Wind of Change - The Year FinTech Came in From the Cold - Polsinelli BitBlog: Year End Edition
Digital assets and Blockchain technologies which were once described as the tools of criminals, are now a key part of efforts by traditional financial services firms to transform their businesses and innovative firms looking to challenge traditional incumbents. Digital assets and blockchain technologies have come in from the cold. This final BitBlog summary of 2019 focuses on recent activity by the U.S. Securities and Exchange Commission (“SEC”) and other highlights of the prior year.
Top 5 Highlights of 2019
As the year comes to a close we have identified our top 5 highlights and trends of 2019 in the blockchain and crypto currency sector.
1. Libra is Not the Grim Reaper
In May 2019 Facebook announced it plan to lead a consortium in the development of a blockchain-based digital currency to allow for the (moderately) decentralized transfer of money. The Libra coin will be backed by US Treasury notes and other assets in order to limit its volatility. Libra has been met with resistance from lawmakers, particularly in the Unites States and Europe. Their primary concern is the claim that the Libra network will be set up to prevent any one company, including Facebook, from having access to users’ personal data. Libra has also raised general regulatory concerns regarding the entire class of digital assets that are supposed to be nonvolatile representations of fiat currency, referred to as “stablecoins.” This concern is driven by several factors, including: (1) fear that the failure of a stablecoin could create systemic risk and financial disruption; (2) concern that a stablecoin could be a competitor to government backed currencies and central bank issued stablecoins; and (3) the difficulty of policing the fiat currency reserves that are often held by the issuer of a stablecoin
Richard Levin, Chair of Polsinelli’s FinTech and Regulation Practice, was interviewed by Bloomberg Television’s Balance of Power program while Mark Zuckerberg, the CEO of Facebook, testified before the House Financial Services Committee regarding Libra. Levin discussed how Congress was struggling with the issue of how to regulate Libra: is it a security, a commodity, or a digital currency? Based on Zuckerberg’s testimony, Levin noted Libra appeared to be a digital currency that would be subject to regulation by the U.S. Treasury and the Financial Crimes Enforcement Network (FinCen).
2. I Fought the Law and the Law Won
The SEC continued to bring enforcement actions against the issuers of digital assets sold as unregistered securities without an exemption from registration with the SEC. The Securities Act of 1933 (the “Securities Act”) requires an issuer of securities to either register the offering with the SEC or to conduct the offering pursuant to an exemption from registration. Most of the enforcement actions by the SEC to date resulted in settlement agreements where issuers agreed to pay a fine and possibly register their token as a security. The largest of these settlements was with block.one EOS, where the company agreed to pay a $24 million fine even though they purportedly made some effort to prevent US persons from purchasing their tokens.
One promising outcome of 2019 was the increased regulatory scrutiny of the Simple Agreement for Future Tokens (“SAFT”) which was used by a number of token offerings. On June 4, 2019, the SEC launched an enforcement action against Kik Interactive claiming the company offered and sold one trillion digital tokens (“Kin”) in violation of the Securities Act. A key component of the Kik token offering was the use of SAFTs. A SAFT is a combination of tokens offered through an initial coin offering (“ICO”) and Simple Agreements for Future Equity (“SAFE”), which the SEC has warned investors are neither simple nor safe. An ICO is a fundraising event in which an entity offers participants a unique digital asset – often described as a “coin” or “token” – in exchange for consideration (most commonly bitcoin, ether, U.S. dollars, or other fiat currency).
From May to September 2017, Kik offered and sold tokens to professional investment funds and other select, wealthy investors using SAFTs. The SAFTs entitled purchasers to the future delivery of Kin that they purchased when they entered into the agreements. Under the SAFTs, investors bought Kin at a discount to the price that the general public would pay, and Kik promised to deliver the tokens pursuant to a schedule, half at the time that it delivered tokens to the general public and half on the one-year anniversary of the first delivery. Kik received a total of approximately $100 million as a result of its offerings and related sales of the SAFTs and direct sales of Kin to purchasers.
Although Kik specifically stated the SAFT was a security, it considered the Kin to be delivered under the SAFT to not be a security. Kik’s private placement memorandum claimed the offer and sale of the SAFTs were effected in accordance with an exemption from registration under Section 4(a)(2) of the Securities Act and Regulation D. Kik did not claim any exemption for the offer and sale of Kin through the SAFTs. Kik filed a Form D for the SAFTs indicating that it had sold securities. Under “Type(s) of Securities Offered,” the Form D stated: “Sale and issuance of rights to receive Kin tokens in the future via a Simple Agreement for Future Tokens.”
The SEC believes that the Kin offered and sold, even indirectly via the SAFTs, were not exempt from registration under Regulation D. The SEC alleges “the exemption does not apply because the offer and sale of Kin via Kik’s SAFTs was part of a single offering of Kin to the general public . . . , or, in the alternative, was integrated with the offering of Kin whose sales began on September 12, 2017, and neither the totality of the offering nor the non-SAFT portion of it was limited to accredited investors.”
