The Bi-Weekly updates took a break during the holiday season, but the Web3 developments did not. It was a busy month in both litigation and regulatory changes, including what is expected to be a wave of approvals for various spot bitcoin exchange traded funds which will make exposure to bitcoin as a store of value more available to institutional and other investors.  It is possible that by the time this is posted the first round of approvals will be granted which we will cover in the next Bi-Weekly installment. These developments and a few other brief notes are discussed below. Mango Markets “Profitable Trading” Strategist Loses Early Dismissal Bid: December 18, 2023 Background: Avraham (“Avi”) Eisenberg lost on his Motion to Dismiss the criminal Complaint against him regarding his October 2022 exploit of the Mango Markets trading protocol. The Order is available here. Avi is facing criminal charges of commodities fraud, commodities manipulation and wire fraud. The Court specifically rejected Avi’s Major Question defense, stating “Eisenberg cites no authority for applying the major-questions doctrine in the context of a single criminal case.” It went on to hold, though, that “this denial is without prejudice to Eisenberg raising his arguments by way of a Rule 29 motion for judgment of acquittal after the close of the government’s evidence…” Summary: As you may remember, in October of 2022, Avi used what he referred to on Twitter as a “highly profitable trading strategy,” using a combination of leveraged trades which resulted in the protocol (Mango Markets) becoming insolvent. This case will determine important issues going forward on what level of human interaction is needed for “wire fraud” in a protocol exploit like this, where the main fraud is being perpetrated against an algorithm. While the Court denied dismissal at the Motion to Dismiss stage, it also demonstrated in its Order the need to see additional facts to resolve disputed issues which isn’t proper at this stage in litigation but may be proper later. The development company behind Mango Markets is also having its own regulatory issues in the fallout from the events leading up to the aforementioned criminal prosecution. Elizabeth Warren Sends Letter to Trade Associations Who Oppose Her Bill: December 18, 2023 Background: Elizabeth Warren sent a letter to the Blockchain Association, Coin Center and various advocacy groups “regarding a troubling new report that your association and other crypto interests are ‘flexing a not-so-secret weapon: a small army of former defense, national security and law enforcement officials.’” Sen. Warren’s letter requests further information on the employment of former government officials by digital asset advocacy groups and industry participants. Summary: It is disheartening that a sitting Senator would send a threatening letter demanding information she has no legal right to regarding former government officials working at advocacy organizations after leaving government. Especially considering her former staffer just left the Whitehouse to go to work directly with an advocacy group that previously lobbied him while in his official capacity. Coin Center’s official response was well put: “Engaging like-minded experts to advocate against legislative proposals that one sincerely believes are unconstitutional and detrimental to the nation's welfare does not constitute 'undermining bipartisan efforts in Congress.' Rather, it is the exercise of the fundamental right to freely associate and petition the government. It’s everyone’s right and no one should apologize for doing it. Resorting to questioning motives often reflects an inability to prevail on the merits of an argument itself.” SEC Wins (Mostly) in Terraform Labs Case: December 28, 2023 Background: The SEC was granted summary judgment against Terraform Labs regarding the SEC’s allegation that the UST, LUNA, wLUNA and MIR tokens are investment contracts under the Howey test while being a bit more nuanced about the UST stablecoin and leaving the possibility open that the investment contract is UST in conjunction with the protocols that allowed it to earn interest. Terraform Labs was granted summary judgment dismissing the SEC’s allegations that it engaged in illegal security-based swaps. The issue of whether Terraform Labs’ actions constitute fraud was left for trial. Summary: The Court held that LUNA and MIR were securities, in large part due to statements from founder Do Kwon indicating that LUNA purchasers were effectively putting their money in a common enterprise with expectations of profits from the efforts of Terraform Labs and Kwon. However, the Court also ruled that Terraform’s Mirror Protocol, which allowed users to mint “mAssets,” mirroring real-world assets on the blockchain, were not security-based swaps under the law. Interestingly, the Court did not even cite Judge Torres’ Ripple ruling, despite previously being critical of it on Motion to Dismiss. 2024 Crypto Tax Reporting Unclear Under Infrastructure Investment and Jobs Act: January 1, 2023 Background: The Infrastructure Investment and Jobs Act, which passed Congress in November of 2021, included a provision amending the Tax Code (“6050I”) to require anyone who receives $10,000 or more in cryptocurrency in the course of their trade or business to make a report to the IRS about that transaction. The law became effective as of January 1, 2024, leaving many unclear as to their reporting obligations. Coin Center filed a lawsuit challenging the law in the summer of 2022 and has posted its current thoughts about it here. Summary: Jason Schwartz had a great thread breaking down the reporting obligations. He and others have reported that the IRS appears to believe that the 6050I reporting requirement doesn't come into effect for crypto until after regulations are issued. This also only applies to receipts of one or more related transactions that were received in business and amount to over $10,000. So, 10,000 people buying a jpg for $100 each is not something that should trigger reporting obligation, nor is most day trading, even at a large scale. Additionally, failure to file is a $50 fine unless intentional (and hard to say it would be intentional here in most cases without clarifying rules). In the meantime, at a minimum, we think it would be prudent to maintain accurate books and records while awaiting further guidance from the IRS or for a market practice to develop.” Briefly Noted: There Will Be No Second Sam Bankman-Fried (“SBF”) Criminal Trial: It looks like there will not be a second SBF trial. Charges on campaign finance fraud would not have looked great and could have had collateral effects on the level of trust in our political and judicial system. That said, SBF is most likely going to jail for at least the next decade or two on his existing convictions, so having another trial on matters that would be much more difficult to prove likely would have been a waste of time and resources. BarnBridge DAO Settles with the SEC: BarnBridge DAO, which you may remember had an attorney purporting to represent the DAO post in their Discord about the SEC investigation and had a DAO vote on how to respond to the investigation, settled with the SEC last week. This is an interesting case study in response of DAOs to criminal and civil investigations. Interestingly, the settlement raised the issue of possible registration under the Investment Company Act for the first time since the Blockfi Settlement. Conclusion: The latest updates in blockchain law reveal a dynamic and evolving intersection of blockchain technology, regulation and legal challenges. From the significant developments in the Mango Markets criminal case to the intriguing nuances of the Terraform Labs ruling, these stories underscore the complexities facing the blockchain and crypto industries. Senator Elizabeth Warren's recent actions and the ongoing ambiguity in crypto tax reporting further highlight the intricate dance between innovation and regulation. As we anticipate further developments, particularly regarding the impact of these events on institutional investment in cryptocurrencies, it's clear that the landscape of blockchain technology and law remains as vibrant and challenging as ever. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

Amidst the recent excitement surrounding bitcoin’s price rally, the past two weeks have been unusually quiet for industry legal updates. Which is a welcome relief, after a very busy few weeks leading up to Thanksgiving. But there were still developments in multiple criminal cases in the space, Congress was busy despite the growing consensus that digital asset regulation won’t get past the House until 2024, and the SEC has asked for a ruling as a matter of law regarding the assets in the Terraform Labs case. These developments and a few other brief notes are discussed below. Finance Founder Ordered to Remain in U.S. Pending Sentencing: November 27, 2023 Background: Binance’s former CEO Changpeng Zhao (“CZ”) was ordered to remain in the U.S. while he awaits sentencing on his guilty plea to one count of violation of the Bank Secrecy Act. The Order was temporarily entered by the magistrate judge overseeing his criminal case and associated plea agreement before being affirmed as the correct determination by District Court Judge Richard Anthony Jones. CZ’s sentencing is set for February 23. Summary: It seemed odd that the DOJ would enter the plea agreement with CZ if they did not trust him to return for his sentencing. But the fact that CZ’s domicile country the United Arab Emirates does not have an extradition treaty with the United States and his large amount of resources weighed in favor of keeping him in the United States until sentencing. We covered the CZ plea agreement and its associated impact on the industry in our previous BitBlog Bi-Weekly post available here. SEC Ask Judge to Rule Assets are Securities as a Matter of Law in Terraform Labs Case: December 4, 2023 Background: The SEC has filed a letter with the Court in the SEC v. Terraform Labs case pending in the Southern District of New York that asks the judge determine that the digital assets in question are investment contracts as a matter of law. If successful, this would remove that determination from consideration by a jury. The SEC’s letter argues that the legal nature of digital assets at issue, particularly in the context of the Howey test, is not a matter which should be presented for jury determination in any trial on this issue. Summary: The SEC has hedged its position, stating the assets at issue are securities as a matter of law or, in the alternative, there is no genuine issue of fact precluding the Court from ruling on the issue prior to trial. Smart considering Judge Rakoff’s previous Order on the Motion to Dismiss indicated he views the issue of efforts of others to hinge on a reasonable investor standard which would be an issue for the jury. Meanwhile, Terraform Labs founder Do Kwon is facing extradition for DOJ charges related to the Terra/Luna collapse in the Spring of 2022, although he may be extradited to Korea instead. House Financial Services Subcommittee on Digital Assets Holds Hearing on Fostering Innovation: December 5, 2023 Background: The House Financial Services Subcommittee on Digital Assets held a hearing titled “Fostering Financial Innovation: How Agencies Can Leverage Technology to Shape the Future of Financial Services.” The focus of the hearing was the government’s approach to new and emerging technologies like digital assets, distributed ledgers, quantum computing, and greater use of artificial intelligence. Witnesses included representatives from the SEC, FDIC, the Federal Reserve, and other administrative agencies. Summary: The biggest takeaway was Representative Emmer’s questioning of the SEC representative witness, who also was a commentator on the now-infamous Hinman speech (those comments were publicly released on June 13). There was also a call from Representative Waters for a smaller session specific to the operation of digital asset companies. Despite attempts by Representative McHenry to include digital asset bills which had passed through committee in the omnibus defense authorization bill, those attempts failed to be attached to larger spending measures, making it unlikely for any substantive digital asset regulations to pass in 2024. Notably, Representative McHenry also recently announced that he will not run for re-election at the end of this term. Briefly Noted: House Committee Unanimously Passes Digital Asset Bill: the Deploying American Blockchains Act was unanimously voted through the House Committee on Energy and Commerce. The bill’s substantive provisions are not expected to have a large impact on the industry, but it shows a growing consensus that these assets are something the government needs to gain a better understanding of. Report on Web3 Gaming Released: Colleen Sullivan of Brevan Howard Digital has released an over 150-page essay on the impact of Web3 digital ownership principles on the rising gaming economy. Well worth the read for anybody wishing to gain better insight into this growing industry sector. Bitzlato Founder Plead Guilty: The Founder of Bitzlato has pled guilty and agreed to not participate in any digital asset exchange venture as a part of the deal. The DOJ brought charges against the founder in January, and despite only having an all-time peak of $6 million held on the exchange at any given time, it was accused of being used in laundering over $700 million over its business lifetime. Department of Treasury Seeks Expanded Powers from Congress: The Department of Treasury sent a letter in response to the Senate’s request for information regarding Treasury’s existing powers and what powers the agency needed to fight illicit use of digital assets. Interestingly, the original draft in which the agency stated it did not have the power to designate smart contracts or protocols under existing powers was replaced with a less comprehensive letter which was released to the public. Federal Reserve Manuel Includes Section on Crypto Activities: The Federal Reserve’s recently released updated bank examination manual includes a new section (Section 5330) focused on crypto-related activities. The section also highlights key Federal Reserve guidance on crypto-asset related risks to banking organizations and supervisory considerations in assessing banks engaged in crypto-asset-related activities. Conclusion: In wrapping up this edition of the Blockchain+ Bi-Weekly, even in a relatively calm period for legal developments it's clear that the blockchain and crypto landscapes are rapidly evolving under the watchful eye of U.S. regulators and lawmakers. From the courtroom drama involving Binance's ex-CEO to the SEC's strategic moves in the Terraform Labs case, these developments paint a vivid picture of the intricate dance between legal structures and the ever-advancing world of digital assets. As we observe the unanimous support for the Deploying American Blockchains Act and other regulatory strides, it's evident that the journey towards a more regulated and understood digital asset sphere is well underway. Stay tuned for more insights as we continue to navigate these exciting and uncharted waters of blockchain and crypto regulation. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The week leading up to Thanksgiving was a busy one in blockchain law, with the SEC instituting another lawsuit against a major U.S.-based cryptocurrency exchange, the DOJ and CFTC reaching a settlement in their cases against international exchange Binance and Tether cooperating with the DOJ to freeze almost a quart of a billion dollars in its stablecoin linked to illicit finance. This all came a week after the House of Representatives held a subcommittee hearing to discuss the links between digital assets and criminal operations. These developments and a few other brief notes are discussed below. House Financial Services Subcommittee on Digital Assets Debates Issues Surrounding Illicit Use of Cryptocurrencies: November 15, 2023 Background: The House Financial Services Subcommittee on Digital Assets met on November 15 to ask questions from industry experts on the scale and use of digital assets in terror and other illegal financing. This was largely due to a wave of false or misleading reporting which is described well in this Forbes article, How Misinformation On Hamas And Crypto Fooled Nearly 20% Of Congress. As stated by Senator Lummis, “Crypto is not the problem, bad actors that exist in every industry are.” This hearing followed a letter that was sent from a bipartisan group of lawmakers asking for an executive study on the use of digital assets in Hamas financing. Summary: The testimony of Gregory Lisa and Jane Khodarkovsky are both worth reading, and by all accounts, this hearing was a fair and honest look at digital assets which didn’t overplay its use in terror financing or underplay the serious security threat it represents. At the end of the day, anything of value, be it art, land, fiat currency, gold, crypto or anything similar, is going to be used by people we do not support for purposes that we do not endorse. However, of all the forms of illicit finance, only the movement of digital assets on a public blockchain can be traced in real-time by anyone with access to the internet. There is no means of exchange that is more anonymous than cash, which truly leaves no footprint, and there is no blockchain for cash. We certainly need to do what we can to limit the use of any asset in terror financing, but we also need to do it in a way that doesn’t abridge the rights of Americans to privacy and financial inclusion. SEC Files Lawsuit Against Cryptocurrency Exchange Kraken: November 20, 2023 Background: The SEC has filed a lawsuit accusing the second-largest cryptocurrency exchange in the US of violating federal securities laws. Payward Inc. and Payward Ventures Inc., which operate the cryptocurrency exchange known as Kraken, are the latest to be accused of “unlawfully facilitating the buying and selling of crypto asset securities.” Summary: It was odd this wasn’t filed when the Coinbase/Binance lawsuits were filed. Many assumed that Kraken’s prior $30 million settlement got the exchange some level of approval from the SEC for its remaining operations. That was wrong. While the SEC alleges that Kraken co-mingled customer funds, this is something Kraken self-reported years ago as an accounting issue which happened when Kraken switched accounting systems and they resolved thereafter. Kraken’s founder has pointed out that its cooperation and settlement with the SEC did not help the exchange avoid further litigation, and encouraged others in the space to avoid the U.S. under its current regulatory regime. Many of the tokens named in the lawsuit are used daily as utility tokens and are up big on the year, creating the question of exactly who the SEC is protecting in these actions? Also, the timing of this is certainly suspicious with SEC Chair Gary Gensler potentially front-running the major Binance settlement news his agency wasn’t a part of. Tether Freezes $225 Million in Cryptocurrency Linked to Pig Butchering Scams and Human Trafficking: November 20, 2023 Background: Tether, working in concert with the DOJ and Chainalysis, has frozen $225 million worth of its own stablecoin linked to an international human trafficking syndicate in Southeast Asia. The freeze occurred across 37 self-custodial wallets. The funds were primarily linked to pig butchering scams, where users are tricked into thinking they are sending funds to a cryptocurrency trading platform only to be robbed and refused the ability to cash out. Summary: It appears that Tether is working closely  with the DOJ based on this and other recent cooperative asset freezes. This coincides with the recent push, at the request of Senator Lummis and Representative French Hill, to crack down on major offshore players in the digital asset space. With the Binance settlement discussed below and the DOJ working with a cooperative Tether, that request for attention was seemingly abided by. This is good for the space and shows when there are lawful reasons and court orders to freeze funds, that an asset freeze can still be done without over-intrusive financial surveillance. Head of Binance Pleads Guilty to Bank Secrecy Act Charge and Steps Down: November 21, 2023 Background: On November 21, Binance and its CEO Changpeng Zhao (“CZ”) admitted to violations of anti-money laundering laws along with sanctions violations and operating as an unlicensed money transmitter. You can read the indictment here and the plea document here. As a part of the deal, CZ agreed to step down as CEO, have no involvement with Binance for 3 years, and Binance is required to appoint an independent compliance monitor for three years. Total fines and sanctions were just under $4 billion. CZ will plead guilty to a single count of failure to maintain an effective Anti-Money Laundering program under the Bank Secrecy Act, which carries a maximum sentence of five years. But due to various sentencing guidelines and downgrades, he is likely looking at a maximum of 18 months. CZ primarily lives in the United Arab Emirates, which is a non-extradition country with the U.S., making CZ’s agreement to appear in Seattle for sentencing all the more impactful. Summary: There were rumors leading up to the eventual press conference regarding the charges and plea deal.  The $4 billion is a massive fine but it looks like Binance was already getting ready to pay that for weeks now. CZ’s departure tweet is available here and the Binance official statement is here. Notably, the SEC was not a part of this settlement so its case against the exchange and CZ continues. It was well-known in the industry that Binance took some regulatory shortcuts in its rise to power, so this is not entirely surprising.  This article provides a neat timeline of events leading up to this settlement. Hopefully the new CEO Richard Teng can continue on the path started by his predecessor of compliance with basic AML/KYC obligations. It is also interesting and likely smart that Binance tapped a former compliance officer and regulator to lead the new era of Binance instead of the other co-founder who is conspicuously absent from the settlement. Briefly Noted: Coinbase Funded Challenged to Mixing Service Sanctions  Decision Appealed: The decision in the Coinbase funded challenge to the Tornado.cash sanctions have been appealed. As you may recall, back in August the lower court hearing that matter ruled in favor of the Treasury Department and issued summary judgment. The Blockchain Association has filed a brief in support of the Tornado Cash request for appeal. This was a solid article breaking down the decision behind the filing and its implication on the larger industry. Blackrock and Fidelity File Spot Ether ETF Applications: the Blackrock Spot Ether ETF application has officially been filed along with a matching filing from Fidelity. This comes at the same time as the SEC delays deciding on a variety of Bitcoin Spot ETF applications. Lawmakers Send Letters to State Agencies on Digital Asset Issues: Patrick McHenry, Richie Torres, and a bipartisan group of other lawmakers sent multiple letters this the past two weeks including this letter expressing concerns with the proposed IRS digital asset broker reporting rules and this letter urging agencies not to enforce SAB 121 after the Government Accountability Office’s finding that the SAB violated the Administrative Procedures Act. Domain Service Providers Fight over Patent Applications: The Ethereum Name Service (“ENS”) is in a fight with Unstoppable Domains over the aggressive patent application approach taken by the latter. ENS claims these patents are based on prior technology invented by ENS and others and intentionally put into the public domain for all to use. Conclusion: The past two weeks have been a whirlwind of activity in blockchain law, illustrating the complex interplay between cryptocurrency, regulation, and enforcement. From the SEC's latest lawsuit against a major U.S. crypto exchange to Tether's proactive measures in freezing funds linked to criminal activities, these events highlight the evolving landscape of digital finance. The House Financial Services Subcommittee's balanced discussion on the use of digital assets in illicit finance, along with significant legal developments involving major players like Kraken and Binance, underscores the ongoing challenge of ensuring security and compliance in a rapidly changing sector. As the industry continues to grapple with these issues, it becomes increasingly clear that the path forward requires a delicate balance between innovation, privacy rights, and the imperative to thwart financial crimes. The above events serve as a powerful reminder of the importance of vigilance, cooperation, and thoughtful regulation in shaping the future of digital currencies and their impact on global finance. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

