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Running on Empty or Running With the Devil?

SEC Commissioner Hester Peirce, known by some as Crypto Mom, has revealed herself as a fellow fan of musically referent prose and has elected to dive into the details of what  a security is in the Twenty-first Century.  As the old adage goes:, “The Devil is in the details.”    

On February 6, 2020, Commissioner Peirce, gave a speech titled “Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization” in which she discussed the devilish problem:

Many crypto entrepreneurs are seeking to build decentralized networks in which a token serves as a means of exchange on, or provides access to a function of the network.  In the course of building out the network, they need to get the tokens into the hands of other people.  But these efforts can be stymied by concerns that such efforts may fall within the ambit of federal securities laws.  The fear of running afoul of the securities laws is real.

Commissioner Peirce also noted the problems with the SEC’s application of the Howey test for investment contracts and recognized:

[S]ome commentators have pointed out that we have elided the distinction between the token and the investment contract.  The “contract, transaction or scheme” by which the token is sold may constitute an investment contract; but, the object of the investment contract—the token—may not bear the hallmarks of a security.  Conflating the two concepts has limited secondary trading and has had disastrous consequences for the ability of token networks to become functional.  Also of concern, suggesting that tokens will increase in value, combined with securing secondary market trading, can trigger a conclusion that those tokens are being sold pursuant to an investment contract. 

Peirce believes the analysis of whether a digital asset is a security:

[S]hould focus on the objective nature of the thing offered to the purchasers.  If the token seller is simply discussing the potential for an increase in the value of a token in the same manner that a seller of any number of other consumer products might appeal to purchasers’ desire to buy a product of lasting or even increasing value, it there an investment contract?  The subjective intent of any particular purchaser should not be controlling.  

In a refreshing acknowledgement of the expansive application of the Howey test, Commissioner Peirce noted:

There are circumstances in which the security label fits, but, in other cases, promises made about tokens increasing in value are nothing more than expressions of the hope that a network will succeed and be used by lots of people. If it were, then is there any end to the Commission’s authority?

Commissioner Peirce proposed a rule that would provide a three-year safe harbor for cryptocurrency projects, subject to certain conditions. The safe harbor would allow companies to sell digital tokens and develop their product without violating the securities laws.[1] During the three-year period, the anti-fraud provisions of the securities laws would be the only regulator of token sales issuers would have to deal with.  The proposed safe harbor would preserve the application of the antifraud provisions of the securities laws in an effort to balance investor protection with the ability to raise capital for technological innovation.

Before anyone decides to issue cryptocurrency based on this proposed safe harbor, it is important to realize that this proposal is far from becoming law, and isn’t a formal proposal from the SEC itself. There are questions as to whether it would be feasible from both a regulatory and an issuer perspective. While we do not believe the safe harbor will be approved by the SEC, we applaud Commissioner Peirce for her willingness to  dive into the devilish details of crafting a practical definition of what constitutes a security in the 21st  century.

Death and Taxes – Is an IRS De Minimis Exemption on the Horizon?

One of the most complicated parts of investing and transacting in crypto currency is the tax treatment. The grant of new digital assets after a fork as a taxable event is one of the biggest issues. Additionally, taxing crypto assets as a commodity makes it difficult to use them for a payment system. Although the Internal Revenue Service (“IRS”) has issued some guidance, much more is need. The Wall Street Blockchain Alliance (“WSBA”) submitted a comment letter to the IRS requesting clarification and proposing relief that they believe will help this market develop.[2] The suggestion that has received the most attention is a de minimis exemption from taxation for small transactions. The WSBA also proposes that stablecoins be treated as tax-free like-kind exchanges, something that is not currently permitted for traditional cryptocurrencies. 

England and Wales Rule that Cryptocurrencies are Property

On January 17, the High Court of Justice of England and Wales provided an in-depth analysis as to why they consider cryptocurrencies to be property under English commercial laws.  In the case, a company was struck by a ransomware attack with the required payment to be made in Bitcoin.  A determination that Bitcoin is property was needed for interim relief to be granted. The court did so, this time in the context of the legal statement on Crypto assets and Smart contracts issued by the UK Jurisdictional Task Force, laying the groundwork for future decisions regarding other digital assets. 

It is important to note that, because the Bitcoin was transferred through a reputable and well-known exchange with tracking capabilities, a significant amount of the assets were able to be recovered and some of the defendants were able to be identified. This highlights the importance of making payments of this sort through traceable means so that stolen digital assets potentially are not lost forever.  This also serves as a reminder of the importance of having strong cybersecurity systems and vigilant training and oversight.  

You’ve Got a Friend in Me – Telegram Amicus Briefs  

The battle between Telegram wanting to sell its gram tokens to the public and the SEC trying to stop them continues to rage. In the latest update, the federal judge handling the case invited the U.S. Commodity Futures Trading Commission (“CFTC”) to give its opinion on the matter.[3] The CFTC, as the regulator with jurisdiction over Bitcoin, at least publicly has provided a unified front with the SEC who have said that “grams” are not commodities.[4] It is unclear what exactly the opinion will address, and it is unlikely that the CFTC will openly break with the SEC on this matter. 

