On April 29, blockchain took over the Cyberlaw Podcast once again with Alan Cohn, Gary Goldsholle, Will Turner, and guest speaker, Jeff Bandman, covering all things blockchain and cryptocurrency. We dove right into the recent activity from the SEC, namely, the Framework for “Investment Contract” Analysis of Digital Assets and the No-Action Letter issued to TurnKey Jet, Inc. (TurnKey) for a digital token. The framework focuses primarily on the reasonable expectation of profits and efforts of others prongs of the Howey test. The TurnKey No-Action Letter was most useful for parties interested in structuring a private, permissioned, centralized blockchain, but the guidance in the Framework would allow for alternative structures. We also discuss the importance of network functionality and the tension between the need for centralization to achieve functionality, and the need for decentralization as a means to avoid meeting the “derived from the efforts of others” prong of the Howey test.
After touching on Blockstack’s Regulation A filing and the recently reintroduced Token Taxonomy Act of 2019, we turn to the interview with Jeff, who describes how he co-founded Global Digital Finance (GDF). GDF has a number of working groups focused on developing high-level principles and standards on a range of topics, including stablecoins, custody, tax, and security tokens. Jeff is also in the process of launching a new transfer agent service, Block Agent, focused on enabling and supporting SEC-regulated issuances.
You can read the full summary and listen to the podcast here.
Bipartisan members of the House are advocating for more clarity in the tax law as it relates to taxation of cryptocurrency.
First, on April 9, Representative Warren Davidson (R-OH), a member of the House Financial Services Committee, reintroduced legislation that would provide clarity on certain tax and securities law issues related to cryptocurrency. The bill, entitled the “Token Taxonomy Act of 2019,” resembles the original bill that Davidson introduced in the 115th Congress with Congressional Blockchain Caucus co-chair Darren Soto (D-FL). The 2019 version of the bill is co-sponsored by Representatives Soto, Josh Gottheimer (D-NJ), Ted Budd (R-NC), Scott Perry (R-PA), and Tulsi Gabbard (D-HI) (who has announced she is running for President).
Davidson said in a statement that “[t]he Token Taxonomy Act is the key to unlocking blockchain technology in America. Without it, the U.S. is surrendering its innovative origins and ownership of the digital economy to Europe and Asia.”
The bill would enact a number of new tax provisions. The new tax provisions apply only to “virtual currency,” which is generally defined as “a digital representation of value that is used as a medium of exchange,” and so would not apply to digital tokens that are not used as a medium of exchange. The tax provisions of the bill would:
Expand like-kind exchanges under section 1031 to include virtual currencies. The tax legislation enacted at the end of 2017 limited like-kind exchanges completed after December 31, 2017 to exchanges of real property. However, taxpayers would still need to determine whether exchanged virtual currencies are treated as “like kind” in seeking to qualify for this tax-deferred treatment. As a result, the ability to conduct like-kind exchanges of virtual currencies would be uncertain, as it was prior to 2018.
Create a de minimis exclusion from gross income for up to $600 (indexed to inflation) of gain from certain sales or exchanges of virtual currency for property other than cash or cash equivalents. This provision would help taxpayers avoid recognizing gain when they use appreciated virtual currencies for small consumer transactions. Under current law, a taxpayer who purchases even a small item—such as a cup of coffee—with appreciated virtual currency generally recognizes gain on the increase in the value of the virtual currency during the time that they held it.
Authorize the Treasury Department to issue regulations providing for information returns on transactions in virtual currency for which gain or loss is recognized. It is unclear how current information reporting rules apply to many virtual currency transactions. Guidance from Treasury could be very helpful to taxpayers who want to ensure that they are compliant with tax reporting rules. However, in order to create an administrable system that is not overly burdensome to taxpayers, the guidance would have to be implemented in a way that is sensitive to the unique issues surrounding transactions executed via blockchain.
Clarify that an IRA may hold virtual currencies under rules similar to those currently in place for certain metallic coins or bullion.
Although the bill has bipartisan support, the challenge will be to find a vehicle for passage. Possibilities include an extenders package or disaster relief, but including additional tax provisions will likely face opposition.
