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Compliance: Navigating U.S. Regulations for Blockchain

By Cory Roberson, Principal at FINCompliance and FIN Community

Ready for “The blockchain” in a town near you?

October 13, 2018.  “Blockchain is not SKYNET.”  The topic may sound like an action-packed sci-fi novel or a machines-taking-over the world-type movie, but there is something more blooming in the world of technology.  Seriously speaking, over the last few years, research projects using Blockchain (aka. distributed ledger technology (DLT)), is disrupting the existing processes for transferring data from one party to another.

Last week, I spent some time to dive into the subject.  Following a weekend-long of activities, that included a hackathon, a panel of attorneys discussed the current regulatory climate for this new technology in the United States. 

Participants included (photo): (1) Roni Rose, Founder of Blockchain Bea Podcast; (2) Caitlin Long, Co-Founder of the Wyoming Blockchain Coalition; (3) Kristen Johns, Transactional/IP/Blockchain/Patent Attorney; and (4) Alexandra Kramer, Blockchain Attorney at CKR Law, LLP. 

The panel discussion, held at New York University’s Law school, was a part of a series of workshops, sponsored by Crypto Chicks and Women4blockchain, two organizations geared towards supporting the careers of women in blockchain.

Fundraising the blockchain venture
Moderator Roni Rose, Founder of Blockchain Bea Podcast, prompted the panelists with an open question regarding the challenges of launching an ICO in the United States.  Alexandra Kramer, an attorney, who is also Founder of a blockchain-based startup Womin.io, presented a series of fundraising scenarios for businesses seeking capital.   

She discussed that many startups fund raise through a securities exemption, commonly referred to as Reg. D. With this strategy, businesses can offer their tokens, which we will discuss later in this article, to an accredited investor for capital.  The exemption is a way for startups to bypass costly securities registration requirements.

According to the Securities and Exchange Commission (“SEC”), accredited investors are defined as person(s) who have: (1) $200,000 in salary for last two taxable years ($300,000 if joint filers); and/or (2) $1 million dollars in net worth.  An entity, with combined assets of more than $5 million, can also be considered as an accredited investor. 

Review the SEC’s Accredited Investor guidance [cc1] :

Opportunities exclusive to accredited investors present a case for “anti-financial inclusion,” as expressed by Alexandra Kramer.  As written, blockchain companies that utilize Reg. D exemptions essentially block the average retail client from involvement in these types of high-risk investment opportunities.  

Restrictions might be a good thing for certain audiences.  Blockchain technology, and its cryptocurrency derivative, still must prove itself in the broader securities industry.  Investment advisors, who serve retail clients, would be hard pressed to prove suitability in making crypto-based recommendations due to many factors. 

Retail investors might get involved at some point.  In recent years, the SEC has enacted other exemptions that could play a role in “lowering the barrier of entry to individuals” as discussed by Ms. Kramer.  She mentioned that Reg. A (crowdfunding/general solicitations) and Reg. S (foreign investors) could provide an opportunity for more parties to enter the blockchain space.  With an optimistic tone, she expressed that each startup should consult with an attorney as each set of exemptions, created before the onset of blockchain, requires explicit guidelines for compliance.

Moreover, blockchain development continues to move forward despite the regulatory challenges of securities laws that weren’t originally designed to regulate digital assets.  

SEC and CFTC oversight of tokens

In the United States, aside from state-supported blockchain initiatives, federal agencies are taking a cautious tone regarding the regulation of tokens.  For now, federal jurisdictions such as the SEC and the U.S. Commodity Futures Trading Commission (CFTC), release guidance based on its own interpretations for the possible use of tokens (see ref. DAO Token).  

Last October, the CFTC also jumped into the legislative fray with its own interpretations for ruling cryptocurrency as a possible commodity.  A district court in New York, ruled in favor of the CFTCs’ viewpoint that cryptocurrency can be considered as a commodity [cc2] 

Overall, both agencies remain malleable towards any final rulings. 

“The SEC continues to be flexible,” said Alexandra Kramer while expressing that the U.S. choose not to ban ICO’s as seen in China [cc3] .  With that said, the SEC continues to take a harsher tone towards its general investor protection measures as demonstrated in its examination priorities for 2018.  For example, as a part of its broad sweeping review into ICOs issued in the U.S., the commission charged a purported crypto fund advisor [cc4] with securities law violations.

"Tokenization": loosely defined in Three Forms

Ultimately, cryptocurrency may be regulated in all three forms: as a utility, security, and/or a commodity.

Utility Tokens consists of “A digital token of cryptocurrency that is issued in order to fund development of the cryptocurrency and that can be later used to purchase a good or service offered by the issuer of the cryptocurrency” as defined by Merriam-Webster.

Security Tokens consists of an “instrument issued with the expectation of rising in value over a certain period of time” as expressed by SEC Director, William Hinman, during Yahoo's All Markets Summit: Crypto summit in San Francisco.

Mr. Hinman, using Ether (“Ethereum”) as a case study, moved away from labeling the instrument under the commissions’ definition of a security to much elation from the overall Crypto community.  The DAO case [cc5] , largely the SEC’s preeminent guidance on defining the "securitization" of tokens, lays out the framework for these highly contested digital assets in the United States

With that said, as regulations change and Ether’s use case evolve towards further adoption, the Decentralized Application (Dapp)-based token could land under the microscope in the future.

Commodity tokens are considered forms of money with an intrinsic value.

