Regulating Initial Coin Offerings: More Heartache Through Expectation
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  • Regulating Initial Coin Offerings: More Heartache Through Expectation

    by Mark White and Larry Perlman

    Published October 12, 2018

    The regulation of initial coin offerings (ICOs) has certainly become the topic du jour in the world of cryptocurrency related crypto tokens. And if there ever was a regulatory moratorium for ICOs, the Financial Crimes Enforcement Network (FinCEN), among other regulatory bodies,[2] is declaring this period officially over. On March 6, 2018, FinCEN publicly declared a leading role in the regulation of ICOs in a letter it sent in February to U.S. Senator Ron Wyden (the “Wyden Letter”).[3] The letter was in response to the Oregon senator’s December 2017 request for information relating to FinCEN’s oversight and enforcement of virtual currency activities, including ICOs.

    In the letter, Assistant Secretary for Legislative Affairs Drew Maloney confirmed that developers that sell a convertible virtual currency, including those conducting ICOs, generally will be considered money services businesses (MSBs) subject to FinCEN regulation.[4] As such, they must likely[5] register with FinCEN as an MSB, collect information about their customers, and comply with anti-money laundering and combating the financing of terrorism (AML/CFT) regulations. Let us be clear at this point in saying that this development is extremely important for all involved in the world of ICOs and related crypto tokens.

    At first glance, the Wyden Letter appears to have cleared up the ambiguity surrounding FinCEN’s role regarding ICOs. However, upon taking a closer read, the letter may actually pose more questions than it answers. First, the letter takes a policy position that could be seen as rather inconsistent with prior FinCEN guidance.[6]

    Second, insofar as the letter clarifies FinCEN’s position, that merely selling a centralized convertible digital currency into the market is sufficient to deem the developer an MSB, the letter does not fully clarify what happens if an ICO is structured in a way that involves an offering or sale of securities or derivatives. In fact, this determination is relegated to a fact-intensive, ambiguous, case-by-case analysis to adjudge if FinCEN, Securities and Exchange Commission (SEC), or the Commodity Futures Trading Commission (CFTC) enforcement jurisdiction ultimately prevails.

    In August 2018, FinCEN Director Blanco explained the agency’s position by stating that individuals and entities engaged in the business of accepting and transmitting physical currency or convertible virtual currency from one person to another or to another location are money transmitters subject to the AML/CFT requirements of the BSA and its implementing regulations.[7]

    Let’s take a closer look.

    Review of Terminology

    For a better understanding of the following discussion, certain terminology should be defined. Fortunately, FinCEN has provided definitions throughout its guidance:

    • Administrator - A person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency.

    • Exchanger - A person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.

    • User – A person who obtains virtual currency to purchase goods or services (e.g., individuals or companies that purchase cryptocurrencies for their own use).

    • Virtual currency - A medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency currently does not have legal tender status in any jurisdiction.

    • Convertible virtual currency – A type of virtual currency that either has an equivalent value in real currency, or acts as a substitute for real currency.

    • Money Transmitter – A person who provides money transmission services, or any other person engaged in the transfer of funds.

    Background

    Long before it was en vogue, FinCEN was one of the first government regulators in the U.S. to examine the regulation of cryptocurrency. In fact, in 2011 FinCEN amended the Bank Secrecy Act definition of money services business to include “virtual currency exchangers” and “administrators.”[8] Under the BSA regulations, a person or entity that is engaged in certain types of activities is considered an MSB.[9] Dealers in foreign exchange, providers and sellers of prepaid access, and money transmitters are all included in the definition of MSB.[10] Additionally, MSBs are subject to certain requirements under the BSA regulations, which are dictated, in part, by the specific activities of the MSB.[11]Such requirements include an obligation to maintain an anti-money laundering program, as well as registration, reporting, and record-keeping requirements.[12]

    Further clarification came in 2013 when FinCEN released FIN-2013-G001.[13]This interpretive guidance illustrates how its regulations would apply to certain actors within the newly emerging bitcoin industry. More specifically, this guidance clarified that an “administrator” or “exchanger” is a money transmitter if it: “1) accepts and transmits a convertible virtual currency, or 2) buys or sells convertible virtual currency for any reason…unless a limitation to or exemption from the definition applies to the person.”[14]

    Then, in 2014, FinCEN released interpretive guidance FIN-2014-R001 describing the circumstances in which a “miner”[15] of convertible virtual currency would or would not be considered a money service business (the “Mining Ruling”).[16]Ultimately, FinCEN determined that so long as a company mines and uses a virtual currency solely for its own purposes, it is a “user,” and therefore not an MSB.[17]

    The Wyden Letter comes on the heels of these FinCEN rulings and stakes out a policy position that attempts to clarify the uncertainty concerning the status of ICOs as MSBs. As noted above, however, discrepancies remain between the guidance and Wyden Letter. Additionally, the lines between FinCEN, the SEC, and the CFTC regarding enforcement of anti-money laundering laws are blurry, making the jurisdictional terrain hard to navigate for those involved in ICOs.

