Blockchain and Digital Assets News and Trends - April 2023Achieving Digital Transformation and Securing Digital Assets
This is our fourth monthly bulletin for 2023, aiming to help companies identify important and significant legal developments governing the use and acceptance of blockchain technology, smart contracts and digital assets.
While the use cases for blockchain technology are vast, this bulletin will be primarily on the use of blockchain and or smart contracts in the financial services sector. With respect to digital assets, we have organized our approach to this topic by discussing it in terms of traditional asset type or function (although the types and functions may overlap), that is, digital assets as:
- Virtual currencies
- Deposits, accounts, intangibles
- Negotiable instruments
- Electronic chattel paper
- Digitized assets
In addition to reporting on the law and regulation governing blockchain, smart contracts and digital assets, this bulletin will discuss the legal developments supporting the infrastructure and ecosystems that enable the use and acceptance of these new technologies.
Notice 2023-27: May we tax NFTs as collectibles? The IRS poses questions for taxpayers
On March 21, 2023, the IRS issued Notice 2023-27 effectively breaking its silence on the tax treatment of non-fungible tokens (NFTs). NFTs soared in popularity over the last few years and have continued to garner significant interest from stakeholders in the industry and other investors. The Notice provides a potential indication of the IRS’ and Treasury’s position that NFTs may be taxed as collectibles in future guidance, however, multiple questions remain. If NFTs were taxed as collectibles, any gain would be subject to a 28 percent rate, which is higher rate than current capital gains rates. Accordingly, how NFTs are taxed may be of great interest to investors and crypto stakeholders. Read more.
Crypto tax proposals in the 2024 Greenbook
On March 9, 2023, the Biden Administration released General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals (colloquially called the Greenbook), which includes prior year proposals and two new crypto tax proposals. In an effort to “modernize” the rules, the Administration first seeks to extend the wash sale rules to crypto and second, to impose an excise tax on crypto mining. These new proposals are in addition to the restated 2023 crypto tax proposals of applying loan security nonrecognition rules to cryptocurrency loans, allowing dealers/traders of cryptocurrency to make mark-to-market elections on certain digital assets, requiring crypto brokers to report information on foreign investors, and expanding the mandatory disclosure requirement for holders of certain foreign financial assets to include digital assets. These are discussed in more detail in our May 2022 issue here. Read more.
Tokenization of financial instruments and the new legal framework in EU: the DLT Pilot Regime and ESMA guidelines
The European Union’s Regulation (EU) 2022/858 (the so-called DLT Pilot Regime) finally came into force on March 23, 2023, allowing market infrastructures to apply for authorization to trade tokenized financial instruments on distributed ledger technology (DLT) platforms in accordance with the provisions of the DLT Pilot Regime. In addition, earlier this month, the European Securities and Markets Authority (ESMA) issued its latest guidelines regarding the applications for the authorization to manage a market infrastructure based on DLT. Read more.
STATUTORY AND AGENCY DEVELOPMENTS
SEC reopens proposed rule changes to include DeFi trading systems as exchanges. On April 14, the Securities and Exchange Commission (SEC) announced issuance of a Supplemental Information and Reopening of Comment Period for Amendments to Exchange Act Rule 3b-16 Regarding the Definition of “Exchange" which reopens the comment period on the SEC's proposal to amend Exchange Act Rule 3b-16 to expand the definition of an “Exchange” to include decentralized finance (DeFi) trading systems - requiring such systems to register as national securities exchanges or comply with Regulation ATS for alternative trading systems and register as a broker-dealer. If this proposed rule amendment passes, it would have significant, material impact on DeFi in the US.
