Digital Assets and U.S. Law

March 11, 2019

Davis Polk & Wardwell LLP Agenda

1. Intro to Digital Assets with a Legal Lens 2

2. Legal Overview 10

3. Legal Deep Dive: The U.S. Securities Laws 13

4. Legal Deep Dive: The U.S. Commodities Laws 19

5. Legal Deep Dive: Other Federal and State Actors 23

1 Agenda

1. Intro to Digital Assets with a Legal Lens 2

2. Legal Overview 10

3. Legal Deep Dive: The U.S. Securities Laws 13

4. Legal Deep Dive: The U.S. Commodities Laws 19

5. Legal Deep Dive: Other Federal and State Actors 23

2 Background on Digital Assets and Distributed Ledgers : THE HISTORY AND KEY ECONOMIC PROPERTIES

Market Price (USD) • Origins − A Cypherpunk’s Manifesto (1993) • “[P]rivacy in an open society requires anonymous transaction systems .” • Encrypted digital communications − Wei Dai’s b-money proposal (1998) • Described peer-to-peer digital cash − ’s bitcoin (2008) • Cracked the code • But who is Satoshi?

Unbacked Limited Total Supply Pseudo-anonymous P2P /Decentralized Irreversible Settlement 21m F I N A L

*but there are caveats

3 Background on Distributed Technology BITCOIN’S KEY INNOVATION

The ledger

[Frank]

The

2 BTC 0.5 BTC 5 BTC 1 BTC 8 BTC 0.1 BTC Alice Bob Carol Dan Ben Fred Hank Rob Sue Lara Tim Ian

4 BTC 7 BTC 3 BTC ABSTRACTION Eric Frank Bill Jen Sam John

Technical features Mining Public Keys Nonce Hashing Private Keys Difficulty Targets Transaction Fees Cryptography Verification SHA-256 Nodes

4 Other Applications for Distributed Ledgers AND BEYOND

• Ethereum (2015) − Ledger with a (Ether, “ETH”) and arbitrary other values

Securities Loans Credentials ( e.g. Diplomas)

Diamonds Land Titles Letters of Credit Identity Collectables

5 Types of CONSIDERATIONS FOR DLT DESIGN AND DEVELOPMENT

Distributed Ledger Design and Development

Public Blockchains Consortium Blockchains Private Blockchains • All participants are • Open to the public, but not • A central authority able to access the all data is available to all manages access and database, store a participants can modify the copy, and modify it. • User rights differ and blocks database. are validated based on • More easily • Examples : predefined rules incorporated with existing IT systems • Examples: • Basically, an encrypted audit trail

• Examples:

6 Digital Asset Market Growth ~$133 BILLION (COINS ALONE)

Top 10 Digital Assets (out of 2,000+) by ~Fully Diluted Market Cap, as of February 21, 2019

Many names: No widely Altcoins, tokens, appcoins, digital currencies, accepted definitions virtual currencies, digital assets, metatokens… Data sources: coinmarketcap.com onchainfx.com

7 The Emerging Ecosystem THE LAW REGULATES ACTIVITIES

Protocol-level innovations aimed to shape blockchain technology Infrastructure

Software, e.g. , mobile apps, Online platforms for users to Wallets/ Exchanges storing private account data Custodians transfer fiat, (USD) to virtual and enabling transactions currencies (and vice versa)

Financial intermediaries Products and services aimed that process Payment Mining at groups or individuals who merchant-consumer Processing run “mining” operations transactions in bitcoin

Organizations enabling Market Institutions facilitating Consortia greater R&D collaboration Makers liquid virtual currency & Advocacy & Traders and creating awareness trading markets

Investment Organizations investing in Smart Smart contracts, DApps, Vehicles/ virtual currencies and Contracts and token platforms, e.g. , VC Funds underlying infrastructure Ethereum and NEO

