This is our fifth monthly bulletin for 2022, 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.
OECD releases public consultation document on crypto tax reporting in effort to increase transparency
The Organisation for Economic Co-operation and Development (OECD) has released a public consultation document, Crypto-Asset Reporting Framework and Amendments to the Common Reporting Standard. The document responds to a request from the G20 to develop a framework to assist in the automatic exchange of information related to cryptoassets, arising from concerns about the rapid adoption of cryptoassets for both investment purposes and other financial activities, and the likelihood that cryptoassets are not within the scope of many international tax reporting regimes (such as CRS, discussed below).
Generally speaking, the public consultation document, released in March, lays out the proposed Crypto-Asset Reporting Framework (CARF), which is a global cryptoasset reporting and exchange of information regime and proposed amendments to the existing Common Reporting Standards (CRS), first released in 2014, which pertains to the exchange of financial account data between countries. Read more.
Biden Administration’s Greenbook signals continued focus on taxation of cryptocurrency and digital assets
The Treasury Department has issued its General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals (the Greenbook – so-called because of its traditional green cover), which describes the revenue proposals that form part of the Biden Administration’s FY2023 Budget Proposal. Among other topics, the Greenbook outlines a number of tax proposals addressing trading and lending of cryptocurrency and digital assets, and further expanded information reporting for such assets. Read more.
DC Blockchain Summit, May 24, 2022, Washington, DC
J5 issues bulletin on red flag indicators for NFTs. On April 28, the IRS announced the J5 issued an intelligence bulletin warning the public of the dangers of NFTs and providing guidance to banks and law enforcement of potential misconduct related to NFTs. The bulletin provides insight and guidance to banks, law enforcement and private industry to help improve fraud detection measures. Reportedly, some of the “strong indicators of potential fraud” identified in the bulletin are:
- NFTs sold for large sums and reacquired from the same party for smaller amounts
- clearly overpriced/underpriced NFTs that are traded frequently in short time windows
- “wash trading” – artificially increasing sale value with each sale between linked accounts
- newly minted NFTs immediately sold at high price points not in line with other NFTs in the collection
- Phishing scams offering NFTs
- Fake token giveaways/airdrops
- Social media impersonation
- Sales in a collection purchased from a mixer
CRS issues report on digital wallets. On April 18, the Congressional Research Service (CRS) published an In Focus on digital wallets and selected policy issues. The report highlighted the following policy considerations: (1) data privacy and security; (2) consumer protection and investor protections; (3) systemic risk and market power; and (4) financial inclusion.
Bitcoin and mining industry respond to environmental concerns. On May 2, members of the bitcoin and mining industry issued a letter to the Environmental Protection Agency (EPA), partially in response to an earlier letter to the EPA from Congressman Jared Huffman (D-CA) and 22 other congressional representatives. In response to allegations by Huffman that the bitcoin and mining industry cause “significant greenhouse gas emission” and “major electronic waste challenges,” among other impacts, the bitcoin and mining industry state those concerns are based on a number of misconceptions, and at least some of the data on which they were based are faulty and biased. The response letter asserts that mining centers are no different from data centers run by major US technology firms and should be assessed the same way by the EPA.
Federal Reserve issues Financial Stability Report. On May 9, the US Federal Reserve announced the issuance of its 2022 Financial Stability Report that identifies and monitors risks to the financial system. The report notes that “the rapidly growing stable point sector is vulnerable to runs” and equates with money market funds and bond and bank mutual funds with respect to risk in the current financial system. The report notes that the increasing use of stablecoins to meet margin requirements in leveraged crypto trades may heighten redemption risks.
CFPB invokes dormant authority to examine “nonbank” companies posing risks to consumers. On April 25, the Consumer Financial Protection Bureau (CFPB) announced that it is invoking a largely unused legal provision to examine nonbank financial companies that pose risks to consumers. This authority is not specific to any particular consumer financial product or service. While the CFPB did implement the provision through a procedural rule in 2013, the CFPB is also issuing and seeks comments on a procedural rule to increase the transparency of the risk-determination process. It is unclear at this time to what extent cryptocurrency and related industries may fall within the scope of “nonbank” companies subject to CFPB dormant authority.
SEC 2022 examination priorities include crypto. On March 30, the Securities and Exchange Commission (SEC) announced issuance of its 2022 Examination Priorities, which include a continuing focus on emerging technologies and crypto assets. “Examinations of market participants engaged with crypto-assets will continue to review the custody arrangements for such assets and will assess the offer, sale, recommendation, advice, and trading of crypto-assets. In particular, EXAMS will review whether market participants involved with crypto-assets: (1) have met their respective standards of conduct when recommending to or advising investors with a focus on duty of care and the initial and ongoing understanding of the products (e.g., blockchain and crypto-asset feature analysis); and (2) routinely review, update, and enhance their compliance practices (e.g., crypto-asset wallet reviews, custody practices, anti-money laundering reviews, and valuation procedures), risk disclosures, and operational resiliency practices (i.e., data integrity and business continuity plans). In addition, the Division will conduct examinations of mutual funds and ETFs offering exposure to crypto-assets to assess, among other things, compliance, liquidity, and operational controls around portfolio management and market risk.”