The SEC asserts in the Supplemental Information that the current Rule 3b-16, without amendment, includes many DeFi systems in its definition of an Exchange as such definition is based on the activities performed using the system. The proposed amendment would explicitly require such DeFi systems to register as national securities exchanges or comply with Regulation ATS. Under the proposal, “groups of persons” as currently set forth in the Exchange Act would be expanded to include development teams, user interface operators, automated market maker developers, developers of “other DTL [distributed ledger technology] code,” DAO governance token holders, validators and miners all acting in concert. This definitional change would effectively include all DeFi protocols in scope by labeling all of these disparate participants as potentially subject to Rule 3b-16 and Regulation ATS. The resulting impact of such analysis would require at least one participant to register as a broker-dealer, thus forcing crypto trading systems out of decentralized, trustless models, and into centralized models more susceptible to manipulation.
The public comment period will remain open for 30 days after publication of the reopening release in the Federal Register.
Federal Reserve denies application of Custodia Bank. On March 24, the Federal Reserve announced publication of its January 27 order denying the 2021 application of Custodia Bank, Inc. of Wyoming to hold a master account and become a member of the Federal Reserve System. Custodia is a Wyoming state-chartered special purpose depository institution (SPDI) that “intends to focus its business model almost entirely on the crypto-asset sector… and seek[s] to become 'a compliant bridge/ between the US dollar payment system and the crypto-asset ecosystem." The Federal Reserve Board states in the order its "fundamental concerns" with Custodia’s proposal and has determined that approval of its application “would be inconsistent with the financial, managerial, and corporate powers factors” required of Federal Reserve System members. The order repeatedly iterates "concerns" because Custodia seeks focus “almost exclusively on offering products and services related to the crypto-asset sector, which presents heightened illicit finance and safety and soundness risks,” and “Custodia’s revenue and funding model relies almost solely upon the existence of an active and vibrant market for crypto-assets. However, crypto-asset markets have exhibited significant volatility.” The order concludes that Custodia's planned operations “could in fact pose significant risk to its community.” Custodia's application was denied without prejudice, allowing Custodia to reapply in the future.
Biden Administration issues annual economic report which doubts future of digital assets. On March 20 the Biden Administration released the 2023 Economic Report of the President. Section 8 of the report is entirely devoted to digital assets and asserts that many of the potential benefits of such assets have yet to materialize. The report lists and describes the following claimed benefits of crypto assets: use as investment vehicles, function as money without reliance on a single authority, facilitation of fast digital payments, support financial inclusion, and improvement of US FinTech infrastructure. The report then states that in reality, crypto assets offer none of these benefits, describing crypto assets as speculative, volatile, risky, and without any underlying value, and cryptocurrencies as failing in broad acceptance as a medium of exchange – in part because even stablecoins tend to be risky and subject to runs. The report laments that crypto asset risk has been difficult to mitigate with regulation.
NFA adopts rule on members engaging in digital asset commodity activities. On March 29, the National Futures Association (NFA) announced the adoption of NFA Compliance Rule 2-51, "which imposes anti-fraud, just and equitable principles of trade, and supervision requirements on NFA Members and Associates that engage in digital asset commodity activities” and “provide[s] NFA with the ability to discipline a Member or take other action to protect the public if a Member commits fraud or similar misconduct with respect to its spot digital asset commodity activities.” The rule is limited to bitcoin and Ether and provides that NFA members engaged in spot digital asset commodity activities must adopt and implement appropriate supervisory policies and procedures.
Utah passes blockchain liability amendment. On March 13, Utah enacted SB160 which creates a cause of action for fraudulent transactions that have been committed on a blockchain that has specific technology implemented to allow reversal of transactions, and authorizes the Attorney General's Office to operate a node on a blockchain that allows the Attorney General's Office to reverse a fraudulent transaction on that blockchain upon receipt of a court order or notice of a binding arbitration award.
Bittrex closes US operations. In March, Bittrex, a Seattle-based cryptocurrency exchange, announced it was winding down US operations and would close operations on April 30, 2023, due to “regulatory uncertainty” in the country. The announcement asserted that the decisions was made, in part, because US "regulatory requirements are often unclear and enforced without appropriate discussion or input, resulting in an uneven competitive landscape" and " it’s just not economically viable for us to continue to operate in the current US regulatory and economic environment." Bittrex further stated that "all customer funds are safe and available to withdraw" and must be withdrawn by April 29. Bittrex noted that this decision does not affect customers of Bittrex Global.
