Last week, members of Polsinelli’s Blockchain+ Team presented via webinar “Web3 Lives! Especially for DAOs.”  They discussed how decentralized autonomous organizations have entered the mainstream via blockchain technologies, legislation developed or being developed for DAOs, and the pros and cons associated with DAOs, including security risks. To view a recording of this webinar, click here. To access an audio-only version of this webinar, click here.  A copy of the webinar PPT can be found here and download the one-page informational sheet here.

As Celsius Network LLC, et al., Case Number: 22-10964 (MG), proceeds in the Bankruptcy Court for the Southern District of New York (the “Court”), the following summarizes an important case update as of November 4, 2022: Adjournment of Bar Date Hearing: Our October 27, 2022 update referenced a hearing scheduled for November 1, 2022, whereby the Debtors planned to request approval for a motion to set a bar date of December 13, 2022 (the “Bar Date Motion”). Under the Bar Date Motion, any claim not filed by December 13, 2022, or listed on the Debtors’ Schedules would be barred from submission.  The purpose of the bar date is to allow the Debtors to assess the value of their assets versus liabilities so that they can institute a plan of restructuring and hopefully pay their creditors. The Debtors also intend to update the proof of claim form to better accommodate claims that consist of cryptocurrency assets. The hearing on the Bar Date Motion has been adjourned to November 15, 2022, at which time the Debtors will also seek approval of the updated Proof of Claim form. No reason was given for the adjournment of this hearing from November 1, 2022, to November 15, 2022. It is our advice both to protect creditors with regard to the Debtors as well as to ease a potential claim sale that creditors file a proof of claim even if they are in agreement with the amounts listed by the Debtors on the schedule. Although creditors should wait for the updated Proof of Claim form to be approved, creditors are advised to gather any relevant documents and, if desired, retain counsel to assist with filing a proof of claim, especially given that the proposed bar date is only five weeks away We expect further updates, possibly related to the treatment of trust assets on or prior to the November 15th hearing.

The Internal Revenue Service (IRS) was one of the first United States regulators to provide guidance on the tax treatment of virtual currencies such as Bitcoin. Starting back in 2014 with its release of Internal Revenue Bulletin: 2014-16, the IRS stated that bitcoin is taxed as a property. Then in 2019, the IRS addressed the tax implications of a hard fork in Revenue Ruling 2019-24. Mindful of the continued expansion and transition of this industry, the IRS released draft filing instructions for the 2022 Form 1040, U.S. Individual Income Tax Return, on October 17, 2022.  The draft instructions provide further clarity that IRS guidance applies to the full spectrum of what are called “digital assets” and address how digital assets should be reported on U.S. tax returns. The draft instructions to the 2022 Form 1040 indicate that the term “virtual currency” is now being supplemented with a broader term, “digital assets.” Since 2019, the Form 1040 has included a question regarding virtual currency requiring filers to check ‘yes’ or ‘no’ to disclose whether they had engaged in any transactions involving virtual currency during the tax year. The draft instructions now expand this disclosure to include all digital assets, “Virtual currency” is defined as: “…a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, or a medium of exchange.” The new “digital assets” definition highlights the IRS’ attempts to catch up with the evolving landscape and vastly broadens the scope of this question. Specifically, the IRS defines digital assets as: “…any digital representations of value that are recorded on a cryptographically secured distributed ledger or any similar technology. For example, digital assets include non-fungible tokens (NFTs) and virtual currencies, such as cryptocurrencies and stablecoins. If a particular asset has the characteristics of a digital asset, it will be treated as a digital asset for federal income tax purposes.” The IRS’ definition of digital assets explicitly includes Non-fungible Tokens (“NFTs”). The IRS’ inclusion of NFTs seems to signal that the IRS plans to treat NFTs like other digital assets rather than as artworks or collectibles, as some may have preferred. However, the IRS has not said anything explicitly in this regard and whether the IRS will tax the sale of NFT collectibles at a lower rate than physical collectibles is yet to be seen. In addition to providing an expanded definition of digital assets, the IRS has provided additional guidance on when to check ‘yes’ in response to the IRS’ question of whether or not the taxpayer has engaged in any transactions involving cryptocurrency. According to the draft 2022 Form 1040, the question will read: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)? (See instructions).” In addition to the inclusion of transactions that involve NFTs in the IRS requirement to check a box on Form 1040, the IRS’ question, as revised also captures other transactions that involve digital assets such as “play-to-earn-games” where taxpayers may earn digital assets. These additional instructions provided by the IRS raise several questions and concerns for tax professionals and for taxpayers. One question is given the broad scope of digital assets, why should the mere fact that a transaction is “cryptography secured” require it to be looked at differently on a tax form?  Another – Is it fair to add additional regulatory burdens on transactions simply for attempting to be more secure and transparent? The update to the form instructions is a signal that the IRS is trying to stay mindful of the developments occurring in the realm of digital assets and working to further enhance the government’s overall enforcement strategy from an income tax reporting perspective. With the adoption of this broader language, we hope that further regulatory guidance will be forthcoming and without that, we recommend taking a conversative and inclusive approach for any filing.

