If there was ever a regulatory grace period for virtual currencies and blockchain technology, it is officially over. Five federal regulators—The Financial Crimes Enforcement Network of the US Treasury Department (FinCEN), the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC), the Internal Revenue Service (IRS) and the Office of Foreign Assets Control (OFAC)—all recently issued statements or took actions in which they clarified their positions on the scope of their jurisdiction over multiple aspects of virtual currency and certain types of blockchain enterprises. State, foreign and multilateral regulators have also taken actions to reign in virtual currencies. Companies and investors that are now working with these technologies, or that are exploring how they might fit into their existing business strategies, must be ready to justify their activities on a comprehensive basis from regulatory, compliance, tax and business perspectives.
Initial Coin Offerings: FinCEN Speaks
FinCEN has now publicly declared a major role in regulating Initial Coin Offerings (ICOs). By way of background, under the Bank Secrecy Act and its implementing regulations, the term "money services business" encompasses any person doing business, whether or not on a regular basis or as an organized business concern, in one or more of the following capacities: a dealer in foreign exchange; a check casher; an issuer or seller of traveler's checks or money orders; a provider or seller of prepaid access; a money transmitter; or the US Postal Service.1 In 2013, FinCEN issued guidance stating its view that "administrators" and "exchangers" of convertible virtual currencies are considered "money transmitters" and, therefore, MSBs. All MSBs, including money transmitters, are required to register with FinCEN as such and to comply with federal laws and regulations meant to detect and deter money laundering and illicit transactions, and to combat the financing of terrorism (AML/CFT requirements).2
At that time FinCEN described an "administrator" as "a person engaged as a business in issuing (i.e., putting into circulation) a virtual currency, and who has the authority to redeem (i.e., to withdraw from circulation) such virtual currency." An "exchanger," on the other hand, was defined as "a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency."3
Now, in a letter to Senator Ron Wyden, Ranking Member of the Senate Committee on Finance, FinCEN has signaled that it also deems certain enterprises that participate in ICOs to fall within the definition of an MSB as money transmitters. Specifically, FinCEN's letter to Senator Wyden states that:
[g]enerally, ... a developer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value that substitutes for currency is a money transmitter and must comply with AML/CFT requirements that apply to this type of MSB."4
According to FinCEN guidance, a "convertible" virtual currency is one that "either has an equivalent value in real currency, or acts as a substitute for real currency."5 In that same guidance, FinCEN stated that "a person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter."6 Now, in its letter to Senator Wyden, FinCEN has indicated that if an ICO will result in the issuance of a coin or token that substitutes for, or has an equivalent value in, fiat currency, the developer may be deemed a money transmitter and, thus, an MSB. As an MSB, such ICO developers would be required to comply with the registration and AML/CFT requirements discussed above.7
Registration and compliance are substantial undertakings and cannot be disregarded. The consequences of failing to register are severe, ranging from civil monetary penalties of $5,000 per day, to up to five years in prison. Any person or company considering an ICO must carefully evaluate whether its plans would trigger FinCEN registration and compliance requirements.
Warnings from the SEC
The SEC and its leadership have issued a series of clear warnings to developers, brokers, distributors, lawyers and others about their involvement in ICOs. They include last Summer's Report of Investigation8 and SEC Chairman Jay Clayton's message earlier this year: "Market professionals, especially gatekeepers, need to act responsibly and hold themselves to high standards. To be blunt, from what I have seen recently, particularly in the initial coin offering (ICO) space, they can do better."9 More recently, Chairman Clayton testified before the Senate Banking Committee that every ICO he has seen was a securities offering and, in a letter to Senator Wyden, he confirmed that the SEC will vigorously enforce federal securities laws as they apply to ICOs.10
The federal securities laws require that offerings and sales of securities be registered with the SEC or comply with specific exemptions from registration. The SEC's pronouncements clarify in no uncertain terms that any given ICO may involve the offer and sale of securities. As Chairman Clayton's letter to Senator Wyden warns, "[m]erely calling a token a 'utility' token or structuring it to provide some utility does not prevent the token from being a security."11
The SEC has also cautioned that participating as a broker, dealer or exchange in sales or purchases of virtual currencies that are securities will generally trigger requirements to register as a broker-dealer, alternative trading system, or national securities exchange. These requirements extend to transactions where the price is expressed in other virtual currencies just as it does to transactions effected in dollars or other fiat currencies.12 A recently-issued joint statement by the SEC's Divisions of Enforcement and Trading and Markets provides that platforms offering related services, such as digital wallet services, "may trigger other registration requirements under the federal securities laws, including broker-dealer, transfer agent, or clearing agency registration, among other things."13
Penalties for failure to abide by these requirements are substantial and may include monetary penalties, court injunctions, criminal penalties and other serious consequences. In addition, any sale of a security in violation of the securities laws is voidable, which effectively grants a put to any dissatisfied investor. Violators may also face longterm consequences, including bars from employment in the financial services industry, ongoing disclosures to investors and counterparties as to past violations, and prohibitions on raising funds from investors in the future. Any companies or individuals that contemplate participating in an ICO or virtual currency trading should consider the costs of an investigation and the enduring effects of a potential violation.14
Developing CFTC Enforcement Power
The CFTC has long asserted that it has general anti-fraud and manipulation enforcement authority over cash markets in virtual currencies as "commodities" under the Commodity Exchange Act (CEA). The CFTC recently received court approval of this interpretation when the US District Court for the Eastern District of New York issued a preliminary injunction against an individual and company accused of fraud and misappropriation in connection with purchases and trading of the virtual currencies Bitcoin and Litecoin.15 Since the beginning of 2018, the CFTC has filed two other civil enforcement actions in federal court in which it has alleged violations of the CEA involving cash market transactions in virtual currencies.16
It is well-established that the CFTC has broad authority to regulate derivatives markets, and it does so on a comprehensive basis, primarily by requiring that transactions in derivatives be executed by and through highly regulated intermediaries and trading platforms. These enforcement actions make clear that, in addition to policing the derivatives markets, the CFTC will actively police the virtual currency cash markets for potential abuses.