As expected with Congress on break, the news the past two weeks was dominated by updates in major industry litigation efforts. While there was some action on the House’s stablecoin bill in the wake of the major announcement by PayPal that it released its own fully backed stablecoin, most of the focus has stayed on the Coinbase litigation against the SEC and the SEC’s decision to appeal the adverse rulings against the agency in Ripple. These developments and a few other brief notes are discussed below. PayPal Announces Launch of U.S. Dollar-Pegged Stablecoin, PYUSD: August 7, 2023 Background: As we noted in the Briefly Noted section of the last Bi-Weekly update, on August 7 PayPal announced it would be launching a fully-backed dollar-denominated stablecoin, PayPal USD (“PYUSD”). The planned token is an ERC-20 token, which means it can be transferred to self-custodial wallets, but similar to USDC and USDT, it does have freezing functionality and can be seized. Summary: Due to the follow-up news from Washington D.C. on this hotly debated issue of regulated stablecoin issuers, the Blockchain+ team wanted to provide a more in-depth background on the payment processing giant PayPal entering the stablecoin issuer field. Republicans have used the PayPal announcement to make a renewed push to pass the Clarity for Payment Stablecoins Act in the House. Democrat Maxine Waters was reportedly “deeply concerned” about PayPal’s new stablecoin. This may just be the first of many private stablecoins to come, as the issuer of the PayPal stablecoin, Paxos, is reportedly working on other white label stablecoins as well. Senator Lummis and Others File Amicus in Coinbase Litigation: August 11, 2023 Background: On August 11, there was an expected bevy of amicus filings in Coinbase’s litigation against the SEC, with filings in support of Coinbase coming from Senator Cynthia Lummis, the Blockchain Association, a16z/Paradigm, the Chamber of Digital Commerce, the DeFi Education Fund, and a group of securities law professors. The SEC has until October 3 to file its opposition. Summary: Most of the focus was on Senator Lummis’ brief which argues that the SEC is overstepping its authority by treating all crypto assets as securities, which contradicts legislative efforts in Congress and requires proper legislation. Senator Lummis is the co-sponsor of currently pending digital asset legislation titled the Responsible Financial Innovation Act. The brief's importance lies in its representation of a congressional perspective that challenges the SEC's approach and urges the court to defer to the legislative branch for creating a holistic crypto regulatory framework. While all the briefs are well-written and worth a read, the group of securities law professors’ brief also provides a cogent argument supporting the idea that and “investment contract” requires both an “investment” and “contract” to fall under the Howey test for a scheme. SEC Files Intent to File Interlocutory Appeal in Ripple and Ripple Responds: August 16, 2023 Background: On August 9, the SEC filed a letter request to file a motion for leave to file an interlocutory appeal of the Court’s July 13, 2023 Summary Judgment ruling. On August 16, Ripple responded with its own letter of intent to oppose the SEC’s request.  The SEC was given until August 18 to actually file its motion for leave to appeal with all briefing on the subject to be completed by September 8. The SEC’s arguments largely followed its letter, claiming the Court erred in its ruling regarding programmatic sales and “other distributions” to employees and charitable organizations as securities offerings. Summary: Seeking this interlocutory appeal is an aggressive move from the agency. Many thought the current leadership would be inclined to ride the issue out until trial, knowing that uncertainty would be better than a potential sped up major loss on appeal. For more background on the Ripple decision which the SEC seeks to appeal, read our breakdown on the BitBlog available here. As we noted at the time, the Court’s ruling as to “other distributions” was the most cursory of the decision, and there may be a factual record at play which was the reason for such a terse decision on a major aspect of the litigation. Court Issues Summary Judgment in Favor of Treasury Department in Tornado Cash Matter: August 17, 2023 Background: In September of 2022, Coinbase funded a lawsuit brought by six individuals challenging the U.S. Treasury Department’s sanctions of digital wallets linked to the Tornado Cash smart contracts. On August 17, the Court hearing that matter ruled in favor of the Treasury Department and issued summary judgment against the six individuals. The ruling found that Tornado Cash – a protocol comprised of a set of smart contracts with no formal organizational structure – is a “person” for purposes of the International Emergency Economic Powers Act, and that an “association” can be comprised of any group of people with a common purpose.  It further found that the smart contracts comprising the protocol are property in which that association has an interest even though nobody has ownership of the smart contracts, in part because of the fees generated by transactions on Tornado Cash.  This was one of two major lawsuits challenging the sanctions, the other brought by CoinCenter and still pending in the Northern District of Florida. Summary: Coinbase Chief Legal Officer took to Twitter in the wake of the decision saying “[w]e’ve always known that Fifth Circuit review is required to resolve these issues, and we continue to support them on appeal.” The language from the ruling is fairly expansive and does not seem to be limited to smart contracts of a type that comprise the Tornado Cash protocol. That said, smart contract can memorialize legally binding promises, facilitate the performance of legally binding promises, or may just be executable code having nothing to do with promises (legally binding or otherwise). Not all smart contracts act or should be treated the same. The Court seems to have missed this nuance when claiming all smart contracts are like vending machines (which, to be fair, is an example used by blockchain innovator Nick Szabo in explaining one of the functions of smart contracts). Briefly Noted: Celsius Network Plan and Disclosure Statement Approved for Voting by Creditors:  On August 17, the Bankruptcy Court approved the Celsius Network Plan of Reorganization for it to be voted on by eligible creditors. Please see our Bitblog post setting out the relevant timelines as well as our highlighting the terms of the Plan of Reorganization.  With this approval “Earn” creditors are significantly closer to getting repaid at least some of their claims. Eligible creditors should expect to be getting ballets to vote on the plan in the very near future. It Is important for any eligible to vote as one’s recovery may be impacted on whether a creditor voted. Federal Reserve Announced Program Directed Towards Blockchain: The Federal Reserve has announced a new program to “novel activities” for banks related to crypto-assets, distributed ledger technology, and complex, technology-driven partnerships with nonbanks. This level of advanced supervision for banking partners of the digital asset industry has been troubling to many and raises questions as to the legality of such practices. Bittrex Settles with SEC: Bittrex settled with the SEC and agreed to pay a $25 million fine. The release points out the fact that Bittrex told token issuers to scrub statements regarding promises of future returns and such prior to listing the asset. Of note was the SEC’s focus on Bittrex advising token issuers to remove statements which may induce others to rely on the efforts of others and/or expect profits in their decisions to buy tokens. Creating a “once a security always a security” issue for token issuers who made early marketing foot faults. Coinbase Gets CFTC Approval: Coinbase announced that it has received regulatory approval from the National Futures Association (the self-regulatory body governing the US commodities derivative industry) to operate a Futures Commission Merchant (FCM) to offer and sell crypto futures.  While there are a number of approved FCMs that were born from traditional commodities businesses or broker-dealers, this is the first time a retail crypto exchange operator has received a US FCM license. Prime Trust Files for Bankruptcy Protection: Nevada based cryptocurrency custodian Prime Trust filed for bankruptcy protection on August 15 in United States Bankruptcy Court for the District of Delaware. This filing comes as no surprise as Prime Trust has had a number of problems and setback over last the few months. These problems include Nevada's Financial Institutions Division attempting to take over the company in June by declaring them insolvent as well as a failed transaction where they were to be taken over by BitGo. Prime Trust stated in its filing that it has assets of between $50 and $100 million with liabilities of between $100 and $500 million with between 25,000 and 50,000 creditors. SEC Brings First Charges for Violating new Marketing Rule: The SEC’s first crackdown regarding the relatively new “Marketing Rule” under the Investment Advisers Act relates to a crypto fund manager.  Allegations include that the manager extrapolated three weeks of performance into a full year to get to 2700% hypothetical annualized return under a certain strategy, as well as inconsistent disclosure regarding custody of cryptoassets. A big part of the problem was that the manager allegedly buried disclaimers and assumptions used in calculating hypothetical performance behind embedded hyperlinks.  Just as a friendly reminder, an attorney or compliance professional should review any performance information (including hypotheticals, case studies, projections and track record) included in investment adviser marketing materials, even if it’s a tool located on a website or within an app. Conclusion: Over the past two weeks, major developments in the digital asset industry's litigation landscape dominated the headlines. PayPal's announcement of its new fully-backed U.S. dollar-pegged stablecoin, PYUSD, further ignited the ongoing discussions about regulated stablecoin issuers in Washington D.C. Additionally, Coinbase's litigation against the SEC saw support pouring in from influential entities, challenging the SEC's broader approach towards crypto assets. The SEC's decision to pursue an interlocutory appeal against Ripple and the summary judgment in favor of the Treasury Department regarding the Tornado Cash issue reflect the increasing complexity of the legal environment surrounding digital assets. With significant updates from Celsius Network, Federal Reserve, Bittrex, Coinbase, Prime Trust, and the SEC's enforcement actions, it's evident that the intersection of digital assets and regulatory frameworks is in a state of flux. These developments underscore the importance of attorneys for the digital asset industry to navigate and help shape the ever-evolving legal landscape. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. As the end of the year approaches, the biggest news story was founder of the now defunct FTX cryptocurrency exchange, Sam Bankman-Fried (“SBF”), being found guilty on all counts in the criminal trial brought against him in the wake of the exchange’s collapse. The SEC stayed busy in their digital asset enforcement actions responding in opposition to cryptocurrency exchange Binance’s request for an early dismissal and bringing new actions with the DOJ against the founders and executives involved in the SafeMoon project. But while these allegations of digital asset fraud dominated the headlines, traditional financial firms have quietly begun taking steps to expand their cryptocurrency-backed ETF offerings and the Presidential Executive Order on AI mentioned cryptographic proofs as an essential tool to preserve privacy in an increasingly digital world. These developments and a few other brief notes are discussed below. SafeMoon Founders Hit with DOJ and SEC Complaints: November 1, 2023 Background: The SEC has brought a civil action against SafeMoon LLC and executives Kyle Nagy, John Karony and Thomas Smith for securities fraud and unregistered sales of securities. At the same time, the DOJ has also brought criminal securities fraud, wire fraud and money laundering charges against Nagy, Karony and Smith. Summary: SafeMoon previously faced private securities fraud actions last year, so this is not the first time these founders have faced legal challenges to their project. However, while the SEC has been active in the space, the DOJ has largely refrained from bringing criminal actions except in the most egregious situations and the allegations in the complaints here are serious, even if currently unproven. One important takeaway is the amount of marketing statements that the SEC and DOJ relied on to support their securities fraud claims, underscoring the importance of legal compliance training for social media managers involved in projects. Sam Bankman-Fried Trial Comes to an End; Guilty on All Counts: November 3, 2023 Background: SBF’s defense team closed out their defense on October 31, and the trial reached its conclusion with jury instructions set and closing arguments concluded. After these weeks of litigation, it only took the jury just a few hours to come back with a guilty verdict on all counts. These verdicts carry a maximum sentence of 110 years, with sentencing scheduled for March 28, 2024. There is also still a trial scheduled for next year on five more charges, plus potential state criminal charges to come. Summary: While there is still sentencing left and there will almost certainly be appeals and ongoing actions, it is a relief for the industry to have the SBF saga mostly in the rearview mirror. His fraud was a stain on the digital asset industry, so this seems cathartic for it to be over. As the prosecutor stated in closing “This is not about complicated issues of cryptocurrency. It’s not about hedging. It’s not about technical jargon. It’s about deception, it’s about lies, it’s about stealing, it’s about greed.” Consumer Financial Protection Bureau (“CFPB”) Proposed Digital Wallet Regulations: November 7, 2023 Background: The CFBP has proposed new federal oversight rules for non-banks which provide digital wallet or payment applications. Read the proposed rule and request for public comment here. In the release announcing the proposal, CFPB Director Rohit Chopra stated "Today's rule would crack down on one avenue for regulatory arbitrage by ensuring large technology firms and other nonbank payments companies are subjected to appropriate oversight." House Financial Services Committee Chair Patrick McHenry released a statement vehemently opposing the proposed rule. Summary: The CFPB estimates that this rule will affect 17 non-bank financial institutions, but of course, it doesn’t name those and the definitions are broad enough that this number seems low. Assumedly they only mean to encompass payment processors in the traditional sense without focusing on digital assets, but they expressly include bitcoin transfers as a payment so any company which allows for digital asset transfers would seemingly also fall in these rules. SEC Responds to Binance Motion to Dismiss: November 7, 2023 Background: The SEC has responded to the Motions to Dismiss filed by the various Binance entities back in September. While Binance was sued a day before Coinbase, due to some strategic lawyering from Coinbase’s attorneys, Coinbase has led the way in the briefing on the cryptocurrency exchange litigation. This latest briefing kept with that theme with the SEC largely restating the points they made against Coinbase in its case against Binance. Summary: The SEC predictably led with their arguments that securities laws are intentionally flexible, without stating any actual limiting principal on what separates a security from something that a person subjectively buys with at least some profit motivations (like a car, house, our countless other assets which value largely comes from actors other than the purchaser/owner). Interestingly, on page 47 of the briefing, the SEC seems to have finally backed off its position that ETH is a security, stating BTC and ETH are the “largest crypto assets in existence but [are] not at issue here.” Briefly Noted: Update in Digital Asset Bankruptcies: If you are having trouble keeping up with all the digital asset bankruptcy cases, you aren’t alone. Luckily, Stephen Rutenberg and Michael DiPietro break them all down in their recent publication with David Brill. Highly recommend reading to get caught up on what is happening in these cases and what to look forward to in the upcoming year. ETH Spot ETF Application on the Horizon: Financial giant BlackRock has registered a corporate entity "iShares Ethereum Trust" in Delaware, hinting at the imminent submission of a spot Ether ETF filing. Similar to the spot Bitcoin ETF filings, ETH has been approved to be trading in futures products but this would be the first offering of an ETH spot ETF. It will be interesting if the SEC resists this product, or if in the wake of the Grayscale decision, an approval is granted without needing judicial intervention. President Releases Executive Order on AI: While not directly focused on digital assets, the Presidential Executive Order on Safe, Secure, and Trustworthy Artificial Intelligence did include some focus on digital assets, including listing strengthening “privacy-preserving research and technologies, such as cryptographic tools…” as an area of emphasis. To read more on the Executive Order, check out the Polsinelli client alert on this subject. SEC Notes Difficulty in Recruiting Talent Due to Crypto Divesting Requirements: The SEC cannot find people to hire in crypto because of an Office of Inspector General rule which says an individual cannot own any crypto at all if they participate in crypto enforcement actions. As aptly stated in an article published by Paradigm Policy: you can’t regulate what you don’t understand. DeFi Education Fund Issues Tax Proposal Comment Letter: The DeFi Education Fund issued its tax proposal comment letter which lists all the ways the proposed rules would have potentially unanticipated and disastrous consequences. With over 115,000 comments so far, the IRS has some work to do on these proposed rules. SEC's Staff Accounting Bulletin No. 121 (“SAB 121”) Rejected by GAO: The Government Accountability Office (“GAO”) rejected the SEC’s attempt at rulemaking-without-rulemaking by ruling that SAB 121, which required custodied digital assets be listed as liabilities on balance sheets, failed to abide by the Congressional Review Act. Conclusion: The recent developments in the blockchain and crypto ecosystems illustrate a dynamic and evolving landscape at the intersection of technology, finance, and law. The guilty verdict in Sam Bankman-Fried's trial and the SEC's ongoing enforcement actions, including those against the founders of SafeMoon, underscore the legal complexities and regulatory challenges in the digital asset space. Meanwhile, traditional financial firms expanding their cryptocurrency-backed ETF offerings and the Presidential Executive Order on AI recognizing the role of cryptographic proofs highlight the growing mainstream integration and significance of blockchain technology. These developments, along with others discussed, reflect a pivotal moment in the digital asset industry, balancing regulatory scrutiny with innovative expansion. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. In a blistering dissent against SEC overreach in digital asset enforcement actions, SEC Commissioner Hester Peirce stated “[the LBRY] case illustrates the arbitrariness and real-life consequences of the Commission’s misguided enforcement-driven approach to crypto.” Polsinelli previously covered the LBRY decision, and Polsinelli attorney Jonathan Schmalfeld is quoted in the dissent, noting the LBRY avoided the questionable fundraising pitfalls of many in the cryptocurrency space at the time and still felt the wrath of the SEC levied against it. However, despite the statements of Commissioner Pierce, the agency has continued in its enforcement agenda the past two weeks. The agency continues to pursue litigation against cryptocurrency exchange Coinbase, and dismissed certain aspects of the ongoing litigation in Ripple to seemingly gain quicker access to appellate review of earlier decisions in that case. There were also important developments in civil cases such as the trademark infringement case brought by Yuga Labs, and an action brought against the owners of the MetaMask wallet technology by certain alleged early developers. The criminal case against FTX founder Sam Bankman-Fried (“SBF”) also continued the past two weeks, with SBF taking the stand in his own defense. These developments and a few other brief notes are discussed below. SEC Dismissing Remaining Claims Against Executives in the Ripple Case: October 19, 2023 Background: The SEC has agreed to dismiss the remaining claims in the agency’s litigation against Ripple regarding the alleged aiding and abetting of securities law violations by Ripple executives Christian Larsen and Brad Garlinghouse. This means the only remaining issues for the underlying case would be measures of damages related to the SEC’s summary judgment win against the company for certain non-programmatic sales. Summary: While Ripple is calling this a win (which it certainly is), the case against the executives was always weak, so it seems like this is just a strategic move by the SEC to allow them to appeal after their request for interlocutory appeal was denied. So when we previously wrote there was “no chance of appellate review prior to 2024 as the SEC hoped for,” that was under the mistaken belief that the SEC would continue to vigorously pursue its case against the executives. In the absence of Congressional action in the near future, which seems unlikely given the House’s current struggles, an appeal of this case seems like the fastest path to anything resembling regulatory clarity. It also shows how motivated the agency is to remove the programmatic sales ruling from the ether. ConsenSys Sued by Former Employees Regarding Transfers of Assets which Devalued Employees’ Equity: October 19, 2023 Background: Joseph Lubin, one of the founders of the Ethereum Blockchain, formed a company in 2014 to develop tools for that network. These tools included the hugely popular MetaMask wallet. As many start-ups do, early contributors were granted equity in the original companies (which were a Delaware entity, and a Swiss “hub” entity”). However, in 2020 The Swiss entity transferred a vast majority of its assets to a new Delaware entity (CSI) in a $46.6 million sale. Even at the time, this was a controversial sale. The employees of the first two entities are now suing, saying this deal was a way to rob them of their equity. Summary: Back in August a similar lawsuit was filed by a former employee, and Joel Dietz also filed a lawsuit in August claiming invention of the MetaMask wallet, so this is another round of expected litigation over a highly successful start-up. Considering CSI raised in a Series D at $7B valuation last year, it is unclear if these are rightfully upset early developers or vultures circling, but time will tell. Either way, the earlier Swiss litigation is going to raise some early jurisdictional challenges for the employees to overcome. Coinbase Files Final Reply in Motion for Judgment vs. SEC: October 24, 2023 Background: Coinbase filed their Reply Memorandum in response to the SEC in what should be the final substantive briefing on the Coinbase Motion for Judgment on the Pleadings. While there may be requests from the parties to supplement their briefings, such as if there is a development in other cases to alert the Court to, this sets the stage for Coinbase’s attempt to gain an early dismissal of some or all of the SEC’s case against them.  Oral arguments on Coinbase’s Motion are scheduled for January 17, 2024. Summary: The Coinbase filing is well-written, but the exchange still faces an uphill battle to get the entire case dismissed at this stage. The briefing does a good job of pointing towards the SEC’s changed stance as to what the word “investment contract” means. However, the SEC names a litany of assets as being “crypto asset securities” and Coinbase concedes that some assets (such as the DAO Report tokens) would be securities which could not be traded on the platform. This means all the SEC had to do was name a single asset which, as plead, could plausibly be an unregistered security listing to survive this Motion for Judgment. Either way, even if Coinbase does not get a complete win on its Motion, even a partial win or a loss which educates the Court on these issues is a step in the right direction for the exchange. Yuga Labs Wins $1.6 Million in Trademark Infringement Lawsuit: October 26, 2023 Yuga Labs, the company behind Bored Ape Yacht Club and owners of the Crypto Punk intellectual property had damages decided in their trademark infringement case against Ryder Ripps and Jeremy “Pauly” Cahen.  Yuga had previously won on all its claims at summary judgment, and a trial was held to determine measures of damages. Yuga was awarded $1,575,362.92 in damages and its attorneys’ fees and costs in an amount still to be determined. Yuag was also granted an injunction over the defendants, which required all the associated domain names, social media accounts, and smart contract controls be handed over to Yuga and to permanently cease infringing on the Yuga trademarks. Tl;dr: Bad day to be an internet troll. The Court through the book at defendants here, in large part due to their conduct throughout the proceeding, stating “Defendants unnecessarily and inappropriately made disgraceful and slanderous statements about Yuga, its founders, and its counsel during litigation, including calling Yuga’s counsel criminals who support racism, antisemitism, beastiality (sic), pedophilia and accusing them of using cartoons to market drugs to young children. These statements were egregious and far exceed the bounds of acceptable conduct.” (internal quotes omitted). The pending appeal for the Rogers test issues which was pursued concurrently with the damages issues being decided in this case was also heard recently, with the judges appearing skeptical of defendants’ claims before ruling in Yuga’s favor. SBF Takes the Stand in Criminal Case Against Him: October 26, 2023 Background: SBF has taken the stand in his defense of the DOJ charges against him.  His first day of testimony largely occurred outside the presence of the jury, with the Court hearing testimony to determine certain pre-trial admissibility motions including details surrounding his proposed advice of counsel reliance testimony. The second day, the jury got to hear SBF’s side of the story on direct exam. As of writing this, the cross examination of SBF has just begun, and we will cover that along with the expected conclusion of the case on the next BitBlog Bi-Weekly  to be published on November 16, 2023. Summary: Most criminal defendants do not take the stand in their own criminal trials for good reason. The Fifth Amendment protects citizens from being compelled into giving self-incriminating testimony. Testifying waives that right, create potential additional charges for perjury, and that testimony can be pointed to by a judge during sentencing if convicted. Here, SBF apparently decided the risk of digging a deeper hole through his testimony was worth the chance he could convince the jury that his mistakes were not made knowingly (i.e., they lacked the requisite level of mens rea for conviction).  Time will tell if this strategic decision works out for the founder of the now-defunct cryptocurrency exchange FTX. Briefly Noted: Treasury Extends Comment Period on Proposed Crypto Reporting Rules: The IRS has extended its crypto tax rule comment period. Industry participants have criticized the proposed rules as unreasonably burdensome and unworkable. Industry group LeXpunK has also developed an AI-enabled tool to facilitate the drafting of comment letters in opposition to certain aspects of the proposed Treasury Regulations. FinCEN Proposed Mixer Designations Released: The United States Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) have published an 80-page proposal arguing that US financial institutions should “implement certain recordkeeping and reporting requirements” on transactions linked to convertible virtual currency mixing. Disproven Narrative on Crypto’s Use in Terrorism Financing Persists: The Wall Street Journal published an article on October 10 titled Hamas Militants Behind Israel Attack Raised Millions in Crypto. Elliptic has said its data was misinterpreted by the Wall Street Journal article, and Chainalysis also released data correcting the record on this issue (Hamas has requested its supporters not donate through digital assets, due to the ease and public traceability of digital asset transfers). Still, the Wall Street Journal article has been cited in multiple letters from legislators recently. dYdX Converts to Public Benefit Corporation: dYdX Trading Inc. has converted its corporate form to a public benefit corporation such that, under its new charter, it will not generate trading fee revenue under v4 of its DeFi trading platform.  As one of the few DeFi platforms that is reportedly incorporated in the United States, we wonder whether this may be an initial step towards being able to utilize any number of exemptions under securities and commodities laws that are available to persons organized exclusively for “religious, educational, benevolent, fraternal, charitable, or reformatory purposes and not for pecuniary profit, and no part of the net earnings of which inures to the benefit of any person, private stockholder, or individual.” If so, is it possible that dYdX (which currently does not allow users located in the U.S.) is looking for an alternative path to open its offering to U.S. persons without registration under SEC and CFTC regulations? SEC Enforcement Direct Gives Remarks: the SEC Director of Enforcement gave some remarks at the New York City Bar Associations’ Compliance Institute focusing on how companies can create a culture of compliance through education, engagement and execution. Firms in regulated industries should ensure they become aware of legal developments (which we can help with if you subscribe to the BitBlog), make applicable employees aware of the rules that might be applicable to them, and proactively executing policies necessary to maintain compliance with the law.  In a lot of areas, the path to compliance is clear; in many others, this is easier said than done in the absence of clear guidance that is supported by the law. Conclusion: The regulatory and legal landscape in the cryptocurrency sector remains both convoluted and volatile. Hester Peirce's outspoken dissent encapsulates a broader sentiment of skepticism towards the SEC's aggressive enforcement strategy, a stance clearly not hindering the agency's ongoing litigation efforts. Civil cases, too, are adding layers of complexity, underscoring the myriad challenges that innovators in the space face. The various unfolding legal sagas—be they criminal cases like that against FTX founder Sam Bankman-Fried or regulatory entanglements involving asset transfers—are emblematic of a sector still grappling with its place in the legal framework. Still, exciting legal and technological developments are occurring every day in the industry, and the attorneys are Polsinelli are excited to continue to assist individuals and entities working in or around the blockchain technology space. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. For the past two weeks, all eyes have been on the trial of Sam Bankman-Fried, the disgraced founder of the defunct digital asset exchange FTX. Of course, it’s only natural for peoples’ attention to be drawn to the biggest alleged financial fraud trial since Bernie Madoff; but the SBF story is more of a story of unchecked power than anything specific to digital assets. While many were focused on that front-page criminal trial, the SEC has been busy the past two weeks as well—to far less media fanfare.  The agency’s request for an interlocutory appeal in Ripple was denied, and it also did not file an appeal in the Grayscale matter signaling potential digital asset financial product approvals in the future. The agency also filed its response to Coinbase’s motion for judgement on the pleadings and had a range of amicus come out in support of its motion. These developments and a few other brief notes are discussed below. Criminal Trial of FTX Founder Sam Bankman-Fried Begins: October 3, 2023 Background: The Sam Bankman-Fried (“SBF”) trial started on October 3, 2023, and is the biggest financial fraud trial since Bernie Madoff. SBF was the founder of the now-defunct digital asset exchange FTX. He is accused of seven counts of fraud, conspiracy and money laundering centering on his alleged use of customer deposits on the crypto trading platform FTX to cover losses at his hedge fund, Alameda Research, and on personal expenses. The trial is expected to last six weeks. Summary: The first two weeks of trial resulted in some headline-grabbing moments, as did the Michael Lewis book “Going Infinite” which follows SBF and was published the weekend before SBF’s trial began. It will be impossible to tell the story of Web3 law in 2023 without mentioning the SBF trial, but this is less a story about cryptocurrency and more a story about standard financial fraud, albeit on a larger scale than most. While we will continue to cover the trial in these updates, we will likely keep the ongoing updates in the Briefly Noted section to not distract from the real developments in blockchain law. SEC’s Request for Interlocutory Appeal in Ripple Denied: October 3, 2023 Background: The SEC was denied its request for an interlocutory appeal at the trial court level, meaning the agency will need to take up its arguments on appeal after the trial on remaining merits issues scheduled for April 23, 2024. This means there is no chance of appellate review prior to 2024 as the SEC hoped for, and there is virtually no chance any decision could reach the Supreme Court before 2026 Summary: The judge in Ripple clarified her Order that a Howey analysis is a facts and circumstances analysis, and her ruling was based on the facts and circumstances specific to this case and not the laws of digital assets generally. Any loss for the SEC is good for the industry at this point. However, there is no way to know if the 2026 or beyond SCOTUS will be made up of justices who are as hostile to agency overreaches as the current SCOTUS is. This leaves lower courts to continue to decide one-off issues until there is Congressional movement, the SEC changes its enforcement strategies or SCOTUS decides the issue in 2026 or beyond. SEC’s Files Response in Opposition to Coinbase Motion for Judgment: October 3, 2023 Background: The SEC has filed their opposition to the Coinbase Motion for Judgment under Rule 12(c). The agency came out swinging, calling the Coinbase argument flawed and attempting to distance itself from prior statements by the agency which seem to contradict its current litigation posture. There were also three amicus filed in support of the SEC—the first from a group of administrative law scholars; the second from the New Finance Institute (which appears to be a blog); and the third from the North American Securities Administrators Association. Summary: The SEC claims in their briefing that both (1) the rights conferred by digital assets are inherent in the code itself (fn. 5); and (2) the SEC is merely there to assure investors receive adequate disclosures (pg. 23). Which is contradictory on its face but does not take digital assets necessarily outside the jurisdiction of the SEC. The agency also claims its briefing in Edward where it said: “‘investment contract’ makes clear that instruments of that name include those in which a return—whether labeled income or profit—is promised in a contract” (emphasis in their briefing) does not mean they were stating a contractual promise is required (fn. 7). That said, despite logical inconsistencies, the briefing is overall strong as could be expected from the top litigators in the agency, so it remains an uphill battle for Coinbase to get a dismissal this early in the case. Amicus Come Out in Support of SEC: October 10, 2023 There were three amicus filed in support of the SEC this week —the  first from a group of administrative law scholars; the second from the New Finance Institute (which appears to be a blog); and the third from the North American Securities Administrators Association. The securities administrators focused on the regulation of digital assets at large, the administrative law scholars focused on major question doctrine issues and the bloggers focused on seemingly just disliking cryptocurrencies generally. Tl;dr: The blogger’s brief is…interesting. It claims that viewing gold as an investment vehicle is incorrect and that the reason there are no cases of an “investment contract” without some contractual arrangement for future work or profits is due to the “base rate fallacy” and not because the SEC is moving the goalpost. It also cites the academic literature of “Wikipedia” and a total of five cases in the briefing.  The administrative law scholars focus on the major question doctrine claiming the doctrine does not apply to agency enforcement actions, even though the Administrative Procedures Act does apply to such situations. The securities regulators of course argue that securities regulations are clear and the SEC’s enforcements have been consistent. In sum, it appears that (as could be expected) the Coinbase amicus with interested industry filers were seemingly stronger than the SEC amicus, as it is rare to see administrate agencies gain support at the trial level for enforcement actions over any industry actors. SEC Lets Appeal Deadline Pass in Grayscale Matter: October 13, 2023 Background: We previously covered the D.C. Circuit’s decision in Grayscale, which found the agency acted arbitrarily and capriciously in denying the Grayscale spot Bitcoin ETF. The Court ruled that there was no basis for the SEC to claim that a Bitcoin Spot ETF would be any more subject to potential manipulation than the Bitcoin futures ETF which had already been granted by the agency. The SEC’s deadline to appeal that decision was October 13, 2023, and the agency apparently decided against filing an appeal in the Grayscale matter, which signals a likely approval for one of the various spot Bitcoin ETFs in the near future. Summary: While the SEC’s failure to appeal the Grayscale matter is an important indicator of the likelihood of future approvals, it does not mean approvals are imminent. It certainly does not help that a recent and since retracted leak of an early approval caused Bitcoin price to quickly rise, only to fall when it was revealed to be false reporting. It is possible the SEC will point to that as evidence of spot market manipulation ability. It is important to note that, at minimum, any decision for approvals or denials on products like a spot Bitcoin ETF would come from a closed meeting of the Commission and is not something that the SEC would delegate this for random approval. Briefly Noted: U.S. Registered ETH Futures Trading Begins: The ETH futures ETF has started trading in the U.S., making it clear that even the SEC does not consider ETH a security, otherwise it would never be allowed to trade in securities markets. The playbook for a spot ETF is clear, with Grayscale again leading the way. SEC Updated Third Circuit on Rulemaking: The SEC sent their Court-mandated update on the status of digital asset rulemaking, and it technically meets the Court’s order but just barely. I can’t imagine this is the expected level of transparency the Third Circuit was expecting when they kept this case on their docket to babysit the agency. Coinbase filed their own reply in response, accusing the SEC of more delays and gamesmanship. California Passes Comprehensive Digital Asset Registration Law: California Governor Newsom has signed the state’s “Bitlicense” bill into law which will go into effect on July 1, 2025. California joins New York as a state with fairly comprehensive regulatory regimes for digital assets. Any companies in the space operating in California should begin working towards compliance now. SEC Includes Crypto Assets on Examination Priorities Report: The SEC released its Division of Examinations Priorities Report outlining the Division's examination priorities for the coming year. Crypto is once again an exam priority for registered investment advisers and broker-dealers. The Division said it will keep monitoring firms and conduct exams "when appropriate," in light of "the continued volatility of, and activity around, the crypto asset markets." Conclusion: In the midst of the high-profile trial of Sam Bankman-Fried and the buzz surrounding the cryptocurrency world, it becomes evident that this legal landscape is evolving rapidly. The SBF trial serves as a stark reminder of the perils of unchecked power, transcending the digital asset realm to illuminate broader issues of financial fraud. Meanwhile, the SEC's recent developments, from the denial of its interlocutory appeal in Ripple to its response in the Coinbase case, hint at the complex and ever-changing regulatory environment for cryptocurrencies. As the legal saga continues to unfold, it is clear that the future of blockchain law will be shaped by these pivotal moments, and we'll be here to keep you updated on these critical developments. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. Litigation and various digital asset legislative actions moved forward since our last Bi-Weekly update, as the digital asset industry prepares for the sensational (by legally unremarkable) criminal case against disgraced FTX founder Sam Bankman-Fried to dominate the headlines. Binance has moved to dismiss the SEC’s lawsuit against both its foreign and U.S. entities and has gained support for that dismissal effort amongst industry amicus filers. Compound DAO, on the other hand, was unable to obtain the dismissal it sought in a private securities class action. There was also legislative movement, with SEC Chair Gary Gensler on the hot seat in front of the House Financial Services Committee, and members of that Committee submitting a bill to curb SEC’s Staff Accounting Bulletin (“SAB”) 121 which required financial institutions treat digital assets held under custody for third parties as liabilities. **Note: After this post was finalized for publication, there were important developments in the Ripple and Coinbase cases against the SEC. Those developments will be covered in the next Bi-Weekly update to be published on October 19, 2023. These developments and a few other brief notes are discussed below. The Compound DAO Securities Lawsuit Continues After Judge Denies Motion to Dismiss: September 20, 2023 Background: The Compound DAO securities lawsuit was allowed to continue after a Northern District of California judge denied the defendants’ Motion to Dismiss. The named Plaintiffs own less than $100 in the tokens in question, and are also named Plaintiffs in the Intuit and Juul Labs class actions. Compound previously attempted to get the case tossed under the Private Securities Litigation Reform Act. Summary: The Motion to Dismiss focused on the lack of contractual privity between certain Compound partners and the Plaintiffs in this case, who brought their tokens on Coinbase. The Court disagreed, holding that certain statements identified raised a plausible claim to make the partners statutory sellers due to solicitations under the Ninth Circuit standard, which is broader than the solicitation standard used to dismiss claims recently in UniSwap. The Motion to Dismiss standard is an extremely high bar, so this isn’t the end of the road for those defenses available to the defendants in this action. It does, however, create a cloud of liability over DAO participants even when they are neither the issuers nor sellers of the tokens in question. Binance Moves to Dismiss SEC Lawsuit Against Various Entities: September 21, 2023 Background: Binance Holdings Limited (“BHL”) and its founder Changpeng Zhao  (“CZ”) filed a Motion to Dismiss in the SEC case against them. Its U.S. counterparts also filed their own Motion to Dismiss. Both motions stated the secondary trading in digital assets at issue do not meet the “investment contract” standard from Howey, and that the SEC’s overreach into the digital asset industry represents a violation of the Major Questions Doctrine. The U.S. entities also argue that the SEC failed to adequately plead its fraud allegations, and BHL argues that as an international entity it is jurisdictionally immune to most of the SEC’s claims. Summary: The motions follow largely the same format at the motion for judgment raised by Coinbase. The primary arguments are that blind bid-ask secondary sales cannot be seen as an investment into a common enterprise as there is no way to know the money is going to some entrepreneurial effort, that there cannot be an “investment contract” if there is no contractual ongoing obligations on some third party, and that if this definition of “investment contract” is to be expanded to fit those asset classes then Congress must be the entity to do so rather than an administrative agency. The BHL motion also raises interesting jurisdictional challenges, and that the SEC must allege the transactions at issue are not “predominantly foreign” to survive. It will be interesting to see if a Court ever addresses what a website must do to block U.S. users to avoid U.S. jurisdiction, especially given the prevalence of VPNs. This is all occurring while the SEC and Binance continue to exchange jabs in their pending litigation regarding discovery and other issues. SEC Chair Gary Gensler Testifies Before House Financial Services Committee: September 27, 2023 Background: SEC Chair Gary Gensler testified before the United States House of Representatives Committee on Financial Services, largely in an effort to tout his own accomplishments during his time with the agency. These include passing comprehensive private fund rules that very few were asking for (under attack as an overreach by numerous trade groups), proposing climate-related disclosures (which still hasn’t been enacted more than 18 months after originally proposed) and bringing numerous crypto-related enforcement actions (which have been a mixed bag). On the bright side, Gensler reiterated that Bitcoin does not meet the definition of security under the Howey test. On the other hand, he wasn’t willing to commit to saying that Pokémon cards, when tokenized, aren’t securities. Summary: The GOP House Financial Services Committee’s X (Twitter) account pinned this April post to the top of their page ahead of the hearing, which demonstrates where that side of the aisle spent a good amount of their time to question the SEC head. Ire for the Chair wasn’t reserved to the Republican side of the aisle, as Democratic representative Ritchie Torres also expressed his frustration in Gensler’s inability to give a straight answer about what does and does not constitute a security. This confusion and seeming unwillingness to answer basic questions stands in stark contrast with the Chair’s frequently repeated statements that the law is clear on digital assets. Bipartisan Uniform Treatment of Custodial Assets Act Proposed: September 27, 2023 Background: Mike Flood (R-NE), along with French Hill (R-AR), Ritchie Torres (D-NY) and Wiley Nickel (D-NC) have introduced legislation titled the Uniform Treatment of Custodial Assets Act to the House of Representatives. The bill would prohibit certain federal agencies from requiring certain institutions to include assets held in custody as a liability. This is in response to the SEC’s Staff Accounting Bulletin 121 (SAB 121) which would require banks list digital assets they held in custodial services to be kept on the banks’ balance sheets as liabilities. Summary: SAB 121 effectively bans banking providers from providing secure custody of digital assets. If the goal is investor protection, it makes zero sense to make it prohibitively difficult for investors to deposit their assets in a trusted institution. There is no surprise as to the sponsors, as Representatives Flood and Hill have long been digital asset proponents and Representatives Nickel and Torres were two of the six Democrats who crossed party lines to vote for the FIT For 21st Century Act. Briefly Noted: SEC Delays Decisions on Bitcoin ETFs: The SEC has delayed reaching a determination on various Bitcoin Spot ETFs which gives the agency further time to consider the applications. After Grayscale won their appeal of the SEC’s denial for their Bitcoin Spot ETF product, it is unsurprising that the SEC is delaying its determination on these similar projects. SEC Objects to Celsius Bankruptcy Distribution: The SEC has objected to using Coinbase as a service provider in the distribution of Celsius bankruptcy assets. The SEC claims this needs to be done by a registered broker/dealer, but there are not any registered broker dealers for the assets in question, because the issuers of the assets cannot comply with reporting obligations. Circle Files Amicus in SEC v. Binance Arguing Stablecoins Aren’t Securities: Circle has requested the Court in Binance reject the SEC’s attempts to regulate stablecoins as securities, filing an amicus brief on the issue in support of Binance. Circle, as the issuer of popular stablecoin USDC, has a vested interest in the outcome of that issue. Paradigm also filed an amicus brief on the matter, focusing primarily on the securities law arguments. Conclusion: Navigating the convergence of code, smart contracts and US law reveals a dynamic terrain of ongoing legal and legislative developments in the digital asset sector. High-profile legal proceedings involving entities like Binance and Compound DAO underscore the prevailing complexities and regulatory nuances within this evolving ecosystem. Furthermore, legislative undertakings, notably by SEC Chair Gary Gensler and via bipartisan efforts like the Uniform Treatment of Custodial Assets Act, emphasize the continuous, and at times contentious, recalibration of legal frameworks surrounding digital assets and smart contracts. These developments are pivotal, highlighting the inherent intertwining of legal considerations and technological innovations in shaping the future landscape of digital assets within the US legal system. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. Over the past two weeks, several government agencies have expanded their reach into digital assets. Notably, the Commodity Futures Trading Commission (“CFTC”) increased its enforcement jurisdiction into decentralized finance (“DeFi”) providers in potential conflict with the recent ruling in UniSwap as to the liability of protocol developers for actions of their users, and the Securities and Exchange Commission (“SEC”) brought enforcement action against a non-fungible token seller that involved individualized tokens intended to be used as “profile pictures” on social media. There was also important digital asset news coming out of Congress, with Representative Emmer reintroducing his Central Bank Digital Currency (“CBDC”) legislation in the House, and the SEC Chair testifying in front of the Senate Committee on Banking, Housing, and Urban Affairs. These developments and a few other brief notes are discussed below. CFTC Issues Orders Against Operators of Three DeFi Protocols: September 7, 2023 Background: ZeroEx (the developer of 0x Procotol), Opyn, and Deridex all entered into consent judgments with the CFTC after being charged with failing to register as a swap execution facilities and other similar charges. The charges were brought against the U.S. development companies for these DeFi protocols, and all agreed to fines and to implement changes to block access to U.S. users. Commissioner Mersinger was the sole commissioner to dissent to the actions. Summary: Understandably, these entities chose to settle rather than spend funds litigating against the U.S. government. However, Opyn in particular already had geoblocks against access to U.S. users, had no fees on the user-created leveraged futures contract pools in question and very limited powers over the protocol through the developer multi-signature wallet. It is possible that a challenge by one or all of these entities could have limited the CFTC from pursuing these types of primarily extraterritorial enforcement actions, but that is an expensive fight so the industry is left with still unsettled questions regarding the necessary level of geoblocking for protocol developers and when developers of protocols can be liable for actions of their users. LBRY Files Notice of Appeal of Summary Judgment: September 7, 2023 Background: LBRY, Inc. has filed a Notice of Appeal of the final judgment entered into against it on July 11, 2023.  LBRY, Inc. was the developer of a project which aimed to create a Web3 version of YouTube, where individuals could pay in tokens to upload videos, and others could pay to those creators for access to the videos or to tip their favorite creators. LBRY argued that, under the precedent set in United Hous. Found., Inc. v. Forman, security laws do not apply when a buyer purchases an asset primarily to use or consume that asset. The Court disagreed, siding with the SEC and ruling that nothing in the case law suggested to the Court that a token with both consumptive and speculative uses cannot be a security. Summary: We covered the LBRY decision on the BitBlog when it was first issued in November of last year.  After the ruling, the SEC lowered its requested damages from $44 million to just over $100,000 due in large part to the fact that LBRY did not have any further funds to cover a greater damages award. That raises questions as to who will be funding and litigating this appeal, which has the potential to create a powerful and groundbreaking appellate-level precedent. House Majority Whip Tom Emmer Reintroduces CBDC Legislation: September 12, 2023 Background: Majority Whip Tom Emmer reintroduced his legislation, the Central Bank Digital Currency (CBDC) Anti-Surveillance State Act, in the House of Representatives. The bill is co-sponsored by 50 other Republicans in the House. The bill prohibits the Federal Reserve from issuing a CBDC directly to individuals, to prevent surveillance into the personal financial information of Americans. Summary: CBDC’s are hot-button issues, as they are undeniably more efficient than the current system which relies on financial service providers like banks to serve as middlemen between the issuer of currencies and the users of those currencies. However, it also would create a government-controlled single point of financial information which raises obvious security and privacy concerns. It is expected that up to 2% of the global money supply could be tokenized in CBDCs and stablecoins by 2028 so this will remain a hot-button issue as state and private actors determine the best form of digital currencies. SEC Chair Gary Gensler Testifies to Congress on Digital Assets: September 12, 2023 Background: SEC chair Gary Gensler testified in front of the Senate Committee on Banking, Housing and Urban Affairs on September 12. His opening statement is available here. He has a follow-up hearing before the House Financial Services Committee scheduled for September 27. Summary: The big news from the hearing was the statement that the SEC was “still reviewing” the Grayscale spot Bitcoin ETF filing after the D.C. Circuit struck down the SEC’s rejection of the Grayscale application. With the Senate largely seen as behind the House in terms of digital asset legislation, it was not surprising that much of the testimony was focused on other aspects of the SEC, including rulemaking regarding environmental disclosures and mutual fund settlement rules. The House Financial Services Committee is expected to cover more digital asset-specific issues when they question the SEC Chair on September 27. SEC Brings Enforcement Action Against “Profile Picture” NFT Project: September 13, 2023 Background: On September 13, the SEC released a Consent Order for an immediate cease-and-desist along with monetary fines for the creators of the “Stoner Cats” NFT project, through which NFTs were sold to fund the creation of an animated series.  Similar to the prior NFT enforcement action, Commissioners Peirce and Uyeda dissented comparing the sales of the NFTs to sales of Star Wars merchandise. The project creators agreed to settle the dispute without admitting or denying any wrongdoing. Summary: The SEC’s first NFT enforcement action was covered in our last Bi-Weekly update. This most recent action is notable not only because of the names behind the project (Mila Kunis and Ashton Kutcher, among others) but also due to this being the first “profile picture project” named for NFTs which have unique artwork for each token in the collection intended to be used as social media profile pictures. As with any regulation by enforcement, this still leaves questions as to when a product sale is an unregistered security offering as opposed to something more properly under the FTC or other agency’s jurisdictional oversight. Certain aspects of the Order, such as pointing to secondary sales royalties, coordination of verification with secondary sales platforms and the requirement that tokens be “destroyed” rather than prohibited from resale are all potentially problematic features of this Order which could do more harm than good to consumers and artists on a going-forward basis. However, NFT creators should carefully consider how they market their products and how they discuss the use of sales proceeds to avoid potential regulatory pitfalls. Briefly Noted: Industry Groups and Participants Write to Senate Regarding Digital Asset Taxation:  The Wall Street Blockchain Alliance (of which Polsinelli is a member) submitted the following letter to the Senate in response to its request for the appropriate treatment of digital assets under federal tax law. Polygon Labs and others in the industry also submitted letters. New York Department of Financial Services (DFS) Updates Listing Guidelines: DFS announced proposals for new guidance for coin listings and a framework for green listed coins that include heightened risk assessment standards for coin-listing policies and tailored, enhanced requirements for retail consumer-facing products or service offerings, along with new requirements for coin delistings.  Each regulated virtual currency licensee would need to have these policies approved by DFS.  DFS is seeking public comment through October 20.  As most of the major US crypto exchanges are regulated by DFS, either as trust companies or through a “BitLicense”, these guidelines could have a significant impact on what coins get listed.  This also seems to run counter to recent efforts by the New York Attorney General to further regulate cryptocurrencies and label most of them (including Ethereum) as securities under the Martin Act. Ethereum Founder Pushes for Compliant Mixing Services: Ethereum founder Vitalik Buterin released a paper with others titled Blockchain Privacy and Regulatory Compliance: Towards a Practical Equilibrium. It argues for the use of a permissioned mixing service, using zero knowledge proofs to only allow participants who confirm their funds were acquired legally to use the service. IOSCO Issues DeFi Policy Recommendations: The Board of the International Organization of Securities Commissions (IOSCO) issued a consultation report regarding decentralized finance (DeFi). The report was largely written by member organizations, the SEC, so the recommendations largely follow the SEC’s policy recommendations on the subject. Advocacy Group Files Action to Invalidate Oracle Patent:  DeFi Education Fund is petitioning to cancel the patent claiming the invention of oracle-like tech and being used to sue MakerDAO and Compound. You can read a blog post about the challenge here. Conclusion: From the CFTC's actions against DeFi protocols to the SEC's groundbreaking enforcement of NFTs, it's evident that the U.S. government is taking significant steps to gain a better grasp on this rapidly evolving ecosystem. What's more, these activities have set the stage for ongoing debates around digital asset taxation, blockchain privacy, and international policy recommendations. Yet, despite all these regulatory moves, numerous questions remain unanswered. The tension between fostering innovation and enforcing compliance continues to be a pivotal concern. This creates an uncertain environment, not just for entrepreneurs and developers, but also for consumers and investors. As we move forward, one thing is clear: the dialogue between the digital asset industry and regulatory bodies is more crucial than ever. It is this dialogue that will ultimately shape the opportunities and limitations of blockchain technology in the years to come. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. The past two weeks have been big for digital asset issues in courts, with Grayscale winning its appeal to the D.C. Circuit and UniSwap obtaining a dismissal of a proposed class action in front of the same judge hearing the SEC v. Coinbase matter. Coinbase Chief Legal Officer Paul Grewal recently stated “when it comes to protecting the rule of law, the courts remain our last, best hope” in regards to the state of digital asset regulation. It wasn’t all good news for the industry, though. The DOJ brought criminal charges against the Tornado Cash developers, the SEC reached a consent judgment with an NFT issuer, and the IRS issued proposed digital asset reporting rules which could dramatically change how digital assets are exchanged in the United States. These developments and a few other brief notes are discussed below. Criminal Charges Brought Against Tornado Cash Developers: August 23, 2023 Background: The U.S. Attorney’s Office for the Southern District of New York has brought criminal charges against Tornado Cash protocol developers Roman Storm and Roman Semenov for the protocol’s role in allegedly “more than $1 billion in money laundering transactions” including transactions by North Korean hackers known as the Lazarus Group. The Department of Treasury’s OFAC has also now sanctioned Roman Semenov as a Specially Designated Blocked Person. Roman Storm was arrested in Washington, while Roman Semenov remains at large. Summary: This action raises serious Fourth Amendment privacy concerns as well as First Amendment free speech issues regarding the line between protected speech in the form of creating software code and unprotected actions in deploying or using that software code in allegedly illegal ways. The DOJ criticizes the developers for creating help guides on how to best protect their privacy through the protocol, but also criticize the use of the protocol by sophisticated hackers that do not need assistance with navigating a user interface and can interact with the code directly. Coin Center, which is currently funding a lawsuit in Florida challenging the sanctions against the protocol itself by OFAC, came out against the criminal charges. As stated in Bernstein “[v]iewed from this perspective, the government’s efforts to retard progress in cryptography may implicate the Fourth Amendment, as well as the right to speak anonymously.” Fellow developer Alexey Pertsev is still awaiting trial for similar charges on house arrest in Amsterdam. IRS Issues Proposes Rules Regarding Reporting of Digital Asset Transactions: August 25, 2023 Background: The Treasury Department released its long-awaited proposal for digital asset reporting obligations. Miners and validators are not required to submit the new Form 1099-DA for reporting non-employment income from digital assets, but most other participants in the transactions will be required to do so. This includes transactions via DeFi, self-custodial wallet providers, and any entity that in any way “facilitates a digital asset sale on behalf of a customer” even if the transaction is peer-to-peer. These proposed rules will now go through the comment and finalization process and would go into effect in the 2025 tax year with “broker” reporting in 2026. Summary: The proposed regulations define “digital assets” and “broker” in ways which would turn website developers into brokers if the websites "facilitate" digital asset sales. These websites are often just appealing user interfaces which allow people to transact directly with the applicable smart contracts. It then becomes an issue of “how helpful is too helpful”? If one website creates the necessary smart contract inputs and initiates a function to do what a person wants, that website would likely be considered a broker. Whereas if another website is doing the same thing, with the exception that the user is copying and pasting the code themselves, that would likely not be considered a broker. The public comment period for the proposed rules is open until Oct. 30, 2023, and many industry groups are expected to weigh in on these proposed rules. SEC Reaches First Settlement for Unregistered Sales of NFTs: August 28, 2023 Background: On August 28, the SEC brought its first enforcement action against NFT issuer Impact Theory, LLC, charging the company with conducting an unregistered offering of crypto asset securities in the form of NFTs. Without admitting or denying the SEC’s findings, Impact Theory agreed to a cease-and-desist order and agreed to pay a combined total of more than $6.1 million in disgorgement, prejudgment interest and a civil penalty. Summary: This is less about Impact Theory and more about the SEC using a consent judgment to sneak in a new legal theory. This time, the theory is that creator royalties are evidence of a security instrument. Commissioners Peirce and Uyeda dissented to the judgment, stating “[w]e do not routinely bring enforcement actions against people that sell watches, paintings, or collectibles along with vague promises to build the brand and thus increase the resale value of those tangible items.” The reality is this: in any form of sale, if an asset is sold in exchange for an investment of money in a common enterprise, and there is an expectation of profit arising from the efforts of a promoter or a third party, that is most likely a security transaction. However, it seems like the shadow factor of “is this something we traditionally regulate as a security” is grinding away. UniSwap Obtains Dismissal in Southern District of New York Class Action: August 29, 2023 Background: The plaintiffs in this case had been allegedly defrauded with a number of memecoins that were the subject of rug pulls and pump-and-dump schemes to which the plaintiffs gained exposure through Uniswsap liquidity pools. Due to Uniswap’s decentralized and anonymous nature, the plaintiffs were unable to locate the scam artists and tried to go after Uniswap (or more precisely, the Uniswap Foundation, Uniswap Labs, Uniswap’s founder and a couple of investors in the Uniswap ecosystem) instead.  The court granted the defendants’ motions to dismiss after finding that the defendants didn’t have liability under Section 29(b) of the Securities Exchange Act of 1934 or Section 12(a) of the Securities Act of 1933. Summary: Although this is a big win for DeFi, the basis for dismissal had nothing to do with decentralization. Section 29(b) is usually used to nullify provisions of agreements that violate securities laws, or entire agreements if the nature of the agreement itself violates securities laws. The court found that the Uniswap smart contract does not de facto violate securities laws. Section 12(a) allows for a cause of action against “statutory sellers” of a security, which can include a) someone from whom title to the security transfers and b) someone who promotes the sale of the security for pecuniary gain.  The court found that title to the tokens didn’t transfer (at least not from the defendants) as a result of Uniswap’s liquidity pool mechanics and that the defendants didn’t promote the sale transaction, and thus the defendants were not statutory sellers against whom the plaintiffs could bring a cause of action.  The court also mentioned several times that if this has created a gap in securities laws, it should be up to Congress to fill that gap.  We’re not sure there actually is a gap here – plaintiffs could have brought an action against the actual fraudsters; they were just unable to find them. Grayscale Wins Appeal of SEC’s Denial of their Application for a Spot Bitcoin ETF: August 29, 2023 Background: Grayscale won their appeal of the SEC’s denial for their Bitcoin Spot ETF product, with a unanimous ruling from a three-judge panel that the SEC’s denial was arbitrary and capricious. The Court ruled that there was no basis for the SEC to claim that a Bitcoin Spot ETF would be any more subject to potential manipulation than the Bitcoin futures ETF which had already been granted by the agency. Summary: This is more egg on the SEC’s face, with three respected judges of differing political backgrounds all looking at the SEC’s actions towards a digital asset product and deeming the SEC as acting “arbitrary and capricious” which is a high standard to meet. It will be interesting if the SEC uses this decision as a way out of a losing battle, or if the agency finds alternative reasons to deny the Grayscale petition along with requests for similar products from financial giants like Blackrock. It is also unclear if this decision will change the agency’s stance on the ETH futures ETF, which was previously expected to be granted. Briefly Noted: OpenSea “Insider Trading” Defendant Gets Sentenced to 3 Months in Prison:  Nathanial Chastain (“Chastain”), the former OpenSea employee accused of front running purchases of NFTs prior to those NFTs being featured on the OpenSea featured page, was sentenced to three months in prison after being convicted of fraud and money laundering. According to the FBI, Chastain made roughly $50,000 “using his knowledge of confidential information to purchase dozens of NFTs in advance of them being featured on OpenSea’s homepage…”. Ripple Opposes SEC’s Request for Appeal: Ripple filed its opposition to the SEC’s request for interlocutory appeal, claiming the SEC’s attempt to frame the issue as a purely legal issue rather than a fact specific application of law to facts Second Circuit Affirms that Syndicated Loans Are Not Securities: On August 24, the United States Court of Appeals for the Second Circuit, in a unanimous decision, affirmed the prevailing market view that notes representing syndicated loans are not securities. This is a case which the SEC refused to weigh in on, despite being asked to by the Second Circuit.   This case is relevant to the digital asset industry regarding tokenized loan products, as well as to the digital asset market as a whole as an example of an asset class with many of the elements of traditional securities but which does not fall under SEC purview. You can read our recent Bitblog post on the decision here. Conclusion: In a rapidly evolving landscape, the past two weeks have illuminated the complexities of digital asset regulation. From Grayscale's landmark appeal to UniSwap's court victory, the digital asset industry has experienced its share of triumphs. However, the criminal charges against Tornado Cash developers, IRS's proposed reporting rules, and the SEC's actions reveal that not all is smooth sailing. These developments have profound implications for privacy, free speech, and the very architecture of decentralized systems. Paul Grewal's assertion that "the courts remain our last, best hope" is not merely an eloquent statement; it is a sobering reminder that legal engagement is indispensable for the maturation and survival of the digital asset industry. The potential repercussions—whether they concern your tax liabilities, your rights as a developer, or the viability of your investment—underscore the importance of staying abreast of legal developments. Now more than ever, it is crucial to maintain a nuanced, well-informed perspective as we navigate the intricate web of legislation, litigation, and regulatory oversight. Ignorance is not bliss; it's a risk that no stakeholder in the digital asset ecosystem can afford to take. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. As expected with Congress on break, the news the past two weeks was dominated by updates in major industry litigation efforts. While there was some action on the House’s stablecoin bill in the wake of the major announcement by PayPal that it released its own fully backed stablecoin, most of the focus has stayed on the Coinbase litigation against the SEC and the SEC’s decision to appeal the adverse rulings against the agency in Ripple. These developments and a few other brief notes are discussed below. PayPal Announces Launch of U.S. Dollar-Pegged Stablecoin, PYUSD: August 7, 2023 Background: As we noted in the Briefly Noted section of the last Bi-Weekly update, on August 7 PayPal announced it would be launching a fully-backed dollar-denominated stablecoin, PayPal USD (“PYUSD”). The planned token is an ERC-20 token, which means it can be transferred to self-custodial wallets, but similar to USDC and USDT, it does have freezing functionality and can be seized. Summary: Due to the follow-up news from Washington D.C. on this hotly debated issue of regulated stablecoin issuers, the Blockchain+ team wanted to provide a more in-depth background on the payment processing giant PayPal entering the stablecoin issuer field. Republicans have used the PayPal announcement to make a renewed push to pass the Clarity for Payment Stablecoins Act in the House. Democrat Maxine Waters was reportedly “deeply concerned” about PayPal’s new stablecoin. This may just be the first of many private stablecoins to come, as the issuer of the PayPal stablecoin, Paxos, is reportedly working on other white label stablecoins as well. Senator Lummis and Others File Amicus in Coinbase Litigation: August 11, 2023 Background: On August 11, there was an expected bevy of amicus filings in Coinbase’s litigation against the SEC, with filings in support of Coinbase coming from Senator Cynthia Lummis, the Blockchain Association, a16z/Paradigm, the Chamber of Digital Commerce, the DeFi Education Fund, and a group of securities law professors. The SEC has until October 3 to file its opposition. Summary: Most of the focus was on Senator Lummis’ brief which argues that the SEC is overstepping its authority by treating all crypto assets as securities, which contradicts legislative efforts in Congress and requires proper legislation. Senator Lummis is the co-sponsor of currently pending digital asset legislation titled the Responsible Financial Innovation Act. The brief's importance lies in its representation of a congressional perspective that challenges the SEC's approach and urges the court to defer to the legislative branch for creating a holistic crypto regulatory framework. While all the briefs are well-written and worth a read, the group of securities law professors’ brief also provides a cogent argument supporting the idea that and “investment contract” requires both an “investment” and “contract” to fall under the Howey test for a scheme. SEC Files Intent to File Interlocutory Appeal in Ripple and Ripple Responds: August 16, 2023 Background: On August 9, the SEC filed a letter request to file a motion for leave to file an interlocutory appeal of the Court’s July 13, 2023 Summary Judgment ruling. On August 16, Ripple responded with its own letter of intent to oppose the SEC’s request.  The SEC was given until August 18 to actually file its motion for leave to appeal with all briefing on the subject to be completed by September 8. The SEC’s arguments largely followed its letter, claiming the Court erred in its ruling regarding programmatic sales and “other distributions” to employees and charitable organizations as securities offerings. Summary: Seeking this interlocutory appeal is an aggressive move from the agency. Many thought the current leadership would be inclined to ride the issue out until trial, knowing that uncertainty would be better than a potential sped up major loss on appeal. For more background on the Ripple decision which the SEC seeks to appeal, read our breakdown on the BitBlog available here. As we noted at the time, the Court’s ruling as to “other distributions” was the most cursory of the decision, and there may be a factual record at play which was the reason for such a terse decision on a major aspect of the litigation. Court Issues Summary Judgment in Favor of Treasury Department in Tornado Cash Matter: August 17, 2023 Background: In September of 2022, Coinbase funded a lawsuit brought by six individuals challenging the U.S. Treasury Department’s sanctions of digital wallets linked to the Tornado Cash smart contracts. On August 17, the Court hearing that matter ruled in favor of the Treasury Department and issued summary judgment against the six individuals. The ruling found that Tornado Cash – a protocol comprised of a set of smart contracts with no formal organizational structure – is a “person” for purposes of the International Emergency Economic Powers Act, and that an “association” can be comprised of any group of people with a common purpose.  It further found that the smart contracts comprising the protocol are property in which that association has an interest even though nobody has ownership of the smart contracts, in part because of the fees generated by transactions on Tornado Cash.  This was one of two major lawsuits challenging the sanctions, the other brought by CoinCenter and still pending in the Northern District of Florida. Summary: Coinbase Chief Legal Officer took to Twitter in the wake of the decision saying “[w]e’ve always known that Fifth Circuit review is required to resolve these issues, and we continue to support them on appeal.” The language from the ruling is fairly expansive and does not seem to be limited to smart contracts of a type that comprise the Tornado Cash protocol. That said, smart contract can memorialize legally binding promises, facilitate the performance of legally binding promises, or may just be executable code having nothing to do with promises (legally binding or otherwise). Not all smart contracts act or should be treated the same. The Court seems to have missed this nuance when claiming all smart contracts are like vending machines (which, to be fair, is an example used by blockchain innovator Nick Szabo in explaining one of the functions of smart contracts). Briefly Noted: Celsius Network Plan and Disclosure Statement Approved for Voting by Creditors:  On August 17, the Bankruptcy Court approved the Celsius Network Plan of Reorganization for it to be voted on by eligible creditors. Please see our Bitblog post setting out the relevant timelines as well as our highlighting the terms of the Plan of Reorganization.  With this approval “Earn” creditors are significantly closer to getting repaid at least some of their claims. Eligible creditors should expect to be getting ballets to vote on the plan in the very near future. It Is important for any eligible to vote as one’s recovery may be impacted on whether a creditor voted. Federal Reserve Announced Program Directed Towards Blockchain: The Federal Reserve has announced a new program to “novel activities” for banks related to crypto-assets, distributed ledger technology, and complex, technology-driven partnerships with nonbanks. This level of advanced supervision for banking partners of the digital asset industry has been troubling to many and raises questions as to the legality of such practices. Bittrex Settles with SEC: Bittrex settled with the SEC and agreed to pay a $25 million fine. The release points out the fact that Bittrex told token issuers to scrub statements regarding promises of future returns and such prior to listing the asset. Of note was the SEC’s focus on Bittrex advising token issuers to remove statements which may induce others to rely on the efforts of others and/or expect profits in their decisions to buy tokens. Creating a “once a security always a security” issue for token issuers who made early marketing foot faults. Coinbase Gets CFTC Approval: Coinbase announced that it has received regulatory approval from the National Futures Association (the self-regulatory body governing the US commodities derivative industry) to operate a Futures Commission Merchant (FCM) to offer and sell crypto futures.  While there are a number of approved FCMs that were born from traditional commodities businesses or broker-dealers, this is the first time a retail crypto exchange operator has received a US FCM license. Prime Trust Files for Bankruptcy Protection: Nevada based cryptocurrency custodian Prime Trust filed for bankruptcy protection on August 15 in United States Bankruptcy Court for the District of Delaware. This filing comes as no surprise as Prime Trust has had a number of problems and setback over last the few months. These problems include Nevada's Financial Institutions Division attempting to take over the company in June by declaring them insolvent as well as a failed transaction where they were to be taken over by BitGo. Prime Trust stated in its filing that it has assets of between $50 and $100 million with liabilities of between $100 and $500 million with between 25,000 and 50,000 creditors. SEC Brings First Charges for Violating new Marketing Rule: The SEC’s first crackdown regarding the relatively new “Marketing Rule” under the Investment Advisers Act relates to a crypto fund manager.  Allegations include that the manager extrapolated three weeks of performance into a full year to get to 2700% hypothetical annualized return under a certain strategy, as well as inconsistent disclosure regarding custody of cryptoassets. A big part of the problem was that the manager allegedly buried disclaimers and assumptions used in calculating hypothetical performance behind embedded hyperlinks.  Just as a friendly reminder, an attorney or compliance professional should review any performance information (including hypotheticals, case studies, projections and track record) included in investment adviser marketing materials, even if it’s a tool located on a website or within an app. Conclusion: Over the past two weeks, major developments in the digital asset industry's litigation landscape dominated the headlines. PayPal's announcement of its new fully-backed U.S. dollar-pegged stablecoin, PYUSD, further ignited the ongoing discussions about regulated stablecoin issuers in Washington D.C. Additionally, Coinbase's litigation against the SEC saw support pouring in from influential entities, challenging the SEC's broader approach towards crypto assets. The SEC's decision to pursue an interlocutory appeal against Ripple and the summary judgment in favor of the Treasury Department regarding the Tornado Cash issue reflect the increasing complexity of the legal environment surrounding digital assets. With significant updates from Celsius Network, Federal Reserve, Bittrex, Coinbase, Prime Trust, and the SEC's enforcement actions, it's evident that the intersection of digital assets and regulatory frameworks is in a state of flux. These developments underscore the importance of attorneys for the digital asset industry to navigate and help shape the ever-evolving legal landscape. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. The past two weeks were filled with legislative activity as members of Congress worked to get digital asset legislation through committees prior to Congress going on its August break. The Securities and Exchange Commission (“SEC”) also had a busy week, bringing charges against Hex Founder Richard Heart, successfully staving off dismissal in the agency’s pending litigation against Terraform Labs, and facing a Motion for Judgement in its case against cryptocurrency exchange Coinbase. With Congress on break, we expect the next few weeks to be primarily focused on the ongoing litigation efforts in the industry with very little movement on the regulatory and legislative fronts. These developments and a few other brief notes are discussed below. House Committees Advance FIT for 21st Century Act After Markup: July 27, 2023 Background: On July 26, the House Financial Services Committee held a hearing to markup the Financial Innovation and Technology (“FIT”) for the 21st Century Act. As covered in prior updates, this is the House’s attempt at comprehensive digital asset market structure regulation. Those hearing materials are available here. After an over seven-hour hearing in the Financial Services Committee and a two-hour hearing in the Agriculture Committee the following day, the bill passed committee review and will now proceed to the full House for consideration. Summary: The Financial Services Committee members voted through the FIT for the 21st Century Act with a 35-15 majority.  6 Democrats of the 23 on the committee voted in favor of the bill. The average age of the Democrats who voted for the bill was 46, while the average age who voted against was 61, marking a stark generational divide on the issue among Democrats. The Agriculture Committee also passed the effort with less fanfare by voice vote. Representative Torres came out in strong support of the bill from the Democrat side, there was expected support from Republicans like Representatives Emmer, Hill, and McHenry, and there was the usual hemming and hawing from both sides of the aisle. Time will tell if the bill has enough support in the House to get consideration from a Democrat controlled Senate. Stablecoin Legislation Clears House Financial Services Committee Amidst Controversy: July 27, 2023 Background: On July 27, the House Financial Services Committee met to markup the Clarity for Payment Stablecoins Act of 2023. The July 27 hearing materials are available here. After a last-minute breakdown in negotiations due to White House concerns regarding the lack of Federal Reserve oversight over state and non-bank stablecoin issuers, the bill proceeded to markup as the original Republican drafted bill to which the Democrats on the Committee strongly objected. Summary: Many expected the stablecoin bill scheduled for markup on July 27 to be a bipartisan effort after Financial Services Committee Chair Patrick McHenry and Ranking Member Maxine Waters signaled being close to agreement on the bill in days leading up to the markup. However, CoinDesk has reported that the White House’s National Economic Council, led by Lael Brainard, resisted reaching an agreement due to the bill not providing federal regulators in a strong enough role in stablecoin issuer oversight. Rather than delaying the bill further until after the August Congressional break, McHenry submitted the bill in its original Republican drafted form for markup. Democrats on committee attempted to stop the proceedings, but the markup went forward. While the bill did pass committee with some Democrat votes, it was certainly a step back in the process while also being a step forward. SEC Charges Hex Founder Richard Heart with Securities Law Violations: July 31, 2023 Background: On July 31, Hex Founder Richard Heart and three unincorporated entities that he allegedly controls were charged by the SEC with conducting unregistered offerings of crypto assets that allegedly raised more than $1 billion from investors. The SEC’s press release announcing the case is available here and the SEC’s Complaint is available here. Summary: Richard Heart (real name, Richard Schueler) is known for his public displays of wealth such as his purchase of a rare ‘Enigma’ black diamond and displays of wealth in social media posts.  The SEC alleges that "Heart called on investors to buy crypto asset securities in offerings that he failed to register. He then defrauded those investors by spending some of their crypto assets on exorbitant luxury goods.” Interestingly, this case is brought by the SEC’s Fort Worth regional office but was brought in the Eastern District of New York. These jurisdictional allegations have raised eyebrows, as one basis for the jurisdiction is Heart’s use of opensource code from Uniswap, the developer of which is headquartered in the Eastern District of New York. While the nature of the allegations makes this seem like a straightforward securities fraud claim, the Complaint placed special emphasis on the protocol’s staking mechanism as being a means through which investors would have an expectation of profits under the Howey test. Terraform Labs Loses Motion to Dismiss in Case Against SEC: July 31, 2023 Background: On July 31, Judge Rakoff in the District Court for the Southern District of New York denied Terraform Labs and its founder Do Kwon’s (“Defendants”) Motion to Dismiss. The Opinion and Order can be found here. The SEC has brought civil claims against Defendants for alleged fraud and sale of unregistered securities in the form of cryptocurrency LUNA, stablecoin UST, and three other types of crypto assets. Summary: Many commentators have focused on the Order’s seeming dissent from the reasoning of fellow Southern District of New York Judge Torre’s ruling in her Ripple Summary Judgment Order which we broke down on the BitBlog here. While that is certainly something worth pointing out, the Defendants in this case brought their Motion to Dismiss under Rule 12(b)(6) as opposed to a Motion for Summary Judgment, so at this stage, Judge Rakoff had to accept all of the SEC’s allegations as true and the Howey test is an inherently fact-intensive standard for dismissal. However, a less discussed portion of the ruling is the Court’s denial of Defendants’ Major Questions Doctrine defense. In it, the Court held the Major Questions Doctrine only applies if the industry in question resembles in political and economic significance of prior Supreme Court cases on the issue such as the tobacco industry at issue in FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120 (2000). With proper factual record, Defendants may be able to establish that digital assets in the United States are as economically significant today as tobacco was in the United States in the early 2000’s. Coinbase Files Motion for Judgment on Pleadings in Case Against SEC: August 4, 2023 Background: As we covered in a prior update, on June 28, Coinbase filed its Answer early and a letter of intent to move for Judgment on the Pleadings in the SEC’s lawsuit against the popular cryptocurrency exchange. On August 4, Coinbase filed their Rule 12(c) Motion for Judgment on the Pleadings. Amicus briefs in support of Coinbase’s motion are due on August 11, and the SEC has until October 3 to respond. Summary: Coinbase’s arguments predictably focused on the Coinbase claim that none of the digital assets sold on its exchange are “investment contracts” under Howey and thus are not securities.  While Ripple presented an “essential ingredients” argument in its litigation, Coinbase took a more subtle approach arguing that an “investment contract” requires both an investment and a contract, and the SEC’s attempt to read out “contract” from the test is an impermissible expansion of Howey. Coinbase also raised a Major Question Doctrine defense, which may be an extension of Coinbase’s strategy when it brought its separate mandamus action against the SEC asking for either approval or denial of the exchange’s request for rulemaking for digital assets. It can be expected that many of the mandamus amicus filers will similarly focus on the investment contract and Major Question Doctrine arguments in their supporting filings in this matter rather than Coinbase’s other arguments regarding its digital wallet and staking services. Briefly Noted: IRS Issues Guidance on Taxation of Staking: The US Internal Revenue Service (IRS), via Revenue Ruling 2023-14, issued formal guidance providing that cash-method taxpayers must report staking income as current gross income as of the date and time at which it is reduced to undisputed possession.  This is consistent with the position the IRS took in Jarrett v. US, where the plaintiffs argued that staking was more akin to baking a cake and the income should only be realized when the rewards are subsequently sold.  That case was eventually rendered moot when the IRS voluntarily refunded the plaintiffs the disputed taxes. While the Revenue Ruling mentioned slashing, it did not address the tax treatment of slashing. SEC Warns Accountants About Digital Asset Audits: The SEC’s Chief Accountant issued a warning for accounting firms against “The Potential Pitfalls of Purported Crypto ‘Assurance’ Work” in recent guidance. Commissioner Hester questioned the purpose of this guidance on Twitter. Binance Files Motion to Dismiss in Case Against CFTC: In addition to the SEC’s case against Binance we previously covered, the exchange is also facing a lawsuit filed by the CFTC currently pending in the Northern District of Illinois. On July 27, Binance filed a Motion to Dismiss in that CFTC case, claiming the CFTC’s lawsuit suffers from jurisdictional defects and improperly alleges extraterritorial conduct as the basis for this U.S. lawsuit. SEC Requires Reporting Companies to Report Data Breach Incidents: Our data breach team at Polsinelli broke down the new reporting obligations under the SEC’s recently published rule. It is unclear how companies with digital asset exposure will need to report things like token or protocol specific code exploits and if those are “breaches” under this new policy. PayPal Announces Stablecoin Launch: PayPal announced the launch of PayPal USD (“PYUSD”), a stablecoin pegged to the U.S. dollar and 100% backed by U.S. dollar deposits, short-term U.S. Treasuries, and similar cash equivalents. “PayPal USD will be available to consumers, merchants and developers to seamlessly connect fiat and digital currencies” according to the company’s press release. As an ERC-20 token, PYUSD will be transferable to external digital wallets. Conclusion: With the current regulatory uncertainty and Congress now on break, it should be no surprise that litigation will dominate the news for the $2 trillion digital asset industry. With limited time left in the Congressional calendar to push through legislation, it is looking to be another year where the industry is left to take its direction primarily from regulatory and judicial actions. In the ever-shifting legal landscape of blockchain and cryptocurrency, understanding and navigating the complexities can be a daunting task. The recent developments highlighted here underscore the importance of remaining vigilant and informed. Whether you are an individual investor, a burgeoning startup, or an established entity within the industry, these changes may impact your operations and strategic decisions. For stakeholders at all levels, seeking appropriate legal guidance and keeping abreast of regulatory shifts is not just beneficial but essential. As the industry continues to evolve, its intersection with law and governance will undoubtedly remain a critical and compelling facet of Web3. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. In the wake of the summary judgment decision in SEC v. Ripple, legislators and litigants have rushed to clarify what the SEC’s first loss against a digital asset issuer means for the larger Web3 industry in the United States. This Ripple decision spurred congressional calls for an updated digital asset regulatory framework. Multiple legislative efforts are underway, including reintroducing the Responsible Financial Innovation Act in the Senate, to bring financial innovations under consumer protection norms. Senators also proposed the Crypto-Asset National Security Enhancement and Enforcement Act to extend the Bank Secrecy Act to certain digital asset transactions, stirring debates on its potential to criminalize software publishing. Lastly, the House introduced the Financial Innovation and Technology for the 21st Century Act, a comprehensive law proposal developed after extensive hearings, marking significant legislative progress in the digital asset space. These developments and a few other brief notes are discussed below. Summary Judgment in SEC v. Ripple Sends Shockwaves Through Industry: July 13, 2023 Background: On June 13, a Motion for Summary Judgment Order in the SEC v. Ripple case was released, with a ruling many in the industry have been advocating for: “XRP, as a digital token, is not in and of itself a contract, transaction, or scheme that embodies the Howey requirements of an investment contract.” (internal quotes omitted). This wasn’t a complete win for Ripple, as over $700 million in contractual sales to institutional investors were ruled to be unregistered securities transactions. But for “programmatic sales” through digital asset exchanges, the Court ruled that buyers did not understand objectively that their funds would go to Ripple to increase the price of XRP, so those were not deemed to be securities transactions. Summary: We provided a full breakdown of the case and the Court’s Order in an article on the BitBlog, which you can read here.  The Court rejected the Ripple “essential elements” arguments and fair notice defense (for institutional sales). However, the Court went on to apply the Howey transaction-by-transaction analysis and reached a determination that some transactions involving the XRP token were securities sales in their totality, and some were not. This ruling has led members of Congress to call for renewed efforts toward creating a workable digital asset regulatory framework in the United States. Senate Digital Asset Legislation Reintroduced: July 14, 2023 Background: On July 14, the Lummis-Gillibrand Responsible Financial Innovation Act (“RFIA”) was re-introduced into the Senate, after failing to get past committee last Congressional session. Senator Lummis tweeted an infographic describing what is new in this version of the legislation. The revised RFIA maintains much of the broad scope of the 2022 version but is updated to reflect developments since then, like the collapse of FTX. Summary: This bill has not received the same level of industry support as the Digital Asset Market Structure bill in the House, but this is a bipartisan effort with seemingly some support in the Senate. While most of the momentum is on the House’s bill, it would not be surprising to see features of the RFIA make their way into any final legislation on the topic. Especially the aspects regarding consumer protection, which may hit home with legislators who saw a lack of consumer protections lead to the implosion of FTX and other prominent digital asset service providers. Senate Introduced Legislation Aimed at DeFi AML Compliance: July 18, 2023 Background: On July 18, Senators Reed, Rounds, Warner, and Romney introduced the Crypto-Asset National Security Enhancement and Enforcement (“CANSEE”) Act in the Senate. The legislation seeks to extend obligations and penalties under the Bank Secrecy Act to persons who (1) “makes available an application designed to facilitate transactions using a digital asset protocol”; and (2) who “control a digital asset protocol, as determined by the Secretary of the Treasury.” Summary: This bill is an attempt to find a way to apply traditional finance’s protections for anti-money laundering (“AML”) and know your customer (“KYC”) to decentralized finance as those rules apply to traditional finance. Coin Center has alleged that the bill is unconstitutional because it creates potential for criminal prosecution against individuals for merely publishing software and failing to register with FinCEN. Any regulation for the space will create pain points for digital asset services providers who have developed those services largely without regulatory burdens thus far. House Introduced the Financial Innovation and Technology for the 21st Century Act: July 20, 2023 Background: On July 20, after a process that included hearings in both the Agriculture and Financial Services Committees in the House, the proposed digital asset market structure law, titled the Financial Innovation and Technology for the 21st Century Act, is finally here. While the Discussion Draft was a comprehensive 162 pages, this checks in at 212 pages. The Agriculture Committee’s press release and all associated documents (including a fact vs. myth breakdown) are available here. Summary: As stated above, the House is seemingly much further along with its legislation than the Senate, with months of hearings on a discussion draft bill leading up to this proposed legislation. Additionally, as Chair of the House Financial Services Committee, Patrick McHenry may have more power to push the House’s bill past committee. However, the House’s bill will need to gain support from across the aisle, potentially from industry proponents like Representative Ritchie Torres, to get this bill to a point where it can pass in the Senate and be signed into law by the President. Briefly Noted: Senators Propose Digital Asset Amendments to National Security Legislation: Senators Warren/Marshall (generally anti-crypto), and Lummis/Gillibrand (generally pro-crypto) proposed a crypto-focused amendment to pending national security legislation. It puts AML reporting burdens on crypto kiosks and some obligations on FinCEN and Treasury to come up with compliance regimes for stablecoins/mixers. Coinbase Litigation Against SEC Update: Coinbase filed its letter response to the SEC’s intent to strike Coinbase’s affirmative defenses, and the parties had a hearing with the Court for over 2 hours as well. Polsinelli Blockchain+ Team Updates: The Blockchain+ team got a big upgrade with the hire of Albert “Bert” W. Stemmler as a shareholder in the firm’s growing Nashville office. Prior to joining Polsinelli, Bert served as Head of Legal and Compliance at a VC fund manager and operator of an accelerator for early-stage companies in crypto/digital assets. Additionally, Jeanne Solomon and William Quick wrote this great article published in Law360 regarding what the Corporate Transparency Act means for DAOs. Conclusion: The ruling in Ripple finding that digital assets are not securities in certain circumstances underscores the need for legislative and regulatory clarity. It shows that a reasonable court could find that there are regulatory gaps in the sale of these instruments, which supports the renewed push from all sides of the issue to put clarifying legislation into place. While Congress traditionally moves slowly on issues of major significance, such as the regulation of a completely new industry, it is possible that the Ripple decision and other developments in the courts could spur legislators to move quickly instead of allowing these issues to be decided piecemeal by the judicial branch rather than through lawmaking from the legislative branch. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted by our attorneys.