ENFORCEMENT ACTIONS AND LITIGATION
SEC charges crypto trading platform Beaxy and its executives for operating an unregistered exchange, broker, and clearing agency. On March 22, the SEC announced charges against the crypto trading platform Beaxy.com and the executives of Beaxy. Artak Hamazaspyan, the founder of Beaxy's platform, was charged with violating securities laws by raising $8 Million through the unregistered sale of the BXY token. Hamazaspyan allegedly committed securities fraud by misappropriating at least $900,000 for personal use. In 2019, Nicholas Murphy and Randolph Bay Abbott, two Beaxy executives, forced Hamazaspyan to transfer control and separate from Beaxy after learning about Hamazaspyan's misappropriation. Murphy and Abbott managed Beaxy through an entity named Windy Inc. The SEC’s complaint alleges that Windy, through the Beaxy platform, violated the SEC Act of 1934 by failing to register as an exchange, clearing agency, dealer, or broker. Windy and its executives agreed to pay civil penalties and disgorgement and cease all activities as an unregistered exchange, clearing agency, broker, and dealer. The SEC will litigate their charges against Hamazaspyan and Beaxy.
SEC issues Coinbase a Wells Notice. On March 22, Coinbase announced that the SEC gave Coinbase a "Wells Notice" (a letter sent to a prospective respondent, notifying him of the substance of charges that the regulator intends to bring, and affording the opportunity to respond in writing). In a blog post, Coinbase stated that it is " confident in the legality of our assets and services, and if needed, we welcome a legal process to provide the clarity we have been advocating for and to demonstrate that the SEC simply has not been fair or reasonable when it comes to its engagement on digital assets." Coinbase believes that the notice relates to "an unspecified portion of our listed digital assets, our staking service Coinbase Earn, Coinbase Prime and Coinbase Wallet." Coinbase further reassured users that its "products and services continue to operate as usual." Brian Armstrong, the Coinbase CEO, provided additional information in his Twitter thread.
DOJ announces sentencing of founder of Titanium Blockchain in $21 million cryptocurrency fraud scheme. The Department of Justice on March 24 announced that Michael Alan Stollery, the CEO and founder of Titanium Blockchain Infrastructure Services Inc. (TBIS), was sentenced to four years and three months in prison for his role in a cryptocurrency fraud scheme involving TBIS’s initial coin offering (ICO) of "BARs" tokens that raised $21 million from investors in the US and overseas. Stollery pled guilty to falsifying aspects of TBIS’s white papers. He also planted fake client testimonials on TBIS’s website and falsely claimed that he had business relationships with the Federal Reserve and dozens of prominent companies to create the false appearance of legitimacy. Stollery did not use the invested money as promised, instead commingling the ICO investors’ funds with his personal funds. For more information, see our August 2022 issue.
CFTC issues charges in digital assets trading scheme. On April 11, the CFTC announced the filing of a civil enforcement action in the US District Court for the Eastern District of New York against New York resident Rashawn Russell. The complaint charges Russell with fraudulently soliciting retail investors to invest in a digital asset trading fund and with misappropriating at least $1 million in investor assets. Russell guaranteed no losses to investors and, in some instances, promised a minimum 25 percent return on investment; allegedly he intentionally and/or recklessly made false and misleading statements regarding the fund’s structure, size, and performance; traded little, if any, of the money and digital assets as represented; and falsely promised to pay withdrawal requests, including falsely promising that he would pay investors in the stablecoin USDC. The CFTC seeks restitution, disgorgement, civil monetary penalties, permanent trading and registration bans, and a permanent injunction. Russell was also charged with one count of wire fraud in the Eastern District of New York for conduct similar to that alleged in the CFTC complaint.