As Celsius Network LLC, et al., Case Number: 22-10964 (MG), proceeds in the Bankruptcy Court for the Southern District of New York (the “Court”), on October 24, the Court issued two rulings related to matters mentioned in our October 14, 2022, update: Approval of Bidding Procedures: As introduced in a previous update, on September 29, 2022, the Debtors filed a motion to set bidding procedures for the auction and sale of substantially all of the Debtors’ assets, including Debtors’ retail platform, account holders, loan portfolio, and related technology, custody, and swap services, and staking and mining operations (the “Sale Motion”). On October 24, 2022, the Court approved the Sale Motion over the objection of the US Trustee and several other parties (the “Sale Order”). One of the core objections of the US Trustee and a number of States is that the Debtors’ proposed (and now Court-approved) bidding procedures are premature since the Court has not yet determined whether the Earn, Custody and Withhold accounts will be part of the bankruptcy estate and thus included in the asset sale.  The objecting parties argue that “trying to proceed to an auction prior to determining what is to be sold would be no more realistic than if one sought to sell a car dealership without being able to tell the buyers whether some, all, or none of the cars on the lot would be part of the assets being purchased.” Although the Court-appointed Chapter 11 Examiner’s initial report is due before the bidding deadline, this report will not resolve the ultimate treatment of the Earn accounts, which represents the vast majority of creditors. While the Sale Motion and Sale Order do not directly address how or in what way the “Earn” creditors will get paid out, they do provide insight into just how the Court and Debtors are understanding and analyzing this bankruptcy case. For instance, though the Court agreed that determination of the treatment of the Earn, Custody, and Withhold accounts would take time, it held that these issues “involve only a fraction of the potential estate assets that the Debtors propose to sell,” may be subject to “months or years” of appeals, and, therefore, the bankruptcy court process should not be delayed. The Court stated in its ruling that a winning bid could deal with the contingency of how these accounts will be treated. In any event, the Debtors have also noted that they “will not sell or purport to sell any Assets absent a finding by the Court that they have title and authority to sell the Assets.” In the Sale Order, the Court appears to accept the Debtors’ view that time is of the essence in this case and gives great deference to the Debtors’ business judgment. (To those less familiar with the United States Chapter 11 system, this deference to the management of a bankrupt entity is likely to come as a surprise.)  Per the Court, the bidding procedures are designed to “maximize value of the Debtors’ assets.” In the Sale Order, Judge Glenn compared the Debtors’ businesses to a melting ice cube in that if the Debtors wait too long to act, liquidity issues are likely to impact the Debtors’ operations in 2023 as the assets available for sale dwindle. This view that “time is not on the side of maximizing recovery by all stakeholders” is in contrast to those “bullish” on crypto prices who would prefer the Debtors to wait for a price recovery before selling assets. Key points on the bidding procedures, as approved by the Sale Order: Debtors intend to try to sell the entirety of their retail platform, including customer earn accounts and coin balances, retail and institutional lending portfolio, swap services, staking platform, Celpay, and CelsiusX. The Debtors also requested the ability to sell their staking and mining operations and any other assets; Sale timeline: Initial bids for the Retail Platform Assets are due November 21, 2022, an auction, if necessary, is scheduled for December 15, 2022, and a sale hearing is set for December 22, 2022; The Debtors have a list of over 30 parties they believe may be interested in bidding; As it remains an open question if certain accounts are part of the bankruptcy estate, it is unclear if bidders will be interested in bidding on accounts given such uncertainty; Debtors anticipate allowing the winning bidder to purchase assets free of potential liabilities; Debtors made clear that they plan, or at least hope, to sell all accounts. However, as seen in another bankruptcy case, bidders may only desire to acquire account information and not accept liabilities assets in accounts; The sale procedures do not appear to contemplate the Debtors making a distribution of crypto assets to creditors; however, nothing in these bid procedures is the final word on how any distribution will be made; and The bid procedures anticipate that any sale under these procedures will happen under a plan of reorganization that will be approved by the Court and creditors. Rejection of the Equity Committee: On October 24, the Court also denied a motion for the appointment of an official preferred equity committee (the “Committee Motion”). The equity holders in question have been active participants in the Debtors’ bankruptcy case from the start, often filing objections to the Debtors’ filings. Both the Debtors and the Official Committee of Unsecured Creditors filed objections to the Committee Motion. In general, under the rules of a Chapter 11 bankruptcy case, the equity holders are not entitled to any proceeds of the bankruptcy estate unless all impaired creditors are paid back in full with interest, something which is not expected to happen in this case. Ultimately, the Court agreed with the objections, holding that appointment of an Official Preferred Equity Committee is inappropriate for three reasons: (1) the equity holders are adequately represented by already existing stakeholders and do not need additional representation; (2) the equity holders have not met their burden to demonstrate that there is a substantial likelihood of equity recovery; (3) other factors, such as the balance of costs and benefits to the bankruptcy estate, as well of the complexity of the bankruptcy, do not weigh in favor or appointing an Official Preferred Equity Committee.