The long battle between the U.S. Securities and Exchange Commission (“SEC”) and Ripple reached a partial resolution with the Court ruling the digital asset at issue (“XRP”) is not itself a security and certain sales of the asset are not securities transactions. This is one of the most significant rulings in digital asset cases thus far and the first final disposition by a court that was in favor of a digital asset issuer and against the SEC. Introduction A federal judge ruled on July 13, 2023, that sales of XRP by Ripple and its affiliates (i) to the general public through anonymous exchanges did not constitute sales of securities but (ii) to institutional investors through contractual arrangements did constitute securities transactions.[1] As will be discussed in more detail below, Ripple is a network for the global transmission of payments, primarily between financial institutions with XRP being the “in network” token used for processing transfers between different currencies. During the period from 2013 to 2020, more than $1.3 billion of XRP was sold by Ripple primarily through two different methods: (i) sales to institutional investors through some sort of subscription documents and (ii) sales to the public anonymously via digital asset exchanges. U.S. District Court Judge for the Southern District of New York (S.D.N.Y.) Analisa Torres ruled in SEC v. Ripple Labs, Inc. that Ripple’s sales of XRP to sophisticated buyers and hedge funds (“Institutional Buyers”) pursuant to written contracts (“Institutional Sales”) were securities because, considering the totality of the circumstances, these buyers would have purchased XRP expecting to profit from Ripple’s efforts.[2] In contrast, sales to the general public anonymously through digital asset exchanges (“Programmatic Sales”) were not securities because there was no evidence demonstrating these buyers (“Programmatic Buyers”) had the same expectation.[3] The Court also found that distributions of XRP as employee compensation or to third parties as a way to develop new applications for Ripple’s platform (“Other Distributions”) were not securities because there was no investment of money.[4] It remains to be seen whether this decision will have a significant “ripple” effect for the crypto industry because other jurisdictions are not bound by the court’s decision and the SEC may appeal the decision once it is able to do so. For now, it marks the first significant judicial headwind to what is perceived by many as the SEC’s attempt to impose rules on crypto entities through enforcement. This ruling also provides some hope that courts will provide material clarity on the regulatory status of digital assets and shape future regulations. Ripple Background Ripple was founded to create a less expensive means of transferring between currencies by creating a more efficient alternative to the Bitcoin blockchain, which it launched in 2012 and was labeled the XRP Ledger (the “Ledger”).[5] The Ledger requires XRP, the native token, to operate and XRP is intended to be used to build software products on top of the Ledger.[6] Unlike Bitcoin where additional Bitcoin is consistently created through “mining,” all XRP was created at the time the Ledger was launched, with 80% of the token supply given to Ripple and 20% given to its founders. Ripple’s stated mission is to revolutionize international financial transactions by reducing both transaction fees and the time to complete a transaction. For instance, Ripple’s network, RippleNet, employs the blockchain to create a payment network designed to provide faster and cost-effective international transactions by enabling financial institutions to transact directly with one another.[7] Likewise, XRP acts as a bridge currency to other currencies to facilitate fast and inexpensive international transfers.[8] Between 2013 and 2020, Ripple allegedly raised more than $1.3 billion from selling or distributing XRP through Institutional Sales, Programmatic Sales, and Other Distributions.[9] During this time, Ripple allegedly marketed XRP as an opportunity for people to invest and grow XRP’s value and use cases. Some of these marketing efforts included informational brochures, public blog posts, or Ripple leaders publicly commenting on XRP’s value.[10] Specifically, Ripple raised approximately $730 million by selling XRP to Institutional Buyers pursuant to written contracts in Institutional Sales.[11] These written contracts often contained resale restrictions and required the Institutional Buyers to indemnify Ripple for claims resulting from selling or distributing XRP. Ripple raised approximately $758 million from Programmatic Sales through blind bid/ask transactions—XRP was sold on digital asset exchanges and neither party knew who was selling or buying the XRP.[12] Further, Ripple allegedly raised approximately $609 million in value from Other Distributions which were distributions of XRP in the forms of grants, charitable giving, and employee rewards.[13] Ripple’s co-founder, Chris Larsen, and Ripple’s CEO, Brad Garlinghouse, each allegedly sold XRP via Programmatic Sales and earned a combined $600 million. Throughout this time, Ripple did not file any registration or financial statements or periodic reports with the SEC.[14] Case Background In 2020, the SEC filed a lawsuit against Ripple, Larsen, and Garlinghouse alleging that the sale of XRP was an unregistered security offering in violation of Sections 5(a) and 5(c) of the Securities Act (15 U.S.C. §§ 77e(a) and 77e(c)).[15] In its motion for summary judgment, the SEC alleged that selling XRP qualified as an “investment contract” under securities law.[16] The SEC advanced an “embodiment” theory in which the token itself embodied the securities transaction it was allegedly being sold under.[17] The SEC supported their assertions, among other things, by citing Ripple’s marketing promises to increase the value of XRP for the benefit of XRP owners and for Ripple, and by pointing to the economic expectations XRP purchasers had for Ripple to increase XRP’s value.[18] In response, Defendants countered in their own motion for summary judgment that XRP transactions did not constitute investment contracts, claiming that the transactions did not have the “essential ingredients” of an investment contract.[19] Defendants also focused on the Blue-Sky laws from which the term “investment contract” originated to support their defense that there are certain essential elements of every investment contract such as privity of contract between the promotor/investor, and contractual post-sale obligations on the promotor/its affiliates.[20] Defendants focused on the transactions where there was no consideration, aiming to demonstrate that not all distributions of XRP fulfilled the necessary elements.[21] Additionally, for all XRP transactions, Defendants underscored the fact that XRP sales lacked a written contract explicitly designating the purchase of XRP as an investment and imposing obligations on Ripple to enhance the value of XRP.[22] Defendants also raised the affirmative defense that Defendants did not have fair notice of the violations by the SEC, alleging the SEC failed to offer clear guidance regarding the sale of cryptocurrencies like XRP, making it unreasonable for individuals to know that XRP qualifies as a security.[23] The Order Under the pinnacle Howey test, the Court laid out the relevant analytical framework: “under the Securities Act, an investment contract is “a contract, transaction[,] or scheme whereby a person [(1)] invests his money [(2)] in a common enterprise and [(3)] is led to expect profits solely from the efforts of the promoter or a third party.”[24] Further, the Court highlighted the requirement for a transaction-by-transaction analysis according to the substance, economic reality, and the totality of the circumstances.[25] The Court’s ruling focused on three key issues. First, determining the applicable test to ascertain whether the sale of XRP constituted an investment contract. Second, establishing a clear distinction between the various transactions Ripple conducted for distributing XRP and determining which transactions were in violation of the Securities Act, if any. Lastly, addressing whether the Defendants had a valid fair notice defense. Is XRP a “Security”? Rejection of Defendants’ “Essential Ingredients” Test and SEC Embodiment Theory The Court declined to accept the Defendants’ “essential ingredients” test, where the Defendants claimed, in addition to the Howey elements, investment contracts must be “‘(1) a contract between a promoter and an investor that establishe[s] the investor’s rights as to an investment,’ which contract (2) ‘impose[s] post-sale obligations on the promoter to take specific actions for the investor’s benefit’ and (3) ‘grant[s] the investor a right to share in profits from the promoter’s efforts to generate a return on the use of investor funds.’”[26] The Court rejected this idea and found the relevant inquiry must focus on whether it was objectively reasonable for XRP purchasers to expect a financial return or profit based on Ripple’s efforts.[27] Additionally, the Court found the current test effectuates the Securities Act’s fundamental policy of giving broad protection to investors regardless of whatever scheme human ingenuity produces.[28] The Court also rejected the SEC’s embodiment theory, that the token itself embodies an investment contract scheme. In a previous digital asset case ruling, the Court in SEC v. Telegram held that the “security” was neither the token nor the sales contracts for those tokens, but rather the entire scheme.[29] The Ripple decision seems to take it a step further holding that the digital asset itself is not a security, but rather the scheme under which the digital asset is sold is the important consideration and is something which needs to be done on a transaction-by-transaction basis. Institutional Sales The Court ultimately found the Institutional Sales were investment contract sales subject to the Securities Act.[30] Under Howey’s first element, the Court found the Institutional Buyers invested money because they provided fiat currency in exchange for XRP thereby providing Ripple with capital.[31] The Court also found the “common enterprise” element was satisfied because Ripple pooled all the proceeds from the Institutional Sales and the Institutional Buyers’ fortune benefitted from XRP’s success.[32] Lastly, the Court concluded there was a reasonable expectation to profits from Ripple’s entrepreneurial and managerial efforts. Utilizing an objective approach, the Court reasoned Ripple’s communications, marketing efforts, and the substance of the written contracts between Ripple and the Institutional Buyers would cause investors to believe Ripple would invest the money received from the Institutional Sales to enhance XRP’s value, which in turn would generate profits for the Institutional Buyers.[33] For instance, Ripple’s marketing brochures conveyed XRP’s value would increase as more people adopted XRP or as XRP’s popularity grew. Notably, the Court rejected the Defendants’ claim that XRP was akin to buying or selling a commodity, like gold or silver.[34] The Court explained that even selling gold or silver could be sold as an investment contract, under certain circumstances.[35] Programmatic Sales On the other hand, the Court determined that the Programmatic Sales of XRP did not constitute the offer and sale of investment contracts.[36] Without evaluating the other two prongs, the Court ruled that the Programmatic Sales did not establish the third Howey prong because Programmatic Buyers could not reasonably expect that Ripple would use the capital from the Programmatic Sales to increase the value of XRP.[37] These buyers were not aware they were buying XRP from Ripple in the first place. In fact, the majority (about 99%) of Programmatic Buyers purchased XRP from secondary owners, meaning Ripple did not directly receive the proceeds from these transactions.[38] The decision is similar to Hocking v. Debois, in which a 9th Circuit Court of Appeals found that the sales of condos with rental service contracts would be a securities transaction if sold by the original developer, but which required a facts and circumstances analysis when sold on the secondary market.[39] Unlike stocks and bonds which are de facto securities,[40] the existence of an investment contract is determined on a transaction-by-transaction basis taking into account the asset purchaser’s objectively reasonable understanding at the time of purchase: it could be an asset (which they could subjectively believe will increase in value, like a car or horse) or an investment contract (in which they are objectively relying on the efforts of others to make the value increase). Here, the Court found there wasn’t an objectively reasonable understanding that some of the purchase price for XRP bought on secondary markets would go to Ripple to increase XRP’s value. “Whereas the Institutional Buyers reasonably expected Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP…Programmatic Buyers could not reasonably expect the same.”[41] The Court used that and other factors, such as lack of contractual lockup provisions for those XRP purchases and lack of evidence that Programmatic Buyers saw or understood the marketing materials of Ripple prior to purchasing XRP on secondary marketplaces, to find the Programmatic Sales were not investment contract transactions.[42] Notably, the Court explicitly rejected the SEC’s arguments that managerial efforts of others could be inferred because Ripple targeted speculative investors or because Ripple “understood that people were speculating on XRP as an investment.”[43] Instead, the Court applied the objectively reasonable understanding standard from Howey, rejecting the arguments by both sides regarding subjective intent to use or subjective belief that the value of XRP would increase after purchase. Other Distributions The Court also ruled that Ripple’s grants of XRP to charities, Ledger developers, and as employee compensation did not constitute an “investment of money” under Howey.[44] While the Court cited to caselaw which establishes that “investment of money” does not need to be fiat currency but can be other forms of tangible and definable consideration, the Court found there was no such investment of money in the Other Distributions.[45] This section of the Court’s ruling is the most cursory, and it is unclear if this is based on the Court’s belief that these particular Other Distributions didn’t meet the “investment of money” standard or if the SEC simply failed to produce a record showing the consideration provided by employees and XRP Ledger developers were tangible and definable. Did Defendants Have Fair Notice? The Court did not accept Defendants’ defense under the Due Process Clause of the Fifth Amendment that they lacked fair notice of what conduct was forbidden or required, asserting that the caselaw provides a clear test for determining what constitutes an investment contract.[46] In alleging their defense, the Defendants focused on the SEC’s lack of clear guidance on digital assets, but the law does not require the SEC to warn all potential violators.[47] The Court found there was sufficient due process because caselaw that defines an investment contract provides a person of ordinary intelligence a reasonable opportunity to understand what conduct it covers, and cases subsequent to Howey show how that test would be applied in various situations.[48] However, in footnote 20, the Court stated its holding was “limited to the Institutional Sales because the SEC’s theories as to the other sales in this case are potentially inconsistent with its enforcement in prior digital asset cases.”[49] What This Means for the Industry Similar to the ruling in LBRY, this is a single decision from a single court with limited precedential value.[50] It is likely to be appealed by the SEC, Ripple, or both, although the courts would need to exercise a fair amount of discretion for the decision to be appealed before the remaining portions of the case – pertaining to aiding and abetting violations – are finally decided or otherwise disposed of. However, unlike LBRY, the Ripple ruling handed the SEC its first true loss against the digital asset industry. It provides both a potential framework on how to structure certain distributions of digital assets and a cogent argument against the “embodiment theory” pushed by the agency that once a token is sold in a securities transaction then it and all other tokens like it are securities. It also provides some additional guidance on how to conduct an offering and sale of digital assets in compliance with applicable laws. While not explicitly stated, the decision provides some vindication to the view that tokens without equity-like characteristics are not themselves securities, but an investment contract could be formed when that token is paired with a transaction. This is similar to Howey itself, which related to the sale of plots of orange groves combined with a service agreement to pick and sell the fruit. That combination created an investment contract, but the oranges weren’t securities. This puts tokens in a category with a myriad of other asset classes – beavers, construction equipment, gold, condominiums, and cattle among them – which, if paired with a contract, the sale could become a securities transaction.[51] By finding that digital assets are not securities in certain circumstances, this case also underscores the need for legislative and regulatory clarity. It shows that a reasonable court could find that there are regulatory gaps in the sale of these instruments – a position that the SEC itself acknowledged as recently as 2021,[52] until changing its tune and stating that the entire crypto industry outside of Bitcoin can be regulated by the SEC.[53] There was already a rising push for some form of digital asset regulation, even amongst detractors, as the industry’s longevity has become less and less deniable. We hope this ruling spurs Congress to work diligently to pass digital asset framework legislation. Currently, both the House and Senate are discussing comprehensive digital asset bills along with other digital asset bills like the stablecoin legislation in the House.[54] It is possible this Ripple decision spurs forward motions on some of these legislative efforts. This decision alone, however, does not substantially change the regulatory and legal environment applicable to digital asset businesses. All it means is that certain anonymous sales of XRP when sold on secondary marketplaces do not constitute securities transactions (for now). It does not necessarily mean any other token is not a security when sold on a secondary marketplace, or that selling through a secondary marketplace is an endorsed end-around to securities laws for other token issuers. Each investment contract case still requires a transaction-by-transaction analysis and not every case will have identical facts to Ripple. That said, when combined with other developments, such as large financial services, companies openly embracing digital assets, and movement amongst members of Congress on digital asset policy, it is hard not to be optimistic for the industry’s growth in the U.S. where previously such optimism was hard to come by. [1] Order 22, ECF No. 874. [2] Order 16, ECF No. 874. [3] Order 25, ECF No. 874. [4] Order 27, ECF No. 874. [5] Order 2, ECF No. 874. [6] Order 2, ECF No. 874. [7] Order 3, ECF No. 874. [8] See Order 3, ECF No. 874. [9] See Order 4-5, ECF No. 874. [10] Order 4-5, ECF No. 874. [11] Order 4, ECF No. 874. [12] Order 4, ECF No. 874. [13] Order 5, ECF No. 874. [14] Order 5, ECF No. 874. [15] Pl’s Memo in Supp. Summ. J. 63, ECF No. 640. [16] Pl’s Memo in Supp. Summ. J. 49, ECF No. 640. [17] See Pl’s Memo in Supp. Summ. J. 49-52, ECF No. 640. [18] Pl’s Memo in Supp. Summ. J. 53-56, ECF No. 640. [19] Def. Memo in Supp. Summ. J. 2, ECF No. 643. [20] Def. Memo in Supp. Summ. J. 2, ECF No. 643. [21] Def. Memo in Supp. Summ. J. 26-28, ECF No. 643. [22] Def. Memo in Supp. Summ. J. 29-30, ECF No. 643. [23] Pl’s Memo in Supp. Summ. J. 69, ECF. No. 640. [24] SEC v. W.J. Howey Co., 328 U.S. 293, at 298–99 (alterations in original). [25] Order 16, ECF No. 874. [26] Order 11-12, ECF No. 874. [27] Order 13, ECF No. 874. [28] Order 12-13, ECF No. 874. [29] SEC v. Telegram, 448 F. Supp. 3d 352, 366 (S.D.N.Y. 2020). [30] Order 16-17, ECF No. 874. [31] Order 16, ECF No. 874. [32] Order 17-18, ECF No. 874. [33] Order 18-22, ECF No. 874. [34] Order 22, ECF No. 874. [35] Order 22, ECF No. 874. [36] Order 22, ECF No. 874. [37] Order 23, ECF No. 874. [38] Order 23, ECF No. 874. [39] Hocking v. Debois, 885 F.2d 1449 (9th Cir. 1989). [40] 15 U.S.C.A § 77B; 15 U.S.C.A. § 78c; & 15 U.S.C.A. § 80a-2. [41] Order 23, ECF No. 874. [42] Order 24, ECF No. 874. [43] Order 22, ECF No. 874. [44] Order 26, ECF No. 874. [45] Order 26-27, ECF No. 874. [46] Order 29-30, ECF No. 874. [47] Order 30, ECF No. 874. [48] Order 29-30, ECF No. 874. [49] Order 29, ECF No. 874. [50] SEC v. LBRY, Inc, No. 21-cv-260-PB, 2022 U.S. Dist. 2022 WL 16744741 (D.N.H. Nov. 7, 2022). [51] Lewis Cohen et al., The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets are Not Securities, DLxLaw. Nov. 2022, at 56-58. [52] Chair Gary Gensler, Testimony at Hearing before the Subcommittee on Financial Services and General Government U.S. Appropriations Committee, U.S. Securities and Exchange Commission (May 17, 2022), https://www.sec.gov/news/testimony/gensler-testimony-fsgg-subcommittee. [53]  Chair Gary Gensler, Testimony of Chair Gary Gensler before the United States House of Representatives Committee on Financial Services, U.S. Securities and Exchange Commission (Apr. 18, 2023), https://www.sec.gov/news/testimony/gensler-testimony-house-financial-services-041823. [54] H.R. 4662 118th Cong. (2023); Responsible Financial Innovation Act S. 4356 118th Cong. (2023); Stablecoin Transparency Act S. 3970 117th Cong. (2022).