OneCoin head of compliance extradited. On March 21, the US Attorney for the Southern District of New York and FBI and IRS officials announced the unsealing of charges against Irina Dilkinska, the purported Head of Legal and Compliance of OneCoin, in connection with her participation in the OneCoin scheme. Dilkinska was extradited from Bulgaria on March 20 and presented before a US Magistrate Judge. According to the press release, instead of ensuring that OneCoin complied with the law, Dilkinska assisted in the creation and management of shell companies to launder OneCoin proceeds and to hold property belonging to OneCoin founders. For more information on OneCoin, see our January 2023 issue.
DOJ announces seizure of over $112 million in funds linked to cryptocurrency investment schemes. The Department of Justice announced on April 3 that it has seized virtual currency worth an estimated $112 million linked to cryptocurrency investment scams. Seizure warrants for six virtual currency accounts were authorized by judges in the District of Arizona, the Central District of California, and the District of Idaho. According to court documents, the virtual currency accounts were allegedly used to launder proceeds of various cryptocurrency confidence scams. In such schemes, fraudsters cultivate long-term relationships with victims met online, eventually enticing them to invest in fraudulent cryptocurrency trading platforms. In reality, however, the funds are instead funneled to cryptocurrency addresses and accounts controlled by scammers and their co-conspirators. The DOJ "will seek to swiftly return [the seized cryptocurrency] to victims."
DOJ announces takedown of ChipMixer. The DOJ on March 15 announced a "coordinated international takedown" of ChipMixer, a darknet cryptocurrency “mixing” service responsible for laundering more than $3 billion worth of cryptocurrency, between 2017 and the present, in furtherance of, among other activities, ransomware, darknet market, fraud, cryptocurrency heists and other hacking schemes. The operation involved US federal law enforcement’s court-authorized seizure of two domains that directed users to the ChipMixer service and one Github account, as well as the German Federal Criminal Police’s seizure of the ChipMixer back-end servers and more than $46 million in cryptocurrency. Coinciding with the ChipMixer takedown efforts, Minh Quốc Nguyễn of Hanoi, Vietnam, was charged today in Philadelphia with money laundering, operating an unlicensed money transmitting business and identity theft, connected to the operation of ChipMixer.
Court refuses to dismiss claims against Ookie DAO. The plantiffs in Sarcuni et al. v. BZX DAO et al. (2023 WL 2657633, USDC, SD Calif. March 27, 2023) allege that each of the defendants was a general partner of the bZx DAO and its successor, the Ooki DAO, and that the plaintiffs were injured by the defendants' negligence after a developer working for the bZx DAO was successfully targeted by a phishing attach which led to the theft of $55 million in cryptocurrency. The defendants filed motions to dismiss the complaint. The court denied one of the motions and granted the other in part, dismissing the claims against certain of the defendants without prejudice. The court held that the plaintiffs had plausibly alleged the following:
- The bZx DAO constitutes an unincorporated general partnership
- All DAO token holders are general partners
- Terms of service on the front-end website that allows access to the protocol were implanted only via a browsewrap, not a clickwrap, and thus not enforceable.
The opinion reflects the inherent risk of unlimited personal joint and several liability to all governance token holders of "unwrapped" DAOs (those not formed within a limited liability company, offshore limited company or foundation).
Texas, Alabama and Montana securities regulators file enforcement action against AI scheme trading digital assets. On April 4, the Texas State Securities Board announced it joined the Alabama Securities Commission and the Montana Securities Commission in filing enforcement actions to stop a fraudulent artificial intelligence investment scheme. The actions accuse YieldTrust.ai and Stefan Ciopraga of illegally soliciting investments tied to a decentralized application (dApp) that purportedly uses quantum artificial intelligence to trade digital assets. The initial scheme recently collapsed, and the respondents are now allegedly perpetrating a Ponzi scheme by raising capital from new investors to cover withdrawals from previous investors. The regulators’ actions accuse the company and its owner of illegally soliciting investments in connection with the company’s DApp that purported to achieve extraordinary returns through the use of AI to trade digital assets.