As Celsius Network LLC, et al., Case Number: 22-10964 (MG), proceeds in the Bankruptcy Court for the Southern District of New York (the “Court”) over the last month there have been a number of important updates in the case. Here are some highlights as of October 14, 2022: Though Debtor filings and Committee investigations have revealed a great deal more to the public about the Debtors’ financial affairs, insider activity, and the path and direction of the bankruptcy case, there is still little indication of how claims will be treated and repaid in this case. This is particularly true of claim holders who have “Earn” accounts where prior withdrawals may be clawed back. Over the next few months, the Court will determine the ownership status of certain accounts and how those accounts will be treated, and the Debtors will present a plan of reorganization for Court approval which will give creditors a better sense of how the Debtors intend to treat all claims. After that plan is presented, creditors will have an opportunity to vote to “accept” or “reject” the plan. Claims and Proof of Claim Process On October 5th, 2022, the Debtors filed their Schedules of Assets and Liabilities with the Court (the “Schedules”). On these Schedules, the Debtors list what they believe to be customer account balances as of July 13, 2022, the day that the bankruptcy petition was filed (the “Petition Date”). Customers can view Debtor Celsius Network, LLC’s Schedules on page 92 of Docket No. 974. Debtor Celsius Network, LLC’s Statement of Financial Affairs is available at Docket No. 973. Interestingly and potentially of concern to certain creditors, the Schedules also list all withdrawals from the accounts in the 90 days preceding the Chapter 11 filing. This likely indicates a serious consideration in the Debtors to claw back these funds. If a creditor agrees with the Schedules as-filed, and if their claims are not listed as “contingent,” “unliquidated,” or “disputed,” the Creditor is not required to file an additional proof of claim. However, it may still be a better practice to file a proof of claim to ensure the claim is correct and that the court has a copy of any supporting documentation. Regardless, a creditor should wait to file a proof of claim since the current proof of claim form available through the Stretto website is expected to be revised to make it easier for customers to submit information related to their crypto balance. More information on this will be provided once the Court makes a ruling about on procedures. The Debtors have filed a motion requesting to establish the general claims bar date (for non-governmental entities) as December 13, 2022 by 5:00 p.m. prevailing Eastern Time. If the Court grants this request, all general creditors must file a proof of claim by that date unless they wish to rely on their claim being listed on a schedule. Classification of Claims and Ad Hoc Committees There are at least four types of creditors who have accounts at Celsius which are currently blocked due to the bankruptcy, and it’s still up in the air as to how the court is going to treat them. Custody Accounts. These are accounts that did not earn interest and where funds were to some extent held on behalf of the owner. The Debtors have agreed to return these funds and not consider them part of the bankruptcy estate, though now it appears that they intend to cap the amount that they are going to return and/or not return assets that were in Earn Accounts prior to the bankruptcy filing. A group of these holders have created an “ad hoc committee” represented by the law firm of Togut Segal & Segal LLP to represent their interests.  Unlike the Unofficial Creditors Committee, the fees of these ad hoc committees are not being paid by the Debtors. The parties will brief these issues to the Court over the coming weeks and will determine how to “treat” these accounts by December. Withhold Accounts. Withhold accounts are very similar to custody accounts where the assets did not earn interest. In many cases withhold accounts were issued to people residing in places such as New York where the Debtor was not authorized to provide custodial services. Like the custody accounts, a number of these holders have set up an ad hoc committee represented by Troutman Pepper Hamilton Sanders LLP. These holders have also agreed with the Debtor that it will decide how it is treating their accounts by December. Earn accounts. These are interest accounts whereby a holder deposited crypto assets with the Debtor and earned interest on the assets deposited. This interest stopped accruing on the bankruptcy petition date. The majority of claims against the Debtor, likely in the amount of about 4 billion USD at current crypto valuation, is in an earn account. The Debtor has not committed to deciding how it views these accounts by a particular date. Chances are these accounts are likely to be viewed as assets of the estate and subject to a 90-day clawback. Borrow Accounts: These are accounts containing collateral which was used for loans that account holders received from the Debtor. See please below regarding obligations to pay interest on these loans. On December 7 and 8, the Court will hold a hearing to discuss the “Custody” and “Withhold” accounts and ownership of the same. In other words, the Court will hold a hearing to determine whether these cryptocurrency assets are property of the bankruptcy estate or not. Appointment of an examiner. Debtors’ CEO Alex Mashinsky (“Mashinsky”) resigned from his position on September 27, 2022. Reports have since emerged that Mashinsky withdrew nearly $2.9 million in cryptocurrency and that entities related to Mashinsky withdrew more than $7.1 million from Celsius accounts in multiple transactions in May 2022. The Court Judge has agreed to appoint a chapter 11 examiner to investigate Celsius leadership’s prepetition conduct, including allegations of both civil and criminal misconduct. The Court appointed Shoba Pillay, a Chicago-based partner at the law firm Jenner & Block, as an examiner in this case. The expected role of the examiner is a bit amorphous but includes looking into the status of the claims as being assets of the estate as well as determining what third parties the Debtors should pursue claims against. Recent news that Mashinsky and other executives withdrew about 17 million dollars from the company around the time of the filing is likely to increase pressure to pursue claims against him. However, in a case involving multibillions in creditor money, it is unlikely that the recovery of less than 20 million dollars will offer meaningful restitution to the creditors. The Examiner has agreed to provide interim findings in a few weeks’ time in order to assist the Debtors in determining the status of the custody and withhold accounts with a final report expected in the not too distant future. The Official Committee of Unsecured Creditors, which commenced an investigation into Machinsky’s conduct and demanded his removal as CEO, filed a statement following Machinsky’s resignation that it remains optimistic that a Chapter 11 plan is possible and that an open and transparent process will maximize value. The Committee stated that it intends to pursue any actionable claims against Mr. Mashinsky, other insiders, and any related parties for the benefit of all account holders and unsecured creditors. Asset Sales. On September 15, the Debtors filed a motion asking the Court for permission to sell its “stablecoin” stock for U.S. dollars. According to the filing, Debtors own eleven different forms of stablecoin, totaling approximately $23 million. Because the stablecoins are pegged to fiat currency, the Debtors argue that the stablecoins offer a stable cryptocurrency option that is not subject to market fluctuations and plans to monetize those assets as needed in order to generate liquidity and fund operations during the bankruptcy case. On September 27, the Debtors noticed a sale of certain “de minimis” assets, which included the sale of 169,467 shares of common stock in Orgenesis Inc., a company that researches and develops cell and gene therapies, which is owned by Debtor Celsius Network Ltd. On September 29, the Debtors filed a motion seeking approval of bidding procedures for a sale of its retain platform. The Debtors’ proposed sale would include the Debtors’ account holders, loan portfolio, and related technology, custody and swap services, and staking and mining operations. A hearing on the motion is set for October 20, 2022. Rejection of Motion to Redact Names of Claim Holders. Debtors had filed a motion for authorization to redact individual names from any documents and to implement an anonymized process by which to identify individuals in connection with account balances on any documents filed publicly on the docket. The Court ruled that while the names of creditors could not be hidden from public view, the email and home addresses of individual creditors could be redacted. The Court’s decision to shield the email and home addresses was made to reduce individual creditors’ risk of identity theft, among other reasons. Request for an Equity Committee. Certain equity holders requested that they be granted an official equity committee to look after their rights to determine whether the equity will have any value and whether they will have any claim to it. Unless all creditors are paid-in-full with interest, there is no value to the equity. The court registered this request. Loan Collection Efforts. On September 30, the Debtors filed a statement regarding Debtors’ loan collection efforts toward account holders with outstanding loans. The statement shared that while a borrower’s obligation to repay maturing loans on the Debtors’ platform remains in force during the bankruptcy case, the Debtors will not seek to enforce payment obligations on account of outstanding loans during the chapter 11 cases and borrowers do not need to repay such loans during these chapter 11 cases. Further, no interest or penalties will be assessed post-maturity. Further, while a borrower can make payments on its outstanding loan, the Debtors will not release any collateral to borrowers or set off any claims until the Court orders otherwise. Next omnibus hearing is set for October 20, 2022.

