemption. The order required BCOT to pay a penalty of US$250,000 for its violations. In exchange for lighter civil penalties, BCOT entered into a settlement with the SEC in which BCOT will, among other stipulations, register the BCOT tokens under Section 12(g) of the Securities Exchange Act as a class of securities, refund token purchasers who purchased tokens prior to July 31, 2018, and make a claim for repayment.
Official Skepticism of Private Global Stablecoins Persists
While many central banks are investigating and even planning their own central bank digital currencies, 2019 will certainly be remembered as the year when the wings of private global stablecoin innovators were clipped by sovereign regulators. Examples of the regulators’ skepticism of private global stablecoins include:
- The Group of Seven Working Group on Stablecoins released a report at the October 2019 International Monetary Fund annual meeting, “Investigating the Impact of Global Stablecoins” (G7 Report). The G7 Report highlighted many of the G7’s concerns with the development of global stablecoins that are linked to a basket of real-world assets or sovereign currencies. Chief among these concerns is the purported threat that global stablecoins may pose to global financial stability and national monetary sovereignty. (See “The G7 Draws a Line in the Sand for Global Stablecoins.”)
20/20 in 2020?
It is clear that token regulation has been a concern — if not a priority — of regulators and lawmakers alike this past year. With 2019 (defined as it was by unsteady steps and piecemeal progress) coming to a close, we can only hope that 2020 affords a clearer vision for the regulation of digital assets.