On Oct. 16, 2019, Bermuda Premier the Hon. E. David Burt JP, MP announced that Bermuda has committed to accept, for payment of government taxes, fees, and services, 1:1 U.S.-dollar-backed digital currencies of entities licensed by the Bermuda Monetary Authority (BMA) under the 2018 Digital Asset Business Act (DABA), becoming the first nation to do so. Known for its established skill in regulating financial services, particularly in the insurance and re-insurance markets, Bermuda has in recent years sought to exploit its market experience by creating a regulatory framework around digital assets.
On Oct. 9, 2019, the Internal Revenue Service (IRS) released revenue ruling (Rev. Rul. 2019-24) and a Frequently Asked Questions (FAQs) document, which provide additional guidance on the tax treatment and reporting obligations for transactions involving virtual currency (also known as cryptocurrency). This guidance supplements the original guidance that was issued in 2014 in the form of a notice (Notice 2014-21), which provides a baseline rule that cryptocurrency is property for federal income tax purposes.
Rev. Rul. 2019-24 addresses questions related to the tax treatment of hard forks. The revenue ruling describes a hard fork as a protocol change that results in a permanent split of a new distributive ledger from a legacy or existing distributed ledger, resulting in the creation of a new cryptocurrency on the new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. Continue Reading
On Sept. 26, 2019, the Securities and Exchange Commission (SEC) announced it had adopted a new Rule 6c-11 under the Investment Company Act of 1940 (the “Investment Company Act” or the “Act”). Rule 6c-11 will permit exchange-traded funds (ETFs) that satisfy certain conditions to operate without the expense and delay of obtaining an exemptive order. The new rule is effective 60 days after it is published in the Federal Register. The new rule was proposed in June 2018 after an earlier version of the rule first proposed in 2009 was not adopted.
In connection with the adoption of new rule, the SEC also announced that one year after the effective date of the new rule, prior ETF exemptive relief granted to provide relief related to the formation and operation of an ETF will be rescinded. However, the SEC did indicate that portions of the prior ETF exemptive orders allowing funds to invest in ETFs in excess of statutory limits are not being rescinded, and the SEC will continue to grant similar relief to newly formed ETFs upon application to the SEC. Prior exemptive relief related to unit investment trust (UIT) ETFs, leveraged and inverse ETFs, share class ETFs, and non-transparent ETFs also will not be rescinded, as such ETFs cannot rely on the new rule.
On Aug. 15, 2019, the staff of the Division of Investment Management at the U.S. Securities and Exchange Commission (the “Staff”) issued a significant no-action letter. The letter clarifies the treatment of certain assets held by an entity seeking to rely upon Section 3(c)(5)(C) to be exempt from registration as an investment company under the Investment Company Act of 1940. The letter recognizes that the way that mortgage lending companies conduct their business has changed significantly since the original adoption of the exemption, and contains the Staff’s pronouncements on how the test will be applied.
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Rocky Mountain States Make Headway in Blockchain-Related Legislation
With Wyoming having become the first state to define “utility tokens” as a new asset class (see article in Blockchain & Cryptocurrency’s Winter 2019 Issue), Montana and Colorado are following close behind with their own cryptocurrency legislation. Both states have blockchain-related bills going into effect in July and August 2019, respectively.
Four Blockchain Regulations are Now Effective in Wyoming
In 2018, four (4) pro-blockchain regulations were signed into law by the governor. Now all are effective:
- HB 19 and HB 70 amend the Wyoming Money Transmitter Act under Wyoming Stat. Sections 40-22-102 and 40-22-104, and Wyoming Stat. Sections 17-4-206, 17-4-102, 40-22-1094 and 40-22-126, respectively.
- HB 19 provides an exemption from money transmitter laws and regulations for digital currency transmission. Signed by the governor March 7, 2018.
- HB 70 provides an exemption from certain securities and money transmission laws for a person who develops, sells, or facilitates the exchange of an open blockchain token (a “consumer” or “utility” token). The Wyoming Uniform Securities Act was amended to provide for the same. Effective July 1, 2019.
- SB 111 exempts digital currencies from property taxation, providing that virtual currency is not “property” for purposes of taxation. Signed by the governor March 12, 2018.