Second, on April 11, a group of 21 bipartisan members of Congress sent a letter to the IRS urging them to provide guidance on the tax consequences for taxpayers that use virtual currencies. While the letter acknowledges the 2014 guidance released by the IRS, it stresses that there are still many open questions. It identified three areas where there is an “urgent need” for guidance: (1) how to calculate the cost basis of virtual currencies; (2) how to allocate basis to particular lots of virtual currencies; and (3) the tax treatment of forks.
Although the IRS has been considering cryptocurrency guidance, it currently has its hands full with implementing the 2017 tax legislation. It is possible that the IRS will consider “informal” guidance, such as FAQs on its website, as previewed by Commissioner Rettig last November.
On April 3, the US Securities and Exchange Commission (SEC) provided important guidance for token issuers. The SEC Division of Corporation Finance issued a No-Action Letter dated April 3 regarding TurnKey Jet, Inc. (the “TurnKey No-Action Letter”) in which the SEC staff confirmed that it would take no action against Turnkey Jet, Inc. (TKJ) for selling tokens without registration. This guidance is most relevant to token issuers who are focused on commercial utility and record-keeping benefits in a centrally controlled network and are willing to minimize or eliminate the profit elements of the token. The TurnKey No-Action Letter, taken together with the Framework for “Investment Contract” Analysis of Digital Assets (“Framework”) issued by the SEC’s Strategic Hub for Innovation and Financial Technology on the same date, offers guidance for structuring the elements of a private, permissioned, centralized blockchain token and network.
The SEC staff emphasized the following elements of tokens sold by TKJ (TKJ Tokens) and the associated network in the TurnKey No-Action Letter:
No proceeds from token sales are used to develop the network or related software;
The network is “fully developed” and operational before tokens are sold;
When sold, the tokens are usable for their stated commercial functionality;
Tokens cannot be transferred outside of the network;
Tokens are sold by the issuer at a stable price throughout network operation;
Each token represents an obligation to supply commercial services valued in a stable amount (i.e., the tokens are stablecoins);
The issuer only repurchases tokens at a discount to their face value; and
Marketing of the tokens emphasizes their functionality, and not potential for increases in market value.
TKJ’s no-action request contains a lengthy description of the proposed network and tokens. These facts may prove significant to the SEC’s evaluation of any subsequently issued tokens seeking to rely upon the TurnKey No-Action Letter. Some features of the TKJ network and token elements that may prove significant to structuring TKJ Tokens and associated networks include:
A network that is a permissioned blockchain, where permission is conditioned upon agreement to contractual terms and conditions;
Fees for participation in the network are permissible;
Distinctions among network users are possible, and may even be required to the extent individual consumers participate;
TKJ Tokens allow the continuing active participation of the token issuer without causing the tokens to be securities, addressing a major focus of the Framework;
The network operator satisfies applicable know-your-customer/anti-money laundering and sanctions requirements for network participants (in this case, in concert with stricter security and identity requirements for users of on-demand private aviation); and
Token marketing materials emphasize the tokens’ consumptive use, and users represent that their purchases are for commercial use.
Of course, some of these may prove less significant than other elements not emphasized above.
Other interesting elements of the TKJ Tokens could prove significant to future responses from the SEC staff. First, the nominal asset underlying the TKJ Tokens is the US dollar, rather than a commodity or company product or service. The Framework seems to contemplate a greater variety of asset pegs, but pegs of commodities, foreign currencies, or in-kind delivery may raise greater concerns of speculative or investment opportunity and may implicate other statutory regimes. Second, TKJ commits to continuous and open-ended sales, which appears to factor heavily in its argument that TKJ tokens would have future price stability. Third, the US dollars underlying the TKJ tokens will be maintained in escrow with banks on a one-to-one ratio, and escrow balances will be subject to independent audit. The escrow arrangement contractually limits TKJ’s discretion over the use of the escrowed funds, but seemingly subjects network participants to risk of contractual breach by TKJ, and the escrowed amounts to the risk of claims by TKJ’s creditors. Finally, TKJ committed to offer no rebate, reward, bonus, or similar program. This commitment creates greater restrictions than are sometimes observed for prepaid and stored value programs.
