Bitcoin and Blockchain: Certain U.S. Regulatory Considerations for Investment Managers By Gavin Fearey, Andrew Rosell and Pax Sinsangkeo Gavin Fearey is Of Counsel in the Fort Worth, TX office of Winstead PC, and is a member of Winstead’s Corporate, Securities/Mergers & Acquisitions Practice Group and the firm’s Investment Management & Private Funds Introduction Industry Group. * This article offers a number of U.S. regulatory considerations and preliminary observations for investment managers exploring or entering the cryptocurrency space. We first provide abasic introduction to blockchain or distributed ledger technologies, looking at the examples of the virtual currencies Bitcoin and Ether, as well as virtual tokens and coins, the offering of which is now under tighter U.S. regulatory scrutiny. We then look at opportunities to acquire assets in these technologies, which vary from trading virtual currencies directly, participating in token launches structured to comply with regulatory requirements or secondary trading of such tokens, acquiring exposure through equity vehicles and deriva- tives, making more traditional venture capital or other investments in companies Andrew Rosell is a shareholder of Winstead PC, and is a member of Winstead’s Corporate, building the infrastructure to use the new technology (such as protocols or Securities/Mergers & Acquisitions Practice trading platforms), or participating in blockchain networks and pursuing op- Group.** portunities in specific sectors. Third, this article provides a brief overview of the emergent state of U.S. regulation of these virtual currencies and other digital assets, and our preliminary observations on the impact of this regulation on investment managers. Fourth, we seek to address the steps an investment manager should consider before a private investment fund acquires exposure to virtual currencies or other digital assets. Among other things, we note that great caution should be exercised in preparing to advise clients on investments in virtual currencies and other digital assets. Significant due diligence should be undertaken and investment managers should be prepared to provide clients with additional counseling and disclosures with respect to the significant risks facing Pax Sinsangkeo is an associate in the Charlotte, these technologies. NC office of Winstead PC.*** ©2017, Gavin Fearey, Andrew Rosell and Pax Sinsangkeo. 28 Practical Compliance & Risk Management For the Securities Industry | January–February SECTION 1 – What is blockchain phones.5 Indeed, the United Nations has imple- mented and experimented with DLT to monitor or distributed ledger the efficacy of foreign aid to refugees.6 Even technology? What is Bitcoin and Delaware corporate law now expressly authorizes what is Ethereum? the use of distributed ledgers or blockchain for tracking share issuances and transfers, as well What are ICOs? as maintaining corporate records.7 This July 2017 In this section, we discuss the recent develop- change in Delaware law is part of a broader, ment of blockchain and other DLT, as well as ongoing blockchain initiative in Delaware, Bitcoin and Ethereum, explaining briefly what which may extend to official documents ranging they are and how they are currently being used. from company filings, land titles, professional This section provides a baseline context for our licenses, collateral claims and birth and death article; therefore, it is optional for those familiar certificates. Further, over the course of 2018, the with cryptocurrencies and up-to-date on block- Depository Trust Clearing Corporation (DTCC) is chain developments who can instead focus on expected to roll out and complete its move to other sections. a blockchain-based platform for the post-trade Bitcoin is the first blockchain or distributed processing and reporting services it provides for ledger technology (“DLT”) to successfully solve a over $11 trillion in credit default swaps.8 problem succinctly described by Marc Andrees- As often accompanies the introduction of any sen: “Bitcoin gives us, for the first time, a way new technology, reactions to digital assets and for one Internet user to transfer a unique piece blockchain range from wild optimism (leading to of digital property to another Internet user, the SEC’s recent warnings about ICOs or ‘initial such that the transfer is guaranteed to be safe coin offerings’9) to healthy skepticism (frequently and secure, everyone knows that the transfer involving use of the term ‘bubble’), to outright has taken place, and nobody can challenge denial or complete indifference (with the CEO of the legitimacy of the transfer.”1 Blockchain JP Morgan slamming Bitcoin as a ‘fraud’10). Some transactions, which need not involve a central U.S. federal