Colorado Securities Commissioner announces settlement with Robinhood. On April 6, the Colorado Securities Commissioner announced a multi-state settlement with Robinhood Financial LLC who will pay up to $10.2 million in penalties for operational and technical failures that harmed main street investors and will implement internal changes. The settlement stems from an investigation spearheaded by state securities regulators in Alabama, Colorado, California, Delaware, New Jersey, South Dakota and Texas regarding Robinhood’s operational failures with respect to the retail market. Robinhood, under the settlement, is required to maintain policies and procedures to supervise its customer support function, including providing accurate disclosure to customers around customer support capabilities. Robinhood will be required to regularly report its customer service responsiveness to senior management, such reports to be available to regulators. Robinhood will also provide access to a FINRA-ordered compliance implementation report to settling states.
North Dakota enters consent order with FTX on money transmission. On March 2, the North Dakota Department of Financial Institutions (DFI) announced it had signed a Consent Agreement and Order with West Realm Shires Services, Inc. d/b/a FTX US. According to the order, FTX agreed to a suspension of the money transmitter license granted by the state. The order expressly does not prohibit FTX from returning fiat currency or cryptocurrency assets to North Dakota residents or allowing state residents to withdraw fiat currency or cryptocurrency assets from their FTX accounts. The suspension shall remain in place until lifted by written notice of the DFI. FTX agreed to the order without admitting or denying the allegations.
SPOTLIGHT ON INTERNATIONAL DEVELOPMENTS
Canada: Proposed changes to AML and terrorist financing laws in 2023 Federal Budget. The 2023 Federal Budget proposes new legislative changes to combat money laundering and terrorism financing. The proposed legislative changes will, among other things, give law enforcement the ability to freeze and seize virtual assets with suspected links to crime. Read more.
Hong Kong: SFC issues proposed regulatory requirements for licensed virtual asset trading platforms. The Securities and Futures Commission (SFC) published a Consultation Paper setting out proposed regulatory requirements for virtual asset (VA) exchanges licensed under the bespoke regime for virtual asset service providers (VASPs) in the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (Cap. 615) (the AMLO VASP regime). The Consultation Paper also includes guidance on transitional arrangements applicable to VA exchanges currently operating in Hong Kong. Read more.
Italy: Court rules on the first case of trademark infringement through NFTs. The Court of Rome has issued the first Italian decision on intellectual property rights infringement through the unauthorized sale of NFTs and took a position on some of the recurring issues in the various NFT lawsuits pending in the different jurisdictions. Read more.
New Zealand: FMA finalizes regulatory return questionnaire for licensed financial advice providers. The Financial Markets Authority (FMA) - Te Mana Tātai Hokohoko has finalized the annual regulatory return requirements for all three financial advice providers (FAPs) license classes. In the final annual return requirements, the FMA reduced and simplified the reporting questions following consultations, which included removing questions relating to virtual assets. Read more.
DLA Piper ranked in Chambers FinTech Guide 2023. DLA Piper is pleased to announce that the firm's FinTech Legal: Blockchain & Cryptocurrencies practice has been ranked nationwide by the prestigious legal publisher Chambers and Partners. Margo Tank and Mark Radcliffe each received individual rankings. Overall, the firm received 21 practice rankings and 16 individual lawyer rankings in the Chambers FinTech 2023 edition.
Cryptocurrency and Digital Asset Regulation, published by the American Bar Association and co-edited by Deborah Meshulam and Michael Fluhr, includes chapters by Meshulam and Fluhr and by Margo H.K. Tank.
Learn more about our Blockchain and Digital Assets practice by contacting any of our editors:
Contributors to this issue
Bamdad Attaran (Articling Student)
Emily Honsa Hicks
Second Circuit upholds CFPB’s funding structure in the wake of Supreme Court certiorari
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