- SF 34, codified at Wyoming Stat. Sections 2-3-1001 to 2-3-1017, regulates fiduciary management of digital assets, including digital currency. Effective July 1, 2019.
In January 2019, the state introduced and passed new legislation. Effective July 1, 2019, (1) House Bill No. HB0185 permits companies to issue digital or “certificate tokens” in lieu of stock certificates, declaring that the words share certificate, share, stock, share of stock, or other similar words also include a certificate token and certificated shares or similar words to include shares represented by certificate tokens; and (2) Senate File No. SF0125 allows for banks to provide custodial services for a range of digital assets, including virtual currencies (such as bitcoin and ether), digital consumer assets (utility tokens, including those used to purchases goods and services), and digital securities.
Montana Cryptocurrency Act Now in Effect
Montana is the third Rocky Mountain state (after Wyoming and Colorado) to pass blockchain-related legislation; House Bill No. 584 went into effect July 1, 2019, and exempts blockchain-based utility tokens from securities laws so long as the tokens have a “primarily consumptive” purpose.
Entitled “Generally Revise Laws Relating to Cryptocurrency,” the new Act defines this purpose as having a primary aim to “provide or receive goods, services, or content, including access to goods, services, or content.” The issuer of the tokens cannot market them as an investment or for speculation.
The Act provides that tokens that qualify for the exemption (i.e., the consumptive purpose of the utility token) must be available no more than 180 days after their date of sale or transfer, and initial buyers of the tokens are not permitted to transfer the tokens until their consumptive purpose is available. Prior to the tokens being offered for sale, the issuer must file a notice of intent to sell them with the state’s securities commissioner.
Additionally, while utility tokens are now exempt from the state’s securities law, the issuers of such tokens still have to notify the securities commissioner, and must file certain disclosures in the state in order to sell such tokens. Such notice must be amended within 30 days for any information previously disclosed that becomes inaccurate in any material respect for any reason.
The Act is codified as a transactional exemption under Section 30-10-105(23) of the Montana Securities Act. The Act terminates Sept. 30, 2023.
Colorado Digital Token Act to Take Effect in August 2019
The Colorado Digital Token Act (Colorado Act) is scheduled to become effective August 2019. The Colorado Act permits Colorado businesses to effect transactions involving the purchase, sale, and transfer between certain persons of digital tokens secured through a decentralized ledger or database, with a focus on the production, distribution, and consumption of goods.
Under the Colorado Revised Statutes Section 11-51-308.7, transactions meeting certain conditions will be exempt from the securities registration requirements under the Colorado Securities Act (CSA), and those persons dealing in these digital tokens will be exempt from the securities broker-dealer and salesperson licensing requirements under the CSA. This issuer exemption requires the issuer of the digital token, and a person engaged in the business of effecting the purchase, sale, or transfer of a digital token, to file a notice of intent, and the consumptive purpose must be available at the time of sale or within 180 days after the date of sale or transfer of such digital token. For more on the Colorado Act, click here.
Click here to read the full GT Spring/Summer 2019 Blockchain & Cryptocurrency Newsletter.
On July 22, 2019, the federal bank regulatory agencies and the U.S. Department of the Treasury’s Financial Crimes Enforcement Network (collectively, the “Agencies”), issued a Joint Statement on Risk-Focused Bank Secrecy Act/Anti-Money Laundering (BSA/AML) Supervision. The Joint Statement emphasizes their risk-focused approach to examinations of banks’ BSA/AML compliance programs and is the third statement from a working group tasked to improve the effectiveness and efficiency of the BSA/AML regime. The prior statements focused on encouraging banks to take innovative approaches to improving their BSA/AML compliance programs. Although the Joint Statement does not establish new requirements, it reminds banks of the Agencies’ risk-focused approach for scoping and performing BSA/AML examinations, and serves as additional guidance to banks in ensuring their BSA/AML compliance programs comply with BSA requirements and satisfy the Agencies’ expectations.
