Cryptocurrency’s Legal Considerations for Asset Managers
The asset management community’s interest in cryptocurrencies (also called virtual currencies) has grown in tandem with the exponential increase in market price of Bitcoin in recent months. As recently as January 2017, a single Bitcoin could be traded for $1,000. Today, a single Bitcoin traded for $16,680; a Bitcoin future is available on the CBOE and another will shortly follow on the CME. Other cryptocurrencies, like Ethereum, Ripple, Litecoin, NEM and Monero, to name only a few, have also attracted great trading interest.
Market observers have varied opinions about cryptocurrencies: some have called them a whole new paradigm; others, a whole new pyramid scheme. Financial market regulators throughout the world have also varied in their responses: today, the status of cryptocurrency trading is murky in China and Russia; in Germany, Bitcoin is legal tender; and in the US, Bitcoin is a convertible currency, but is not legal tender. Soon, Bitcoin futures will be available on the CME and CBOE, and for the first time, Bitcoin bears will have the ready ability to short Bitcoins in the futures market—the previous inability for participants readily to short Bitcoin in a marketplace may have contributed in part to its exponential rise. The technological underpinnings of cryptocurrencies and their supporting blockchains has been frequently described, such as in this article by PriceWaterhouseCoopers.
It is vital that a US-based asset manager trying to decide whether and how to participate in cryptocurrency markets keep in mind the positions of the SEC, the CFTC and the IRS on the offer and trading of cryptocurrencies. Of course, as regulators and tax authorities grapple with fitting cryptocurrencies into existing regulatory frameworks, just as asset managers grapple with fitting them into their portfolio management strategies, those frameworks and strategies will change. But just because cryptocurrencies are new does not mean that current rules don’t apply to them—in fact, the rules do apply and can be ignored only at peril. Briefly summarized below are current positions of the SEC, the CFTC and the IRS on cryptocurrencies. Those current positions may well change over time. Nevertheless, asset managers would be well-advised to address the nuances of these positions and issues with counsel before entering the cryptocurrency marketplace, either to participate in ICOs (Initial Coin Offerings), to take positions in cryptocurrencies as part of a more general portfolio strategy, or to offer cryptocurrencies to investors or advise investors about buying or selling them. Trading or offering cryptocurrencies without considering the legal ramifications of doing so could lead to violations of US securities, tax and commodities laws and significant legal consequences. This brief note does not consider the special risks arising for participants in the cryptocurrencies marketplace, including difficulties for regulators of policing that marketplace, with the consequent risks to market participants.
It is important to distinguish “cryptocurrencies” or “virtual currencies” from the “blockchains” that undergird them. A blockchain is a form of decentralized digital ledger in which all participants in the blockchain have copies of the entire contents of the constantly-updated ledger and there exists no central “privileged” repository of the ledger’s contents (such as, for example, at a traditional bank or brokerage which keeps a master record of all of its clients’ accounts). A blockchain supports the issuance and transfer of Bitcoins or other virtual currencies. It is already the case that blockchains will likely replace many traditional ledgering systems in use by banks, brokerage firms and other entities that use ledgers as part of their business activities.
It is also important to distinguish “cryptocurrencies” from fiat currencies, which are backed by central banks. Fiat currencies include US dollars, British pounds, Chinese renminbi, and European Euros, along with hundreds of others, which are legal tender in their country of issuance. Many cryptocurrency advocates believe this status beyond the control of central banks is a principal attraction of virtual currencies; other observers cite the same status as a principal drawback, in that cryptocurrencies can be used to transfer value anonymously, making them especially useful to persons wanting their financial transactions to be “off the grid”, whether for libertarian or criminal reasons. Whether banking regulators throughout the world will willingly accommodate a reduction of their ability to control the medium of exchange in their countries remains to be seen. And cryptocurrencies do not share with fiat currencies the characteristic of being a store of value because of the dramatic and enormous fluctuations in the value of cryptocurrencies relative to fiat currencies.