Polsinelli is pleased to announce that in conjunction with the publication of the Multilaw FinTech Guide, Stephen A. Rutenberg, Co-Chair of Polsinelli's FinTech and Blockchain practice, will be speaking at an upcoming Multilaw Webinar on November 10th. Cryptocurrency & Blockchain: When do the benefits outweigh the risks? Featuring Polsinelli’s Shareholder Stephen Rutenberg The panel discussion gathers experts from across the network to discuss the development of cryptocurrency and blockchain usage in their jurisdictions, how the technology adoption is being received by regulators, its impact on wider initiatives (e.g. ESG), the current status in the tokenization of assets (e.g., financial streams, real estate, music rights, etc.) in the respective countries and what trends are likely to be important in the future. This webinar is open and relevant to all those who are interested in this growing area and will take place on Thursday 10 November at 3.00pm - 4.00pm (GMT) / 10.00am - 11.00am (EST). To register, or to learn more, click here. Panelists: Jill Wong, Howse Williams, Hong Kong Andreas Walter, Schalast, Germany Stephen Rutenberg, Polsinelli, USA Oded Ofek, M.Firon & Co., Israel Moderator: Jacob Kirkham, Growth Manager, Multilaw Multilaw is a global network of law firms bound together by enduring relationships. Across industries and practices, Multilaw shares client advice and active referrals, combining the highest legal standards and local expertise. Multilaw recently released its Global FinTech Guide. Put together by industry experts from member firms across the network, it presents a multi-jurisdictional analysis of the relevant legal framework and economic conditions under which FinTech services can be provided. A great resource for individuals and organizations involved in the FinTech sector from founders, companies, investors and advisors to other stakeholders across the industry. "We're proud to have partnered with Multilaw to draft the U.S. portion of the FinTech Guide and to collaborate with other highly-valued members of our global network," said Daniel L. McAvoy, Co-Chair of Polsinelli's FinTech and Blockchain practice. Multilaw also hosts a program of in-person and virtual events, both member-only meetings and webinars open to clients, covering some of the latest topics and sharing knowledge from across our global network.

Listen to Counsel Robert Lamb discuss the current and new laws for cryptocurrencies and how to decipher them.

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.