SEC doubles size of cryptoasset and cyber enforcement unit. On May 3, the SEC announced the allocation of 20 additional positions to the unit responsible for protecting investors in crypto markets and from cyber-related threats. The newly renamed Crypto Assets and Cyber Unit (formerly known as the Cyber Unit) in the Division of Enforcement will grow to 50 dedicated positions. According to the SEC press release, the Unit will focus on investigating securities law violations related to cryptoasset offerings, cryptoasset exchanges, cryptoasset lending and staking products, decentralized finance (DeFi) platforms, NFTs and stablecoins.
Idaho enacts law defining legal status of digital assets. On March 28, the governor of Idaho signed into law HB 583, which adds a new chapter to Idaho’s Commercial Transactions Title to address the legal status of digital assets. The law classifies digital assets as personal property and specifies the rights of purchase, possession and control. Note that Idaho did not adopt the Uniform Law Commission’s draft model UCC Article 12. Please see DLA Piper’s most recent coverage of the development of Article 12.
California governor issues Executive Order to study crypto and blockchain. On May 4, the governor signed an Executive Order which aims to create a transparent regulatory and business environment for web3 companies. Under this executive order California will assess how to deploy blockchain technology for state and public institutions and build research and workforce development pathways. The state has seven priorities under the order:
- Create a transparent and consistent business environment for companies operating in blockchain, including cryptoassets and related financial technologies
- Collect feedback from a broad range of stakeholders to create a regulatory approach to cryptoassets harmonized between federal and state authorities
- Collect feedback from a broad range of stakeholders for potential blockchain applications and ventures, with particular attention to cryptoassets and related financial technologies
- Engage in a public process and exercise statutory authority to develop a comprehensive regulatory approach to cryptoassets
- Engage in and encourage regulatory clarity via progress on the processes outlined in the federal executive order
- Explore opportunities to deploy blockchain technologies to address public-serving and emerging needs
- Identify opportunities to create a research and workforce environment to power innovation in blockchain technology, including cryptoassets.
Tennessee enables decentralized organizations. On April 20, the governor signed HB 2645 to provide for the formation, conversion or qualification of an LLC as a decentralized organization. The new law also provides that a membership interest in such an organization may be a digital asset. The new law took effect immediately.
Utah enacts law creating Blockchain Taskforce. On March 24, the governor signed HB 335, creating the Blockchain and Digital Innovation Task Force (Task Force). The Task Force is directed to develop knowledge and expertise about blockchain and related technologies as well as make policy recommendations related to blockchain and related technologies. The Task Force must make an annual report.
Washington enacts law creating Blockchain Working Group. On March 30, the governor signed SB 5544 into law, creating the Washington Blockchain Work Group. The group was established to examine potential applications for blockchain technology, such as computing, banking and other financial services; the real estate transaction process; healthcare; supply chain management; higher education; and public recordkeeping.
NYDFS advises on use of blockchain analytics. On April 28, 2022, the New York Department of Financial Services (NYDFS) issued guidance to all entities licensed under New York’s Bitlicense law or chartered as limited-purpose trust companies under New York’s Banking Law regarding the use of blockchain analytics. The NYDFS emphasized that the characteristics of virtual currencies – with immutable, on-chain information – make the use of blockchain analytics important in addressing anti-money laundering requirements under New York law, and a range of Bank Secrecy Act/Anti-Money Laundering (BSA/AML) and Office of Foreign Assets Control (OFAC)-related compliance controls.
ENFORCEMENT ACTIONS AND LITIGATION
SEC halts fraudulent cryptomining and trading scheme. On May 6, the SEC announced fraud charges against MCC International Corp., which does business as Mining Capital Coin Corp., its founders Luiz Carlos Capuci, Jr. and Emerson Souza Pires, and two other entities controlled by Capuci, CPTLCoin Corp. and Bitchain Exchanges, in connection with the unregistered offerings and fraudulent sales of investment plans called mining packages to thousands of investors. According to the SEC’s complaint, Defendants MCC, Capuci, and Pires allegedly netted at least $8.1 million from the sale of the mining packages and $3.2 million in initiation fees. On April 21, 2022, the United States District Court for the Southern District of Florida issued a temporary restraining order against all of the defendants and an order freezing defendants’ assets, among other relief. The SEC’s complaint seeks injunctions against future securities law violations, disgorgement of the defendants’ ill-gotten gains, civil penalties, and officer and director bars against Capuci and Pires.
The Department of Justice (DOJ) also announced the unsealing of an indictment against Capuci charging him with conspiracy to commit wire fraud, conspiracy to commit securities fraud, and conspiracy to commit international money laundering. If convicted of all indictment counts, he faces a maximum total penalty of 45 years in prison.