and state regulators are wholeheart- authority or middleman, were first used to make edly embracing their role in regulation of new payment transfers without the involvement of applications of the technology while others had, any financial institution (or in some cases, any at least until recently, been observing from the government currency). Entrepreneurs, businesses sidelines, gathering data and considering their and governments are now seeing the possibili- next move. Similarly, mindful of both potential ties for public and private blockchains to be rewards and pitfalls, investment managers are applied to a host of activities and industries considering whether (and, if so, when) to invest in which intermediaries control the process of client assets in, or obtain exposure to, virtual transfers and maintain the necessary systems in currencies (such as Bitcoin and Ether) or other exchange for a fee. They also see the potential to digital assets. The meteoric rise in the prices reach new customers and markets. of Bitcoin and other prominent coins over the Following Bitcoin’s introduction in 2008, course of 2017, as well as the introduction of numerous virtual currencies or “altcoins” have Bitcoin futures in December 2017, only increased since been created, utilizing DLT for a variety of attention from both new and existing investment purposes.2 By December 2017, there were more managers. Reportedly, there were more than than 1,300 virtual currencies in existence, with 100 U.S. or non-U.S. cryptocurrency hedge fund a total market capitalization in excess of $590 managers by mid-November 2017 with funds billion.3 More than half of the world’s largest which have either launched or are planned.11 corporations are reportedly actively consider- What is blockchain? ing or deploying blockchain.4 In FinTech, there is excitement about the potential for payment Blockchain has been boiled down to a simple systems to reach millions of the so-called statement: connected computers reach agree- ‘unbanked’ (not only in the U.S. but particularly ment over shared data.12 In essence, blockchain in emerging markets) who might be able to use is just a database or ledger. However, blockchain DLT and other new technologies with mobile and other DLT use public key cryptography Bitcoin and Blockchain: Certain U.S. Regulatory Considerations for Investment Managers 29 and certain other technologies to maintain (“CFTC”) and the Internal Revenue Service the integrity of the ledger on a decentralized (“IRS”) have each identified virtual currency as “peer-to-peer” computer network. Blockchains a digital representation of value that functions and other DLT can be used in novel and power- as a medium of exchange, a unit of account, ful ways because they rely less — or sometimes and/or a store of value, but does not have legal hardly at all — on a central authority and require tender status in any jurisdiction.16 Sometimes, no central server or database to function. virtual currencies are also called cryptocur- Instead, each ‘node’ or computer on the network rencies or digital currencies. There are many runs the same protocol or software (which is different virtual currencies in use today. Some often open-source) and has an identical copy are decentralized while others rely on a central of the ledger. For a new block of transactions authority. The two most prominent decentral- to occur, each node must verify the proposed ized virtual currencies are Bitcoin and Ether transactions. Once the appropriate level of con- sensus occurs between nodes, the transactions are recorded on the ledger, as further explained Blockchain has been boiled down below for Bitcoin. In other words, no central- ized server controls or stores the ledger and no to a simple statement: connected manual process, human verification or ‘trusted’ intermediary is required at any point of each computers reach agreement over blockchain transaction or, generally speaking, to maintain the ledger on an ongoing basis. shared data. Many believe that applications of blockchain have the potential to reduce transaction costs (on the Ethereum network), which we briefly and the need for intermediaries in entire indus- profile below. In June 2017, theNew York Times tries. For instance, fees charged by many existing reported that the value of all Ether and Bitcoin payment systems are 1% to 3%. The potential to was approaching the size of Goldman Sachs.17 reduce transaction costs in payment systems has The prices of those two virtual currencies have led many to invest in Bitcoin infrastructure or grown dramatically since that report. The market develop other DLT. There are so many types of DLT value of all Bitcoin is estimated at over $324 bil- and potential uses for DLT that one U.S. Federal lion