As a product of the SEC, the TurnKey No-Action Letter does not address potential issues associated with other applicable regulatory frameworks. For example, the creation and maintenance of a centralized, permissioned blockchain operating in whole or substantial part within the United States may trigger US anti-money laundering (AML) regulations administered by the US Department of the Treasury’s Financial Crimes Enforcement Network (FinCEN) applicable to Money Services Businesses (MSBs). Notably, administrators and exchangers of convertible virtual currency could be viewed as a type of MSB known as a money transmitter. Additionally, use of fiat currency to purchase a digital token of this type may be subject to rules about acting as a provider or seller of prepaid access, a different type of MSB. However, the regulations contain a number of potential exemptions or limitations, which centralized, permissioned blockchain creators may be able to avail themselves of in certain scenarios. Such activity may also trigger money transmitter laws at the state-level, depending on the particular facts and circumstances.
The TurnKey No-Action Letter appears to provide a path for issuing stablecoins with potential widespread applicability as an alternative to stored value and prepaid programs without registration as securities. TKJ Tokens may provide their issuers with the following benefits, among others:
Prepayments for products or services that provide positive cashflow (i.e., “float”);
Avoidance of wire, credit card, and other intermediary fees;
Avoidance of foreign exchange translation costs;
Interest income on escrowed balances supporting token redemption obligations;
GAAP income as fulfillment obligations are written-off for non-redemption;
Records management efficiencies from blockchain recordkeeping;
Transaction settlement and auditing efficiencies from blockchain recordation speed, immutability, and multiplicity;
Processing of transactions outside of normal banking hours; and
Smart contract implementation that may lead to reduced personnel costs and fewer commercial disputes.
On the other hand, the path represented by the TurnKey No-Action Letter may not be attractive to other types of start-up businesses and protocol developers, in particular, those intending to create protocols or networks with decentralized management and governance decision-making. In sum, the TurnKey No-Action Letter brings welcome clarity to one type of token offering—i.e., a token issued in conjunction with a developed private, permissioned, centralized blockchain network—but the Framework and guidance from other regulatory agencies is needed to understand the broader landscape of token offerings.
 The TurnKey No-action letter and Framework are expressions of staff views and are not binding upon the SEC. Further, the TurnKey No-action Letter is not formally applicable to any issuer other than TKJ. Nevertheless, no-action letters and staff bulletins reflect substantial deliberation by the SEC staff and in practice are often highly influential on the SEC. We therefore believe that the TurnKey No-Action Letter and Framework provide important guidance to future token issuers.
 While the operational element would seem to be satisfied by a network that has reached the minimum viable product stage, it is not clear whether full development is intended to represent some later stage of development.
 It appears that redemptions (i.e., “burns”) of tokens in exchange for the underlying value can be made at par, at least to commercial users.
 See additional insight from Steptoe on the Framework here.
 It is possible that further measures of security could affect the determination of TKJ’s counsel that the tokens are not notes under the Reves test. Reves v. Ernst & Young, 494 U.S. 56 (1990). However, the SEC staff’s response in the TurnKey No-Action Letter makes no mention of this issue.
 These regulations generally apply to the creation and issuance of tokens constituting convertible virtual currency, but may also be triggered by engaging in other activities that could be viewed as the administration or exchange of such tokens or currency.
The Framework offers the clearest indication yet of the SEC staff’s thinking on the Howey test, with the TurnKey No-Action Letter and the Hinman speech providing examples of where a digital asset fails to meet a necessary element of the test. For purposes of clarity, it helps to think of the Howey test as having four elements: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) derived from the efforts of others.
The first two prongs are essentially throwaways inasmuch as the Framework devotes only three sentences to them in total. SEC staff note that these prongs are “typically satisfied” in evaluating digital assets. On the other hand, the Framework pays significant attention to the third and fourth elements.