The Taxman Cometh
On March 23, the Internal Revenue Service issued a reminder to taxpayers that "income from virtual currency transactions is reportable on their income tax returns" and that "[v]irtual currency transactions are taxable by law just like transactions in any other property."17 The IRS's Notice notes that "[t]here are currently more than 1,500 known virtual currencies" and that "[b]ecause transactions in virtual currencies can be difficult to trace and have an inherently pseudo-anonymous aspect, some taxpayers may be tempted to hide taxable income from the IRS." For those who may fall to temptation, the IRS warns:
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.
Two days later, the IRS issued a notice in which it provided answers to frequently asked questions on the tax treatment of virtual currency, such as bitcoin. The FAQs follow prior guidance from 2014, and address such matters as determining the tax basis for a virtual currency, treatment of wages paid in virtual currencies, classification of gain or loss as capital gain or loss, or ordinary income or loss.18
Office of Foreign Assets Control Acts on Digital Wallet Addresses
As detailed in our recent Advisory, on March 19, the Treasury Department's Office of Foreign Assets Control published five frequently asked questions and responses relating to digital currency and sanctions compliance.19 The FAQs make clear that compliance obligations imposed on US persons are the same regardless of whether a transaction is denominated in digital currency or fiat currency. In this vein, OFAC will add digital currency addresses that are associated with blocked persons to OFAC's List of Specially Designated Nationals (the "SDN List") to ensure that those digital wallet addresses are included in OFAC screenings.20 The FAQs instruct financial industry participants to develop and maintain risk-based compliance programs tailored to the particularized risks posed by digital currencies. OFAC's action reflects an understanding that a number of blockchain wallets may be controlled by persons and entities involved in illegal transactions, money laundering and/or terrorist finance.
State and International Regulators Weighing In
Federal regulators are now making their positions clear, but state authorities are also increasingly assertive in this area. In just a few examples, authorities in Massachusetts, Texas and New Jersey have all recently taken actions under state securities laws against various cryptocurrency-related enterprises.21 Further, state money transmitter laws continue to be a significant consideration for participants in the cryptocurrency markets. While many states continue to assess the extent to which existing money transmitter (or similar) laws apply to the various participants in cryptocurrency transactions, some states have already staked out positions. Notably, New York has for several years offered a so-called "BitLicense," a license directed specifically at cryptocurrencies. As it is a federal crime to engage in money transmission in contravention of state law, these issues cannot be understated.
On an international scale, leadership of the Bank for International Settlements, the International Monetary Fund and the European Central Bank are actively considering appropriate regulatory oversight for cryptocurrencies.22 Chinese regulators are reported to be exploring the creation of a national digital currency while also cracking down on ICOs and virtual currency exchanges.23 In South Korea, authorities are examining how to regulate cryptocurrency even as exchanges and traders confront significant threats to security.24
As we have previously noted, blockchain technology may greatly accelerate payments, increase transparency, and foster principal-to-principal transactions.25 However, any sober assessment of the current situation makes clear that law enforcement's patience has disappeared. The actions of the agencies have had, and will continue to have, significant implications for industry participants. As the regulation of ICOs and the cryptocurrency markets continues to expand, companies operating in the virtual currency ecosystem must develop policies, technologies, and controls to comply with a complex and increasingly demanding framework of federal laws.
1 See 31 C.F.R. § 1010.100(ff).
2 See our prior Advisory Busy Times and a Challenging Future for Bitcoin and Virtual Currencies (Feb, 2014).
3 FinCEN, Application of FinCEN's Regulations to Persons Administering, Exchanging or Using Virtual Currencies, FIN-2013-G001 (Mar. 18, 2013).