Highlights of the Last Two Weeks in Blockchain+: The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. In this latest Blockchain+ Bi-Weekly, we were planning to welcome a slowdown in Web3 legal developments with Congress on the Fourth of July break and federal agencies also largely quiet. However, directly before this blog was scheduled for release on July 13, possibly the most important court ruling related to digital assets came down. The dueling motions for summary judgment by the parties in the highly anticipated SEC vs. Ripple Labs case were decided. In a split ruling, the SEC was granted summary judgment regarding "institutional sales" of XRP and summary judgment was granted to Ripple with a ruling that "programmatic sales" of XRP to the public "did not constitute the offer and sale of investment contracts."  Overall, the decision is being viewed as an immensely positive milestone for digital assets in the United States.  We are working on a full BitBlog post breaking down the decision and its industry implications, which should be out next week. In this update, we highlight an interesting strategic move made by counsel for Coinbase in its litigation defense against the SEC, an unexpectedly stout defense by crypto exchange Bittrex in its own battle with the agency, an update on comprehensive digital asset legislation meandering forward in both the House and Senate, and a few other brief notes. Coinbase Files Early Answer in Legal Fight Against SEC: June 28, 2023 Background: On June 7, Coinbase waived formal service in the SEC’s lawsuit against it, giving Coinbase until early August to Answer or otherwise plead. In a shock to many, Coinbase, instead this past week, filed its Answer, and local rule required a letter of intent to move for judgment on the pleadings under FRCP 12(c). Due to the Fourth of July holiday weekend overlapping with the SEC’s applicable due date under the local rules, the SEC was given until July 7 to respond, which they did, announcing their expected intent to oppose. Summary: This move is the fruition of months of strategic legal decisions by Coinbase going back to its amicus in the Wahi case and the Writ of Mandamus action Coinbase filed against the SEC in April. In football terms, Coinbase was running a hurry-up offense and ran a trick play/Hail Mary with its first possession in the game. And Coinbase ran months of decoy plays to set it up. The unique use of FRCP 12(c) and the use of a 33-page "Preliminary Statement" in its Answer to save page space, later on, is just some of the impressive lawyering that went into this strategy by Coinbase. This also puts Coinbase on a separate scheduling track from Binance, which is not expected to answer or otherwise plead in its separate action until September 21, 2023. Bittrex Files Motion to Dismiss in SEC Lawsuit Against Departing US Entity: June 30, 2023 Background: Back in March, Bittrex announced it would be winding down US operations after nine years due to regulatory uncertainty.  The SEC brought its lawsuit against them shortly thereafter, which caused Bittrex to convert its orderly winddown into bankruptcy. Bittrex has now filed a Motion to Dismiss the SEC’s lawsuit against it, arguing the secondary sales of the tokens at issue are not securities transactions and that the SEC lacks the authority to bring its lawsuit under the Major Question Doctrine. Summary: As an initial matter, one could question how the SEC protects investors by bringing a lawsuit and forcing a company into bankruptcy where it was already winding down its US operations with the intent to return investor funds. One explanation is that winddown may be why the SEC took a seemingly aggressive approach in the case. For example, the SEC’s lawsuit alleges that DASH, a token with none of the usual securities hooks like a sale of pre-mined tokens and/or funding from investors instead of funding by validators out of block rewards, is a digital asset security. It is surprising to see Bittrex put up the stout defense it has under these circumstances, and it will be interesting to see how the Major Question Doctrine issue is argued after the recent SCOTUS ruling in Biden v Nebraska. The Major Question Doctrine is a recently revived legal principle that limits the executive branch’s power on issues of major economic or political significance unless there is a clear congressional delegation of power over that issue to an administrative agency. The Major Question Doctrine is often brought up regarding executive orders, and it’s unclear if it applies to enforcement actions like those brought by the SEC against Bittrex. Treasury Department and SEC to Provide Opinions on Digital Asset Market Structure Bill: June 30, 2023 Background: Ranking House Financial Services Member Maxine Waters requested input on the Digital Asset Market Structure Bill discussion draft from both the Treasury Department and the SEC. Representative Waters is not known to be a proponent of the bill or the digital asset industry in general. Still, she is expected to be heavily involved in bill edits after her own stablecoin legislation died during the last Congressional session. Summary: Congresswoman Waters requested the feedback by June 30, 2023, but nothing has been publicized regarding the agencies’ findings as of the publication of this blog post. With an expected bi-partisan digital asset bill to be introduced into the Senate in the near future, it appears there is a real possibility that legislation gets done this session, and previous opponents are looking to get their fingerprints on whatever that bill is rather than kill it completely. Briefly Noted: Unchained Podcast Hosts Debate on Crypto Compliance: Laura Shin hosted Rodrigo Seira of Paradigm and Aaron Kaplan of  Prometheum on the Unchained Podcast to discuss the path to compliance for digital asset marketplaces. It was a hotly debated podcast and is worth listening to hear alternative sides of the regulatory debate amongst industry attorneys. Blockchain Association Asks for Gensler Recusal: The Blockchain Association has taken the position that Gary Gensler should recuse himself from all digital asset enforcement decisions due to his alleged inability to stay impartial on such matters. This comes as even former SEC and CFTC Chairs criticize the litigation strategy taken by the current SEC. Celsius Disclosure Hearing Date Set: The Bankruptcy Court in the Celsius case set August 8, 2023, as the hearing date for the court to consider and potentially approve and Disclosure Statement and proposed plan of reorganization of the Celsius Network. Objections are due by Aug 3, 2023. Senate Finance Leaders Ask for Input on Crypto Taxation: In a letter dated July 11, 2023,  the Republican and Democratic leaders of the Senate Finance Committee requested input regarding many aspects of taxation crypto and other digital assets from members of the digital asset community and other interested parties. LBRY Gets no Relief from Federal Judge: On July 11, 2023, a Federal Judge in New Hampshire refused to provide any relief to LBRY and allowed for the SEC to impose an injunction and civil fines on them. We have previously written about the SEC’s success in obtaining Summary Judgment against LBRY and how this ruling shows the difficulty that many blockchain businesses have even when they are trying to comply with regulations. With this ruling, LBRY is all but certain to shut down and the question is if this ruling will have any impact on the expected upcoming decision in the Ripple case. Corporate Transparency Act Compliance for DAOs: Polsinelli’s own Jeanne Solomon and William Quick authored a great article regarding the applicability of the Corporate Transparency Act to DAOs and anticipated legal pain points with compliance by decentralized and often anonymously run organizations. Worth a read for anybody in the industry who hasn’t previously considered these mandatory disclosure obligations beginning in 2024. Conclusion: The summer break in Web3 legal developments is ending, and industry legal developments will pick up as litigation advances and legislative efforts move forward. The next update is expected to have many more developments, including an expected bi-partisan Senate bill on digital assets. If there was one major takeaway from the past two weeks, it looks like even some of the cryptocurrencies’ biggest prior detractors have accepted the inevitability of the technology’s use in everyday finance. Traditional finance is making more public moves into the sector, and it is increasingly likely that some form of digital asset legislation will reach the President’s desk this year. It is still unclear, however, what that legislation will look like or how the ongoing litigation will affect demand for the technology in the United States. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted from our attorneys. JULY 14, 2023

