This article is written to provide an overview of the blockchain, blockchain investment and US regulations. Technologies always advance faster than the development of laws. However, the laws always regulate technologies eventually. I hope this article is fun to read for both legal professionals and tech gurus.
A blockchain, is a growing list of records, called blocks, which are linked using cryptography. Each block contains a cryptographic hash of the previous block, a timestamp, and transaction data. Blockchain is an open distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.
Currently, there are three types of blockchain network.
Public Blockchain – A public blockchain has no access restrictions. Anyone with an internet connection can send transactions to it as well as become a validator. Most known public blockchains are Bitcoin and Ethereum.
Private Blockchain – A private blockchain is based on permission. Once cannot join it unless invited by the network administrator. These networks are proprietary networks that specific individuals or entities use to conduct transactions, such as a group of banks processing financial transactions.
Consortium Blockchain – A consortium blockchain is often said to be semi-decentralized. A number of companies, instead of a single organization, might each operate a node on such a network.
Pros and Cons about Blockchain
Transactions using blockchain technologies may experience pros and cons, including:
- Real-time records. Transactions through blockchain technologies are updated in real time as transactions occur. Participants of transactions have the benefits of up-to-date records of transactions.
- Transactions through blockchain technologies are processed through automated process without a centralized record keeper. Therefore the efficiency has been substantially increased and the transactions cost has been substantially reduced as well.
- True records. Transactions through blockchain technologies create permanent and unalterable records.
- It is easier for transactions users to hide their true identities with blockchain technologies. It will be more difficult for market players to be in compliance of anti-money laundering regulations.
- Security risk. Blockchain networks are targets of hackers. Despite that no blockchain has been successfully hacked or manipulated, the market players may be subject to security risk.
- Tax complication. Blockchain involving virtual currency also brings unanticipated tax complication on how authorities treat virtual currency.
US Regulations and Enforcement on Blockchain and Initial Coin Offering (“ICO”)
In the United States, a variety of state and federal agencies have shown interest in regulating blockchain activities, especially virtual currencies. Most likely, violations in blockchain activities may trigger investigations from multi state and federal agencies.
The following agencies are most likely to investigate blockchain activities: the Securities and Exchange Commission (“SEC”), Commodities and Futures Trading Commission (“CFTC”) and The Financial Institution Regulatory Authority (“FINRA”), the Financial Crimes Enforcement Network (“FinCEN”) and the Office of Foreign Assets Control (“OFAC”).
In July 2017, the SEC released an Investor Bulletin iterating its position:
- The SEC will interpret certain ICOs as an offer and sales of securities, requiring the ICO issuer to either: (a) register the tokens with the SEC; or (b) identify an applicable exemption from the registration requirements;
- If tokens or coins are considered securities, only registered investment professionals and their firms may sell them.
- If a token sales is described as a crowdfunding contract, it must adhere to regulation Crowdfunding.
The SEC also recently announced two enforcement proceedings on blockchain activities in December 2017.
- The company issued a fraudulent securities offering by claiming the investment to the company would yield a 1,354% profit in one month. The SEC filed its first action to halt the fast-moving ICO which raised nearly $15 million in just a few month in late 2017.
- Munchee, Inc. Munchee, Inc. sold what it represented as a utility token. The token did not bear obvious marks of a security because the token did not carry any equity share, profit share, or dividend. However, the company conducted a token sale before its platform was operational, yet marketed the tokens as almost assured to provide token purchasers an outsized return on secondary exchange. The SEC determined that even if a token had no obvious marks of securities, the lack of functional platform, combined with the manner in which the token sold and return promised to token purchasers, could render the utility token as a security.
On November 16, 2018, the SEC issued a statement on digital asset securities issuance and outlined the following activities to be regulated by enforcement actions:
- Initial offers and sales of digital assets securities, including those issued in ICOs on a blockchain. The SEC took enforcement actions against AirFox and Paragon and the two companies agreed to pay penalties and to register to tokens sold as securities under Section 12(g) of the Exchange Act. The statement provide a roadmap for compliance for other token issuers, even where issuers have already conducted an illegal unregistered offering of digital asset securities.