4 Letter to Senator Ron Wyden from Drew Maloney, Assistant Secretary of the Treasury for Legislative Affairs, at 3 (Feb. 13, 2018).
5 FinCEN, Application of FinCEN's Regulations to Persons Administering, Exchanging or Using Virtual Currencies, FIN-2013-G001 (Mar. 18, 2013).
7 Depending on where the developer does business, registration with state financial regulators may also be required. Busy Times and a Challenging Future for Bitcoin and Virtual Currencies, at 2.
9 Opening Remarks at the Securities Regulation Institute, Washington, DC (Jan 22, 2018).
10 Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission (Feb. 6, 2018); Letter to Senator Ron Wyden (Feb. 5, 2018).
11 Letter to Senator Ron Wyden (Feb. 5, 2018).
12 Registered broker-dealers and alternative trading systems must also be aware that their self-regulatory organization, the Financial Industry Regulatory Authority (FINRA), has identified ICOs and virtual currency transactions as an examination priority in its 2018 Regulatory and Examination Priorities Letter, issued in January. FINRA members engaged in cryptocurrency transactions should be prepared to explain their operations and compliance systems to examiners.
13 Statement on Potentially Unlawful Online Platforms for Trading Digital Assets (Mar. 7, 2018). In the fund management industry, the SEC staff has publicly identified significant issues that would face any sponsor of mutual funds proposing to invest in virtual assets. Staff Letter to the Investment Company Institute: Engaging on Fund Innovation and Cryptocurrency-Related Holdings (Jan. 18, 2018). Further illustrating its caution in this area, the SEC recently took the unusual step of initiating proceedings to potentially disapprove an exchange's proposal to list exchange-traded funds based on cash-settled bitcoin futures contracts. SEC Rel. No. 34-82939, SR-NYSEArca-2017-139 (Mar. 23, 2018).
14 The SEC already has initiated several enforcement actions against companies and individuals for offering virtual currencies that were unregistered securities (See, e.g., SEC v. PlexCorps, Lit. Rel. 24079; SEC v. REcoin Group Foundation, Lit. Rel. 24081) and for operating an unregistered exchange (SEC v. Jon Montroll and Bitfunder, Lit. Rel. 24078). The REcoin and Montroll matters also involve criminal actions filed by the Department of Justice. In addition, the SEC is reported to be investigating numerous other virtual currency matters. SEC Official Says 'Dozens' of Crypto Investigations Underway, Coindesk (Mar. 16, 2018); Cryptocurrency Firms Targeted in SEC Probe, The Wall Street Journal (Feb. 28, 2018).
15 CFTC v. Patrick McDonnell, and CabbageTech, Corp. (18-CV-361) (E.D.N.Y. Mar 6, 2018).
16 See CFTC Charges Randall Crater, Mark Gillespie, and My Big Coin Pay, Inc. with Fraud and Misappropriation in Ongoing Virtual Currency Scam(Jan 24, 2018); CFTC Charges Colorado Resident Dillon Michael Dean and His Company, The Entrepreneurs Headquarters Limited, with Engaging in a Bitcoin and Binary Options Fraud Scheme (Jan. 19, 2018).
17 IR-2018-71, IRS Reminds Taxpayers To Report Virtual Currency Transactions.
19 OFAC Publishes Digital Currency-Related Guidance (March 23, 2018).
20 See OFAC Resource Center, OFAC FAQs: Sanctions Compliance, Questions on Virtual Currency, FAQs 559-63.
21 Secretary of the Commonwealth of Massachusetts: Securities Division, Secretary Galvin Issues Orders in Connection with ICO Cryptocurrency Sweep (Mar 27, 2018); Matter of LeadInvest, Texas State Securities Board Emergency Cease and Desist Order (Feb. 26, 2018); New Jersey Bureau of Securities Orders Online Cryptocurrency Promoter "Bitcoiin" to Stop Offering Unregistered Securities (Mar. 9, 2018); New Jersey Bureau of Securities Orders "Bitstrade to Stop Offering Unregistered Securities (Feb. 9, 2018).
22 IMF Chief: Cryptocurrency Regulation Is 'Inevitable', CNN Money (Feb. 11, 2018); France, Germany Call For Joint G20 Action On Cryptocurrencies, Reuters (Feb. 9, 2018); BIS Chief Sees 'Strong Case' For Cryptocurrency Intervention, Bloomberg (Feb 6, 2018).
23 China To Crack Down On Digital Currencies, The Hill (Mar. 29, 2018); China Central Bank Will Launch Crackdown On Virtual Currencies, Reuters (Mar. 29, 2018).
24 South Korean Insurer Denies Hacked Cryptocurrency Exchange's Claim, The Wall Street Journal (Mar. 29, 2018); Facts And Myths Surrounding Crypto In South Korea: Death, Taxes And Bans, Forbes (Feb. 28, 2018).
25 See our prior Advisory Busy Times and a Challenging Future for Bitcoin and Virtual Currencies (Feb, 2014).
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