    Ambiguities and Discrepancies

    Discrepancies between the guidance and Wyden Letter

    Although FinCEN claims the Wyden Letter is a reiteration of its previous position, the application of the BSA to ICOs is actually less clear than the letter claims when compared to the previous guidance.

    In its 2013 guidance, FinCEN stated, “a person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter.”[18] The 2014 Mining Ruling, however, partially contradicts this statement and indicated that the use of a token by a business, and not the origin of the token, is the principle factor in determining BSA applicability.[19]The Mining Ruling then went on to state that if a token was sold for a person’s or business’s “own use” the person or business would be deemed a user rather than an exchanger or administrator of the virtual currency. And, as discussed above, the 2013 FinCEN guidance makes clear that users of virtual currency are not MSBs, but exchangers and administrators certainly are.[20] Unfortunately, FinCEN does not address this discrepancy in the Wyden Letter.

    The Ripple Labs Case

    In 2015, the U.S. Department of Justice (“DOJ”), working with FinCEN, prosecuted Ripple Labs for violating the BSA by selling a virtual currency known as XRP, without registering as an MSB, and for failing to implement and maintain an adequate AML program.[21] Ripple Labs is the popular payment system, currency exchange, and remittance network that is now known as the first digital currency exchange to have a civil enforcement action successfully brought against it. In the settlement agreement, the U.S. government emphasized that Ripple Labs operated as a digital trading platform, which is quite at odds with FinCEN’s guidance discussed above.[22]

    The settlement statement said that, “Ripple Labs has previously described itself in federal court filings and in a sworn affidavit as a currency exchange service providing on-line, real-time currency trading and cash management… Ripple facilitates the transfers of electronic cash equivalents and provides virtual currency exchange transaction services for transferrable electronic cash equivalent units having a specified cash value.”[23]

    This statement clearly suggests that something more than selling a centralized virtual currency is required before a developer of an ICO that sells the virtual currency will be branded an “exchanger” that must register as an MSB. However, the settlement statement then strangely contradicts itself by stating that, “Ripple Labs continued to engage in transactions whereby it sold Ripple currency (XRP) for fiat currency even though it was not registered with FinCEN as an MSB.”[24] This contradiction suggests that FinCEN considers merely selling a centralized convertible virtual currency for a fiat currency, and nothing more, makes the entity an exchanger required to register as an MSB.

    This ambiguity was partially addressed by FinCEN in the Wyden Letter by stating that any sale of a centralized convertible virtual currency requires the seller to register as an MSB. Per the Wyden Letter, “Generally under existing regulations and interpretations, a developer that sells convertible virtual currency, including in the form of ICO coins or tokens, in exchange for another type of value that substitutes for currency is a money transmitter and must comply with AML/CFT requirements that apply to this type of MSB.”[25]

    On its face this language seems clear enough, but problems begin to arise when considering FinCEN’s jurisdictional enforcement limits (i.e., where does FinCEN’s jurisdictional enforcement authority begin and where does it end when viewed in conjunction with the jurisdictional enforcement authority of the SEC and CFTC?).[26]

    Which Regulator?

    FinCEN’s regulations clearly state that MSBs do not include, “a person registered with, and functionally regulated or examined by, the SEC or the CFTC.”[27] This would certainly include broker-dealers registered with the SEC and futures commission merchants (“FCM”) registered with the CFTC. Interestingly, the SEC has recently taken the position that most ICOs are issuances of securities and anyone facilitating virtual currency trading must register as a broker-dealer.[28]

    Additionally, like the SEC, the CFTC has staked out an interest in regulating certain ICOs and cryptocurrencies in general. Adding to the confusion regarding jurisdictional authority, the CFTC has determined that virtual currencies are, in fact, commodities and that anyone who accepts orders to buy or sell futures contracts on virtual currencies are subject to registration as FCMs.[29]