Banks seeking assistance with the review and/or enhancement of their BSA/AML compliance programs including their BSA/AML risk assessments, or with BSA/AML audit or examination remediation, may contact any of the authors in this GT Alert or their GT counsel of preference. GT’s Financial Regulatory & Compliance team can assist with any questions regarding the Joint Statement and/or any other BSA/AML compliance matter.
Click here for the full GT Alert.
The SEC’s Division of Trading and Markets and the Office of the General Counsel of FINRA (Financial Industry Regulatory Authority) published on July 8, 2019, a joint staff statement (Custody Release) on broker-dealer custody of digital assets. The statement has been eagerly awaited by market participants, including broker-dealers, given significant uncertainty in the application of securities laws to novel digital asset transactions.
In the new digital world, broker-dealers currently grapple with possession and control to safeguard customers’ digital asset securities and their own duties and responsibilities under Rule 15c3-3 of the Securities Exchange Act of 1934, also known as the Customer Protection Rule. This rule requires broker-dealers to safeguard customer assets and to keep customer assets separate from the broker’s assets, thus increasing the likelihood that customers’ securities and cash can be returned to them in the event of the broker-dealer’s failure. Digital assets present heightened risk for broker-dealers charged with maintaining custody of the assets. Unlike having possession of a tangible stock certificate stored in a vault, in the digital asset realm, a broker-dealer could be victimized by fraud or theft through the loss of a “private key” necessary for the transfer of the asset, and potentially have no recourse.
The Custody Release additionally addresses financial responsibility rules, the maintenance of books and records, noncustodial broker-dealer models, regulatory approvals needed for existing broker-dealers engaging in digital asset securities for the first time, and limited coverage under SIPA (Securities and Investor Protection Act of 1970) unless the security meets the definition of a “security” under SIPA (which is different than under the Securities Act of 1933 by, in general, limiting it to securities which are subject to a filed and approved registration statement). If the digital asset security does not meet the definition of “security” under SIPA, protection likely would not apply in the event of failure of the broker-dealer and holders of those digital asset securities would have only unsecured general creditor claims against the failed broker-dealer.
As a practical matter, the Custody Release makes clear that broker-dealers are encouraged to engage with the SEC Staff to discuss solutions for compliance issues. Unregistered broker-dealer entities that intend to engage in broker-dealer activities involving digital assets will be required to submit New Membership Applications to FINRA. Existing registered broker-dealer firms will be wise to now evaluate the need for a Continuing Membership Application (CMA). Under FINRA rules, an existing broker-dealer is prohibited from changing its business operations to incorporate material digital asset securities activities for the first time without FINRA’s prior approval of the CMA.
This GT Alert is part of the firm’s Blockchain & Cryptocurrency Newsletter – Spring/Summer 2019, available here.
In connection with the U.S. financial crisis 10 years ago, legislation was adopted to enhance the safety and soundness of the commercial banking system in the United States. Amendments to the Bank Holding Company Act of 1956 required five federal financial agencies to adopt joint regulations to (i) limit the authority of commercial banking institutions to place capital at risk in certain areas involving investment banking, and (ii) forbid banks to permit the name of the bank or certain affiliates of the bank to be used in connection with the operations of private funds. That provision, placed in Section 13 of the 1956 Act, is generally referred to as the “Volcker Rule.”
In 2018 legislation amended the requirements to permit the adopting agencies to revise their rules to exclude from the prohibitions of the Volcker Rule smaller banks previously covered by the rule that have total assets of less than $10 billion and liabilities that aggregate less than five percent of the total assets of the entity.
Click here for the full GT Alert, which provides background on the Volcker Rule and summarizes the changes made under the latest amendments.
In July 2019, the SEC qualified the first token offerings under Regulation A+, approving blockchain startup Blockstack’s bitcoin-like digital tokens on July 10, and live video streaming platform YouNow’s offering of its “Props” tokens on July 11. These decisions will likely serve as new fundraising templates for many blockchain businesses.
Blockstack describes its services as being an open-source decentralized computing platform, whose software libraries enable developers to build decentralized applications, that have no single point of failure or control. The company provides decentralized protocols for authentication, data storage, and software distribution.