Since the publication of the SAFT whitepaper in October 2017, many members of the FinTech Bar as part of the Cardozo Blockchain Project at Cardozo Law School in New York questioned the soundness of the SAFT model. One member of the same group has described the SAFT as a Frankenstein financial product that combines the worst attributes of the SAFE, which the SEC deems unsafe, with issuances of digital tokens which the SEC generally believes often involve an illegal offer and sale of securities.
3. Action through No Action
In what is hopefully a big step toward formal regulatory guidelines, the staff of the SEC granted three no action letters this year allowing for the development of blockchain-based projects in some fairly limited circumstances. The first two no action letters involve the sale of ecosystem tokens; (1) Turnkey Jet, which is a token for the use of private jets, and (2) Pocketful of Quarters, a token to be used as standard currency on a multigame platform. In both of these cases, certain key facts were identified by the SEC staff as the basis for the issue of the no action letters. Most importantly, that neither token traded on primary or secondary markets, the tokens were not being sold for purposes of building the platform, each ecosystem was centralized, there was a fixed value assigned value to the token, and there was an unlimited supply of the tokens. The third no-action letter granted relief to the Paxos Trust Company to settle equity securities trades on a blockchain platform for brokers. As noted by the SEC staff in each no action letter, the no action relief is directed to the specific party requesting the relief and is based on the particular facts and circumstances identified in the request for no action.
4). Everything is Awesome - Is Blockchain the Solution to Building Enterprise Infrastructure?
From payment systems to stock ledgering, 2019 saw continued building and development of blockchain based solutions by most large financial institutions and tech companies. These investments are likely to bear fruit in the coming years as these technologies are implemented on a widespread basis. However most of these platforms have yet to be launched commercially and those that have are often used internally by one company without a decentralized blockchain. The extent of blockchain research and implementation is demonstrated in the seminal article by Michael del Castillo in Forbes titled Blockchain 50: Billion Dollar Babies where he looks at the blockchain projects at 50 companies with revenue or valuation of above $1 billion.
5. Making-up is Hard to Do – FinTech Firms Try to Comply with the Law
The efforts of fintech innovators to use blockchain to provide greater efficiency, liquidity, and transparency for the sale of securities continues to expand. Platforms for the innovative transfer of digital assets as well as service providers for custody continue to raise funds and attract talent. Successful use cases of blockchain sales of securities and real estate occur on a frequent basis. 2019 did not, however, see digital assets sold as securities in a manner compliant with the securities laws reach a critical mass of commercial adoption.
The Accredited Investors Club Might Just Get a Whole Lot Bigger
One of the common critiques of current financial regulation and a justification that many in the crypto community use for wanting to sell to the public is the fairly limiting criteria for determining the eligibility of investors to purchase securities that are sold pursuant to an exemption from registration with the SEC. The current test is simply a test of income or net worth to otherwise sophisticated individuals who just may not have the resources yet.
On December 18, 2019, the SEC issued a proposal to revise the definition of accredited investor in Regulation D under the Securities Act and the definition of qualified institutional buyer in Rule 144A under the Securities Act. I f approved, this would mark the first update to the definition of accredited investor since the SEC’s adoption of Regulation D in 1983. SEC Chairman, Jay Clayton, noted the current definition of accredited investor applies a “binary approach” to determine which individuals qualify for accredited status: they either have a net worth of at least $1 million or they must have a high enough annual income to qualify.
As proposed, the revised definition of accredited investor would expand the definition to permit additional individuals and entities to invest based on professional knowledge, amounts invested, experience or certifications. The proposed rule change is intended to promote greater access to and higher participation in our private capital markets by lowering the barriers to entry. Additionally, the proposed revision to the rule would add spousal equivalents along with legal spouses, making it possible for domestic partners or any other individuals in a relationship which parallels a spousal relationship to pool their finances in order to meet the net worth or income to qualify as accredited investors. Notably, the proposal would not increase any thresholds for accredited investor status to account for inflation.
Bitfinex and Tether Meet Clubber Lang – aka The State of New York
New York’s Attorney General is standing firm in their belief that the state has the authority to investigate what could be “potential securities and commodities fraud” involving the world’s largest stablecoin, Tether. Under the Martin Act, a New York state law predating the Securities Act and that grants the New York Attorney General the power to investigate potential securities issues, the OAG accused the operator of the tether stablecoin, Tether, and iFinex, the owner of the Bitfinex virtual currency exchange, of fraud based on a “series of conflicted corporate transactions whereby Bitfinex gave itself access to up to $900m of Tether’s cash reserves, which Tether for years repeatedly told investors fully backed the tether virtual currency ‘1-to-1.’”
Bitfinex and Tether argue that the suit against them should be dismissed for three reasons: (1) improper service of the original lawsuit; (2) a lack of jurisdiction when none of the activity by either party occurred in New York; and (3) the fact that tethers are not securities or commodities under the Martin Act. On December 4, the OAG continued to press the offensive, asking the Supreme Court of New York to deny the defendants’ motion to dismiss.