As Celsius Network LLC, et al. Case Number: 22-10964 (MG) proceeds in the bankruptcy court for the Southern District of New York (the “Court”) here are some highlights as of September 7: The Court has approved procedures proposed by the Debtor to govern the sale of “de minimis” assets, which are defined as assets with a fair market value of less than $4,000,000. This approval will not allow the company to sell any cryptocurrency, cryptocurrency tokens, or other digital assets. The Debtors would not need further permission from the bankruptcy court to sell these “de minimis” assets. Allowing the Debtor to run its business and sell “de minimis” assets is standard practice in a Chapter 11 bankruptcy. The Court has approved bidding procedures for the potential sale of certain of Debtors’ assets, including the Debtors’ GK8 Ltd. assets. The final bid deadline is September 21, 2022, an auction (if necessary) will be held on September 23, 2022 (remotely, at 10:00 a.m.), and a sale hearing is scheduled for October 6, 2022. The Court has appointed an Official Committee of Unsecured Creditors, represented by the law firm of White and Case LLP. This UCC is the official representative of the interests of the unsecured creditors with the fees and expenses of the UCC paid for by the Debtor. The UCC  pledged to be active in the Chapter 11 cases, including: ensuring the Debtors are effectively safeguarding their account holders’ assets; overseeing the Debtors’ efforts to develop a viable business plan that reduces overhead and preserves the Debtors’ limited cash reserves; investigating the prepetition conduct of Alex Mashinsky and other Celsius insiders, including the problematic asset deployment decisions, prepetition transfers, and other issues; exploring strategic options to reorganize or sell the business (or portions thereof) to maximize value for account holders and unsecured creditors; balancing the need of transparency with protecting the confidentiality of information received from the Debtors and non-Debtor parties so that it has the information to efficiently protect its constituents’ rights. The Court has approved Debtors’ request to continue mining cryptocurrency during the pendency of the Chapter 11 Case. The Debtors have stated that they will use any profits made via mining to support its restructuring efforts.  It appears that the Debtor has spent hundreds of millions on its mining operations which with energy prices is likely not consistently profitable. However, shutting down the mining business would preclude any ability to recoup this investment for the benefit of the creditors. Debtors have received an extension of time to file their schedules and statement of financial affairs. Multiple extensions have been granted to-date and such is common practice in Chapter 11 Cases. Debtors have requested permission to release nearly $56 million in cryptocurrency to its customers. This requested the release of cryptocurrency which are held in “Custody” and “Withhold” accounts. The Debtors state that it has determined these specific assets are free and clear of any claims by Celsius in its Chapter 11 case and do not constitute property of the bankruptcy estate. The Debtors contend that assets in the Earn Program and the Borrow Program are likely property of their estates, and that customers that transferred those assets to Custody or Withhold within a certain time period may be subject to preference claims. Debtors have filed a motion for authorization to redact individual names from any documents filed publicly on the docket and implement an anonymized process by which to identify individuals in connection with account balances on any documents filed publicly on the docket. The Motion is still pending, and the Ad Hoc Group of Withhold Account Holders have filed a statement in support of the Debtors’ motion. Relatedly, in a recent hearing, Judge Glenn stated that he is not going to allow anonymous proofs of claim to be filed in the Case. Under the Chapter 11 process the Court is given the power to adjudicate any litigation that relates to the Debtor this  includes  the following three cases filed to-date: Ad Hoc Group of Custodial Account Holders v. Celsius Network LLC et al: Ad hoc group is seeking a declaratory judgment that the Custody Assets (cryptocurrency transferred into the Celsius Custody Service) are not property of the estate under section 541 of the Bankruptcy Code. Celsius Network Limited et al v. Prime Trust, LLC: Celsius is seeking the turnover and transfer of crypto assets that are in the possession of Prime Trust worth approximately $17 million. Celsius Network Limited et al v. Stone et al: Celsius seeks to require defendants Jason Stone and KeyFi, Inc. to turn over certain assets and coins to the Debtors, among other causes of action. Next omnibus hearing is set for October 6 at 10:00 a.m. where many of these issues will be further discussed.