8 International Response to Digital Assets (A Sample)

Ecuador: . Banned issuance, promotion, or circulation of Bangladesh: virtual currencies . Government has warned that transactions conducted in virtual . Plans to issues own virtual currency convertible to currency could be punishable by up to 12 years in prison US dollars under strict anti-money laundering laws European Union: . Issued warnings to public about the risk of investing in Bermuda: virtual currencies . New legislation creates novel class of bank to service fintech . In December 2017, EU authorities agreed to amend companies as part of effort to establish itself as leading 4th Anti-Money Laundering Directive. Member states cryptocurrency jurisdiction will have 18 months to adopt the amendments, which will apply KYC requirements to virtual currency Bolivia: exchanges . Explicit ban on any currency or coins not issued or regulated . ECB rejected Estonia’s plans to launch a state-run by government, including a list of virtual currencies virtual currency, and has indicated it will not allow any . Citizens banned from denominating prices in unapproved EU member to introduce its own virtual currency currency . 22 member states join partnership to cooperate on blockchain regulation and education Canada: France: . Taking a light-touch approach, delays awaited regulation of . Recently released AMF guidance very friendly to and blockchain companies ICOs confirmed tokens would not normally qualify . Ontario Securities Commission granted regulatory relief as equity securities or debt securities given rights from registration for a Toronto based ICO usually attached to them . Bank of Canada published discussion paper on whether . New law sets friendly guidelines for ICO issuance Russia: Switzerland: central banks should issue virtual currency Gibraltar: . After initial plans to ban virtual currencies, . Recently released FINMA categories of payment tokens (currency, subject . Major Chinese mining operations reportedly considering . EU-regulated Gibraltar Stock Exchange to launch government said it is preparing laws to regulate relocating to Quebec virtual currency exchange their use to AML laws), asset tokens (securities, subject to securities laws), utility tokens (not securities or China: . President Putin has directed the Central bank to currency if utility exists when issued) . Reports that electricity use by miners is being restricted India: issue an official virtual currency to be legal tender . Swiss banks to allow business accounts for . Government reportedly blocking access to all virtual . Reserve Bank of India launched new unit to tackle within Russia crypto companies currency exchange and ICO websites, and banning blockchain and crypto regulation commercial venues from hosting cryptocurrency events in Saudi Arabia: Beijing’s financial district Iran: . Saudi Arabian Monetary authority plans to United States: . ICOs considered illegal activity, government seeking to . Iran reveals national crypto features in response to US launch a pilot project for a virtual currency . Virtual currencies regulated by CFTC as “annihilate and destroy” blockchain based pyramid sanctions available to be traded by banks commodities; SEC treats some as securities; IRS schemes treats them as property Japan: . Financial institutions and third-party payment providers South Africa: . FinCEN money services business licensing . Enacted law authorizing use of virtual currency as payment banned from accepting, using, or selling virtual currencies . Central Bank issued warning that bitcoin has no . State licensing regimes for certain virtual . Requires licensing for virtual currency companies . People’s Bank of China has ordered financial institutions to legal status, and value is not guaranteed, but no currency activities . Financial Services Agency has granted several licenses for stop providing banking or funding to any activity related to regulatory action . US Senators raise crypto mining concerns, virtual currency exchanges virtual currencies . Local Bitcoin exchanges see spike in usage propose government blockchains . Despite the heavy enforcement for virtual currencies, the during leadership turmoil at finance ministry China Banking Regulatory Commission recently published Kazakhstan: Uzbekistan : a paper calling for adoption of blockchain technology in . Announced plans to issue blockchain-based bonds South Korea: . President issues order welcoming cryptocurrency China’s credit markets . Ban on anonymous digital trading accounts, with exchanges with new tax and licensing benefits Malta: authority to close exchanges that do not comply Colombia : . Maltese parliament passes three blockchain bills with KYC rules Venezuela: . Colombian banks shut down Buda crypto exchange into law, establishing friendly regulatory . South Korean Supreme Court rules Bitcoin is an . President Maduro orders banks to adopt petro accounts framework for blockchain sector asset cryptocurrency as a unit of account