Polsinelli’s own Richard Levin, Chair of the Fintech and Regulatory Practice, noted in New Money Review that recent developments in the cryptocurrency field show that US law enforcement bodies will keep their gloves strapped on in this fight. “Often the regulators will start with the smaller players and work their way up the ladder. The fact that the SEC sued Kik and that New York State sued Bitfinex is a signal to the crypto industry that they are coming,” Levin said. The outcome of this lawsuit may serve as a beacon of warning for those in the crypto industry who have yet to face a court of law.
Self-Proclaimed Bitcoin “Inventor” Might be Hit with Heavy Sanctions
Craig Wright, the increasingly assertive, self-proclaimed “Satoshi” (the “inventor” of Bitcoin), might have found himself in hot water as the estate of his former business partner, David Kleiman, insists that the court ordered sanctions imposed on are “absolutely justified.” Kleiman’s estate filed a $10.2 billion lawsuit in February 2018 alleging that Wright had stolen hundreds of thousands of bitcoins and related IP from Kleiman’s estate after Kleiman’s death. A magistrate judge has previously determined that Wright and Kleiman entered into a 50-50 partnership to develop Bitcoin intellectual property before Kleiman’s 2013 passing, giving Kleiman’s estate the right to receive a portion of the proceeds.
Wright’s conduct in defending his cause has not been without controversy. He has failed to comply with court orders regarding production of identifiers or public addresses of his bitcoin holdings, and he has previously tried to state his case by claiming the existence of a “blind trust,” which he evidenced with supposedly authentic documents and encrypted files. Kleiman’s estate was able to prove that the documents were forgeries. If a ruling were to be entered against Wright, he could have to hand over billions of dollars’ worth of bitcoin to Kleiman’s estate, assuming such coins exist, as well as possibly being hit with hefty sanctions for contempt of court and forgery. This controversy does not appear to put a damper on Mr. Wright’s speaking engagements or the promotion of the Bitcoin SV (Satoshi Vision) which he claims to be the “real” bitcoin as originally envisioned at conferences throughout the world. The controversy created by Mr. Wright, and those of a similar ilk, may be a factor in delaying the embrace of crypto currency and blockchain technology by institutional investors.
Robinhood Gives A Little Back to FINRA
Popular trading platform Robinhood Financial recently entered into a $1.25 million settlement with the U.S. Financial Industry Regulatory Authority (“FINRA”), after allegedly failing to ensure broker-dealers executing trades for users were trading as effectively as possible. FINRA noted, Robinhood failed to properly ensure compliance with FINRA’s best execution rule, which requires FINRA-registered broker-dealers to execute trades for their clients based on a variety of factors designed to protect clients. During the period in question, Robinhood “routed its customers’ non-directed equity orders to four broker-dealers, all of which paid Robinhood for that order flow.” Robinhood’s best execution assessments during that time only dealt with the four broker-dealers paying it for business.
In 2019 digital assets and blockchain technology were embraced by traditional financial services firms and early and mid stage companies worked to change the face of financial services through the development of new digital assets and blockchain based technologies. However, when laws, laws adopted between 1930 and 1975 are used to regulate innovative technologies and when early stage technology firms move into one of the most highly regulated industries in the world, the process is like watching sausage being made – a very messy exercise. Many early stage and mid stage FinTech companies that were ignorant of the fact they were operating in a highly regulated industry faced the long arm of the law – SEC and CFTC enforcement actions. Left with laws that are poorly suited to the regulation of innovative technologies like blockchain, the SEC, the CFTC, and other regulators have used a combination of informal guidance, no action letters, and enforcement actions in an effort to provide guidance to FinTech companies. However, such actions provide little opportunity for the public comment that is required under the Administrative Procedure Act.
It is unlikely in a presidential election year that legislation to amend the U.S. securities laws to address the challenge of innovative technology being governed by laws that date back to the 1930s will be addressed. FinTech companies should expect more SEC and CFTC enforcement actions, and more informal guidance, and no action letters from the SEC and the CFTC. FinTech firms should take advantage of opportunities to engage in a constructive dialogue with the SEC, the CFTC, and other regulators through mechanism like the SEC’s FinHub and the CFTC’s FinTech Lab. FinTech firms should also continue to have a dialogue with members of Congress and the U.S. Treasury regarding the need to bring the securities and commodities laws into the Twenty First Century.
Where There is a Will There is a Lawsuit
Finally, as noted by famed architect, Addison Mizner, “Where there is a will there is a lawsuit.” As with the development of all transformative technologies, disputes related to digital assets and blockchain technologies will abound in 2020. In 2018 the FinTech industry learned of the first class action against the issuer of a digital asset, Ripple Labs. In 2019 the FinTech industry saw the fight continue as Ripple and the plaintiffs continued their ligation over whether the XRP digital currency sold by Ripple is an illegally offered security. This fight is the first of what may be a proliferation of class action law suits against issuers of digital assets sold with either a registration statement filed with the SEC or pursuant to an exemption from registration. We also anticipate litigation related to securities sold under a SAFT where the expected digital token is unable to be legally issued.
 The Saft Project