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 March 8, 2022, President Biden signed Executive Order 14067, “Ensuring Responsible Development of Digital Assets.” The order set national policy for digital assets emphasizing six priorities. Those priorities were consumer and investor protection, financial stability, illicit finance, U.S. leadership in the global financial system and economic competitiveness, financial inclusion, and responsible innovation. The signing received wide media coverage. Later that month, the President submitted his FY 2023 budget to Congress which also received wide coverage. What did not get much notice was his proposed $10.9 billion (over 10 years) of new taxes on digital assets. What follows are excerpts from the Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals” concerning digital assets, followed by a discussion concerning the outlook for the proposals. Modernize Rules Treating Loans of Securities as Tax-Free to Include Other Asset Classes and Address Income Inclusion The Administration proposes to amend the securities loan nonrecognition rules to provide that they apply to loans of actively traded digital assets recorded on cryptographically secured distributed ledgers, provided that the loan has terms similar to those currently required for loans of securities. The proposal would require that income that would be taken into account by the lender if the lender had continued to hold the loaned asset must be taken into account by the lender in a manner that clearly reflects income. The proposal would be effective for taxable years beginning after December 31, 2022. Financial Institutions and Digital Asset Brokers Reporting The Foreign Account Tax Compliance Act (FATCA) provisions of the Internal Revenue Code generally require foreign financial institutions to report to the IRS comprehensive information about U.S. accounts. Such institutions that fail to comply may be subject to U.S. withholding tax on certain U.S. payments. The Administration is proposing to require that certain financial institutions report the account balance (including, in the case of a cash value insurance contract or annuity contract, the cash value or surrender value) for all financial accounts maintained at a U.S. office and held by foreign persons. When reporting with respect to digital assets held by passive entities, the proposal would require brokers, such as U.S. digital exchanges, to report information relating to the substantial foreign owners of the passive entities. The proposed change would leave it to the discretion of the Secretary of the Treasury with respect to sales of digital assets with respect to customers, and in the case of certain passive entities, their substantial foreign owners. The Secretary would have further authority to promulgate regulations or other guidance as deemed necessary to carry out the purposes of the proposal. The proposal would be effective after December 31, 2023. Reporting of Foreign Digital Asset Accounts Section 6038D of the Internal Revenue Code requires any individual that holds an interest in one or more specified financial assets with an aggregate value of at least $50,000 during a taxable year to attach a statement with required information to the individual’s tax return by the due date. A specified foreign financial asset means (a) a financial account maintained by a foreign financial institution as those terms are defined by section 1471 of the Code, and (b) certain specified foreign assets not held in a financial account maintained by such a financial institution. The proposal would amend section 6038D(b) of the Code to require reporting with respect to a new third category of asset. The new third category would be any account that holds digital assets maintained by a foreign digital asset exchange or other foreign digital asset service provider. Reporting would be required only for taxpayers that hold an aggregate value of all three categories of assets in excess of $50,000 (or such higher dollar amount as the Secretary may prescribe). The proposal would be effective for returns required to be filed after December 31, 2022. Amend the Mark-to-Market Rules for Dealers and Traders to Include Digital Assets Section 475 of the Code requires dealers in securities to use the mark-to-market method of accounting for inventory and non-inventory securities held at year end. For this purpose, a security includes corporate stock, interests in widely held or publicly traded partnerships and trusts, debt instruments, and certain derivative financial instruments. Dealers in commodities and traders in securities or commodities may elect to use the mark-to-market method. A commodity means any commodity which is actively traded, any notional principal contract with respect to any such commodity, and certain other derivative financial instruments and hedges with respect to such commodities. The proposal would add a third category of assets that may be marked-to-market at the election of a dealer or trader in those assets. Assets in the third category would be actively traded digital assets and derivatives on, or hedges of, those digital assets, under rules similar to those that apply to actively traded commodities. The Secretary of the Department of Treasury and her delegates would have authority to determine which digital assets are treated as actively traded. The determination of whether a digital asset is actively traded would take into account relevant facts and circumstances, which may include whether the asset is regularly bought and sold for U.S. dollars or other fiat currencies, the volume of trading of the asset on exchanges that have reliable valuations, and the availability of reliable price quotations. A digital asset would not be treated as a security or commodity for purposes of the mark-to-market treatment only under the rules applicable to the new third category of assets. This would not affect treatment of a digital asset as a security or commodity for securities law or commodity law purposes. The proposal would be effective for taxable years beginning after December 31, 2022. Outlook There has been a great deal of discussion in Congress about how to regulate cryptocurrency/digital assets. The media has pushed stories about how some individuals have lost their investments. But little on the revenue proposals. The crypto wash trading proposal that was in an earlier failed infrastructure bill and supposedly would have raised $16 billion over ten years was conspicuously absent from these proposals. Congressional outlook for new revenue proposals is not positive. In a 50-50 Senate, Democrats need everyone of their members to support key legislation. Senator Kyrsten Sinema [D-AZ] has announced opposition to any new taxes on corporations. Senator Joe Manchin [D-WV] has expressed limited support for new business taxes. Republicans are expected to oppose all new tax legislation. The one possibility for new tax legislation depends on whether all Senate Democrats can agree on a scaled-down spending bill with limited revenue. However, time is running out. Stay tuned.

Polsinelli is pleased to share the Tech Transactions & Data Privacy 2022 Report. The articles contained in this report highlight the forward-thinking advice and counsel our attorneys provide our clients throughout the year. In this report: Top 5 Privacy Issues of 2022 Discoverability of Forensic Expert Incident Reports Market Changes in Cyber Liability and Options for Your Business Ransomware Reporting Requirements: A Look Forward into Evolving Security Incident Notification Rules The FTC’s Expanding Role in Cybersecurity and Data Privacy Enforcement in 2022 Third-Party Data Incidents: Preparing and Responding as the Volume of Incidents Rise The Current Landscape of Data Sovereignty Laws and A Universal Compliance Strategy Roundup of International Privacy Laws Look in on the Status of Passed, Pending and Failed State Comprehensive Privacy Bills Ransomware Playbook for 2022 – Four-Point Plan from the Biden Administration Data as an Asset: Considerations in Technology Transactions and M&A Due Diligence #Compliance: Legal Pitfalls in Social Media Influencer Marketing Content Distribution on the Blockchain: A Case Study in the Use of Smart Contracts View the full report.