Starting with the “efforts of others” element, the Framework introduces the concept of an “Active Participant” (AP) as a promoter, sponsor, or other third-party (or affiliated group of third-parties) that provides essential managerial efforts that affect the success of the enterprise. The Framework then gives examples of when the actions of the AP are likely to indicate that a purchaser of a digital asset is relying on the efforts of others. In prior cases, the SEC has focused on whether a network is fully functional or still in development, and whether it has achieved the requisite level of decentralization. On this latter point, the Framework confirms that decentralization is to be viewed from a governance and managerial standpoint. The staff is interested in whether the AP has a “central role” in the maintenance and ongoing development of the network. It also may be worth noting that the Framework characterizes this element as “reliance on the efforts of others” in contrast to the DAO report and the Hinman speech, which use the phrase “derived from the managerial efforts of others.” There is no explanation given for this shift in phrasing.
The Framework’s analysis of the “reasonable expectation of profits” element further introduces many new characteristics that may not have historically been viewed as evidence that a purchaser has a reasonable expectation of profits. These include whether the digital asset is transferrable or likely to be so in the future; whether there is correlation between the purchase price of the digital asset and the value of goods or services for which it can be exchanged; or whether the AP is able to benefit as a result of holding the digital asset.
However, the clearest understanding of the staff’s thinking on this element comes from the TurnKey No-Action Letter in which the SEC Division of Corporation Finance staff found a purchaser of tokens sold by TurnKey Jet, Inc. (TKJ and TKJ Tokens) would not have a reasonable expectation of profits. In this case, the token is essentially a dollar-denominated stablecoin that can be used solely to purchase air travel priced in USD, and where any redemptions by the issuer would be at a discount (i.e., less than one USD). The TKJ Token is a means for users and providers of air travel services to avoid various transaction costs and delays associated with credit cards and wire transfers. TKJ Tokens are not likely to appeal to many entrepreneurs who seek the benefits of open-source software development and community networking, such as speed to execution, diverse development activities, sharing of expenditures among multiple network participants, fostering alternative network uses and commercial providers, and diversity of viewpoints in network governance. (See additional insight from Steptoe on the TurnKey No-Action Letter here.)
Fortunately, an investment contract must meet all four elements of the Howey test, and thus most entrepreneurs will focus on whether the purchaser of a token is relying on “the efforts of others.” It was this element upon which Director William Hinman in his June 2018 speech concluded that Ether was not a security. Many of the factors cited in his speech have been incorporated into the Framework, but they are now better understood because they are placed directly in the context of each element of the Howey test, and because there is a greater understanding of what is meant by when a “network on which [a token] is to function is sufficiently decentralized.” These factors include:
Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset;
Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts; and
Whether the efforts of an AP are no longer affecting the enterprise’s success.
While expectations were flying high that the Framework and TurnKey No-Action Letter would answer all outstanding questions concerning token issuances, we believe the Framework and TurnKey No-Action Letter – read together with the Hinman speech – are a positive step forward to providing a clearer flightpath to compliance.
 In the Framework, the SEC describes the Howey test as having three elements, treating the “reasonable expectation of profits derived from efforts of others” prongs as a single element, but then identifying separate characteristics for determining whether there is (i) reliance on the efforts of others; and (ii) a reasonable expectation of profits.
 The “efforts of others” element is clearly satisfied because TKJ is retaining total control over all aspects of the network.
Last week, U.S. District Judge Gonzalo Curiel of the Southern District of California reversed his previous November 2018 order and issued a preliminary injunction against Blockvest LLC (Blockvest) and its founder, Reginald Buddy Ringgold, III, after finding that the Blockvest token (BLV token) met the definition of an investment contract under the Howey test and was therefore a security. While we are keen to see an example of a digital asset that falls outside the definition of a security either through application of the Howey test or a new test, we are relieved that Judge Curiel did not use the Blockvest case to set forth this precedent.
Blockvest and its BLV token – like many initial coin offerings (ICOs) – had a website and a whitepaper, and conducted a pre-sale (claiming to have raised $2.5 million in seven days). However, Mr. Ringgold later allegedly said that BLV tokens were never sold to the public and only 32 pre-vetted “testers” with a personal relationship to him collectively invested less than $10,000 of Bitcoin and Ether into the Blockvest Exchange. It was under these disputed facts that Judge Curiel initially held that the BLV token was not a security.