    The question thus becomes, if the SEC will require broker-dealers to apply AML/CFT rules to sellers of convertible virtual currencies and the CFTC will likewise regulate the same as FCMs, why is FinCEN also subjecting these sellers to regulation as MSBs? The Wyden Letter, unfortunately, does not clarify this problematic issue beyond stating that it will “coordinate” with the SEC and CFTC “to clarify and enforce the AML/CFT obligations of businesses engaged in [ICO] activities.”[30] Additionally, the letter states that “to the extent that an ICO is structured in a way that it involves an offering or sale of securities or derivatives,” the applicable regulations could be imposed by the SEC or CFTC.[31]

    Clearly FinCEN is taking the position that not all ICOs are convertible virtual currencies and that this determination is made on a case-by-case basis using a factual test that, frustratingly, is yet to be standardized. Without a doubt, virtual token and currency projects will need to consider carefully their own facts and circumstances in navigating the separate agency requirements. One thing that is certain, however, is that FinCEN is paying attention to the token sale and ICO marketplace. It sees a role for itself from the standpoint that the market attracts financial crimes and BSA non-compliance issues and is putting the industry on notice that a robust compliance program is now a must.

    Ultimately, regardless of the uncertainties inherent in the Wyden Letter, persons engaging in the creation of ICOs will be scrutinized and regulated by one of the regulatory agencies.  It would make sense, then, to adhere to the specific regulations of each regulator and consult competent counsel to chart the proper course of action when engaging in these activities.[32] 

    Lingering Questions and Conclusion

    As discussed above, FinCEN clearly takes the position that the development and sale of ICO tokens is presumptively MSB activity. However, FinCEN does not explain in the Wyden Letter how these activities fall within the statutory or regulatory definitions, nor does it specify the difference between the activities of an “administrator” or an “exchanger” as those terms are used in its previous guidance. The letter also fails to address whether or when statutory or regulatory exemptions may apply to the creation or sale of virtual currency, such as the exemption for funds transmission that is central to the sale of goods or provision of services.

    Further, and more glaringly, FinCEN does not clarify how or why it interprets creating, manufacturing, mining, and the subsequent sale of a virtual currency (like bitcoin) as unregulated activity in FIN-2014-R001, but interprets the development and subsequent sale of ICO tokens as regulated activity per FinCEN’s Wyden Letter. While questions such as these remain unanswered, one can be hopeful that more regulatory activity and guidance will follow.

    In spite of all the confusion and lack of definitive clarity, promoters of ICOs would be wise to monitor FinCEN’s public statements and should be hard at work developing BSA compliance programs to protect themselves from the potentially substantial fines and criminal liability associated with FinCEN actions.[33] And although the Wyden Letter is not a formal interpretive ruling or formal guidance, the letter should nonetheless be taken as a serious warning to all current ICOs and prospective ICOs that FinCEN is paying attention and expects full compliance with the BSA. Additionally, and of no less importance, potential regulation by the SEC and CFTC are not to be overlooked, since the same liabilities and fines may be imposed as a result of regulatory deficiencies in this world of burgeoning ICO activity.



    [1] William Shakespeare, "Oft expectation fails, and most oft there where most it promises."  All's Well That Ends Well, act II, i, 145.

    [2] To date, five federal regulators - Financial Crimes Enforcement Network (FinCEN), Office of Foreign Assets Control (OFAC), Commodity Futures Trading Commission (CFTC), Internal Revenue Service (IRS), and Securities and Exchange Commission (SEC) - have recently taken action by having issued statements clarifying their positions on the scope of their jurisdiction over various aspects of cryptocurrency and certain types of blockchain enterprises.

    [3] Letter to Senator Ron Wyden from Drew Maloney, Assistant Secretary of the Treasury for Legislative Affairs. https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-center.pdf.

    [4] Id. at 3.

    [5] It is considered “likely” due in part to FinCEN’s statement that “generally” those conducting ICOs will be considered MSBs subject to regulation. The determination will be based on a case-by-case, factual basis. 

    [6] In 2011 FinCEN amended the Bank Secrecy Act’s definition of “money services business” to include virtual currency exchangers and administrators.  In 2013, FinCEN released FIN-2013-G001 “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies.” In 2014, FinCEN released FIN-2014-R001, the “Mining Ruling,” declaring that certain harvesters of virtual currency are considered money services businesses.