SEC Position on Cryptocurrencies: The DAO Report (July 25, 2017)
Three key questions animate the SEC’s analysis: whether a particular cryptocurrency, such as Bitcoin, in a particular context (such as in the context of an ICO or Initial Coin Offering), is a “security”; whether the platform on which the cryptocurrency is bought and sold is an “exchange”; and whether the cryptocurrency offering is itself an “investment company” or whether an entity speculating in cryptocurrency may itself be an investment company. In addition, once a cryptocurrency is determined to be a security, then those who advise about buying or selling it may be “investment advisers”.
Cryptocurrencies May Be Securities; When They Are, They Must Be Registered or Exempt or They Are Illegal
The SEC’s Report was issued after its investigation of The Decentralized Autonomous Organization (The DAO) and The DAO’s effort to create a crowdfunding smart contract through the use of a distributed ledger or blockchain. Participants used ether (the Ethereum cryptocurrency) to acquire “DAO Tokens”, which in turn enabled participants to vote on which projects The DAO would fund and would also entitle the participant to “rewards” if the projects became successful. Participants could also monetize their positions in DAO Tokens by re-selling them on special web-based platforms that supported secondary trading in the Tokens. Both the promoters and its potential participants were geographically dispersed. One of the issue’s promoters described the DAO model as akin to that of “buying shares in a company and getting…dividends.” Approximately $150 million worth of ether was subscribed for DAO Tokens. After the offering closed, but before the proceeds could be invested in particular projects, the DAO was hacked and one-third of its assets were stolen; the theft ultimately triggered a “hard fork” in the Ethereum blockchain so that the stolen funds could be returned to The DAO.
In analyzing the structure of The DAO offering, the SEC cited the 70-year-old Howey case to determine that DAO Tokens were”investment contracts” and therefore, securities and whether their offering by The DAO was a securities offering. Since the SEC determined the DAO Tokens to be securities (specifically, the SEC found that DAO Tokens were a form of “investment contract”), the SEC asserted that they fell within the purview of the SEC’s regulatory authority over securities, just as do common stocks, bonds, options and the like. In applying the Howey test to DAO Tokens in the DAO offering, the SEC said that an “investment contract” involves (1) the investment of money (2) in a common enterprise, (3) with the expectation of profits (4) attributable to the efforts of others. The SEC then found each of these four elements to be present in the facts before it in the structure of The DAO’s offering. The SEC explicitly noted that “The automation of certain functions through this technology, “smart contracts,” or computer code, does not remove conduct from the purview of the U. S. federal securities laws.”
Whether the facts and circumstances of a particular offering structure would have the four elements the SEC has identified to be relevant to whether an offering involves a “security” should be carefully considered with counsel, but the SEC’s Report provides useful insight into how the SEC would approach the issue with any cryptocurrency offering.
Platforms Making Secondary Markets in Cryptocurrencies That Are Securities Must Be Registered or Exempt National Securities Exchanges or Registered as Broker-Dealers or They Are Illegal
In the case of The DAO, the organizers created online platforms allowing customers of each platform to buy and sell DAO Tokens in the secondary market, using virtual currencies or fiat currencies on an anonymous basis. The platform would match customer orders with those of other customers of that platform for automatic execution and publicly displayed quotes, trades and daily volume. Under these facts, the SEC’s Division of Enforcement concluded that the platforms were exchanges and therefore either should be registered under the Exchange Act; or should be registered as a broker-dealer with an “alternative trading system” (ATS), in which case the platform would be exempt from the requirement of registration as an exchange.
Virtual Companies Investing in ICOs or Acquiring Cryptocurrencies May Be Investment Companies and If They Are Must Be Registered Investment Companies or Exempt From Registration or They Are Illegal
Although the SEC Report did not analyze the question of whether The DAO was an “investment company” (because it never commenced its funding operations), the SEC did urge that “those who would use virtual organizations should consider their obligations under the Investment Company Act.”