9 Agenda

1. Intro to Digital Assets with a Legal Lens 2

2. Legal Overview 10

3. Legal Deep Dive: The U.S. Securities Laws 13

4. Legal Deep Dive: The U.S. Commodities Laws 19

5. Legal Deep Dive: Other Federal and State Actors 23

10 Who has Jurisdiction in the U.S.?

Federal Government • Securities Exchange Commission (SEC) • Commodity Futures Trading Commission (CFTC) • U.S. Treasury Department - Financial Crimes Enforcement Network (FinCEN) • Internal Revenue Service (IRS) • Federal Trade Commission (FTC) States • Securities Laws • Commodities Laws • Lending Laws • Consumer Protection and Anti-Fraud Laws • Money Transmission Laws (i.e., BitLicense)

11 U.S. State Response to Virtual Currencies and Blockchain (A Sample)

WA – July 2017: HI – Jan. 2018: NH – June 2017: ID – Jan 2018: Governor signs law applying WA’s money HI lawmaker introduces Uniform Regulation of Governor signs law exempting persons using virtual Department of Finance issues warning about transmitter laws to cryptocurrency exchanges Virtual Currency Businesses Act currencies from registering as money transmitters investments in cryptocurrencies

WY – Feb 2018: KS – Jan. 2018: VT– Jan. 2018: NE – Jan 2018: WY recently enacted legislation exempting certain Office of Kansas Securities Commissioner issues VT lawmaker proposes bill that would classify LLCs NE lawmaker proposes three bills that non-investment, utility tokens from state securities warning about investments in cryptocurrencies using digital currency systems as “digital limited would amend AML laws to account for regulation liability companies” and exempt such firms from cryptocurrencies, allow for blockchain tech AL– Aug. 2017: taxes other than a $0.01 transaction tax to be used for notarization, prohibit local NV – June 2017: Alabama Governor signs Alabama Money municipalities from regulating use of DLT NV enacts law recognizing blockchain technology Transmission Act into law, including “virtual Jan 2018: as a type of electronic record and prohibiting local currency” in definition of money transmission NE lawmaker introduces Uniform governments from taxing or imposing restrictions on Regulation of Virtual Currency the use of blockchain FL – Jan. 2018: Businesses Act Lawmaker introduces bill that would recognize CA – Aug 2017: smart contracts and blockchain signatures as valid CA reintroduces bill to create a Digital Currency electronic records and valid electronic signatures, Business Enrollment Program, which would require respectively qualification as a “digital currency business” to store, transmit, exchange or issue digital currencies NC – Jan. 2018: State Securities Division issues temporary AZ – Jan. 2018: cease-and-desist order against BitConnect for AZ lawmaker submits bill that would allow payment offering investments in NC when not registered of state tax liabilities using bitcoin or other as a securities dealer or salesman cryptocurrencies Feb. 2018: TN – Jan. 2018: AZ Senate passes a bill that would allow residents TN lawmaker files bill that would recognize to pay taxes with Bitcoin and other cryptocurrencies blockchain signatures as legal electronic records and smart contracts as valid under TN law TX – Jan. 2018: Texas Department of Banking orders WV – Apr. 2017: cryptocurrency platform AriseBank to cease and WV legislature passes amendment to the State’s desist from implying that it is engaged in the AML statute, including cryptocurrencies in the business of banking in Texas definition of “monetary instruments” Jan.-Feb. 2018: Texas State Securities Board issues cease-and- NY – Aug. 2015: desist orders against BitConnect, R2B, and NYDFS BitLicense regime becomes effective DavorCoin for violations of state securities laws Nov. 2017: NYDFS grants 4th ever BitLicense to bitFlyer. AK – Jan. 2018: Feb. 2018: Division of Banking and Securities issues warning NYDFS issues guidance for all “virtual currency about investments in cryptocurrencies business entities” warning that they are required to implement measures to prevent market manipulation, fraud, and other wrongful activity