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. The summer solstice has not led to a slowdown of regulatory interest and challenges to the digital asset ecosystem. The House Financial Services Committee held a hearing on the future of digital assets as it hopefully works to craft bills to provide a workable framework for regulating digital assets while the European Union moves ahead with its separate digital asset regulatory framework law. The legal battle between Coinbase and the SEC on Coinbase’s mandamus action continues, with both sides litigating strategically to advance their positions in the separate lawsuit by the SEC against Coinbase. Binance also continues to litigate fiercely against the SEC, even in the face of recent consent order limiting the United States Binance entity’s ability to transfer certain assets during the pendency of the litigation. These developments, together with a few other brief notes, are discussed below. EU’s Comprehensive Digital Asset Legislation is Published: June 9, 2023 Background: In April 2023, the European Parliament voted through landmark legislation on cryptocurrency titled EU’s Markets in Crypto Assets (“MiCA”) with 517 votes in favor and 38 against. MiCA does not attempt to fit digital assets into an existing framework, but instead creates an entirely new disclosure and registration regime specific to digital assets. On June 9, the official version of the bill was published in the EU’s Official Journal, signaling formal passage of a bill onto the EU’s statute book. Summary: Europe is one of largest digital asset markets in the world, so it is an important step for this industry for the EU to draft a specially tailored digital asset framework for fungible digital assets and other common assets such as stablecoins. This is particularly the case when the United States is still in the very early stages of creating any form of digital asset framework.  When finalized, MiCA will apply directly across the EU without the need for special national implementation laws which many  EU consumer protection initiatives that are passed are directives require. . Due to the official publication, MiCA’s provisions will primarily begin to apply on December 30, 2024, with certain provisions taking effect slightly earlier on June 30, 2024. House Financial Services Committee Holds Hearing on Stablecoin and Digital Asset Market Structure Draft Bills: June 13, 2023 Background: On June 13, the House Financial Services Committee held a hearing titled, “The Future of Digital Assets: Providing Clarity for the Digital Asset Ecosystem” to discuss the Digital Asset Market structure discussion draft bill and the new stablecoin bill. Both hope to provide a framework for regulating digital assets. The House Financial Services Committee oversees the country’s economy through supervision of banks, the United States Treasury, capital markets, and currency production and distribution. The details on the hearing, including opening statements of the witnesses and committee memorandum are available here. Summary: On June 6, it was the Committee on Agriculture holding a hearing on the draft digital asset legislation; this week the Financial Services Committee got their chance to analyze the Digital Asset Market Structure discussion draft bill. Coy Garrison, who was former counsel to SEC Commissioner Hester M. Peirce, answered a wide range of questions, ranging from what requirements trading platforms must meet to register with the SEC to the timeframe for how assets should transition from securities to commodities. Notable moments from the hearing include Chairman McHenry’s opening statement and witness questions. Representative French Hill also pointed out that both the Secretary of Treasury and the Chairman of the CFTC have emphasized the need for Congressional action to fill regulatory gaps over the market. An increasing number of Democrats (including Ritchie Torres, Josh Gottheimer, and others) are acknowledging the enduring presence of the crypto industry and need for regulations tailored to the industry. Even if this legislation is passed in Congress, there will still be several questions to be answered by regulators regarding the interpretation and implementation of the legislation. SEC and Coinbase Provide Further Briefing in Coinbase Mandamus Action Asking SEC to Give Regulatory Clarity: June 13, 2023 Background: Back in April, Coinbase filed a mandamus action asking the Third Circuit to Order the SEC to respond to Coinbase’s Petition for Rulemaking, either agreeing to provide a regulatory framework for digital assets through tailored rulemaking or denying Coinbase’s request and standing by the SEC Chair Gary Gensler’s assertion that the rules are clear as is. The three-judge panel issued a letter order asking for answers on three questions from the SEC, and both sides have now responded. The SEC’s response is available here, while Coinbase’s rebuttal to that response is available here. Summary: After the three-judge panel asked the SEC for clarification on certain issues, the SEC was firm in their assertion that there was no merit to those issues and asked for the panel to dismiss or issue a 120-day stay for SEC staff to further consider the Petition for Rulemaking. Coinbase responded, asking the panel to deny the SEC’s stay request or limit the stay to 60 days, after which the SEC would need to have a firm answer to the Petition for Rulemaking. Both sides are litigating strategically. The SEC’s 120-day stay request would not require the SEC to file anything additional in this mandamus action until after Coinbase’s expected Motion to Dismiss is fully briefed in a separate action by the SEC against Coinbase. Coinbase’s requested deadline would fall in the middle of that briefing. The panel ended up retaining jurisdiction over the matter as requested by Coinbase but granting the SEC’s 120-day stay to allow the SEC staff to further consider Coinbase’s Petition for Rulemaking. “Hinman Speech” Documents Unsealed: June 13, 2023 Background: In June of 2018, then acting Director of the SEC’s Division of Corporate Finance gave a now-famous speech titled Digital Asset Transactions: When Howey Met Gary (Plastic) in which he (in his personal capacity) opined that “sufficiently decentralized” opined that digital assets such as Bitcoin and Ethereum were not securities and should be exempt from securities disclosure regimes. After a protracted legal battle, the SEC was forced to unseal comments made by SEC staff to draft versions of the “Hinman Speech” documents, and those comments were publicly released on June 13. Summary: The documents unsealed had some expected, but interesting comments from members of the SEC staff from 2018 when the industry was still in its very early stages. Those comments included apparent recognition of “regulatory gap[s]” in the space regarding decentralization, and the SEC staff not believing an issuer holding a large amount of tokens is of any significance in a Howey analysis (an issue which LBRY got dinged on in dicta). But largely, these were the types of comments which would be expected from the SEC staff at the time and does not significantly change the regulatory environment for digital assets in 2023. Binance.US Has Asset Transfer Limited by Consent Order: June 17, 2023 Background: On June 5, 2023, the SEC filed 13 charges against various Binance entities, including its U.S. entity Binance.US. The full complaint can be reviewed here. The SEC alleges that Binance has been operating as an unregistered securities exchange against U.S. law. This comes at the same time that Binance entities and Binance’s founder Changpeng Zhao are defending against a separate action brought against them by the CFTC. The SEC also requested that Binance.US’s funds be held in a U.S. bank for potential freezing during the legal proceedings. Summary: Even though they are in a challenging position, Binance.US is litigating fiercely in their defense on many issues alleged by the SEC and CFTC. On June 12, Binance.US added four more attorneys to its defense team, including George Canellos, a former co-director of the SEC’s enforcement division. Binance.US also opposed the SEC’s motion to freeze their assets in an emergency motion on June 12. After that hearing, at the direction of the Court for the parties to reach an agreement without requiring the Court issue its own ruling,  the parties filed a Consent Order. The Consent Order prevents Binance.US from spending corporate assets except for ordinary business purposes and gives the SEC expedited discovery into how Binance.US custodies its assets. Additionally, Binance.US must transfer control of the access keys for its digital wallets to the U.S. within 14 days.  Binance has also filed a motion taking issue with the SEC’s press release following entering of the agreed Consent Order by the parties. Briefly Noted: Celsius Discloser Statement Filed: On June 27, the greatly anticipated Disclosure Statement for the Joint Chapter 11 Plan of Reorganization of Celsius Network LLC and certain of its affiliates was filed. The statement and related plan of reorganization outlines the expected recovery for among others the “Earn” creditors. We are analyzing these documents and will be sending a separate update about it. Coinbase Supreme Victory: Though not related directly to digital assets, it’s good to see a digital asset company winning at the Supreme Court level. The Supreme Court recently ruled in favor of Coinbase, holding that Coinbase’s mandatory arbitration provision was binding and consumers seeking to sue the entity would need to resolve those disputes in arbitration rather than public courts. Conclusion: The digital asset market and regulatory landscape has experienced significant developments in the last few weeks. The SEC continues its legal efforts against industry actors who they view as non-compliant. Congress also gets one step closer in its legislative efforts to provide regulatory clarity. These develops are expected to slow down as Coinbase and Binance prepare initial responsive pleadings to the SEC’s actions against them and as Congress goes on break from June 24 until July 9. Then a rapid succession of further developments can be expected again. These events highlight the evolving regulatory landscape surrounding digital assets and set the stage for further discussions and legal battles. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance. Also, please subscribe to the BitBlog for alerts when new stories or updates are posted from our attorneys.

Highlights of the Last Two Weeks in Blockchain+ The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law. The past two weeks have seen a rapid succession of blockchain legal developments, a few of which we touch on below. On a positive note, the US House of Representatives released a comprehensive 162-page Digital Asset Market Structure Bill discussion draft, marking a significant step towards a regulatory framework for digital assets. The House Committee on Agriculture also held a hearing to discuss the Digital Asset Market Structure discussion draft. On the less positive side of things, while the Securities and Exchange Commission (“SEC”) settled its insider trading case against a former Coinbase employee and it also filed lawsuits against Binance and Coinbase, alleging that these two prominent businesses in the industry operated unauthorized securities exchanges. Each of those developments is broken down below. US House of Representatives Releases Discussion Draft on Digital Asset Market Structure Bill: June 2, 2023 Background: On June 2, a comprehensive 162-page Digital Asset Market Structure Discussion Draft was released, accompanied by a concise 2-page summary of the bill and a detailed 9-page section-by-section breakdown. A hearing was scheduled for Tuesday, June 6, with the House Committee on Agriculture, responsible for overseeing the CFTC, under the title “The Future of Digital Assets: Providing Clarity for Digital Asset Spot Markets.” This hearing discussed the draft in detail, and you can read more about the hearing results below. Notably, this bill stands out as the most comprehensive proposal on digital assets put forth by Congress to date. Summary: This bill fulfills the pledge made by House Financial Services Committee Chair Patrick McHenry in late April to present a regulatory framework bill for digital assets through the House in the coming months. While it is likely that a significantly amended version of this bill will pass the House, its chances of successfully passing the Senate and obtaining the President’s approval are uncertain. Nonetheless, we hope there may be a change of perspective in the Senate and Executive branches concerning their current stance on cryptocurrencies. You can read more about this bill in our in-depth breakdown on the BitBlog, available here. SEC Reaches Settlement in Insider Trading Case Involving Former Coinbase Employee: May 30, 2023 Background: The SEC recently sought a consent judgment (i.e., settlement) in its legal battle against a former Coinbase employee, Ishan Wahi, and his brother, Nikhil Wahi. The case revolves around allegations of insider trading concerning specific digital assets listed on the Coinbase platform. Prior to the SEC’s announcement of the settlement, the Wahi brothers had filed a Motion to Dismiss, with several industry players offering strong amicus support. Summary: While the SEC is positioning this settlement as a victory, the settlement doesn’t admit any conclusions about whether the tokens themselves are securities. Additionally, the settlement does not impose any fines on the Wahi brothers, as they are already subject to penalties through their criminal pleas to the Department of Justice (“DOJ”). One could speculate that the SEC recognized the weaknesses in its case regarding the secondary sales of digital assets and chose to retreat from the unexpectedly robust opposition. Alternatively, a more realistic perspective suggests that the SEC recognized the need to allocate resources for a significant legal battle against Coinbase and decided not to use those resources for a relatively insignificant fight against the Wahi brothers. SEC Files Lawsuit Against Binance: June 5, 2023 Background: The SEC has filed 13 charges against Binance, including its US entity and its primary platform, its founder Changpeng Zhao (known as “CZ”), and several related companies. The full complaint can be reviewed here. Binance has disputed the allegations, expressing its intention to challenge the claims in court. The lawsuit contains several alleged and potentially damaging internal communications from the prior CFTC lawsuit and an additional quote where the Binance Chief Compliance Officer in 2018 allegedly stated, “we are operating as a [expletive] unlicensed securities exchange in the USA, bro.” The SEC is requesting that Binance.us’s funds be held in a US bank for potential freezing during the legal proceedings. Summary: Ever since the unflattering communications were disclosed in the CFTC lawsuit, the industry has been awaiting follow-up SEC/DOJ legal actions. The SECs focus on the publicly traded and relatively compliant US firm, Coinbase rather than the overseas entity Binance has always been somewhat perplexing. Binance’s alleged strategic decision to separate operations from Binance.us, at least in part to buffer its international operations from US enforcement actions, will be tested. The SEC lawsuit allegations name ten tokens as securities: SOL, ADA, MATIC, FIL, ATOM, SAND, MANA, ALGO, AXS, and COTI. SEC Files Lawsuit Against Coinbase: June 6, 2023 Background: The SEC has also formally initiated anticipated charges against Coinbase, with the SEC accusing Coinbase of functioning as an unauthorized securities exchange, broker, and clearing agency. The full complaint can be accessed here. In response, Coinbase’s CEO, Brian Armstrong, issued a statement via Twitter, available here. The SECs lawsuit alleges 13 digital tokens as securities: SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO. The collective market value of these 13 tokens amount to $37 billion. Summary: The SEC v. Wahi settlement, which was speculated to conserve resources for the impending Coinbase lawsuit, proved accurate. While the allegations against Coinbase list several new tokens as opposed to Wahi, the Coinbase Complaints format is predominantly consistent with the allegations in the Binance and Wahi lawsuits. Noteworthy allegations include claims by the SEC that the Coinbase non-custodial wallet and staking-as-a-service offerings operate as unauthorized broker/dealer services/products. Further state actions are anticipated. The industry has been gearing up for this significant lawsuit, so initial reactions will likely be intense, followed by a protracted legal battle. House Committee on Agriculture Holds Hearing on Digital Asset Legislation Proposal: June 6, 2023 Background: On a notably active Tuesday, the same day the Coinbase lawsuit was announced, the House Committee on Agriculture conducted a hearing titled “The Future of Digital Assets: Providing Clarity for Digital Asset Spot Markets.” The hearing focused on the above-discussed Digital Asset Market Structure discussion draft. Access to the hearing can be found here, and the materials, including written versions of the opening statements by the witnesses, are available here. Summary: This two-part hearing featured influential witnesses, including CFTC Chairman Rostin Behnam (during Part 1), followed by Coinbase CLO Paul Grewal, Robinhood CCO Dan Gallagher, and others (during Part 2). Committee Chair Glenn “GT” Thompson (R-PA) began with a statement addressing the SEC’s legal actions against Coinbase. Without discussing specifics, he noted that this type of regulatory action underscores the need for the hearing. There was broad agreement at the hearing that legislative measures for the industry are necessary, and the conversation focused on the form of this legislation. There was also a Financial Services Committee hearing on Tuesday, June 13, but that hearing occurred after the drafting of this bi-weekly update was finalized and is expected to be covered in the following update. Conclusion: The digital asset market and regulatory landscape has experienced significant developments in the last few weeks. The SEC has redoubled its legal efforts against its viewed industry non-compliance, and Congress’s prospective legislative efforts are rapidly developing. These events highlight the evolving regulatory landscape surrounding digital assets and set the stage for further discussions and legal battles. If you have any questions about how the above developments affect your blockchain plans or any other questions regarding the legalities around various aspects of this rapidly developing industry, contact any member of the Polsinelli Blockchain+ team to set up a time to talk and see how we can be of assistance.