Blockchain-supportive legislation in Wyoming

Some states, and its constituents, are meeting the call for regulations in the face of federal bureaucracy.  Evident with state technology initiatives, such as the Wyoming Blockchain Coalition, Wyoming is paving the way with legislation in support of blockchain initiatives.  As a result, many businesses are moving towards these blockchain-friendly environments.

Caitlin Long, Co-Founder of the Wyoming Blockchain Coalition, discussed the process of token-based regulations in the state of Wyoming.  Her organization is a proponent for moving tokens out of the definition of a security (and instead) labelling them as a “digital property.”

Wyoming Blockchain Coalition consists of educators and technologists that are working to build the ecosystem in the state of Wyoming.  “The mission of the Wyoming Blockchain Coalition is to educate Wyoming citizens about the power of blockchain technology to cut costs, streamline administrative processes and spur entirely new businesses in Wyoming.” http://wyomingblockchain.io/

Wyoming enacted five bills in support of blockchain technology (source: The National law Review)[cc6] .

HB 19 provides a virtual currency exemption (within Wyoming) from money transmitter laws and regulations.  Cryptos seeking this exemption are subject to a filing to garner “specified verification authority” within the Wyoming Secretary of State and the Wyoming Banking Commissioner.

HB 70 provides a utility token exemption (within Wyoming) from money transmitter laws and regulations.  Cryptos seeking this exemption are subject to a filing to garner “specified verification authority” with the Wyoming Secretary of State and the Wyoming Banking Commissioner. Utility tokens, issued for non investment purposes, will generally be exempt from registration requirements under Wyoming’s securities laws.

SF 111 provides a virtual currency taxation exemption in Wyoming.  In the state, virtual currency is deemed to be “personal property,” not subject to property tax in Wyoming.

HB 101 enables corporate records of Wyoming entities to be stored on blockchain as long as digital security mechanisms are in force (e.g. electronic keys, network signatures and digital receipts).
HB 126 permit Series LLCs-- known to be a favorable corporate structure for blockchain-based businesses.
Other State Blockchain initiatives
Some states are also making headway with blockchain-based legislations (source: NCSL website). 

New York (A.B. 9782) says state agencies “are allowed to accept cryptocurrencies such as bitcoin, Ethereum, Litecoin and bitcoin cash as payment.”

Photo: Showing Crypto accepted at a restaurant in Elmhurst (Queens), NY. 

Vermont (S.B. 269)
enables “the creation and regulation of personal information protection companies; creates studies for expanding the use and promotion of blockchain technology; enables the creation of blockchain-based limited liability companies; and creates a study for the potential use of blockchain technology in government records.”

Overall, most states are in a stage of either proposing bills to define “virtual currency” and/or promote research for blockchain technology.[cc1]   Unfortunately, many state legislation are in the infancy stages of rule making, likely due to budget constraints as expressed by Caitlin Long in her discussion of regulatory progress in the U.S. 

Because of the limited regulatory framework, state-specific businesses will have its challenges when expanding across the U.S.  For example, blockchain-based businesses that operate outside of the borders of Wyoming (and its protection laws) are open to SEC authority.  This activity could prompt a shift in new businesses operating only in “blockchain-friendly” states.

Chamber of Digital Commerce (NCSL.org) provides a summary of blockchain regulations per state here [cc7] 
Blockchain, Taxes, and Congress

Snafus in crypto legislation (and its underlying Blockchain technologies) demonstrate a lack of a central force in U.S.-based regulations.  Arguably, as with new technology, there is a learning curve or “grace period” needed as regulators spend time in research.  There is much to learn about the benefits, and potential pitfalls, of rushing towards adopting a largely misunderstood technology.  After all, aside from the earliest adopters, Bitcoin was foreign to many less than just two years ago.  

Simply put, governmental agencies are backlogged with decisions in the space.  The Internal Revenue Service (IRS) code provides little guidance on the taxation of digital assets, and likewise, congress with its exhaustive legislative process, has yet to vote on several recent blockchain legislation. (ref. H.R. 6974 [cc8] ).

Our thoughts on blockchain legislation

Regarding state-based initiatives, we believe that blockchain regulations could pose a stronger footing with the adoption of uniform standards, such as those enacted by the NASAA’s Uniform Securities Act, a derivative of the SEC’s Advisors Act of 1940.  

Tips on compliance for your blockchain startup.

Speak with a blockchain attorney about regulations
Structure your business model to fit within appropriate jurisdictions
Delegate a point person or compliance to carry out policies and procedures
Stay flexible should you need to change or adapt your business.
Have courage—its going to be a tough road.

About Women4Blockchain and Hackathon

The Women4Blockchain hackathon and conference lasted from October 5-8th at New York University.  As a hands-on learner, I decided to participate in the hackathon which required teams to formulate a business use case using blockchain.  On Friday night, we formed our team and crafted an idea using blockchain technology to provide immutable transaction protocols.  By Sunday, we completed our pitch deck and presented the idea in front of a panel of judges.  Because of our efforts, we ended up tying for second place.

Women4Blockchain (W4B) is dedicated to building and empowering pioneers in the world of blockchain technology. https://www.women4blockchain.com/

Photo (L-R): Mentor: Daniel Dewar. Team: Amanda J. Dunne, Pooja Mehta, Onyeka M. Obasi, and Cory Roberson
Lessons from “Block-chaining”

Blockchain is emerging as a disrupter of current technological mediums in data and automation. In terms of security and immutable protocols, Blockchain is poised to solve some of our most pressing issues.  With that said, there is much to learn about  Blockchains’ use case with replacing existing technology systems.   Rather, I see blockchain as a means of supplementing other technology, and only when cost efficient, replacing vulnerable legacy systems.

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