OCC issues cease and desist against Anchorage Bank for inadequate BSA/AML controls. On April 21, the Office of the Comptroller of the Treasury (OCC) announced it issued a cease and desist order against Anchorage Bank (a recently formed crypto custodian and national bank) for inadequate BSA/AML controls. According to the letter, the bank failed to adopt and implement “internal controls for customer due diligence and procedures for monitoring suspicious activity, BSA officer and staff, and training.” Among the criticisms, the OCC wants:
- A “qualified BSA Officer,” subject to OCC right to object to the appointment, and “sufficient staff”
- Improved customer due diligence at account opening
- Improved monitoring and reporting of suspicious activity, including a program which must “establish and implement a formal process that ensures sufficient information is collected on digital asset transactions conducted by or through the Bank to be able to effectively identify and report suspicious activity”
- Undertake (with an approved third-party consultant) a look-back of prior onboarding and activity monitoring to identify instances where suspicious activity should have been reported, but was not
- Independent testing of the program
- Improved training
US Treasury issues sanctions on a virtual currency mixer. On May 6, the US Department of the Treasury’s Office of Foreign Assets Control (OFAC) sanctioned virtual currency mixer Blender.io (Blender), which is used by the Democratic People’s Republic of Korea (DPRK) to support its malicious cyber activities and money-laundering of stolen virtual currency. On March 23, Lazarus Group, a DPRK state-sponsored cyber hacking group, carried out the largest virtual currency heist to date, worth almost $620 million, from a blockchain project linked to the online game Axie Infinity; Blender was used in processing over $20.5 million of the illicit proceeds. Under the pressure of robust US and UN sanctions, the DPRK has resorted to illicit activities, including cyber-enabled heists from cryptocurrency exchanges and financial institutions, to generate revenue for its unlawful weapons of mass destruction (WMD) and ballistic missile programs.
Federal court orders BitMEX’s 3 cofounders to pay $30 million. On May 5, the US Commodity Futures Trading Commission (CFTC) announced that the US District Court for the Southern District of New York (SDNY) entered consent orders with three co-founders of the BitMEX derivatives trading platform. The consent orders required each founder to pay civil penalties of $10 million and enjoined them from committing further violations of the Commodity Exchange Act. For more information on BitMEX, see our March issue.
Texas and Alabama issue cease and desist orders against casino for fundraising using NFTs as illegal securities. The states of Texas and Alabama have issued cease and desist orders against Sand Vegas Casino Club and its founders, alleging they were using non-fungible tokens (NFTs) as an illegal, unregistered security to fund the development of a virtual casino in the metaverse. The parties are funding the Internet and metaverse casinos through the sale of more than 12,000 NFTs to the public. Purchasers of the NFTs were allegedly told they had become owners of the metaverse casino, but also that they would purportedly share in half of the profits generated by the club’s virtual operations. According to one of the orders, on April 9, 2022 the listing price for a Sand Vegas Casino Club NFT ranged from 0.23 Ether (valued at approximately $744.38) to 777.77 Ether (valued at approximately $2.5 million).
Five states file enforcement actions against casino show halt sales of NFTs. On May 11, five state securities regulators issued a joint press release announcing the filing of enforcement actions against Flamingo Casino Club, a metaverse casino, ordering the casino to halt the sale of its NFTs. The cease and desist orders, filed in Alabama, Kentucky, New Jersey, Texas, and Wisconsin, allege that Flamingo Casino Club “has … been fraudulently soliciting NFTs that purportedly convey ownership of a metaverse casino,” and claim that the NFTs were unregistered securities. The state agencies further accuse Flamingo Casino Club of using a phony office address and phone number to conceal the identities of the principals.
SPOTLIGHT ON INDUSTRY DEVELOPMENTS
DeFi platform receives S&P credit rating. Reportedly, on May 9, Compound Treasury received a B- credit rating from S&P Global Ratings. According to the press release, this makes Compound Treasury the first institutional decentralized finance (DeFi) offering to be rated by a major credit rating agency, and signals progress in the crypto industry’s maturity, as traditional institutions begin to judge the risks of digital asset powered financial offerings. In assigning its rating and stable outlook, S&P cited the uncertain regulatory regime for stablecoins (USDC), stablecoin-to-fiat convertibility risks, Compound Treasury’s currently limited capital base and four percent return obligation; S&P views the Compound protocol (the source of yield for Compound Treasury) track record of zero USDC losses as partially mitigating the capital risks of the offering.
Chainalysis posts report on stabilizing NFT activity. On May 5, Chainalysis posted NFT Transaction Activity Stabilizing in 2022 After Explosive Growth in 2021. The blog post reports that “NFTs saw explosive growth in 2021, but this growth hasn’t been consistent and has leveled off so far in 2022.” Among other findings, the blog post documents the “fits and starts” of NFT transaction growth, with two big spikes in August 2021 and late January 2022. Further, the post identifies increasing numbers of active and NFT buyers and sellers.
SPOTLIGHT ON INTERNATIONAL DEVELOPMENTS
BIS issues results of survey on CBDCs. On May 6, The Bank for International Settlements (BIS) announced the release of Gaining momentum – Results of the 2021 BIS survey on central bank digital currencies (CBDCs). The survey received responses from 81 central banks, with nine out of 10 central banks exploring CBDCs, and more than half developing them or running concrete experiments. The survey also found that more than two thirds of central banks consider that they are likely to or might possibly issue a retail CBDC in either the short or medium term.