Upon reconsideration, though, the judge looked more expansively at the promotional materials, the whitepaper, and the use of social media surrounding the BLV token ICO. He found that any legitimate aspects of the BLV token were dwarfed by the numerous alleged fraudulent misrepresentations by Blockvest, including:
That the BLV token is “registered” and “approved” by the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and the National Futures Association (NFA);
That Blockvest “partnered” with and is “audited by” Deloitte Touche Tohmatsu Limited (Deloitte); and
That Blockvest is overseen by the fictitious Blockchain Exchange Commission (BEC), which has a seal, logo, and mission statement nearly identical to those of the SEC (conveniently enough, the BEC also shares the same address as the SEC).
Based on this collection of evidence, Judge Curiel found that the BLV token satisfied the three elements of the Howey test – (1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others. (Judge Curiel, though, still continues to believe that there are disputed issues of fact with respect to the offers and promises made to the testers and other investors.)
In issuing the preliminary injunction, Judge Curiel also found a reasonable likelihood that the fraudulent conduct would be repeated. In his earlier order, Judge Curiel was satisfied by Mr. Ringgold’s statements that he intended to comply with the federal securities laws and that he had ceased all efforts to proceed with the ICO. As to the fraudulent misrepresentations noted above, Mr. Ringgold acknowledged that “mistakes were made.” Judge Curiel now seems less sympathetic to Mr. Ringgold, questioning how creating a fictitious agency that so closely resembles the SEC could merely be a “mistake.” It also appears that the decision of Blockvest’s counsel to withdraw, after being asked to file documents that it could not certify were factually or legally supported, influenced the judge’s view that the alleged fraud is likely to continue.
In sum, this preliminary injunction is a victory for the SEC – and a favorable outcome for the cryptocurrency community. If the alleged fraudulent activities were capable of skirting the federal securities laws, the reputation of the industry could have suffered and the potential for unnecessary and potentially reactive legislative fixes could have intensified.
And while we do not share SEC Chairman Jay Clayton’s view that all token offerings are securities, we agree with him and the SEC that the BLV token is not the example that disproves this view. Judge Curiel – in reversing his previous order and holding that the BLV token is a security – has essentially saved for another day an example of when a token issued through an ICO is not a security. The wait continues.
The Global Blockchain Business Council (GBBC) recently published its 2019 Annual Report, “Beyond the Hype: Building Blockchains for Real World.” The report provides a comprehensive update on the global regulatory landscape surrounding blockchain technology along with an overview of some of the blockchain solutions being built by GBBC members.
Steptoe authored an overall insights piece, titled “Regulation in the US: Where are We, and Where are We Going?,” which looks at where the United States stands in terms of regulation and predicts what we’ll see in terms of regulation in 2019. Steptoe also provided regulatory updates for the United States as part of a global regulatory overview, with specific insights on ICO regulation in the US.
Last month the Texas Department of Banking published an updated supervisory memorandum discussing the application of the state’s money transmitter law to digital assets. Nearly every state has a money transmitter statute regulating businesses engaged in the transfer of money within that state, but states vary considerably with respect to how their laws apply to digital assets. A number of states, including Texas, have taken the position that their money transmitter laws apply only to fiat currency and not cryptocurrency. Such laws might still apply to a cryptocurrency company, for example one that exchanges cryptocurrency for fiat currency, but don’t govern companies that do not offer fiat-based services.
Most observers have assumed that stablecoins, a type of cryptocurrency tied to an underlying asset in order to promote price stability, would be treated like other types of cryptocurrency and not regulated in states whose laws apply only to fiat currency. However, the recent guidance from Texas, a fiat-only state, takes a more nuanced approach.
Under the new Texas guidance, stablecoins that are (1) backed by fiat currency and (2) issued with a redemption right to convert the stablecoin into fiat currency at a future date are considered “money or monetary value” under the Texas Finance Code and therefore may be subject to the state’s money transmitter licensure requirement. The guidance adds, “This is true regardless [of] whether the redemption right is expressly granted or implied by the issuer.”
Notably, the Texas guidance on such stablecoins appears to apply to any entity “receiving [the stablecoin] in exchange for a promise to make it available at a later time or different location.” This means that in addition to the issuer of the stablecoin, other entities dealing in the stablecoin, such as an exchange, may need to obtain a license to operate within Texas. This could have important implications for a variety of digital asset companies, including crypto-to-crypto exchanges, which may have previously viewed themselves as outside the scope of the state’s regulations.