12 Agenda

1. Intro to Digital Assets with a Legal Lens 2

2. Legal Overview 10

3. Legal Deep Dive: The U.S. Securities Laws 13

4. Legal Deep Dive: The U.S. Commodities Laws 19

5. Legal Deep Dive: Other Federal and State Actors 23

13 The U.S. Securities Laws and the SEC WHEN IS A DIGITAL ASSET A SECURITY?

• The offer and sale of a security must be registered “I have yet to see an ICO that under the Securities Act, unless conducted under an doesn’t have a sufficient number applicable exemption. of hallmarks of a security.” When is a digital asset a security? • Jay Clayton, SEC Chairman − (1) The digital asset represents a “traditional” security interest; or − (2) The security represents an “ investment contract ” • Howey Test (1942) • An investment of money Case Study: Munchee ICO • In a common enterprise . MUN tokens meant to be used • With a reasonable expectation of profits with an app / platform • From the entrepreneurial or managerial . Sold to public to finance efforts of another development − Key takeaway : A highly nuanced analysis. Not a . Deals with marketers “check-the-box” exercise. . Platform not yet developed . App development centralized • SEC has been laser-focused on this since late 2017 . SEC: Cease-and-desist

14 The U.S. Securities Laws and the SEC ENFORCEMENT ACTIVITY INVOLVING TOKEN SALES

DAO • The DAO was a distributed investment fund which planned to use proceeds from a token sale to invest in profit making projects.

EtherDelta and Zachary Coburn • EtherDelta is a unregistered decentralized exchange that allows users to trade, purchase, and sell tokens built on the Ethereum network. Zachary Coburn was the creator and developer of EtherDelta, but had not managed it since December 2017, when he sold it.

Paragon and Airfox • Paragon and Airfox each conducted ICOs and each of their tokens were subsequently determined to be securities at the time they were issued.

Gladius Network • Gladius self-reported to the SEC, expressed an interest in taking prompt remedial steps, and cooperated with the investigation. No penalty because the company self-reported the conduct, agreed to compensate investors and will register the tokens as securities.

15 The U.S. Securities Laws and the SEC A PATH FORWARD FOR TOKEN SALES? MAYBE.

1. Register Your Offering • File a registration statement to register the token as a security with the SEC. • Process will vary depending on whether the token is an investment contract or an equity security. • Allows for broad sales and marketing activities, including to unaccredited investors. • Expensive and time consuming.

2. Execute an Exempt Offering • Reg D and Reg S provide avenues for token issuers to sell tokens in unregistered offerings. • Reg D is a limited offering exemption that involves manner of sale, holding period and other requirements. (506(b) vs. 506(c)). • Reg S is used for offerings that take place outside the US to non-U.S. persons. • Requires access to the private markets (e.g., angels, VCs, strategics)

16 The U.S. Securities Laws and the SEC A PATH FORWARD FOR TOKEN SALES? MAYBE NOT.

2018 Initial Coin Offerings Total Raised

Jan

Source: Token Data

17 The U.S. Securities Laws and the SEC A PATH FORWARD FOR TOKEN SALES? MAYBE NOT.

Venture Capital Firms Blockchain Investments Still on Largest Venture Capital the Rise Deals (2018)