- Investment vehicles investing in digital asset securities and those who advise others about investing in these securities. The SEC issued an order on September 11, 2018 against the manager of a hedge fund formed for the purpose of investing digital assets, who had failed to register the fund as an investment company. The SEC reminded the investment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities to be incompliance with their registration, regulatory, and fiduciary obligations under the Investment Company Act and the Investment Advisers Act.
- Secondary market trading of digital asset securities. On November 8, 2018, the SEC issued an cease-and-desist order in its first-ever enforcement action against a trading platform. The platform, EtherDelat, is an online platform for secondary market trading of ERC20 tokens, a type of blockchain-based token commonly issue din ICOs. The order found the platform was operated as an unregistered national securities exchange. On September 11, 2018, the SEC issued an order against TokenLot, a self-described “ICO superstore” where investors could purchase digital assets, including digital asset securities, during or after an ICO, including in private sales and pre-sales. As mentioned in the statement, an entities that facilitates the issuance of digital assets securities in ICOs and secondary trading in digital asset securities may also be acting as a “broker” or “dealer” that is required to register with the SEC and typically become a member of the FINRA.
The CFTC has stated that it considers virtual currency to be a commodity subject to the same regulation and oversight authority as other commodities.
On June 2, 2016, the CFTC ordered Bitcoin Exchange Bitfinex to pay $75, 000 for offering illegal off-exchange financed retail commodity transactions and failing to register as a futures commission merchant. Bitfinex is a Hong Kong based bitcoin exchange. It operates an online platform for exchanging and trading cryptocurrencies, mainly bitcoins. The order found that from April 2013 to at least February 2016, Bitfinex permitted users to borrow funds from other users on the platform in order to trade bitcoins on a leveraged, margined, or financed basis. The order also found that Bitfinex did not actually deliver those bitcoins to the traders who purchased them. Instead, Bitfinex held the bitcoin in deposit wallets that it owned and controlled.
On July 6 2017, the CFTC granted LedgerX LLC permission to register as a swap execution facility (SEF) and as a derivatives clearing organization (DCO) for bitcoin-based swaps. LedgerX is a limited liability company registered in Delaware with its primary place of business in New York, NY. SEFs are platforms that operate under the CFTC’s regulatory oversight for the trading of swaps. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Act) authorized the creation of SEFs. The CFTC issued the Order under Section 5h of the Commodity Exchange Act (CEA) and CFTC Regulation 37.3(b). After review of the LedgerX application and associated exhibits, the CFTC has determined that LedgerX demonstrated compliance with the CEA and the CFTC’s regulations applicable to SEFs. LedgerX also must comply with all representations and submissions made by it in support of its application for registration as a SEF, including, but not limited to, its representations that it will not list an intended to be cleared swap until it has a clearing agreement with a derivatives clearing organization registered under Section 5b of the CEA and it will not list a swap that is not intended to be cleared until it submits to the CFTC revisions of its rulebook and other pertinent registration materials, pursuant to the provisions of Part 40 of the CFTC’s regulations, to provide for the execution of uncleared swaps.
The Chicago Board Options Exchange (“CBOE”) and the Chicago Mercantile Exchange (“CME”) began trading bitcoin futures on December 10, 2017. The CFTC has signaled its intent to set policy for virtual currency and blockchain activities and to develop a corresponding regulatory framework. The efforts include approval and oversight of virtual currency futures contracts, as well as oversight of virtual currency transactions conducted on margin through virtual currency exchanges.
FINRA is a non-profit and non-governmental securities industry regulator. FINRA oversees broker-dealers through a combination of rulemaking and disciplinary actions.
FINRA oversees more than 4,500 brokerage firms, approximately 160,000 branch offices and more than half a million registered securities representatives, as of 2016. FINRA regulates the trading of equities, corporate bonds, securities futures and options. Unless a firm is regulated by a different self-regulatory organization it is required to be a FINRA member firm. FINRA operates from headquarters in Washington, D.C., and New York, and also from 20 regional offices around the country. In addition to overseeing all securities firms, FINRA oversees all firms that offer professional training, testing and licensing of registered brokers. It also is in charge of monitoring arbitration and market regulation by contract for the New York Stock Exchange (NYSE), the NASDAQ stock market, the American Stock Exchange LLC and the International Securities Exchange LLC. FINRA provides regulatory oversight to industry utilities, such as trade reporting facilities and over-the-counter (OTC) operations.
In a regulatory notice issued on July 6, 2018, FINRA requested its member firms to submit a wide range of details relating to their cryptocurrency-focused activities.