On February 9, 2023, the U.S. Securities and Exchange Commission (the “SEC”) charged Kraken with offering and selling Kraken’s Staking Program – its staking-as-a-service product – as an unregistered security. Kraken, more formally known as Payward Ventures Inc. and Payward Trading Ltd is among the more significant and reputable crypto trading platforms in the United States. To settle these charges, Kraken has agreed to immediately and permanently cease offering or selling securities through any crypto asset staking services or staking programs as well as to pay $30 million in disgorgement, prejudgment interest, and civil penalties. Numerous blockchains, including Ethereum and Solana, operate their consensus mechanisms at least in part based on something called “proof of stake.” This differs from the original blockchain of the Bitcoin protocol, which generates rewards by obtaining a consensus to validate transactions based on a complicated math problem called “proof of work.” In contrast, proof of stake generates rewards by requiring validators to lock up a certain amount of their crypto tokens for a period of time. Usually, staking is not available to the average retail cryptocurrency customer, and more lucrative results are obtained when crypto is staked in larger quantities. One reason is that typically, a minimum number of tokens is required to be staked to become a validator eligible for rewards. Also, the more that is staked, the greater the chance of rewards for properly validating new blocks on the chain. Further, staked amounts may be at risk of ‘slashing’ if the validator fails to validate transactions properly. Many chains also charge transaction fees at the start of or during staking to incentivize longer staking periods and higher staking amounts. They often include on-ramps and off-ramps known as ‘bonding’ during which such crypto is not actually staked but also unable to otherwise be used.  These impediments have led many service providers to launch staking-as-a-service platforms, such as the Staking Program, to allow individual retail customers to benefit from the rewards of staking. The SEC specifically noted several ways the Staking Program differed from how staking would work should a proof-of-stake cryptocurrency holder itself stake its crypto, making it more closely resemble an investment product than a tech platform. Rather than using the staking payouts determined by the proof-of-stake protocols, Kraken itself determined the amount that would be paid out for staking crypto through the Staking Program. These returns did not necessarily correlate with the amount that Kraken actually earned by staking the customer’s crypto, and Kraken was able to keep any positive differential between advertised returns and actual staking returns. Payouts of rewards were to occur continuously – generally once or twice a week – rather than on a variable basis dependent on when staking rewards are earned. Unlike staked crypto, which cannot be withdrawn while staked and is often subject to lengthy ‘bonding’ and ‘unbonding’ periods before and after the crypto is staked, crypto assets locked into the Staking Program was able to be withdrawn at any time. A portion of crypto provided by customers to the Staking Program was not actually staked at all and instead maintained as a “liquidity reserve” to permit the withdrawal of assets from the Staking Program. Staking was not subject to transaction and deposit fees imposed by many staking protocols and was not subject to any minimum amount as is typical across staking protocols. Kraken’s platform, which included cybersecurity and proof of reserves, allowed users to stake in a way that would not have been possible had customers directly staked crypto assets themselves. These distinctions help show that the Rewards Program was clearly a different product than direct staking itself. According to the SEC’s allegations, these distinctions show that the Staking Program met each of the prongs of the test outlined in SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946), making the Staking Program an investment contract that is a security. Under Howey, an investment contract is a security if it involves an investment of money into a common enterprise with a reasonable expectation of profits or returns derived from the entrepreneurial or managerial efforts of others. Of note, Kraken allegedly touted the Staking Program as an investment opportunity, using words like “earn” and “returns” in its marketing materials, and the Staking Program indeed generated well over a hundred million dollars in investment returns. The CEO of Kraken himself conceded that “some product/marketing/ToS differences might make a different decision” on whether to challenge the SEC’s allegations. The SEC complaint never alleges that staking itself is an offer or sale of securities. It is also questionable whether other staking-as-a-service models might not be securities. For instance, it is unclear if the result may have been different if, rather than offering a product where Kraken set different terms than the staking protocols, Kraken had merely facilitated the aggregation of customer crypto to stake that crypto on their behalf directly. The SEC complaint also makes a novel argument that could have wider-range implications in the DeFi space. In a seemingly out-of-place allegation, the SEC claims that Kraken’s managerial efforts of others included “[p]roviding a user-friendly, one-stop-shop investor interface” and “simplifying a complex staking process with an easy-to-use interface in a secure and trustworthy environment operated by technical experts.” In addition to raising the question as to why the SEC is focusing on activities that it does not deny lowers risk, this raises the question of whether the SEC might take the position that merely providing a user interface that provides access to a blockchain-based protocol could be either an investment contract or evidence of sufficient ‘efforts of others’ to meet that prong of the Howey test. Such a position would seem at odds with the SEC’s long-standing position that it is technology-neutral and seeks to govern securities rather than tech platforms. Also of note was the relatively high amount of the penalty that Kraken agreed to pay in respect of the Staking Program. While investors had staked over $2.7 billion through the Staking Program and earned nearly $150 million in total rewards, Kraken’s reported net income attributable to U.S. investors was just under $15 million. This means the penalty being paid by Kraken is slightly more than double its profits from engaging with the Staking Program with U.S. persons.

While the blockchain crypto community is processing the latest round of “crypto contagion,” potentially lost in the busy news week was a significant legal development regarding what digital assets qualify as securities under existing federal law. On November 8, 2022, the long-awaited decision in the U.S. Securities and Exchange Commission (“SEC”) v. LBRY, Inc. (“Library”) case was released, granting summary judgment to the SEC. This result means that there will be no trial on the facts and is a complete victory for SEC against the decentralized content sharing and publishing platform. Click on the following links to read the Full Order, Library’s Motion for Summary Judgment (“MSJ”), the SEC’s Response in Opposition to Library’s MSJ, and the transcript of oral arguments on this issue. While this is a limited ruling from a single district court with fact-specific holdings, it demonstrates how the current interpretation of securities laws may make it difficult for blockchain-based networks to launch in the United States. Library Background Library is a company founded with the goal of creating an open-source, censorship-resistant protocol using blockchain technology to allow users to easily publish, share, and view digital content without interference from centralized intermediaries. One of the ways that blockchain technology allows for transactions to take place in a decentralized manner is by using multiple nodes or computer systems that validate a transaction. Many blockchain networks, including the LBRY Network, generate native tokens as rewards for validating transactions. Library raised initial capital for the development of the LBRY Network through traditional investments such as from angel and venture capital investors and not through presales of its native tokens, as was common with many ICO-era projects. In June 2016, Library launched the LBRY Network and a companion desktop application, which users could immediately use to publish and consume digital content on the LBRY Network. The native token of the LBRY Network is called LBC. At launch, Library pre-mined 400 million LBC tokens, meaning Library was able to claim those tokens to run the LBRY Network before any individual could. The remaining 600 million LBC tokens can be mined by any individual with the necessary computing and energy required as they assist with validating transactions on the network, similar to how Bitcoin is mined. The LBC token was designed to be necessary to access certain functions on the LBRY Network, i.e., it is consumptive. Users must pay a fee in LBC to publish content, create a channel to organize content, subscribe or purchase the ability to view certain content or boost content to the top of people’s video feeds. Users can also “tip” their favorite content creators in LBC. Library did not sell any of its 400 million pre-mined LBC tokens until July of 2017, slightly over a year after the launch of the LBRY Network. It did, however, give away roughly 142 million tokens from launch until the action by the SEC as incentives for users and as compensation to software developers, software testers, strategic partners, employees, and contractors. In July of 2017, Library began selling its remaining tokens, both on exchange and directly through a buying portal on the Library website. Case Background In March 2021, the SEC filed an action against Library alleging that Library’s sale of LBC tokens violated sections 5(a) and (c) of the Securities Act, 15 U.S.C. § 77(e). This was a notable case because it was one of the first brought by the SEC against a blockchain developer, which didn’t involve sales of tokens through an Initial Coin Offering (“ICO”). While many coins sold through ICOs had no immediate utility and were sold with the promise of some future utility, Library didn’t sell any of its LBC until it arguably had a working LBRY Network and limited content sharing functionality on the LBRY Network for over a year. In its MSJ, Library presented the sworn declarations of around 300 users who declared under oath that they purchased LBC to transact on the LBRY Network and not for speculative or investment purposes. Library argued that, under the precedent set in United Hous. Found., Inc. v. Forman, 421 U.S. 837 (1975), securities laws do not apply when a buyer purchases an asset primarily to use or consume that asset. Library further pointed to the many examples of telling individuals not to buy LBC for speculative purposes, but rather for its use on the LBRY Network. Library further distinguished itself from prior SEC actions against token developers, as LBC was not sold through an ICO, nor did Library release a whitepaper to describe some theoretical future use of the token. Instead, Library launched what it argued was a fully functional blockchain network and did not sell any of the native tokens for that network until over a year later. The SEC countered in its own MSJ, pointing to various statements by Library employees and moderators on the Library Reddit page, which indicated that the price of the LBC tokens would rise as the success of the LBRY Network rose. It also linked statements from Library around its own stake in LBC as an indication to potential buyers of LBC that they could depend on the entrepreneurial efforts of Library based on Library’s vested interest in the success of its tokens held in reserve. The SEC also pointed to the relatively low user number and limited token price to publish content on and use the LBRY Network as evidence that users primarily purchased the LBC tokens for speculative purposes. Notably, the MSJs were limited to two issues – whether LBRY had fair notice that the SEC was taking the position that digital assets such as LBC would be treated as securities and whether purchasers of LBC were relying on the efforts of Library to achieve profits. The Order Under the test articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”), as interpreted in the First Circuit where New Hampshire is located, an instrument is an “investment contract” that is treated as a security if three elements are met: (1) an investment of money, in; (2) a common enterprise, with; (3) an expectation of profits to be derived solely from the efforts of the promoter or a third party. LBRY conceded the first two elements and instead focused on the fact that there was no reasonable expectation of profits derived primarily from the efforts of others. We note that this test is not consistently applied across all circuits, with some considering it to be a four-part test (expectation of profits and efforts of others being separate prongs) and many looking at different factors to determine whether there is a common enterprise. The Court sided with the SEC, stating that “[Library] has – at key moments and despite its protestations – been acutely aware of LBC’s potential value as an investment. And it made sure potential buyers were too.” It went on to cite various statements by Library which the Court stated “amounts to precisely the ‘not-very-subtle form of economic inducement’ the First Circuit identified…as evidencing Howey’s ‘expectations of profits.’” The Court went on to hold that the statements by LBC purchasers regarding the consumptive motivations for those purchases had limited relevance in determining if Library’s sales of LBR constituted unregistered sales of securities because nothing in the case law suggested to the Court that a token with both consumptive and speculative uses cannot be a security. Notably, in dicta, the Court held that: “The Problem for [Library] is not just that a reasonable purchaser of LBC would understand that the tokens being offered represented investment opportunities – even if [Library] never said a word about it. It is that, by retaining hundreds of millions of LBC for itself, [Library] also signaled that it was motivated to work tirelessly to improve the value of the blockchain for itself and any LBC purchaser. This structure, which any reasonable purchaser would understand, would lead purchasers of LBC to expect that they too would profit from their holding of LBC as a result of [Library]’s assiduous efforts” It is also worth noting that the Court did not opine on whether the LBRY Network was “sufficiently decentralized,” a term mentioned in a now somewhat infamous speech by then acting SEC Director of Corporation Finance Bill Hinman in 2018, explaining why Bitcoin and possibly ETH may not be a security even if they were at one point. Under that argument, “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts” due to decentralization. The Court also declined to rule on if future sales of LBC would be deemed the sales of securities because future sales were not at issue in the case. No relief was specified in the ruling, but the SEC is seeking a permanent injunction, civil penalties, and disgorgement. Ramifications of the Court’s Order This was a significant blow to Library, as they were denied the opportunity to present their case to a jury and will now need to appeal this Order based on the current record. The CEO of Library reacted to the ruling by saying that “[t]he language used here sets an extraordinarily dangerous precedent that makes every cryptocurrency in the US a security, including Ethereum.” While this is one ruling by one judge in one district court and thus has limited precedential value, it will certainly be cited by the SEC in other cases and is likely to provide a morale boost to the SEC staff. In particular, the decision creates some precedent that could limit arguments under Howey regarding lack of an ICO, lack of marketing through a whitepaper, or the ability to consumptively utilize tokens. On the other hand, this was also a case against a lightly-funded defendant that didn’t even attempt to make numerous arguments as to LBC’s status as a security which was brought in one of the smallest court districts in the country. With this case seemingly decided, for now, all eyes in the blockchain/web3 legal community turn to the high-profile battle between the SEC and Ripple Labs, Inc. (“Ripple”) over its release and sale of XRP tokens. The result in XRP may be different from LBRY given the large number of amicus briefs sent by industry participants, the level of skepticism to the SEC’s position seemingly voiced by the judges in the case, the defendant being well-funded, and the number of additional arguments being made. While Library conceded various sections of the securities analysis under Howey and its progeny; Ripple has not conceded any point, which will require the Court to analyze every prong of the Howey test. Although the SEC has argued that no new laws are needed, and projects can comply under existing SEC regulations and guidance, the fact remains that many projects that are releasing tokens for legitimate, consumptive uses are moving offshore. The system of registration of securities – which focuses on the health and activities of the company issuing the security and not on the platform or project on which a consumptive asset is used – makes little sense in the context of consumptive assets from either the perspective of investor/user protection or the perspective of allowing the proliferation of new technologies. This movement offshore not only denies access to these projects to U.S. users, but it is also harmful to users and investors by placing these projects outside of the oversight of the U.S. regulators at a time when the renowned expertise of these regulators may be most needed. There are now multiple examples where regulatory arbitrage has harmed retail and other users and consumers, including with respect to the initial crypto contagion caused by the collapse of Luna and Three Arrows Capital and, more recently, another meltdown of a prominent exchange. Good actors will have no choice but to play this game until a real, workable system for the launch of digital assets projects in the U.S. is developed. It makes little sense that major US exchanges are reportedly under investigation for listing assets that the SEC deems to be securities under the broadest possible interpretation of the Howey test and that Kim Kardashian gets fined for touting a cryptocurrency while millions of retail investors get directly or indirectly harmed because a project was smart enough to escape regulation. A logical, workable and not overly burdensome means of oversight could prevent projects from moving offshore to avoid a registration regime that makes absolutely no sense in this context. The best way to limit these arbitrage opportunities is to create a system where projects that want to be compliant can be compliant. This critique also includes internal criticism from SEC commissioner Hester Peirce who recently said on Bloomberg, “[w]e’ve been unwilling to work with people in the industry and people who are interested in participating in the industry to develop guidelines that make sense for the industry. Instead, we’ve preferred to take an approach rooted in enforcement….” Regardless of whether other courts will follow the ruling in Library, it is clear that Congressional action is needed. The alternative is continued regulation by enforcement, which leaves market participants and developers of consumptive digital assets to choose between not participating in the Web3 environment at all or accessing the environment in a way that leaves them completely unprotected.

On September 15, 2022, the Senate Committee on Agriculture, Nutrition, and Forestry (the “Ag. Committee”) held a hearing to discuss Senate Bill 4760, titled the Digital Commodities Consumer Protection Act of 2022 (the “Bill”) which was introduced by Senators Debbie Stabenow (D-MI) and John Boozman (R-AR). Senate Minority Whip John Thune (R-SD) and Senator Cory Booker (D-NJ) joined as original co-sponsors. The Bill lays out a framework for potential oversight by the Commodity Futures Trading Commission (“CFTC”) over certain parts the cryptocurrency market. The Ag. Committee has been charged with overseeing the CFTC ever since the CFTC’s creation roughly one hundred years ago following the enactment of the Grain Futures Act of 1922. The CFTC was created in large part to oversee what was, at the time, a new and developing commodities futures market. The Bill is one of a number of bills currently before Congress regarding the regulation or reform of the digital asset industry, including Senate Bill 4356 titled the Responsible Financial Innovation Act, sponsored by Senator Cynthia Lummis (R-WY) and Senator Kristen Gillibrand (D-NY) which also attempts to create a more comprehensive regulatory framework for digital assets Current CFTC Chairman Rostin Behnam commented in his opening remarks the appropriateness of discussing the CFTC’s potential role in overseeing another developing market, the digital asset commodities market, on this hundred-year anniversary. Chairman Behnam’s complete opening remarks are available here. The Ag. Committee meeting was split into two sections: the first of which Chairman Behnam served as the sole witness for, and during the second session committee members asked questions of various industry experts who were invited to speak. Through both sessions, digital assets were classified in three separate groupings: (1) digital asset commodities (which Ag. Committee Chairwoman Deborah Stabenow specifically said Bitcoin (“BTC”) and Ethereum (“ETH”) fall under); (2) digital asset securities; and (3) stablecoins. The bill’s proponents made clear that this bill only sought to regulate the first grouping (digital asset commodities) and merely be a “piece of the puzzle” on digital asset regulation which necessarily would require other regulations covering digital asset securities and stablecoins. Topics of Discussion During Hearing Throughout both sessions of the hearing, there was an emphasis on the need for regulation which provides regulatory clarity and keeps innovation and market development in the United States, while also providing much needed consumer protection. Some potentially interesting discussions from the hearing include: As stated above, Chairwoman Stabenow and many others on the committee treated it as a forgone conclusion that BTC and ETH are in fact commodities and should be regulated as such. This somewhat follows the position of the now controversial  “Hinman Speech” in which then acting SEC Director of Corporation Finance Bill Hinman took the position that ETH along with BTC had become “sufficiently decentralized” to no longer be considered securities. The SEC has since distanced itself from that position with respect to ETH. There was significant focus about the access digital assets can provide to individuals and communities who are underserved by the traditional banking industry, while also noting the lack of regulation has made these already vulnerable communities even more vulnerable to fraud and mismanagement. There seems to be strong interest by the Ag. Committee to get at least some regulation related to digital assets through Congress in the next 6-12 months, even if political realties make that unlikely. Chairman Behnam stated his office estimates it will need an additional $112 million in the next three years to fund the necessary resources to oversee the digital asset commodities industry, including rulemaking, hiring, training, and outreach. This increased budget is anticipated to be paid for by user fees on digital asset commodities trading platforms under the Bill. This request does open the Chairman to the cynical view that at least part of his motivation is to expand his judication and budget. Multiple Senators emphasized that they do not believe blockchain technology and the overarching Web3 ecosystem is a phase, and the pressing need for regulatory clarity in the United States on many issues facing this industry to prevent the country from falling behind economic rivals (primarily, China). Senator Gillibrand and many of the industry expert witnesses applauded the Bill as a great first step, but they noted that the Bill’s current form, including definitions of decentralized finance (“DeFi”), what constitutes a “digital asset commodity” vs. a “digital asset security”, and what actions make an entity a broker/dealer, will need revisions before the Bill can move forward. While there appeared to be almost universal acknowledgement of the committee members and witnesses that this Bill is not a complete solution to the lack of regulatory clarity in the digital asset industry, committee members generally indicated support on a bipartisan basis. There is hope that due to the bipartisan nature of the Bill, its seemingly large support amongst Ag. Committee members, and the almost unquestioned need to have some regulatory clarity in this space, that the Bill’s next round of edits and comments can be expected on an expedited basis. However even if the Ag, Committee were to vote in support of the Bill, its passage by the full Senate and of a comparable bill in the House remains fraught with challenges. Other Digital Asset Related Hearing on September 15, 2022 The Ag. Committee hearing on the Bill took place at the same time as the Senate committee on Banking, Housing, and Urban Affairs conducted a hearing to question Gary Gensler, Chair of the U.S. Securities and Exchange Commission (“SEC”) regarding the SEC’s regulation of the digital assets industry. It is unclear if these overlapping hearings were coincidental. During the Ag. Committee hearing on the Bill, multiple committee members questioned the CFTC’s ability to work together with the SEC to avoid creating a bureaucratic quagmire of competing federal agency oversights which would be harmful to the industry and, ultimately, the consumers. While Chairman Behnam was confident the agencies could work together on this, similar to how they work together in the swaps markets and oversight of other duel registered entities, Chair Gensler indicated that the two agencies often have overlapping jurisdiction and suggested that the SEC should implement a security-based swap execution facility regime similar to that implemented by the CFTC when Gensler was the head of that agency. It remains to be seen, however, if the SEC will endorse or support the Bill’s attempt to place a level of regulatory oversight over the digital asset industry into the hands of the CFTC instead of being under the sole purview of the SEC.

With the proliferation of non-fungible tokens (“NFTs”), particularly in the art space, an interesting and potentially groundbreaking practice has developed where certain intellectual property (“IP”) pertaining to the NFTs is licensed to the NFT buyers and their subsequent transferees. This type of IP license was made famous by the developers of the Bored Ape Yacht Club, who included a commercial use license in their terms and conditions and, based on public statements, intended that these licenses would allow NFT holders to more fully commercialize their Bored Apes. Granting the owner of an NFT, or for that matter, any reproduction of a work of art, a commercial use license has until now not been common practice, as traditionally, the buyer is only allowed the use of that item. This trend of granting greater IP rights to NFT owners is aligned with the ethos of Web3 - allowing holders to have more control over digital assets and contents. This licensing of commercialization rights to a particular NFT holder presents interesting opportunities for buyers to monetize their NFT purchases. It also presents new challenges as developers try to work out the most appropriate legal construct to serve the interests of both the overarching project and individual owners of the NFTs. Some of those challenges recently played out when major changes were made to the license terms in two popular NFT projects: Moonbirds and CryptoPunks, each demonstrating a different strategy of allocating IP ownership of NFTs.  Moonbird NFTs have been sold for as high as 350 ETH (approximately $570,000 based on current price of ETH as of August 22), and CryptoPunk NFTs have sold for as high as 8,000 ETH, approximately $13 million based on current price of ETH as of August 22). Moonbirds Shift to CC0 One approach to licensing, which is uniquely “Web3,” is the placement of otherwise protectable copyright IP into the public domain through the use of Creative Commons “No Rights Reserved” (“CC0”) agreements. The idea behind CC0 is that when art is placed into the public domain, it allows more people to use and otherwise advance that art without fear of infringement, which in turn increases the notoriety and value of the original works. The original Moonbirds Terms of Sale licensed the artwork in the individual Moonbird NFTs to the holders of those NFTs for commercial use.  The relevant excerpt from those original terms is below: On August 4, 2022, Kevin Rose (a founder of the Moonbirds project) announced on Twitter that Moonbirds would be moving to a CC0 public license. This change from licensing the artwork only to individual owners - to now allowing the public at large to have equal rights over the use of that artwork has upset certain Moonbirds NFT holders who previously had greater IP rights and suddenly were left with diluted commercialization rights due to the sudden change in license terms. Yuga Labs Releases Long-Awaited CryptoPunks Licensing Another example of the potential decentralization of the IP ownership of NFTs is contained within the terms recently released by Yuga Labs in conjunction with CyptoPunks. When Yuga Labs acquired CryptoPunks in March of 2022, they issued a press release that said “[w]ith this acquisition Yuga Labs will own the CryptoPunks and Meebit brands and logos, and as they’ve done with their own BAYC collection, Yuga Labs will transfer IP, commercial, and exclusive licensing rights to individual NFT holders.” On August 15, 2022, those long-awaited licensing terms were finally released. Some interesting features of those terms include: An explicit coupling of licensing rights to the asset itself, which means when the asset is transferred the licensing rights which accompany that asset follows. Listing of the smart contract which the applicable NFTs were deployed on, potentially to  preemptively cut off claims by V1 CryptoPunk owners to IP rights under the agreement. V1 CryptoPunk owners purchased an NFT with an error in the code for the smart contract.  To fix the coding error, the original creator (Larva Labs) sent out a new smart contract. V2 CryptoPunks became successful and popular.  Recently, original V1 CryptoPunk owners decided to wrap their V1 CryptoPunk NFTs in a new smart contract and sell them.  The wrapped version of the V1 CryptoPunks fixes the coding error but resulted in duplicate CryptoPunk NFTs (i.e. the artwork is identical between V1 and V2). No explicit reservation of rights to amend the IP licensing terms on a going-forward basis (as was included in the Moonbirds terms). These terms by Yuga are far more comprehensive than the Bored Ape Yacht Club licensing agreement. Ed Lee, the author of Nau NFT, put together a helpful infographic showing certain differences between the CryptoPunks and Bored Ape Yacht Club licenses. It is unclear if this CryptoPunks license was released first to determine any potential weaknesses or holes before releasing a revised license for Bored Ape Yacht Club holders, or if it was simply done to create clarity after their statement on the issue regarding their CryptoPunk IP purchase. Final Thoughts The Web3 industry mentality surrounding the decentralization of ownership, including ownership of copyrights and other IP, is a new development which is likely to have legal ramifications across all industries. As with any developing industry, it will likely take time for law to be established regarding these current Web3 industry practices. As shown in the above Moonbirds and CryptoPunks licensing changes, these current practices and the laws surrounding them are constantly changing. That is why it is important for developers to engage legal counsel early to assist those developers in creating an appropriate IP strategy for their particular goals. While there are clearly challenges in expanding and decentralizing the IP of NFT owners, these trends are an exciting development in that it demonstrates Web3 being put into commercial practice.