Company Size (Mn) Led by

Bitmain $400 SequoiaCapital

Andreessen Horowitz, DFINITY $163 Hashed, Polychain

Basis $133 Bain Captial Ventures

companies Bank of America, R3 $122 SBI Holdings, HSBC

Circle $110

Seba Black River Ventures, $104 Crypto Summer Capital

Ledger $77 Draper Esprit

RRE Ventures, Liberty Paxos $65 City Ventures, Jay Jordan

Uphold $57.5 Hard Yaka Ribbit Capital, DCM Figure $55 Ventures

18 Agenda

1. Intro to Digital Assets with a Legal Lens 2

2. Legal Overview 10

3. Legal Deep Dive: The U.S. Securities Laws 13

4. Legal Deep Dive: The U.S. Commodities Laws 19

5. Legal Deep Dive: Other Federal and State Actors 23

19 U.S. Commodities Laws CFTC GUIDANCE AND ENFORCEMENT

• In 2014, the CFTC declared virtual currencies to be a “commodity” subject to CFTC oversight under the Commodity Exchange Act (the “CEA”) • Since then the CFTC has… − Taken action against unregistered bitcoin futures exchanges − Enforced laws prohibiting wash trading and prearranged trades on a derivatives platform − Issued proposed guidance on what transactions are treated as spot versus derivatives under CEA − Issued warnings about valuations and volatility in spot virtual currency markets − Addressed virtual currency Ponzi schemes − Cracked down on pump and dump scammers and price manipulators

In the news: CFTC wins trial against virtual currency fraudster On August 23, 2018, U.S. District Court Judge Jack B. Weinstein rejected arguments by Patrick McDonnell, operator of the New York-based CabbageTech Corp., that the CFTC lacked authority to regulate his cryptocurrency promotion business. The CFTC won a court order permanently banning CabbageTech’s efforts to prey on investors using “trickery, false statements and misappropriation of funds.” This holding lays the foundation for future CFTC enforcement actions in the area of market manipulation, given the court’s finding of CFTC jurisdiction over antifraud and antimanipulation in the virtual currency spot markets. – CFTC v. McDonnell and CabbageTech Corp.

20 The SEC-CFTC Jurisdictional Divide LOTS OF GROUND COVERED

. GBI . LabCFTC Report . CabbageTech

Investment schemes . Potential for both CFTC and SEC anti-fraud and other regulation

21 The SEC-CFTC Jurisdictional Divide LOTS OF GROUND COVERED

. GBI . LabCFTC Report . No federal agency has yet asserted full authority to regulate spot . CabbageTech cryptocurrency markets . What exactly would that regulation entail? . Exchange registration requirements . Surveillance and monitoring of exchanges . Transaction reportingInvestment requirements schemes . Establishing personnel. Potential conduct for both standards Engaging in consumerCFTC education and SEC . anti-fraud and . Imposing operationalother standards regulation . Capital adequacy . Trading system safeguards . Cyber security examinations or other requirements

22 Agenda

1. Intro to Digital Assets with a Legal Lens 2

2. Legal Overview 10

3. Legal Deep Dive: The U.S. Securities Laws 13

4. Legal Deep Dive: The U.S. Commodities Laws 19

5. Legal Deep Dive: Other Federal and State Actors 23

23 Tax Issues THERE ARE MANY

Some Consequences Under IRS Notice 2014-21 Many Unknowns Notice 2014-21

• Under IRS Notice 2014-21, • Fair market value (“ FMV ”) of • Basis of blocks of virtual “convertible” virtual currency, virtual currency received as currency acquired at different such as bitcoin: payment taken into account in times – Is property determining income . Can separate lots be – Can be held as a capital • Use of virtual currency as mode identified for a disposition? asset of payment treated as sale of • Is virtual currency such as virtual currency for FMV bitcoin a “commodity” for U.S. – Is not treated as “currency” federal income tax purposes? that can generate foreign • Payments made in virtual currency gain or loss (which currency may be subject to • Is a token issued in an ICO a is generally treated as information reporting and security for U.S. federal income ordinary income) backup withholding tax purposes? • Is a fork a realization event? If so, what is the proper treatment of that realization event? • What are the tax consequences of an “air drop”?

24 Others – FinCEN, DOJ, FBI, CIA

25 State Laws EXAMPLE: BITLICENSE

“Virtual Currency Business Activity” is defined as any of the following involving New York:

1. Receiving virtual 2. Holding virtual currency 3. Buying and selling virtual currency currency for transmission for others as a customer business or transmitting it

4. Exchange services as a 5. Controlling, Exempt from BitLicense customer business administering, or issuing virtual currency . Certain entities chartered under New York Banking Law . Mere merchants, consumers, investors . Mere software developers/distributors

See Davis Polk visual memo, New York’s Final “BitLicense” Rule

26