The Texas guidance marks the first time a state regulator has explicitly addressed the issue of stablecoins. It remains to be seen whether other states with fiat-only money transmitter regimes will move to regulate fiat-backed stablecoins. In the meantime, the new Texas guidance will create an additional layer of complexity for digital asset companies seeking to comply with the complex and differing web of state money transmitter laws.
Have you ever wondered how blockchains can be considered secure even though hacks of cryptocurrency exchanges routinely make headlines? Or whether distributing a permanent ledger to every participant in a network might run afoul of privacy laws and regulations? Data security and privacy are frequently part of the conversation about blockchain and technology in general, and they raise complicated legal issues for practitioners and clients to consider.
In a recent article for Practical Law, Jared Butcher offers in-depth analysis of these issues, surveying the rapidly evolving landscape where blockchain intersects with data security and privacy. The article focuses on the fundamentals that practitioners should understand when thinking about the cyber threats and potential vulnerabilities in blockchain applications. It then provides an overview of the developing privacy landscape, including the potential tension between blockchain’s immutability and the GDPR’s mandates such as the right to be forgotten. Although there are no easy answers, the article walks through the questions with an eye toward fostering a better understanding of the current state of blockchain security and privacy.
Click here to read the article, “Cybersecurity Tech Basics: Blockchain Technology Cyber Risks and Issues” and learn more about these issues.
Evan Abrams recently published an article on CIO Review titled “Blockchain and The Law: How a Simple Project can get Complicated Quickly.” In his article, Evan discusses a number of complex legal regimes that CIOs should consider when building enterprise blockchain applications. Companies should assess which legal regimes apply to their specific application from both a federal and state level and keep in mind the laws applying to blockchain technologies can change rapidly. At the federal level, oversight may come from the Department of Treasury’s Financial Crimes Enforcement Network, the Securities and Exchange Commission, the Commodity Futures Trading Commission, and the Internal Revenue Service, among others. Companies seeking to enter the blockchain space should also look at state regulation, which varies widely. For example, New York has adopted a regulatory regime known as the BitLicense that covers a variety of virtual currency business activity.
On December 17th, Alan Cohn hosted the 244th episode of The Cyberlaw Podcast. We took a deep dive into all things blockchain and cryptocurrency discussing recent regulatory developments and projections for 2019.
Our episode begins with Alan welcoming Will Turner, who recently joined Steptoe’s Corporate and Blockchain Practices as partner in the firm’s Chicago office. Will Turner explains why the crypto market became bear in 2018, associating this development to the increase in mergers & acquisitions activity in the crypto market. Moving into 2019, Will projects the “hot items” will be anti-money laundering and securities compliance. Evan Abrams discusses the joint statement issued by the Federal Reserve, the Federal Deposit Insurance Corporation, the Treasury’s Financial Crimes Enforcement Network, the Office of the Comptroller of the Currency, and the National Credit Union Administration urging use of technology to bolster anti-money laundering compliance. Abrams also highlights the New York Department of Financial Services (NYDFS) recent announcement authorizing Signature Bank, a New York State-chartered bank, to offer a digital payment platform that leverages blockchain technology called Signet. Finally, Josh Oppenheimer covers recent LabCFTC updates from the Commodity Futures Trading Commission. Oppenheimer also discusses the pledge the G20 nations made earlier this month regarding their commitment to regulate crypto-assets to further a resilient and open global financial system.
For the interview portion of our podcast, Alan welcomes back Gary Goldsholle, who joins the firm as partner, after serving nearly four years as deputy director and senior adviser of the Securities and Exchange Commission’s (SEC) Division of Trading and Markets. Goldsholle discusses some of the SEC’s recent activity, including charging two cryptocurrency companies who conducted initial coin offerings in violation of the securities registration rules and settling an order against EtherDelta for operating as an unregistered “exchange.” This activity has significant implications for the industry regarding regulatory oversight and enforcement of cryptocurrency companies.
You can read the full summary and listen to the podcast here.