According to Blockstack’s filings on EDGAR, it intends to conduct a cash offering under the Regulation A+, Tier 2, framework. Unlike traditional registered IPO filings, this framework allows the sale of Blockstack’s tokens to retail investors as well as to accredited investors and institutions. As part of the offering, an additional supply of tokens is proposed to be allocated to Blockstack’s App Mining Program, which rewards developers who create the top-ranked applications within the Blockstack ecosystem.
Following on the heels of the Blockstack qualified offering, on July 11, 2019, the SEC approved YouNow’s “Props” token offering under the Regulation A+, Tier 2 framework. According to its filings on EDGAR, YouNow has created an Ethereum-based blockchain token, which it intends to distribute to those who create content using its app for activities that “drive community engagement” or as a reward for administration of its own blockchain. The Reg A+ offering also includes a secondary distribution of tokens to be distributed by its affiliated foundation for grants to persons developing key apps or otherwise contributing to the development of the network. The company also said that users will begin to receive tokens for engaging with the platform.
Both offerings are significant in that they establish a basic framework for companies that have sought to issue tokens as rewards for specific platform users and developers. In the past, issuers have attempted to structure such tokens to fall outside the Howey test as something other than a security. The Blockstack and YouNow precedents clarify that such attempted structures are unlikely to be acceptable to the SEC in the absence of fact-specific no-action relief. This is not surprising in light of the two recent no-action letters issued by the SEC in TurnKey Jet and Pocketful of Quarters, as highlighted in this newsletter. The SEC draws a clear line between tokens developed for use strictly on a particular platform or “in-app” versus tokens that may be transferred outside the platform or publicly traded on an ATS or other exchange.
The Howey test is based on the U.S. Supreme Court’s landmark case, SEC v. W.J. Howey Co., setting the standard for what arrangement constitutes an investment contract and is therefore regulated as a security. In the context of blockchain tokens, the Howey test asks if a party has invested funds, in a common enterprise, with the expectation of profits, based on the efforts of a third party.
Click here for the full GT Blockchain & Cryptocurrency Newsletter for Spring/Summer 2019.
In a significant step forward for the cryptocurrency industry, the U.S. Securities and Exchange Commission issued its first “no-action” letter (NAL) to a U.S.-based company using utility tokens created for consumptive use rather than investment. The regulator sent the letter to TurnKey Jet, Inc. (TKJ) on April 3, 2019, agreeing with the Florida-based air charter and air taxi service’s interpretation that the tokens it uses in its token membership program for sale of air charter services via a private blockchain network are not securities. Therefore, the SEC noted, TKJ can use them under certain conditions.
These conditions include:
- the tokens will be immediately usable for their intended functionality (purchasing air charter services) at the time they are sold;
- TKJ will restrict transfers of tokens to TKJ Wallets only, and not to wallets external to the platform;
- TKJ will sell tokens at a price of one USD per token throughout the life of the program, and each token will represent a TKJ obligation to supply air charter services at a value of one USD per token;
- If TKJ offers to repurchase tokens, it will only do so at a discount to the face value of the tokens (one USD per token) that the holder seeks to resell to TKJ, unless a court within the United States orders TKJ to liquidate the tokens; and
- the token is marketed in a manner that emphasizes its functionality, and not the potential for the increase in market value of the token.
A second NAL was issued by the SEC on July 26, 2019, to Pocketful of Quarters, Inc., an online video gaming company, allowing the company to issue its “Quarters” to video gamers. The Quarters are described as a “universal gaming token” and an in-game currency having an unlimited supply and fixed price. The conditions outlined in the NAL mirrored those in TKJ while also adding an additional condition that the Quarters could only be exchanged by the game’s developers and influencers (with approved accounts) for ETH at pre-determined exchange rates. The SEC Division of Corporation Finance’s response further provided those developers and influencers with the ability to exchange their Quarters. Developers and influencers must undergo Know Your Customer/Anti-Money Laundering checks on an ongoing basis.
Both NALs indicate that the SEC is willing to allow a token offering to proceed without registration under the Securities Act of 1933, or reliance upon an exemption therefrom, in the narrow circumstances where, among other things, the tokens are limited to use on a particular platform/network/application and have no external transfer capability or trading market.
Click here for the full GT Blockchain & Cryptocurrency Newsletter for Spring/Summer 2019.