Under that Act, an “investment company” is defined to be any issuer that holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities or which is engaged in that business and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the issuer’s total assets (Investment Company Act §3(a)(1). The definition is complex and subject to exceptions which will not be described in this brief post. The important point is that a virtual company itself may be an investment company and possibly subject to registration, depending in part on what it acquires with its capital; for example, if it is acquiring cryptocurrencies which are themselves “securities”, then it in turn may well be an investment company. That the company is virtual is not relevant to the analysis of whether it is an investment company. The detailed factual inquiry necessary to resolve that question should be carefully undertaken, and is ignored at one’s peril.
Once a Token is Determined To Be A “Security”, Giving Advice About Buying or Selling It Makes One an Investment Adviser
If a cryptocurrency is determined to be a security (using the Howey analysis), then a person being paid for advice about whether to buy or sell that cryptocurrency is acting as an investment adviser and may need to register as such under the Investment Advisers Act. Investment advisers must also comply with the requirements under that Act concerning custody, fiduciary obligations, codes of ethics and limits on principal transactions. Compliance with custody requirements may be difficult to achieve.
CFTC Position on Cryptocurrencies: They Are Commodities And Are Therefore Subject to Regulation by the CFTC: LabCFTC: A CFTC Primer on Virtual Currencies (October 17, 2017)
The CFTC treats Bitcoin and other cryptocurrencies (the CFTC refers to them as virtual currencies) as commodities, and has asserted jurisdiction over derivatives contracts involving virtual currencies and where there is fraud or manipulation involving a virtual currency traded in interstate commerce.
Several platforms, including TeraExchange, LLC, North American Derivatives Exchange Inc. and LedgerX, LLC have registered with the CFTC as swap execution facilities, derivative clearing organizations or designated contract markets, depending on the cryptocurrency activities they facilitate. In addition, the CBOE listed Bitcoin futures for trading on December 10 and the CME plans to list futures contracts based on Bitcoin on December 18.
The CFTC also has authority to regulate and in many cases to register market participants that offer cryptocurrency futures to customers or advise customers about the purchase and sale of cryptocurrency futures. Participation in the market without proper registration or other proscribed activities can result in criminal violation of the Commodity Exchange Act, and the CFTC may refer matters to the Department of Justice for criminal prosecution.
So Where Do the SEC’s and CFTC’s Analyses Leave Us?
Assuming that a fund manager wishes to create a fund to speculate in cryptocurrencies, it could certainly do so, provided that it either registered the offering or structured the offering to be exempt under the 1933 Act; registered the offering or structured the offering and participants to be exempt under the 1940 Act (as is the case with plain vanilla hedge funds); complied with the Advisers Act, and with relevant state securities laws that would vary based on the locus of the offering. Key to the offering would be reliance on offering documents providing a full description of the special risks pertinent to cryptocurrency offerings, along with all other material facts. If the portfolio manager wished to speculate in cryptocurrency futures, it would also have to comply with the Commodity Exchange Act and related CFTC regulations, including those related to offering documents and registration as commodity pool operators (CPOs) or commodity trading advisors (CTAs).
IRS Position on Cryptocurrencies: They Are Taxable as Property (But Not as Foreign Currency): IRS Notice 2014-21 (March 25, 2014)
The IRS treats cryptocurrencies as property for US federal tax purposes, and so the general rules for property transactions apply. A taxpayer who receives cryptocurrency as payment for goods or services must include the fair market value of the cryptocurrency received in gross income. Even though cryptocurrencies, relative to the US dollar in the US, share certain characteristics with foreign currencies, cryptocurrencies do not generate foreign currency gain or loss for US federal tax purposes.
Conclusion
This brief post is intended to alert readers to some of the legal issues that should be carefully considered (i) before a person provides paid advice about buying or selling cryptocurrencies or derivative contracts based on cryptocurrencies, (ii) before offering units of interest in an entity that may be subscribed in cryptocurrency or concern the issuance of new cryptocurrency units to participants; or (iii) before participating in a platform through which cryptocurrencies are bought and sold. Any of those activities may come within the ambit of the SEC and the CFTC and expose the participant, the offeror and the trading platform to US securities and commodity laws.
If you would like to discuss your firm’s participation in the cryptocurrency market, please contact me at the address below.
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