    [7] Prepared Remarks of FinCEN Director Kenneth A. Blanco, delivered at the 2018 Chicago-Kent Block (Legal) Tech Conference, August 9, 2018. https://www.fincen.gov/news/speeches/prepared-remarks-fincen-director-kenneth-blanco-delivered-2018-chicago-kent-block.

     

    [8] Federal Register Vol. 76, No. 140, Thursday, July 21, 2011. Department of the Treasury, FinCEN, 31 CFR Parts 1010, 1021, and 1022, Bank Secrecy Act Regulations; Definitions and Other Regulations Relating to Money Services Businesseshttps://www.gpo.gov/fdsys/pkg/FR-2011-07-21/pdf/2011-18309.pdf.

    [9] 12 C.F.R. 1010.100(ff).

    [10] Id.

    [11]  12 C.F.R. 1022.210.

    [12] 12 C.F.R. 1022.210(d). Policies, procedures, and internal controls must include verifying customer identification, filing reports, creating and retaining records, responding to law enforcement, integrating compliance procedures with automated data processing systems, designating a person to assure compliance, providing training to personnel, and providing for an independent review of the program.

    [13] FinCEN’s Guidance FIN-2013-G001 issued March 18, 2013, Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies at: https://www.fincen.gov/sites/default/files/shared/FIN-2013-G001.pdf.

    [14] Id.

    [15] A “miner” of convertible virtual currency uses a computer program to perform algorithms that allow a person to verify and add transactions to the public ledger (blockchain), and thereby release new virtual currency.

    [16] FinCEN’s Guidance FIN-2014-R001 issued January 30, 2014, Application of FinCEN’s Regulations to Virtual Currency Mining Operations can be found at: https://www.fincen.gov/sites/default/files/shared/FIN-2014-R001.pdf.

    [17] Id.

    [18] FIN-2013-G001, supra note 10.

    [19] FIN-20140R001, supra note 13.

    [20] FIN-2013-G001, supra note 10.

    [21] U.S. Department of Justice, Unites States Attorney, Northern District of California, Settlement Agreement with Ripple Labs can be found at: https://www.justice.gov/sites/default/files/opa/press-releases/attachments/2015/05/05/settlement_agreement.pdf.

    [22] Id.

    [23] FinCEN, ATTACHMENT A: STATEMENT OF FACTS AND VIOLATIONS (May 5, 2015) available at

    https://www.fincen.gov/sites/default/files/shared/Ripple_Facts.pdf.

    [24] Settlement Statement, supra note 18.

    [25] The Wyden Letter, supra note 2.

    [26] FinCEN was established in 1990 but was not a bureau of the U.S. Treasury Dept. until its designation by Section 361 of Title III of the USA Patriot Act (Pub. L. No. 107-56, Oct. 26, 2001). Although FinCEN plays a central role, in certain cases (as referenced therein) it assists other law enforcement and regulatory authorities in anti-money laundering efforts rather than directly engaging in enforcement activities.

    [27] 31 C.F.R. 1010.100(ff)(8).

    [28] SEC Chairman Jay Clayton Statement on Cryptocurrencies and Initial Coin Offerings, December 11, 2017 https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11.

    [29] CFTC Release Number 7664-17, December 15, 2017, CFTC Issues Proposed Interpretation on Virtual Currency “Actual Delivery” in Retail Transactions.https://www.cftc.gov/PressRoom/PressReleases/7664-17.

    [30] The Wyden Letter, supra note 2.

    [31] Id.

    [32] FinCEN/U.S. Treasury, 31 CFR Parts 1000-1099; SEC, 17 CFR Parts 200-399; CFTC, 17 CFR Parts 1-199. Based on specific facts, ICOs may be securities offerings or commodities, and fall under the SECs or CFTCs jurisdiction of enforcing either federal securities or commodities futures trading laws.

    [33] Any group or individual developer who both (1) sold newly created tokens to buyers (i.e., ICOs) involving U.S. residents and (2) failed to register with FinCEN as a money transmitter, and perform the associated compliance Know Your Customer/AML obligations, can be charged under federal felony criminal statute, 18 U.S.C. § 1960, with unlicensed money transmission. Penalties include up to five years in prison and liability may extend to employees of, and investors in, the business that sold the cryptocurrency.



    Mark White, JD, is a senior banking compliance analyst with Wolters Kluwer. Larry Perlman, JD, LLM, is a tax and regulatory specialist with Wolters Kluwer. They gratefully appreciate the assistance of their Wolters Kluwer colleague, Stevie Conlon, with this article.



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