On August 9, 2022, the U.S. Securities and Exchange Commission (“SEC”) issued a Cease and Desist Order against Bloom Protocol, LLC (“Bloom”) and agreed to a related Offer of Settlement in respect of Bloom’s unregistered initial coin offering (“ICO”). While the SEC entered into many similar settlements with ICO issuers late in the tenure of former Chair Jay Clayton, this appears to be the first such settlement under the stewardship of current Chair Gary Gensler with an ICO issuer where there were no allegations of misconduct other than conducting an unregistered offering of securities. The alleged facts of the Bloom ICO are similar to those of many other SEC settlements with ICO issuers such as Airfox, Paragon Coin, and Enigma. Bloom offered and sold its tokens to the public, raising nearly $31 million from the sale of tokens to over 7,000 investors. While the tokens were sold by a non-US subsidiary of Bloom, the SEC alleged that the funds were actually controlled by the US entity. Tokens were then allegedly sold to a number of US investors in a “pre-sale” that appears to have been conducted under Rule 506(c) – private placements using general advertising or general solicitation to all verified accredited investors – followed almost immediately by a public sale that included US purchasers and made no attempt to verify accredited investor status. The release then goes to great lengths to establish that the tokens were securities under the Howey test, particularly focusing on investors’ expectations of profits. The other prongs of that test – an investment of money, into a common enterprise, and efforts of others – are largely assumed. The terms of the settlement also largely match the terms of prior settlements. Bloom is to issue a press release notifying the public of the order, permit investors to make claims, file a Form 10 registration statement under the Securities Exchange Act of 1934 to register the “BLT” tokens, and then offer rescission of the token once the registration statement is effective. In addition, Bloom was charged a civil penalty of a little more than the total amount it raised in the pre-sale and public sale. The Order contains an interesting new paragraph, not present in any of the prior ICO settlements, that could hint to the SEC’s view on making future determinations of whether a digital asset is a security: “If Respondent plans to file a Form 15 to terminate its registration pursuant to Rule 12g-4 under the Securities Exchange Act of 1934 on the grounds that the BLT no longer constitutes a “class of securities” under Rule 12g-4 because the BLT is no longer a “security” under Section 3(a)(10) of the 1934 Act, Respondent will notify the Commission staff at least thirty (30) days prior to such filing. Upon such notification, the Commission staff may make reasonable requests for further information, and Respondent agrees to provide such information, as applicable.” This appears to be an admission by the SEC of a belief held by many practitioners in the digital asset industry - that a token that was once a security could, under the right circumstances, cease to be a security at some point in the future. It is unclear from the Order what basis the SEC might assent to a digital asset’s treatment as a non-security. While in the past, the SEC released guidance on when a digital asset might be an investment contract under Howey with a heavy focus on operationality and decentralization of the underlying protocol, the Division of Enforcement has tried to walk this back in its prosecution of the XRP case against Ripple. This language could hint that the SEC may at some point become willing to make determinations that digital assets are not securities beyond the extremely limited three examples where the SEC has granted no-action relief in Turnkey Jet, Pocketful of Quarters, and VCOIN. Similarly, it appears that there may be a glut of forthcoming enforcement actions against issuers of ICOs that happened shortly after the publication of the “DAO Report,” particularly as applicable statutes of limitations come close to expiring. For example, on August 16, the SEC filed a complaint against Dragonchain with similar allegations. Additional lawsuits are likely to be filed in the near future.

On July 21, 2022, the Department of Justice (DOJ) and the US Securities and Exchange Commission (SEC) each alleged insider trading violations against a former Coinbase employee, his brother, and another alleged acquaintance of his. Coinbase is one of the leading exchanges in the United States for the trading of cryptocurrencies. The DOJ brought charges of wire fraud against the three defendants in the Southern District of New York without any allegations of securities law violations, while the SEC brought a civil claim for insider trading in violation of Section 10(b) of the Securities Exchange Act of 1934 [15 U.S.C. § 78j(b)] and Rule 10b-5 thereunder in the Western District of Washington against the same three defendants. The SEC action raises questions about the state of digital asset regulation in the United States and could hamper digital asset development in the United States if there are not changes to this “regulation by enforcement” strategy by the SEC. The Case as Presented by the SEC/DOJ and the DOJ Indictment: The factual allegations by both the SEC and DOJ cases are largely the same. According to the DOJ Indictment and SEC Complaint (available here and here), Ishan Wahi (“Ishan”), is a former Coinbase product manager assigned in the asset listing team. In that role, Ishan “was involved in the highly confidential process of listing crypto assets on Coinbase’s exchange” DOJ Indictment, ¶2. Coinbase has numerous requirements before it will allow a digital asset to be listed for trading, including that it does not list tokens which it considers to be securities under US federal securities laws. Due to the rigorous criteria for listing a digital token on Coinbase, typically the market price of the token increases once there has been a public announcement that the token will be listed. As such, advance knowledge that Coinbase will approve a token for listing could be used to purchase the token at a potentially unfair discount. Id. Ishan allegedly took his advance knowledge of Coinbase’s asset listings and informed his brother Nikhil Wahi (“Nikhil”) and former college roommate Sameer Ramani (“Sameer”) of those upcoming listings. This allowed Nikhil and Sameer to buy those assets ahead of the listings and realize at least $1.5 million in combined gains after those assets had predictable bumps in value after being announced for listing on one of the largest cryptocurrency exchanges in the world. DOJ Indictment, ¶3. The scheme appears to have been detected by Coinbase. On May 11, 2022, Coinbase’s director of security operations reached out to Ishan to schedule a meeting regarding a suspected breach in confidentiality which resulted in assets being heavily traded ahead of Coinbase’s listing announcements. This increase in trading was also deduced in the market and discussed on Twitter, in large part due to Twitter influencer @Cobie tweeting about suspicious trading activity. The Cobie tweet is cited in the DOJ’s indictment. DOJ Indictment, ¶15. Possibly to avoid appearing for the interview with Coinbase’s director of security, Ishan purchased a one-way plane ticket to India and sent emails to his friends and colleagues explaining he had to go home for a family issue. DOJ Indictment, ¶18. However, this attempt to flee was thwarted when Ishan was apprehended by authorities and prevented from leaving the United States. According to the indictment, when apprehended Ishan had in his possession “an extensive array of belongings, including, among other items, three large suitcases, seven electronic devices, two passports, multiple other forms of identification, hundreds of dollars in U.S. currency, financial documents, and other personal effects and items.” DOJ Indictment, ¶20. While Ishan and Nikhil were arrested and will face charges with a possible penalty of 20 years of incarceration, Sameer is still at large and believed to be in India, having departed the US shortly after being informed by Ishan of the internal Coinbase investigation. SEC Complaint, ¶16. The DOJ charges alone are certainly newsworthy with similarities to the DOJ allegations against former OpenSea executive Nate Chastain (which we covered on the BitBlog here). Viewed in a bubble, the DOJ action appears to demonstrate effective compliance, enforcement, and collaboration among government, industry leaders, and social media activists as the combined investigative efforts of all three parties led to the perpetrators being brought to justice. Indeed, it was the public nature of the blockchain which allowed individuals on social media to bring these suspicious transactions to light.  Coinbase also cooperated with the DOJ’s investigation. The DOJ action shows how fraudsters can be apprehended under existing laws without an expansion of the securities laws. While the DOJ uses “insider trading” language in its press release, the charges are brought under the federal wire fraud act (18 U.S.C. § 1343) for Ishan’s alleged breach of his confidentiality agreement with Coinbase and Nikhil/Sameer’s use of that confidential information. Charges in the SEC Civil Action: When the DOJ indicts defendants on criminal charges of insider trading, it is not uncommon for the SEC to also bring a parallel civil action which typically gets stayed during the pendency of the criminal action.  This matter is unusual, however, because the DOJ alleged insider trading under traditional wire fraud laws rather than under securities laws.  Still, the SEC decided to file a civil complaint for securities insider trading against the same parties.  Because the charges being brought by the SEC are not identical, and there are major questions of law (such as whether the tokens are securities) that are unlikely to be addressed in the DOJ matter, it is unclear whether these proceedings will stay during the DOJ prosecution. Coinbase has repeatedly taken the position that none of the coins it lists are securities. For example, in Coinbase’s written testimony for the Congressional Subcommittee on Capital Markets, Securities, and Investment, they stated: “To help potential market participants, we published our Digital Asset Framework to provide transparency about how we consider listing new assets. A key factor in our framework analysis is a determination that the potential new asset is not a security under U.S. law. The absence of regulatory clarity has slowed our willingness and ability to list new assets.” (Full written testimony available here). However, the SEC has affirmatively alleged that at least nine of the 25 tokens traded by the defendants ahead of their Coinbase listings are “crypto asset securities,” the trading of which on non-public information constitutes a violation of Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)] and Rule 10b-5 thereunder. The nine assets alleged to be crypto asset securities by the SEC are $AMP, $RLY, $DDX, $XYO, $RGT, $LCX, $POWR, $DFX, and $KROM. SEC Complaint, ¶¶ 39, 45, 50, 57, 71, 78, and 82.  While neither the SEC nor DOJ has released the full list of assets traded by Ishan, Nikhil, and Sameer, we do know by comparing the DOJ’s indictment to the SEC’s Complaint that $TRIBE, $ALCX, $GALA, and $ENS are all coins traded by the indicted individuals but not alleged to be securities in the SEC Complaint. Following the filing of the SEC Complaint, Coinbase continued to state that these tokens are not securities by issuing a statement from their Chief Legal Officer (and former Magistrate Judge for the Northern District of California) Paul Grewal titled “Coinbase does not list securities. End of story.” (available here). The SEC did not charge Coinbase with trading in securities which Coinbase would not be allowed to do without becoming an SEC registered exchange. The SEC failed to charge any of the 9 token issuers that it alleges are securities with violations of the securities laws. Implications and Ramifications: Bringing this action was an interesting strategic decision by the SEC.  Rather than bringing an action against Coinbase, a large public company with nearly unlimited resources to defend a regulatory action, or even against the token issuers, the SEC is bringing this claim against three individuals who are facing criminal charges, one of whom likely won’t defend himself at all because he is still on the lam.  Because these defendants have limited resources and probably are more interested in staying out of prison than being punished by the SEC, it is unlikely that they would challenge the SEC’s characterization of the tokens as securities.  While Coinbase could try to join the case by interpleader, it is unlikely that they could have much influence on the civil action. Many, including Coinbase, feel that the SEC would be fulfilling its duty of protecting consumers by setting up a framework for what is and is not considered a security in the digital asset space. On July 21, Coinbase issued an additional statement which “calls on the SEC to develop a workable regulatory framework for digital asset securities guided by formal procedures and a public notice-and-comment process, rather than through arbitrary enforcement or guidance developed behind closed doors.” (Full statement available here).  Coinbase has stated that the timing of this statement was incidental and that they had planned on making this statement even when they had no knowledge that the SEC would bring a civil claim in the case. The SEC action here has even raised a rare public rebuke from another government regulatory body.  CFTC Commissioner Caroline Pham issued a statement on the SEC case, describing it as “a striking example of regulation by enforcement.” (Full statement available here).  Separately, according to Bloomberg, it has been leaked that Coinbase is also the subject of an SEC investigation on whether it has been improperly listing unregistered securities.  In the wake of the XRP action that has dragged on since late 2020 in which the SEC has lost a number of prominent motions, this action could be used to create a “precedent” where there is no meaningful voice opposing the SEC’s theories. The crypto industry needs meaningful regulatory guidance. As these cases indicate, fraud is a real problem, but this particular action does not appear to have any meaningful deterrent effect, given the DOJ’s case which does not involve allegations regarding securities.  The stated mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.  This can only be accomplished in the crypto space once the market understands what is or is not a security and there is a workable path to compliance.

In what may be the first of its kind, a New York state court has authorized service via token airdrop in a case regarding allegedly stolen cryptocurrency assets. This form of alternative service is novel but could become a more routine practice in an industry where the identities of potential parties to litigation may be difficult to ascertain using blockchain data alone. Background on the Dispute According to the Complaint in the case, the plaintiff LCX AG (“LCX”) is a Liechtenstein based virtual currency exchange. As alleged in the Complaint, on or about January 8, 2022, the unknown defendants (named in the Complaint as John Does 1-25) illegitimately gained access to LCX’s cryptocurrency wallet and transferred $7.94 million worth of digital assets out of LCX’s control. Cryptocurrency wallets are similar in many ways to bank accounts, in that they can be used to hold and transfer assets. In the same way a thief can transfer funds from a bank account if they gain access to that account, thieves can also transfer cryptocurrency assets if they gain access to the keys to the wallet holding digital assets. Following the alleged theft, LCX and its third-party consulting firm determined that the suspected thieves used “Tornado Cash,” which is a “mixing” service designed to hide transactions on an otherwise publicly available blockchain ledger by using complicated transfers between unrelated wallets. While Tornado Cash and other mixing services have legal purposes such as preserving the anonymity of parties to legitimate transactions, they are also utilized by criminals to launder digital funds in an illicit manner. Even the use of these mixing services, however, can often also be unwound. This is especially true in transactions of large amounts of cryptocurrency, similar to how transactions utilizing complex money laundering schemes in the international banking system can be unwound. According to the blockchain data platform Chainalysis, although Illicit crypto transactions reached an all-time high of $14 billion in 2021, these suspected nefarious transactions accounted for 0.15% of crypto volume last year, down from 0.62% in 2020. While the Complaint alleges the suspected thieves used Tornado Cash, LCX believes its hired consultants were able to unwind those mixing services to identify a wallet which is alleged to still hold $1.274 million of the allegedly stolen assets. Unlike bank accounts which have associated identifying information, there are often no registered addresses or other identifying information connected to digital wallets. This makes it difficult to provide the actual proof of service required to institute an action or obtain a judgement against an individual where the only known information is their digital wallet addresses. Service via token airdrop into those wallet addresses solves that issue. Service Via Airdrop Service of lawsuits is traditionally made on the defendant personally at a home or business address via special process servers. In cases where service on the individual is not possible for some reason, many states authorize alternative means of service if the plaintiff can show that the alternative means of service likely to provide actual notice of the litigation to the defendant. For example, courts have historically allowed notice via newspaper publication as an alternative means of service where the defendant cannot be serviced personally. Here, the Court permitted service via “airdrop” in which a digital token is placed in a specific cryptocurrency wallet, similar to how a direct deposit can place funds in a traditional bank account. This particular token contained a hyperlink to the associated court filings in the case, and a mechanism which allowed the data of any individual who clicked on the hyperlink to be tracked. While this is a novel way to serve notice of a lawsuit, similar airdrops have been used to communicate with the owners of otherwise anonymous cryptocurrency wallet owners. Such was the case recently when actor Seth Green had his Bored Ape non-fungible token (“NFT”) stolen and the unknowing buyer of the stolen NFT was otherwise difficult to locate. While this type of digital service is new, it could be implemented in many disputes in the future regarding digital assets. Similar to the authorization of service that was seen recently in the Facebook Biometric Information Privacy Act litigation (where notice was served on potential class members via email and directly on the Facebook platform), service via airdrop may be the most efficient way to inform potential lawsuit participants of the pending dispute and how they can protect their rights in that dispute. This type of airdropped service is not without issues, though. First, transactions on the blockchain are largely publicly available, meaning any individual with the wallet address would also be able to see service of the lawsuit notice. Additionally, many users are hesitant to click on unknown links (such as the one in the airdropped LCX) due to legitimate cybersecurity concerns. While service via airdropped token is unlikely to replace traditional methods of service, it may be a useful means of serving process on unknown persons where there is a digital wallet linked to the acts which the applicable lawsuit relates.

In the generally opaque emerging world of “DAOs”, a rare public dispute recently played out between the Web3 investment group Yield Guild Games (“YGG”) and Merit Circle DAO, a decentralized autonomous organization, or “DAO”, from which YGG had purchased certain “tokens” relating to the governance and purpose of the DAO. The parties to the dispute released a joint statement (available here) which seems to resolve the issue amicably, but the alleged facts underlying the dispute bring up important considerations for purchasers of tokens and related instruments issued by DAOs. Background on DAOs A decentralized autonomous organization, or a “DAO,” is an “organization” encoded as a transparent computer program, controlled by the organization members, and not by a central corporate entity. Certain legal considerations regarding the structuring of DAOs are discussed in a prior BitBlog post available here. In many cases DAOs, or supporting organizations active in the formation of DAOs, are funded through simple agreements for future tokens (or “SAFTs”). In a SAFT, an investor agrees to invest capital (often to fund initial costs for start-up of a DAO or the development of a project to which the DAO relates), and in return the investor is promised an allocation of the relevant “tokens” that govern the DAO or are to be used in its related platform. As the term implies, a SAFT is an agreement for future tokens. In any SAFT, the tokens would not be released to the investor until such time as the tokens are minted or there is otherwise a time that the tokens are formed and publicly released, often called a token generation event. Additionally, SAFT tokens are typically subject to a lock-up period where no tokens are issued until sometime after the token generation event. Even after the full lock-up expires, the tokens are usually gradually released, to the SAFT buyers, over the course of a vesting schedule. These lockups and vesting schedules frequently are in place both for legal compliance purposes and to prevent the market from being flooded with DAO tokens that could make DAO governance prone to manipulation, misalign the incentives of DAO participants, or adversely affect the price of DAO tokens. Sometimes, SAFT investors are intended to receive their tokens before complete governance of a project, or its associated tokens, are shifted to a DAO. In others, such as this instance, governance migrated to DAO members before the initial investors received their tokens and, accordingly, before they were able to vote those tokens, even though their initial investments helped seed the DAO community. YGG and Merit Circle Dispute In October 2021, YGG announced it was investing or had invested $175,000 in Merit Circle, a decentralized autonomous organization (DAO) focused on Web3 gaming. This reportedly entitled YGG to 5,468,750 Merit Circle DAO tokens, which were to unlock and begin linear vesting in May or June of 2022. At some point after that investment, the governance of Merit Circle DAO was turned over to the holders of Merit Circle DAO tokens. That DAO’s particular governance mechanisms are described in further detail here. On May 20, 2022, a community member submitted a proposal (“Proposal 13”) which it summarized as “[t]his proposal aims to demonstrate the lack of value YGG has provided the DAO since becoming a seed investor. It also aims to cancel YGG’s SAFT, refund their initial investment, and remove their MC seed tokens.” This led to a public community debate (available for review in the above proposal link) on the merits of the proposal. In the end, the community voted to approve the proposal with a clause allowing for time “for Merit Circle ltd and YGG to propose a solution that would be more beneficial for the DAO and all parties involved in case of a YES vote.” Proposal 13 set the price at $175,000 to “have their seed investment refunded, and their MC seed tokens returned to the DAO.” At the time of Proposal 13, Merit Circle’s token ($MC) was trading at around $1.00. After Proposal 13 passed, an additional proposal (“Proposal 14”) was submitted and passed, which proposed “Merit Circle DAO buys out the YGG and Nifty Fund allocation, a total of 5,468,750 $MC tokens at $0.32. For a total of $1,750,000 USDC.” This was also voted on and passed. While this amount was significantly greater than the $0.032 per token for which YGG purchased the tokens under the SAFT, it was also less than the amount for which the tokens were trading on the open market at the time, though discounts due to illiquidity of the tokens could be reasonably expected. In their joint statement, YGG and Merit Circle Ltd. (the entity which formed the DAO but allegedly was no longer in control after hand-off to community governance) stated: We both recognized the arbitrary nature of the MIP-13 proposal and the danger a precedent like this could set for the Merit Circle DAO and the industry as a whole if agreements are not upheld and investors are not respected. The chosen tool was too crude and did not do justice to prior agreements. The divergence between the prior agreement and the DAOs proposal would have likely led to legal action against Merit Circle Ltd. While the legal question is one that could probably be argued at length, both parties agreed it was better to settle. This would spare both parties from a costly, time-consuming legal process with uncertain outcomes. None of the parties had to settle, but both parties chose the constructive path to help Merit Circle move forward. While this joint statement and associated agreement likely settles the dispute between the parties, it brings up a valuable lesson for future investors into DAOs. Lessons from YGG and Merit Circle Dispute It is fairly common for early investors to DAOs or other similarly decentralized organizations to have their allocated tokens vest only after organizational governance has been handed over to the community. A purchaser of a SAFT may not even know, at the time the SAFT is sold, what entity or organization ultimately will issue the tokens, or what functionality the tokens will eventually have. While this is not always inherently problematic, it requires significant trust and can lead to situations like this where by the time the tokens are in the hands of the SAFT buyer, there is a divergence between the interests of the early investor and the community running the DAO. The SAFT is in many ways inspired by the simple agreement for future equity, or the “SAFE” commonly used by early-stage venture capital investment in more traditional businesses. While, similar to a SAFT, the traditional form of SAFE is designed to provide no guarantees that equity eventually will be issued to investors, SAFE issuers rarely choose to breach the agreement and not issue the equity provided that the conditions to the grant of the equity are met. If the issuer were to blatantly breach the agreement, it is likely that the issuer would suffer severe financial and other repercussions. An investment in a DAO has some inherent differences regarding enforcement and governance from traditional investing. Because of a DAO’s decentralized nature and the difficulty of getting DAO members informed, there is a risk that members of a DAO could choose to breach a contract or even break the law without fully knowing the consequences. In more traditional early-stage investments a jilted investor is less likely to settle for pennies on the dollar because the investor can sue the issuer for breach of contract. However, when a DAO is involved, locating the correct entity or individuals to sue can be difficult, as seen in the Sarcuni v. bZx DAO, 22-cv-00618 (S.D. Cal. 2022) litigation. This is especially true when many otherwise anonymous DAO members could be unlocatable or even possibly insolvent if a lawsuit was brought, and thus have limited financial incentive not to breach. To prevent this type of abuse, investors or DAO sponsors may wish to place a limit in the DAO’s governance smart contract which prevents certain types of actions from being voted on or approved. If that happened, the community would not have complete control over the organization, limiting their ability to take full advantage of “efficient breach” where it makes financial sense to breach contracts in certain situations. It also could be seen as curtailing a core ethos of a DAO, which is that that members have full control over its destiny. However, such a limitation could give initial investors the peace of mind that they cannot be later cut out of the fruits of their investments right before they become ripe. This dispute is a reminder to investors to perform their due diligence into the risks they face when investing in DAOs, where enforcement and governance is a work in progress, and in particular to be cautious in situations where token control is intended to be handed over to the community prior to the investor receiving its agreed-upon tokens. While DAOs are an exciting new form of corporate governance with many potential upsides regarding transparency and ownership by participants, disputes like this can be expected as DAO investors and contributors navigate the Web3 intersect between code-is-law and various jurisdictional and contractual laws.

A former employee of OpenSea, the largest marketplace for the purchase and sale of non-fungible tokens (NFTs), has been indicted and charged with wire fraud and money laundering allegedly in connection with actions he took while employed by OpenSea. NTFs bought and sold on the OpenSea platform mostly consist of digital assets that represent the ownership interest in a piece of digitally generated and displayed works of art.  The full ten-page indictment is available here. While not charged with actual insider trading under Securities Exchange Act Rule 10b-5 or other applicable securities laws, in a press release the Department of Justice (DOJ) has framed this to be the first ever “digital asset insider trading scheme” to be prosecuted in the United States. Nathaniel Chastain (“Chastain”) was arrested on June 1, 2022 and released on $100,000 bond after entering a plea of “not guilty” in federal court. According to the indictment, in September of 2021, Chastain resigned from his position as product manager at OpenSea after it was revealed he was purchasing NFTs based on confidential information about the identities of artists and collections that would be placed on OpenSea’s front page.  The placement of art on OpenSea’s front page is alleged to be relevant to its price since highlighted projects and artists often enjoy a price bump while featured more prominently on OpeaSea’s website. The DOJ indictment is based on Chastain’s alleged breaches of the fiduciary duties he owed to his employer at the time (OpenSea), along with Chastain’s use of “burner” (anonymous) cryptocurrency wallets in an alleged attempt to hide his actions. The NFTs Chastain purchased were largely art projects with no utility outside of ownership of the artwork, which may in part explain why Chastain is being charged with wire fraud and not securities fraud. Works of art have not, in-and-of-themselves, traditionally been treated as securities by the U.S. Securities and Exchange Commission (SEC) or other government entities. A few other interesting facts of the case not otherwise mentioned in the pleading documents themselves but found reported elsewhere by others include: At the time of Chastain’s actions, OpenSea did not have a policy explicitly prohibiting using confidential information to purchase or sell any NFTs, whether available on the OpenSea platform or not. That was only implemented after Chastain’ actions were revealed. Chastain’s purchases largely occurred after the items were available on display on the front page of the OpenSea platform (albeit, only by mere seconds in some cases). This means, at the time of purchase, there arguably was public knowledge that the items were being promoted on the front page of OpenSea and that Chastain was not necessarily “front running” trades of the NFTs in the traditional sense.  That said, under the allegations he may have been able to use advance knowledge of the proposed listing locations to make trades before the market had time to digest the information. These alleged front running actions were initially uncovered by individuals on Twitter in September of 2021, who were able to connect Chastain’s actions to various otherwise anonymous cryptocurrency wallets by tracking transactions through a public blockchain. The total amount Chastain made from these purchases and sales is currently believed to be less than $150,000. While Chastain was not formally charged with securities fraud, the DOJ’s use of “insider trading” verbiage throughout the indictment and in their press-release seems to indicate a clear signal of future enforcement actions to come. These statements by the DOJ along with the recently released DOJ report on detection and prevention of crimes involving digital assets likely portend for securities law actions in respect of NFTs that have other characteristics that could cause them to be deemed “investment contracts” under the Howey test, such as a right to redistribution of profits. It also shows that the DOJ likely has been paying much closer attention to this space closer and for a longer period of time than is conventionally thought, as not many outside of the NFT community knew about or paid attention to this relatively minor scheme when it was uncovered in 2021, and that even relatively minor players risk becoming the subject of law enforcement.

On January 3, 2022, the Commodity Futures Trading Commission (CFTC) announced an order against and settlement with Polymarket, a blockchain-enabled prediction market that allows users to “bet” on the occurrence of certain future events, for offering off-exchange event-based binary options contracts that constituted “swaps” and failure to obtain designation as a designated contract market (DCM) or registration as a swap execution facility (SEF). Polymarket describes itself as a “decentralized information markets platform” that allows users to bet on their beliefs.  Users build a portfolio based on forecasts, buying and selling “shares” based on how a future event resolves, such as whether Bitcoin will be worth more than a certain amount on a certain date or whether a particular candidate would win a political election.  The CFTC determined that these shares instead are binary options contracts that constitute swaps and are thus subject to the CFTC’s jurisdiction and related regulatory obligations.  Under the U.S. Commodity Exchange Act (the CEA), as amended by the derivatives regulatory reform provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, swaps generally can only be offered on a bilateral basis among eligible contract participants, or over a platform that is registered as a DCM or SEF.  Specifically, the CFTC noted the use of an algorithmic “automated market maker” (AMM) to price premiums for the options based on relative demand for each position, with trading volume and liquidity automatically adjusting based on demand and other factors.  Market participants were charged a 2% fee on each transaction which was used to compensate the liquidity providers, although Polymarket itself claimed to have reaped no profits. The definition of “swap” as a category of regulated product under the CEA is very broad, and could be read to encompass most financial contracts that provide for an exchange of value on the basis of some external reference like the occurrence of an event or the price of some asset or index, even where those contracts are not commonly referred to among market participants as a swap.  The principal exclusions from the definition of “swap” are products that are subject to an alternate regulatory regime, such as options on securities that are subject to the jurisdiction of the U.S. Securities and Exchange Commission (the SEC).  Therefore, any offering of financial contracts whose value is linked to the occurrence of an event or the price of some asset or index runs the risk of enforcement action by the CFTC to the extent they are not already subject to an alternate regulatory regime. The SEC has taken similar action against providers of financial contracts linked to the price of securities.  In 2015, the SEC instituted an enforcement action against the Sand Hill Exchange, which was billed as a platform for investors to purchase contracts linked to the price of pre-IPO technology companies, arguing that the contracts constituted “security-based swaps” subject to the SEC’s jurisdiction and associated regulatory requirements.  Accordingly, there is also a risk of enforcement by the SEC against issuers of financial contracts linked to the price of digital assets that the SEC has determined to be securities. Because the betting contracts were deemed swaps, the CFTC found that Polymarket violated Section 5h(a)(1) of the Commodity Exchange Act and Regulation 37.3(a) thereunder which prohibit the operation of a facility that offers a trading system or platform in which more than one other market participant has the ability to execute or trade swaps with more than one other market participant unless such facility is registered as a SEF or a DCM. Under the order, Polymarket is required to cease offering access to trading in noncompliant markets and to wind down those markets unless the offering, solicitation or trading in those markets complies with CFTC regulations.  Polymarket was also ordered to pay a $1.4 million civil penalty.  While Polymarket did not admit or deny the findings in the order, it is required to cooperate with the CFTC on an ongoing basis and is prohibited from making statements denying the findings or conclusions of the order and from giving the impression that the order is without factual basis. The CFTC previously has granted limited no-action relief for operators of prediction markets.  For example, in CFTC Letter No. 14-130, the CFTC granted no-action relief for Victoria University of Wellington, New Zealand, to operate a submarket for binary contracts concerning political elections and economic indicators.  Importantly, nobody was to receive compensation for operating the market, which was being used for educational purposes, with strict limitations on the number of contract participants, the size of the contracts, the maximum “bet,” and how the site would be advertised, including prominent disclaimers that the proposed market is unregulated, experimental, and being operated for academic purposes.  Similar relief was granted to the University of Iowa in 1993 for the operation of Iowa Electronic Markets. This could create significant regulatory burdens for a provider that seeks to launch as a commercial enterprise a platform for trading event contracts, whether linked to cryptocurrency or other events.  Providers could proceed under an existing regulatory model, such as the CFTC’s futures and options regulatory regime, the CFTC’s swap regulatory regime, or, potentially for contracts relating to securities, the SEC’s securities or security-based swap regulatory regime.  Each would subject the platform to conditions and criteria imposed by the relevant regulators and would require regulatory approval prior to launch.  See, for example, the current CFTC review of the proposal by Eris Exchange, LLC to offer event contracts linked to sports on a CFTC-registered futures exchange, or the rejection by the CFTC in 2012 of a proposal by the North American Derivatives Exchange to list event contracts related to certain political events. The CFTC order continues its trend of bringing enforcement actions against participants in the crypto industry.  For instance, in September 2021 the CFTC filed charges against 14 cryptocurrency options exchanges, many of whom falsely claimed to be regulated by the CFTC, and settled charges with cryptocurrency exchange Kraken for allegedly offering margined retail commodity transactions in digital assets to U.S. customers who were not eligible contract participants. Per public statements, the CFTC apparently is also looking at more conventional DeFi swaps facilities, such as Uniswap and Sushiswap.  It may also be considering whether the very presence of an AMM within a DeFi protocol might be viewed as operating a swap execution facility (or an alternative trading system, if the digital assets in question are securities rather than commodities) and whether staking or lending of tokens in liquidity pools could be deemed entering into a regulated commodities option.  Furthermore, this raises questions regarding other prediction-based platforms and decentralized autonomous organizations (DAOs) attempting to prove the governance theory of futarchy (a theoretical form of government where decisions are made by prediction markets to determine which policies would have the most positive effect). The settlement may also give the CFTC an angle to bring enforcement actions against those participating in, rather than operating, certain DeFi swaps markets, due to their status as major swap participants.   On the other hand, the CFTC’s order goes into significant detail about how Polymarket was not decentralized, but rather internally decided on the outcome of any bet and resolved any dispute. Per the order, “Polymarket’s market resolution conditions are defined solely by Polymarket. Any dispute or ambiguity in the market resolution—i.e., the determination of which contracts are winners and which contracts are losers—is resolved solely by Polymarket’s ‘Markets Integrity Committee’, which is staffed solely of Polymarket personnel.” This focus on centralization raises the question whether the outcome might have been different for a fully decentralized platform. Going forward, other operators of blockchain-enabled prediction markets are likely to pay close attention to whether Polymarket is able to continue running a prediction market in the United States and if so, how it complies with the conditions of its settlement with the CFTC.