On September 11, 2018, FINRA charged Timothy Tilton Ayre, a Massachusetts resident, of fraud and unlawful distribution of unregistered cryptocurrency securities. This is the first disciplinary action from FINRA involving cryptocurrencies. In the complaint, FINRA alleges that Ayre from January 2013 to October 2016 attempted to lure public investment in his worthless public company, Rocky Mountain Ayre, Inc. by issuing and selling HempCoin, which he publicized as “the first minable coin backed by marketable securities” and making fraudulent positive statements about the company’s business and finance. FINRA alleges that Ayre bought the rights to HempCoin and repackaged it as a security backed by the company’s common stock. Ayre marked HempCoin as “the world’s first currency to represent equity ownership” in a publicly traded company and promised investors that each coin was equivalent to 0.10 shares of the company’s common stock.
FinCEN is a bureau of the U.S. Department of Treasury that collects and analyzes information about financial transactions in order to combat domestic and international money laundering, terror financing, and other financial crimes. The Bank Secrecy Act (BSA) is administered by FinCEN to govern US financial institutions. An individual or organization that facilitates transactions in virtual currency or tokens may constitute a money services business (MSB) if conducted in whole or part within the U.S. FinCEN intends to enforce Anti Money Laundering requirements against MSBs and money transmitters and to apply scrutiny to virtual currency exchanges and the systems that provide services to those exchanges.
Under current regulations, an organization qualifies as an MSB if it transmits money or representatives of money, or exchanges money into foreign currency. If an organization meets this definition, it may be required to both:
- Register with FinCEN;
- Report suspicious activities by its customers, counter-parties, and personnel.
In July 2017, FinCEN assessed a civil monetary penalty of over $110 million against Canton Business Corporation, which administered a virtual currency exchange called BTC-e, and a $12 million penalty against Alexander Vinnik, a Russian national who allegedly controlled, directed, and supervised BTC-e’s operations, finances, and accounts. This is the first supervisory action against a foreign entity operating as an MSB in the US. FinCEN asserted jurisdiction on the grounds that BTC-e processed substantial transactions (totaling over $296 million) involving US customers. The FinCEN found a variety of compliance breaches, including BTC-e’s failure to (a) register as an MSB; (b) Maintain an effective AML program; (c) File suspicious activity report; and (d) keep transaction records.
OFAC is a financial intelligence and enforcement agency of the U.S. Department of Treasury. It administers and enforces economic and trade sanctions.
OFAC enforces economic and trade sanctions principally through:
- Comprehensive embargoes against Cuba, Iran, North Korea, Syria, and the Crimea region of Ukraine, and their governments or instrumentalities.
- Its Specially Designated Nationals (SDNs) list, which identifies individuals and entities with whom US citizens and residents are prohibited from doing business.
- Its Sectoral Sanctions Identification (SSI) list, which restricts certain types of new debt and credit activities, principally with persons in Russia and Venezuela.
On November 28, 2018, OFAC sanctioned two Iranian individuals for cyberattacks against US networks. For the first time, OFAC targeted both individuals who committed the offense and their associated bitcoin addresses. OFAC alleges that the two Iranian individuals helped exchange digital currency (bitcoin) ransom payments into Iranian rial on behalf of Iranian malicious cyber actors involved in SamSam ransomware scheme that targeted over 200 known victims. OFAC identified two digital currency addresses associated with these two financial facilitators. Over 7,000 transactions in bitcoin, worth millions of U.S. dollars, have processed through these two addresses – some of which involved SamSam ransomware derived bitcoin.
Least but not Last, Tax Treatment of Virtual Currencies
In April 2014, the IRS issued a notice indicating that it will treat virtual currency as property rather than currency for tax purpose, which means that a transaction may create the need to recognize a gain or loss on the exchanged cryptocurrency.
In November 2017, the IRS pursued enforcement actions against Coinbase virtual currency exchange. The Coinbase summons sought all customer records for a period from 201 to 2015. This included all records of account activity, including transaction logs and other records. The summons also asked for any correspondence between Coinbase and its users.
On March 23, 2018, the IRS issued a notice urging taxpayer that income from virtual currency transactions is reportable on their income tax returns. In the notice, the IRS indicates Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest.
In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return. Anyone convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000.
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