I. What We Saw in 2021 The year 2021 saw enormous growth in the use, interest and diversification of blockchain technologies. From the rise of non-fungible tokens (NFTs) as a digital art medium to the establishment of numerous bespoke cryptocurrencies, blockchain stood at the nexus of intellectual property, content creation and finance. The year 2022 will be another exciting year in blockchain as the gap between traditional contracting and contracting using blockchain continues to narrow.  Polsinelli’s Technology Transactions team was at the forefront of bridging that gap in 2021 through a novel fusion of Ethereum’s smart contracting capabilities with sophisticated in-bound and out-bound content licensing. This article sets forth the fundamentals of how Ethereum blockchain was used to navigate complex licensing issues arising from the creation and hypothecation of digital assets. II. How Ethereum Smart Contracts Work Foundationally, Ethereum blockchain is a platform that uses distributed ledger technology to execute and validate smart contract transactions. Each transaction is called a “block” and connects with the previous transaction as the next link in the chain of transactions (hence the term “blockchain”). Each participant in a blockchain holds a complete copy of the entire ledger and all of its transactional history (NFTs use this feature, for example, to prove digital art ownership and provenance). When a new transaction or a change occurs to the blockchain, the new transaction must be approved by the blockchain network using a consensus mechanism.  The consensus mechanism used depends on whether the blockchain is privately or publicly accessible. A blockchain is public when it is open to all participants and does not require permission from others. A private blockchain requires permission to transact from a private party authorized to transact on the network. Because of this permission structure, private blockchains may be subordinated to written agreements between parties related to the use of the blockchain. III. A Novel Approach to Content Licensing Leveraging the ability to establish top-level written agreements on a private blockchain, Polsinelli developed a novel licensing model for digital assets (Assets) on behalf of an independent gaming platform (Platform). The process starts with a traditional content license and hosting agreement (License Agreement) that transfers Assets to the Platform which are then published on the Platform’s web-based digital asset marketplace. The License Agreement further establishes key transactional issues such as intellectual property rights, the division of royalties between the Platform and content creator, the number of License Tokens (described below) available per Asset, the cost of each License Token to an end user and the overall process by which the Platform will sublicense and market the Assets to end users. Once the Asset is published on the Platform, an end user can procure access to the Asset by purchasing a License Token. The License Token serves as the gatekeeper for accessing Assets. If the end user does not have the required License Token, the Platform provides the end user with ability to purchase said License Token and once the License Token is added to the end user’s digital wallet, the end user can access the Asset (subject to any stipulations on use e.g., end user license agreements). This process is executed via Ethereum smart contract, which manages both the distribution of the Asset to the end user and the real-time payment of royalties to the content creator and the Platform. IV. A Bottom-Up Approach to Content Creation End user use and consumption of Assets is not the only benefit the Platform offers. Through the Platform, content creators can list, sell or license their Assets, which can then be leveraged by other content creators to build new digital content in a collaborative or derivative manner. As digital content creators generate new content, the Ethereum smart contracts tied to the underlying Assets comprising the new content are again leveraged to facilitate real-time royalty payments for the licensing and sale of the new digital content as whole. This process creates a decentralized model allowing for a bottom-up approach to content creation and monetization. This, in turn, creates additional incentive for independent creators to develop new and diverse content. Content creators also have the option of developing new content as a “work made for hire” directly for the Platform under a content authoring agreement. This approach can award a larger initial payment to the creator but a smaller royalty on sublicenses to end users. That gives flexibility to how content creators engage in the development and monetization of their works. V. Looking Ahead in 2022 We expect the model above will be further refined in 2022 and deployed in other unique ways for the distribution and monetization of digital content. We foresee, for example, the creation and management of decentralized autonomous organizations (DAOs) that leverage smart contracts to raise capital for the creation and sale of digital assets. In theory, a DAO could award voting share tokens (similar to the License Tokens discussed above) to investors according to their respective contributions to the DAO. Investors would then be able to vote their tokens on unique content creation proposals with smart contracts reviewing the votes and the corresponding tokens to determine if the proposal is approved. If approved, funds from the DAO would then flow in real time to content creators to fund their digital asset creation. Naturally, royalties resulting from the sale of these digital assets would be automatically distributed to investors according to their respective voting share tokens. VI. Conclusion Using Ethereum smart contracts and distributed ledger technology to execute transactions on the blockchain to establish rights in the use and distribution of content allows both content creators and content hosting services to financially benefit from sublicensing of content to end users and relicensing content to other creators. In 2022, Polsinelli will both assist digital content creators in refining and deploying this model in the distribution of their content and guide platforms through the process of leveraging private blockchains to manage the distribution of digital content to consumers and royalties to content creators. To read the full 2022 Tech Trans & Data Privacy Report, please click here.

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.