On November 9, 2021, the U.S. Securities and Exchange Commission’s (SEC) Division of Examinations (the “Division”) released a Risk Alert regarding various compliance issues for investment advisory firms offering robo-advisory services, also known as internet advisers. This Risk Alert is the product of the Division’s examinations under its Electronic Investment Advice Initiative (the “Initiative”).  While firms providing investment advice have been regulated for over two decades, their prevalence has dramatically increased in recent years.  This includes both investment advisers that provide investment advice exclusively through an interactive website under Rule 203A-2(e) under the Investment Advisers Act of 1940 (the “Advisers Act”), along with traditional investment advisers who supplement their investment advice through automated means. Electronic Investment Advice Initiative In the course of the Initiative, the Division focused on the following areas: Compliance programs to assess whether compliance policies and procedures, particularly those related to the provision of robo-advisory services, were adopted, implemented, reasonably designed, and tested at least annually pursuant to the “Compliance Rule” under Rule 206(4)-7 of the Advisers Act, which requires all registered investment advisers to maintain and enforce policies and procedures reasonably designed to ensure compliance with the Advisers Act. Formulation of investment advice to evaluate whether advisers gathered sufficient information from clients to form a reasonable belief that clients were receiving investment advice that was in their best interest based on each client’s financial situation and investment objectives. Where applicable, the staff also reviewed conflicts of interest disclosures and “customization” representations for adequacy and accuracy. Marketing and performance advertising practices for compliance with the old “Advertising Rule” or new “Marketing Rule” under Rule 206(4)-1 of the Advisers Act. Also, if relevant, the Division’s staff reviewed whether the advertised securities selection and portfolio management techniques were used when managing client accounts. Data protection practices to understand the firms’ policies and procedures regarding client data protection, including cybersecurity practices. Registration information to determine whether the advisers were eligible for SEC registration as investment advisers or eligible to rely on Rule 203A-2(e). Observations The Division noted a number of observations in the course of the Initiative, including the following: Compliance programs. o   Most the examined advisers had inadequate compliance programs. Specifically, many advisers’ policies and procedures regarding robo-advisory services did not adequately assess their performance, disclose changes in asset allocation or balancing policies, or take sufficient measures to protect client log-in credentials. o   Providers of “white label” platforms often lacked policies and procedures addressing the platform providers’ attention to these matters.  This underlies the obligation that may be created for a registered investment adviser to have policies covering its service providers or users under circumstances where others may affect the advice offered. o   Additionally, advisers also often failed to adopt a strict adherence with the Code of Ethics Rule under the Advisers Act by not identifying “all access persons” and then, in turn, not receiving all access persons’ required holdings or transactions. Formulation of investment advice o   While advisers commonly used questionnaires to collect data for investment advice, the Division staff found that some firms relied on just a few data points to form their advisement advice and did not sufficiently account for evolving client needs.  This is consistent with several recent enforcement actions where the SEC settled with advisers who failed to monitor clients for changing circumstances and suitability despite still charging fees. o   A number of advisers had disclaimers in their online terms and conditions that were not consistent with the SEC’s view of an investment adviser’s fiduciary duties.  For example, the SEC long has taken the position that a waiver of claims for violations of securities laws is inconsistent with an investment adviser’s fiduciary duties. Marketing and performance advertising practices o   Robo-advisers often made inaccurate or incomplete disclosures in their Form ADV filings, particularly regarding conflicts of interest, advisory fees, investment practices, and ownership structure. o   Advertisement-related noncompliance included: Vague or unsubstituted claims regarding services provided, investment options, performance expectations, and costs incurred; and Hypothetical performance results without adequate disclosures pursuant to Rule 206(4)-1 of the Advisers Act. Data protection practices o   Only a few robo-advisers had policies and procedures that addressed the firm’s systems and response following a cybersecurity event. Therefore, those advisers were not in compliance with Regulation S-ID or Regulation S-P, as applicable, because their services did not have written policies and procedures designed to detect, prevent, and mitigate identity theft. Further, many advisers did not deliver all required privacy notices. Registration information o   Notably, nearly half of the examined robo-advisers claimed reliance on the internet adviser exemption under Rule 203A-2 of the Advisers Act. This exemption requires that the adviser (a) provides investment advice exclusively through an interactive website (subject to a 15 client de minimis exception), (b) maintain for at least 5 years an easily-accessible record of its eligibility to rely on this exemption, and (c) is not an affiliate of another registered adviser relying on umbrella registration.  Many of these advisers either (1) did not have an interactive website, (2) concurrently provided investment advice outside of the interactive website (e.g. financial planning), or (3) were actually adviser affiliates in a control relationship and therefore ineligible to the Internet adviser exemption. Discretionary Investment Advisory Programs Additionally, the Initiative included a review of over two dozen robo-advisers who sponsor “discretionary investment advisory programs” under Rule 3a-4 under the Investment Company Act of 1940 (the “Investment Company Act”).  This rule serves as a safe harbor from Investment Company Act registration for certain discretionary investment advisory services of managed accounts. o   The Risk Alert notes that certain discretionary investment programs may meet the definition of “investment company” under the Investment Company Act unless the investment adviser fully complies with the nonexclusive safe harbor for discretionary investment advisory services under Rule 3a-4 of the Investment Company Act. o   Reliance on the safe harbor requires roboadvisers to (1) obtain client’s financial information and objectives and (2) inquire into whether the client wishes to impose reasonable restrictions on the management of the client’s account. Clients are also entitled to retain “certain indicia of ownership” as well as annual communication from the robo-adviser that provides an opportunity to make any changes to the client’s financial condition or objectives or account restrictions. The “indicia of ownership” must be to the same extent as if the clients held the securities and funds outside of the discretionary investment advisory program. o   Many robo-advisers collected insufficient amounts of information from clients. In particular, many advisers asked too few questions or received too few data points to be able to provide adequately personalized investment advice. o   Further, many advisers did not adequately allow clients to impose reasonable restrictions on their own accounts, or made it difficult for clients to impose these restrictions.  In particular, this was inconsistent with the Investment Company Act Rule 3a-4 requirement that clients be able to designate securities or types of securities that should not be purchased or that should be sold. o   Additionally, clients in discretionary investment advisory programs faced restrictions on the client’s ability to withdraw funds, voting rights, bring a legal course of action against an issuer in the client’s account, or did not receive legally-required documents such as trade confirmations and prospectuses. o   The Division staff also reiterated that Rule 3a-4 is designed to address only the status of the program under the Investment Company Act, not the obligations of any investment adviser under the Advisers Act.  Accordingly, investment advisers to registered investment companies relying on this rule should ensure that they are also compliant with the Advisers Act. Key Takeaways This Risk Alert, one of the longest and most detailed it has ever issued, shows that robo-advisors clearly are in the SEC’s crosshairs.  While there is a lot of content, we believe there are a few key takeaways: There may be quite a few investment advisers relying on Advisers Act Rule 203A-2(e) who may not rely on that rule. If an adviser is providing advice outside its interactive website, it may need to look to other exceptions and if it does not have any assets under management, it might be more proper for the adviser to be registered at the state level. Robo-advisers may be at risk of enforcement action if they do not collect sufficient information in their questionnaires to be able to select an appropriate investment strategy for their clients. All investment advisers – not just robo-advisers – should ensure they are compliant with applicable marketing and advertising rules.  Even if an adviser is relying on the new “Marketing Rule,” it may also have other restrictions under applicable state laws. Tech companies in the investment advice space should ensure that their related terms, conditions, and policies relating to their websites and applications do not result in a lapse of compliance obligations by their related investment advisers In addition to reviewing internal compliance with the applicable rules under both the Investment Company Act and the Advisers Act, robo-advisory service providers may also consider referring to the SEC’s Division of Investment Management 2017 “Guidance Update” regarding robo-advisers.  Advisers who provide automated internet investment advice – particularly those relying on Advisers Act Rule 203A-2(e) – should consider having their practices, policies, and procedures audited by compliance professionals, such as Polsinelli’s Investment Management and Funds team, in light of this Risk Alert.

Thoughts on Recent SEC statements and Action on Enforcement Related to Decentralized Autonomous Organizations (DAO) On November 10, 2021  the US Securities and Exchange Commission (the SEC) announced that it had halted the first ever attempt to register digital tokens issued by a decentralized autonomous organization (DAO) under the US federal securities laws. American CryptoFed – also the first DAO to take advantage of Wyoming’s new “DAO Law” that attempts to give DAOs legal status – filed Form 10 and subsequently filed a Form S-1 in an effort to register its digitals assets in the form of two coins designed to operate in tandem issued under the names Locke and Ducat. A DAO is an organization encoded as a transparent computer program, controlled by the organization members and not by a central corporate entity, often through a governance token utilized on a blockchain. In the SEC’s announcement, they alleged that the registration statement filed by American CryptoFed contained a number of deficiencies, including purportedly misleading statements such as claims that the tokens were not intended to be securities and may be distributed on the form of registration statement used for registration of securities under an employee benefit plan.  Perhaps just as importantly, the registration statement failed to provide substantive information about the issuer as is required to be disclosed in the form, such as information regarding its business, management, and financial condition. One telling example of the deficient information concerns the issuer’s ownership structure, which a pure DAO would be unable to produce by its very nature of being a DAO. This highlights several issues with being able to register DAO-issued tokens under the current regulatory framework.  The SEC disclosure forms rightly require financial statements and business information regarding the issuer.  That said, a DAO is not really an entity.  There often is a supporting entity in place alongside a DAO, and in some instances an organization that isn’t really decentralized may be mislabeled as a DAO, but the DAO itself in almost all circumstances would not be able to produce financial statements prepared in accordance with generally accepted accounting principles.  If the DAO does not have a definable business and truly is decentralized, then there may not be a management structure for which information can be provided.  Further, depending on the circumstances, the financial condition of a DAO may be of limited relevance to holders of the tokens, particularly if there truly is a level of decentralization that would allow the project to move forward even if the ‘entity’ sponsoring the token were to collapse (or the financial statements of the issuer could be looking at the wrong thing if the treasury of the DAO is not housed in that entity).   Simply put, this action implies that it will be difficult if not impossible for true a DAO to register its tokens under the current regulatory framework, even if it sets itself up in a way to attempt robust compliance. Avoiding the Line and Counsel? Any spurt of innovation, particularly the one we are experiencing now with decentralized finance and DAOs, will test the boundaries of existing regulation and hopefully lead to regulatory flexibility and updated regulations. For this reason, a recent statement by SEC Chair Gensler could use additional clarification.  On November 4, 2021, a few days before the American CryptoFed halt, at the first SEC Enforcement Forum since he became Chair, Gensler laid out a number of enforcement directives of the SEC, putting an emphasis on a the economic reality of a transaction regardless of what form it is in. In particular, he emphasized that terms such as “decentralized finance” (DeFi), “currency,” or “peer-to-peer lending” should not be taken at face value without looking at what the transaction is really doing. While it is important to understand the spirit of the law and never act fraudulently regardless of the law, the role of legal counsel is to help clients work within the law, even if it is near the boundary of the law. Gensler’s statement - “if you’re asking a lawyer, accountant, or adviser if something is over the line, maybe it’s time to step back from the line” – has the potential to deter entrepreneurs from seeking counsel and encourage haphazard action. While a measure of caution is not undue, it does have the potential to stifle innovation. This is after all a new frontier of finance where advances are made in the margins often by those who get there first. Consulting with responsible counsel is something that any innovator should be encouraged to do. Seemingly discouraging innovators from seeking counsel, and asking those who are trying to be responsible and comply with the law to not even attempt to do so, would only increase the prevalence of bad actors, exposing all parties - including investors - to the very risks that regulators are trying to avoid. Rulemaking Under Any Other Name… A few days after Chair Gensler’s statement, Gurbir Gruwal, the new Director of the Division of Enforcement gave prepared remarks discussing the role of that Division.  The remarks were largely a defense against the assertion that, with respect to the crypto industry, the SEC has been “regulating by enforcement” rather than creating new regulation.  Mr. Gruwal gave three examples to show how the Division’s Cyber Unit’s enforcement of digital assets actions are enforcing existing laws and not creating new law.  The first example he gave was the Kik ICO, followed by a recent Ponzi scheme that claimed to use DeFi but did not actually support a DeFi network and, last, the BitConnect project that also was long thought to be a Ponzi scheme.  While there was not complete consensus within the digital asset legal community about how Kik’s KIN token would be treated for federal securities law purposes, the latter two were blatant frauds of what would have obviously been securities, had they existed at all. Selecting those straightforward examples out of hundreds does not mean that there haven’t been other enforcement actions in areas where the law was quite unsettled. While the Division of Enforcement is doing a lot of great work, the speech shows that there is a fundamental misunderstanding of the industry’s frustration over “rulemaking by enforcement.” Rather than coming out with new regulations that provide somewhat bright lines, one must wade through a gallimaufry of enforcement actions, press releases, risk alerts, and speeches to determine the current state of the law. Even then, there is a wide gulf between what the SEC has endorsed and publicly warned against with any level of specificity.  In the nearly 10 months since the current administration took office, there have only been a small handful of new proposed rules and only in the last week have any new substantive regulations been approved.  “Rulemaking by enforcement” is really shorthand for the lack of clear, concise guidance needed for those who want to comply with the law to actually comply with the law.  This particularly rings true for aspects of many blockchain technologies that are fundamentally incompatible with existing regulations, even if they are compatible with the spirit of the law.  The SEC Staff has announced that it will try to tackle this problem with respect to the Advisers Act “Custody Rule” by modernizing it, but it does not appear that any other meaningful regulation relating to digital assets or decentralized finance is on the horizon. Maybe the SEC should also consider a framework under which a DAO or a supporting organization of a DAO can register securities, particularly as the discussion regarding regulation of stablecoins and DeFi starts to heat up. The prepared remarks close out as follows: “This is not “regulation by enforcement.” This is not “regulation by enforcement.” This is not “regulation by enforcement.” There. I have said it thrice and what I tell you three times is true.” This is (not) regulation by speechmaking at its finest.

An interesting and thoughtful whitepaper called “A Legal Framework for Decentralized Autonomous Organizations” was co-authored by a general counsel of one of the major venture investors in the blockchain space suggesting a framework for DAOs under the legal system in the United States.  A decentralized autonomous organization, or a “DAO,” is an “organization” encoded as a transparent computer program, controlled by the organization members, and not by a central corporate entity. Currently, many DAOs are not established as legal entities, potentially exposing their members to a number of risks and liabilities. The whitepaper highlights some of the major legal issues facing DAOs, including difficulty with tax reporting, difficulty in entering contracts, and potential general partner liability for DAO participants. The whitepaper suggests that an ideal solution will involve new laws that recognize a type of non-entity that could at least have sufficient legal personality to provide some protections for these above-mentioned concerns. However, there are several hurdles facing a new type of regulation both from the regulators themselves, as well as from many people involved with DAOs who believe that constituting these organizations as a legal entity is antithetical to the philosophy behind a DAO. In the meantime, prior to the introduction of a new corporate structure, the whitepaper proposes the use of an unincorporated nonprofit association (UNA) as a ‘wrapper’ for a DAO to give which would give such organizations sufficient legal coherence including the ability to pay taxes, make filings, and the like.  Unincorporated nonprofit associations are broadly defined and, in many jurisdictions, can consist of just a few people agreeing to work, either orally or with an agreement, on a charitable endeavor together. Many states provide for a simple mechanism for these groups to obtain a tax ID number, and, while it may not be feasible for many DAOs due to their activities or structure, they also are permitted to apply for tax-exempt status under Section 501(c)(3) of the tax code.  Much of the question as to the applicably of UNA for a DAO will rest on the whether the activity of that DAO is considered “not-for-profit” under something called the Uniform Unincorporated Nonprofit Association Act (UUNAA) that has been adopted by many states. While many DAO generate profits, in general that is allowed under the UUNAA if the profits are not being distributed to members. Another existing legal structure suggested by one of the members of Polsinelli’s nonprofit organizations group for use by DAOs is a public benefit limited liability company, which he believes may be a more effective structure for these organizations. While it would mean that the DAO would need to more formally adopt a corporate structure than a UNA requires, it would also create limited liability for its members as a matter of law.

On October 28, 2021, The Financial Action Task Force (FATF), an inter-governmental body that sets international standards with an aim to prevent global money laundering and terrorist financing, released updated guidance related to Virtual Assets and Virtual Asset Service Providers (VASPs).  This updates guidance previously released by the FATF in 2015, October 2018, and June 2019. One of the most important hurdles for the virtual assets and cryptocurrency to overcome is to convince regulators, legislators, and the public that this growing industry does not foster money laundering and other financial crimes. Key to this challenge is dealing with the fact that many anti-money laundering regulations focus on “know your customer” rules.  On the other hand, a defining feature of much of the virtual asset industry is the anonymity of the “customer” and that “service providers” may be a decentralized code running on a series of nodes without the ability to track or know anything about a customer’s identity or background. In general, the report does a good job focusing on where its authors perceive actual risk to be, particularly systematic risk, and trying to not hamper technological innovation. Among the important changes between this guidance and the guidance issued by the FATF from June 2019 which it replaces is a focus on stablecoins, virtual assets whose values are pegged one or more other currencies. The potential for stablecoins to be adopted for widespread commerce has led to increased scrutiny of them by global regulators, as these digital assets pose a systemic risk to the economy if a stablecoin were to be criminally exploited or to just flat out fail. For the growing NFT (non-fungible token) market, this guidance is likely to be of some relief since it indicates that it does not consider most assets that are bought for purely speculative purposes to be a virtual asset subject to legal scrutiny. Finally, with regard to DeFi, or decentralized finance, the guidance indicates that a truly decentralized software protocol would not be considered a VASP under the FATF standards, as the Standards do not apply to underlying software or technology. However, care must be taken that even if those arrangements seem decentralized it may fall under the FATF definition of a VASP where they are providing or actively facilitating VASP services.”  There are also other important updates related to peer to peer platforms and the “travel rules,” among other matters. Learn more

As the United States Senate considered H.R. 3684, the “Investing in a New Vision for the Environment and Surface Transportation In America Act (INVEST in America Act)”, an attempt to modify legislative language concerning cryptocurrency failed on a procedural basis. The Invest In America Act is an historic $1 trillion bipartisan bill that, if passed, will fund physical infrastructure in the United States, including spending for roads, bridges and public transportation as well as providing funding for high speed internet, electric vehicles and modernizing the power grid. Much of this bill is to be funded though increasing the national deficit, in other words, debt, as well as some spending cuts. A portion of the bill is to be funded by new sources of revenue, including tighter enforcement of cryptocurrency transaction reporting, which has been estimated to amount to $28 billion over 10 years, accounting for approximately 25% of all new revenue sources under the bill. This would mandate reporting of cryptocurrency transactions by certain intermediaries and other affiliated parties. In some ways the crypto tax provisions of the Act shows how the cryptocurrency industry has been legitimized by government regulators, being viewed as stable and secure enough to serve as a primary revenue source for public works projects over the next 10 years. That said, there is real concern that these provisions of the Act will effect the growth of a fledgling digital asset industry since it has the potential to drive a lot of activity outside of the United States, which in turn could decrease the amount of revenue actually raised. Under the Act, a cryptocurrency broker will be obligated to report digital asset transactions to the IRS. As introduced, Section 80603 of H.R. 3684 contained a broad definition of a “cryptocurrency broker” as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” For taxing purposes, this definition means a sale on behalf of someone else. Many in the cryptocurrency industry are concerned that parties who are not acting as true brokers, such as cryptocurrency miners, developers, network validators and stakers, could be caught in this definition. The U.S. Department of the Treasury, the Congressional Joint Committee on Taxation and others believe the language in H.R. 3684 is sufficiently clear that reporting requirements only cover actual brokers who have custody over assets. In a sign of growing lobbying strength of the blockchain industry, Sens. Patrick Toomey (R-PA), Mark Warner (D-VA), Cynthia Lummis (R-WY), Kyrsten Sinema (D-AZ) and Rob Portman (R-OH) reached a compromise on an amendment to the Act that would have alleviated some of the concerns of the crypto community. The authors intended for their amendment to clarify that the definition of “broker” applies only to persons who regularly effectuate transfers of digital assets on exchanges where people buy, sell and trade cryptocurrency.  Persons who solely engaged in validating distributed ledger transactions would not be covered for those activities, whether they utilize proof-of-work, proof-of-stake or other new consensus mechanisms. Further, the definition clearly would not have applied to individuals solely engaged in selling hardware or software with the sole function of permitting someone to control private keys used to access digital assets. Cloture in the Senate and Why the Cryptocurrency Amendment Failed Even with Widespread Support Cloture in the Senate is the procedure by which a vote can end debate without also rejecting the bill, amendment, conference report, motion or other matter it has been debating. Under Senate Rule XXII, the process usually begins when the Majority Leader files a cloture petition containing the signatures of 16 Senators who express a desire to close debate on a matter. The petition then lies over in the Senate for 48 hours plus one hour after the Senate convenes. Cloture can be invoked with the vote of 60 Senators. Senators who desire to offer revisions to a bill or amendment on which cloture has been invoked must submit their amendments in writing before the cloture vote takes place. First-degree amendments, which propose to change the text of a bill or a committee amendment in the nature of a substitute, must be submitted in writing when the Senate is in session no later than 1:00 p.m. on the day after the cloture motion is filed. The Senate voted to invoke cloture on the Invest in America Act on August 8, 2021, by a vote of 68-29 (3 not voting). Sens. Portman, Toomey, Warner, Lummis, Sinema and Portman reached a compromise on their revised amendment only the next day. Under Senate rules, amendments offered after cloture is invoked require the unanimous consent of all 100 members of the Senate.  On August 9th, Senator Toomey requested unanimous consent that the compromise cryptocurrency amendment be adopted.  Senator Richard Shelby [R-AL] “reserved the right to object”. The Senator had an amendment to increase defense spending by $50 billion and asked Senator Toomey if he would agree to a unanimous consent request to add his (Shelby’s amendment). Toomey agreed, but Senator Bernie Sanders [I-VT], Budget Committee Chair, objected to the Shelby amendment, which was viewed as a poison pill for Democrats (and Sen. Shelby ultimately did vote against final passage of H.R. 3684). Therefore, Senator Shelby objected to the Toomey amendment, killing amendment in the Senate. Next Steps and Cryptocurrency in the House Although the blockchain industry came up short with this amendment, the fight is far from over. Cryptocurrency advocates are lobbying to change the bill in the House by adding the failed Senate bipartisan amendment. In addition, the House Congressional Blockchain Caucus sent a letter to the entire House expressing concerns about the Senate provision in H.R. 3684. Advocates state that they are asking the House to tax cryptocurrencies fairly with minimum administrative burden. Shortly after the Senate completed action on H.R. 3684, Rep. Anna Eshoo [D-CA], Chairwoman of the Health Subcommittee of the House Energy and Commerce Committee, sent a letter to Speaker Nancy Pelosi [D-CA] requesting that the Speaker amend the bill with regard to the broker definition in Section 80603. She noted the bipartisan amendment which failed on a procedural objection had the support of Treasury Secretary Janet Yellen. Additionally, there are numerous impediments to passing the Act in the House, which puts its fate in doubt. House Speaker Nancy Pelosi has vowed not to take up the Senate bipartisan infrastructure bill until that body passes a separate huge $3.5 trillion budget through a process called reconciliation under which a bill can be passed with only a majority.  Meanwhile, nine House Members sent the Speaker a letter saying they would vote against the House budget reconciliation bill unless she brings up the Senate infrastructure bill first. Speaker Pelosi has said she will not do that. The House is scheduled to return early from its recess on August 23rd. Stay tuned. Finally, even if the Act passes in its current form, the IRS would need to approve implementing regulations. These regulations could ultimately include much of the clarity that cryptocurrency advocates are seeking.

On Tuesday, April 20, 2021, the House of Representatives passed the Eliminate Barriers to Innovation Act of 2021 (the “Act”). The Act was initially introduced in March with an overarching aim to clarify the roles of the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) in the policing of cryptocurrencies in the U.S., and create collaboration between the two agencies. If passed in the Senate, the Act would require the CFTC and the SEC to jointly establish a digital asset working group (the “Working Group”) within 90 days of enactment.  This is landmark legislation as it is the first time either branch of Congress has passed a blockchain-related bill.  If passed, the Act could help provide some much-needed clarity in determining which regulators have jurisdiction over different digital asset issuers. The Working Group’s directive would be to submit, within one year, a report that contains an analysis of the current CFTC and SEC legal and regulatory framework for digital assets, the impact a lack of clarity has had on primary and secondary markets in the U.S., and the country’s competitive standing in comparison to developments in other countries. The report would also be required to include recommendations addressing the following: Creation, maintenance, and improvement of primary and secondary markets in digital assets; Legal treatment of custody, private key management, cybersecurity, and business continuity relating to digital asset intermediaries; and Future best practices to reduce fraud and manipulation of digital assets, improve protection of investors, and assist in compliance with banking and anti-money laundering laws and regulations. The Working Group’s composition would be comprised of an equal number of employees and non-governmental representatives appointed by the SEC and CFTC. The non-governmental representatives in the Working Group would be required to include at least one representative from each of the following sectors: FinTech companies providing digital assets products or services; Financial firms under the jurisdiction of the SEC or the CFTC; Institutions or organizations engaged in academic research or advocacy relating to digital asset use; Small businesses engaged in FinTech; and Investor protection organizations - Institutions and organizations that support investment in historically-underserved businesses (women-owned, minority-owned, and rural businesses). The full text of the Act can be found here.