This order follows Telegram being required to submit its bank records to the court by February 26 and the filing of two amicus curiae brief, both in support of Telegram in the case though one much more strongly so.

On January 21, the Chamber of Digital Commerce (“Chamber”) filed an amicus curiae brief in the case.  In the brief the Chamber does not take a position on whether securities laws apply to the $1.7 billion Gram token sales that are a subject of the case, but instead states that it is most interested in ensuring that there is transparency and clarity with respect to the application of regulations to cryptocurrencies. 

The primary determination that the Chamber seeks to distinguish in its brief is between the subjects of an investment contract (the digital asset) and the securities transaction associated with it. In its brief the Chamber stresses that uncertainty as to how the federal securities laws apply to digital assets is stifling economic development in the United States.

Also on January 21, The Blockchain Association (“Association”) filed its own brief, where it argues that Telegram did not violate the securities laws. The Association also argues that before Telegram launched its ICO, the SEC provided no clear rules regarding whether and when digital assets are securities. 

The Fights Continue - Blockchain Litigation Year in Review

The first part of this series has just been released, and highlights fifteen court cases illustrating the evolution of FinTech litigation.In short, blockchain litigation showed us that there are more ways than we can count to get in trouble offering, selling or promoting tokens or coins that are unregistered and non-exempt.

Part two of the series will document the guidance we received in 2019 from enforcement actions at the SEC, orders by the Commodity Futures Trading Commission, IRS revenue rulings, and advisory opinions by the Federal Election Commission.

CryptoCharacters - Episode 18 – Alex Chung - Founder of Giphy

On Episode 18 of Nagi’s CryptoCharacters Podcast. Listen to the episode to hear Chung’s take on gifs as stories, culture, vocabulary, replacements for the written word, and why he believes writing is a low-bit solution for communication. Make sure to take note of the Giphy founder’s thoughts on the future of innovation and development in technology and the most likely way cryptocurrency will be adopted.

[1] Running on Empty: A Proposal to Fill the Gap Between Regulation and Decentralization

[2] Comments and Responses from the Wall Street Blockchain Alliance, Accounting Working Group - Re: IRS FAQs and Revenue Ruling Issued Q4 2019

[3] Order tot invite CFTC

[4] SEC’s reply memorandum of Law in Support of Motion for Summary Judgement 27.01

© Polsinelli PC, Polsinelli LLP in CaliforniaNational Law Review, Volume X, Number 45

About this Author

Stephen A. Rutenberg Shareholder Polsinelli New York Bankruptcy and Financial Restructuring Bankruptcy Litigation Capital Markets ,Commercial Lending ,Debt and Claims Trading, Financial Services, Insolvency, Financial Technology FinTech and Regulation

Stephen Rutenberg’s practice focuses on the intersection of special situations investing and FinTech including cryptocurrency and blockchain technology. 

A significant component of Stephen’s practice relates to his work in the distressed debt market, representing clients in the purchase and sale of loans and securities of distressed and bankrupt companies. Recent representations include advising on the purchase, sale and financing of bankruptcy trade claims in several major chapter 11 cases, including Lehman Brothers, and the MF Global and Icelandic bank liquidations. He works with...

Richard Levin Polsinelli Fintech Attorney

Richard Levin is the Chair of Polsinelli’s Chambers rated FinTech and Regulation Practice.  He brings his experience as a senior legal and compliance officer on Wall Street and in London to bear in advising clients on corporate, securities and regulatory issues. A problem-solver by nature, his practice focuses on helping financial services and technology (FinTech) clients identify and address regulatory issues as they build their businesses.

The FinTech sector is...

Daniel L. McAvoy Shareholder Investment Funds Securities & Corporate Finance Mergers, Acquisitions and Divestitures Corporate and Transactional Joint Ventures and Strategic Alliances

Dan McAvoy focuses his practice on private closed-end investment funds, corporate finance and M&A with a focus on private investment fund transactions, including complex GP-led restructurings and secondary transactions. Dan is a trusted adviser to numerous investment advisers, fund sponsors and investors, and has represented a range of companies, from startups to Fortune 500 companies. Dan has also represented portfolio companies and sponsors through all parts of the corporate life cycle, including formation, venture financings, add-ons, stock sales, asset sales, private and...

Peter Waltz, Polsinelli Law Firm, Denver, Corporate and Finance Law Attorney

Peter Waltz is dedicated to helping clients achieve their objectives by employing a comprehensive, interdisciplinary approach to their legal and business challenges. He advises companies in all phases of the business cycle and provides ongoing advice and counsel on day-to-day operational, business, and legal issues. This focus includes the preparation and negotiation of documents related to entity selection and formation, corporate structure, corporate governance, and commercial contract matters. Peter advises a variety of clients with their business transactions,...

Carter D. Gage Associate Corporate and Transactional Investment Funds

As an associate in the Corporate and Transactional practice, clients rely on Carter Gage to deliver a wide range of legal services during the life cycle of the client’s business. His practice focuses on advising clients on mergers and acquisitions and general corporate and transactional matters, ranging from selecting the appropriate choice of entity to dispositions and exit strategy. 

Carter focuses on building quality relationships with clients in order to better understand their needs and better project what issues their businesses might encounter in the future. He believes that...