Effective December 1, 2021, the Loan Syndication and Trading Association (LSTA) has issued a revised suite of loan trading documents modified to replace LIBOR (London Interbank Offered Rate) with SOFR (Secured Overnight Financial Rate) as the metric by which “cost of carry” will be calculated for all new loan trades regardless of the interest rate or currency of the underlying loan. The LSTA publishes the trading documents, including standard terms and conditions for the form trade confirmations, participation agreements and a purchase and sale agreement for distressed trades, that are used for more than $800 billion in loan trades annually representing most secondary trades in US dollar loans.  These trading documents set out the legal obligations of each party to a trade as well as the economic provisions for settlement, with the goal of decreasing settlement times and creating fairness between buyer and seller. A defining feature of the LSTA pricing terms is the concept of delayed compensation of which “cost of carry” is a central facet.  Under the LSTA documents, if a trade remains open beyond a certain period of time after the trade date (T+7 for par and T+20 for distressed trades), the buyer is entitled to interest as of the  last day of such period (the “Commencement Date”) provided the Buyer has met certain obligations set forth in the Standard Terms and Conditions for primary allocations, par and distressed trades, respectively.  However, offsetting the benefit of such interest, the buyer is obligated to pay the seller a fee for the buyer’s use of capital, with such fee accruing daily for each business day during the “Delay Period,” beginning on the Commencement Date and concluding one day prior to the delayed settlement date. This fee is called “Cost of Carry.” Charging the buyer Cost of Carry prevents the buyer from unjustly reaping the benefits of the economics of the loan, including accruing interest, for a period where the buyer has not yet paid for the loan. Additionally, particularly in a high interest rate environment, charging the buyer Cost of Carry incentivizes the buyer to close the trade. Cost of Carry is generally added to the purchase price and netted off against the accrued interest which seller will owe to the buyer. Until now, Cost of Carry has been calculated at a rate equal to average one-month LIBOR during the pendency of the delay period [1] in the applicable currency of the transaction for underlying loans earning the LIBOR [2]. One week and two-month USD LIBOR will cease to be published by the relevant administrator after December 31, 2021 and one, three- and six-month USD LIBOR will cease to be published after June 30, 2023. For several reasons, most notably that LIBOR no longer reflects actual transactions between banks and thus may not be a reliable proxy of funding costs and may be subject to manipulation. Following the announcement by the administrator for LIBOR that all tenors of LIBOR would cease to be published in 2023, the LSTA set out to find or create a replacement rate at which to calculate Cost of Carry. As an interim step, on September 13, 2021, the LSTA revised the standard terms of the LSTA trade documents to allow for Cost of Carry to be calculated based on a number of different rates often corresponding to the interest rate of the underlying credit agreement. However, since the vast majority of all the relevant loan agreements still use LIBOR rather than an alternative rate, Cost of Carry for most trades would still be calculated using LIBOR [3], meaning that these updates to the standard terms had minimal effect. On December 1, 2021, the LSTA took the further step of issuing revised documents to be used for all trades entered into on or after December 1, 2021 and removed the reference to LIBOR within the Cost of Carry Rate definition. Cost of Carry is now calculated on the basis of daily SOFR for the period beginning two Business Days before the Commencement Date and ending two Business Days before but not including the Delayed Settlement Date divided by the total number of days in such period, plus a spread adjustment to compensate for certain structural differences between LIBOR and SOFR equal to 11.448 basis points. Note that while all LSTA documents are now reissued dated as of December 1, 2021, the LSTA only changed the Standard Terms and Conditions for the Trade Confirm for par and distressed loans, and the Primary Allocation Confirm for use in the primary market. None of the other standard LSTA documents were affected by the above modifications. SOFR is the rate recommended to replace U.S. dollar LIBOR for specified markets by the Alternative Reference Rate Committee (ARRC.), an advisory committee encompassing a range of market participants which was convened by the US. Federal Reserve to guide the market in the transition away from LIBOR. SOFR is based on the approximately $1 trillion of daily transactions in the overnight repurchase markets for US Treasuries. The massive size of the underlying market makes SOFR an actual transaction-based rate that better reflects current financing cost than LIBOR and is less prone to manipulation than LIBOR. In the current low interest rate environment, the rates for one-month USD LIBOR and average daily SOFR over a 30-day period are now about 0.10 and 0.05 respectively. Although these rates are both low by historical standards, what they reflect is meaningfully different. While SOFR is based on the actual borrowing costs for a huge volume of transactions, these transactions are all secured by U.S. Treasuries, and is therefore an economically different metric than LIBOR, which represents unsecured overnight or term borrowing among banks in the Eurodollar market.  To bridge this structural gap between LIBOR, which involves credit risk for interbank lending, and SOFR, which is based on transactions secured by U.S. Treasuries and so is essentially a “risk-free rate”, pursuant to the December , 2021  documents ,  a spread adjustment equal to 11.448 basis points has been added to the Cost of Carry calculation   11.448 basis points is the ARRC-recommended spread adjustment for the replacement of one-month LIBOR. It is important to note that for a trade entered into prior to December 1, 2021 (under the LSTA documents published on September 13, 2021 or earlier) the prior regime of LIBOR rates will continue to apply. This means that operations personnel will need to use multiple methods of calculating pricing possibly even under the same loan. [1] The period from (and including) the date two (2) Business Days before the Commencement Date and to (but excluding) the date that is two (2) Business Days before the actual settlement date. [2] Calculations of additional Cost of Carry calculations for non-LIBOR loans can be found in the Standard Terms and Conditions of the Par and Distressed Trade Confirmations published by the LSTA dated September 13, 2021. [3] A “RFR” (Risk Free Rate) is an example of a Cost of Carry that is calculated not using the underlying interest rate of the credit agreement under the September 13, 2021 documents.

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.

The Federal Trade Commission (“FTC”) recently announced an updated rule to strengthen data security safeguards for financial institutions. 16 C.F.R. § 314. As a result of increasing cyberattacks and data breaches, the FTC augmented requirements to protect customer financial information. The updated rules include limiting access and authentication protocols using encryption to secure information and laid out incident response plans and security programs based on risk assessments. Institutions will be required to explain their policies and practices, specifically administrative, physical, and technical safeguards. Financial institutions will also have to designate a single “qualified individual” to oversee the information security program.  The individual must also report to the board of directors of the institution or to a senior information security officer there. The rule also requires non-banking institutions such as mortgage brokers, vehicle dealers and small loan lenders, to develop and implement comprehensive security systems to keep customer data safe. These new safeguards reflect the FTC’s increased focus on preempting cyberattacks by requiring that businesses and institutions implement processes and procedures that safeguard user data. The final rule can be found here.

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.