Cryptocurrency: Evolving Regulatory

Landscape, Recent SEC, CFTC, FinCEN,

IRS Enforcement Actions

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WEDNESDAY, APRIL 18, 2018

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Stefan Savic, Partner, Shipkevich, New York

Felix Shipkevich, Principal, Shipkevich, New York

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Cryptocurrency: Evolving Regulatory

Landscape, Recent SEC, CFTC,

FinCEN, IRS Enforcement Actions

Felix Shipkevich

Stefan Savic

April 18, 2018

Shipkevich PLLC

t. 212.252.3003

f. 212.591.6179

www.shipkevich.com

Felix Shipkevich

Stefan Savic

April 18, 2018

Shipkevich PLLC

t. 212.252.3003

f. 212.591.6179

www.shipkevich.com

Stefan SavicPartner at Shipkevich PLLC

Felix ShipkevichPrincipal of Shipkevich PLLC

• Overview

• SEC

• IRS

• CFTC

• Money Transmission

• FinCEN

Agenda

Blockchain Technology and

Cryptocurrency Overview

Distributed Ledger?

• Investopedia Definition of Distributed Ledger:

A distributed ledger is a database that is consensually shared andsynchronized across network spread across multiple sites, institutions orgeographies. It allows transactions to have public ‘witnesses,’ therebymaking a cyberattack more difficult. The participant at each node of thenetwork can access the recordings shared across that network and can ownan identical copy of it. Further, any changes or additions made to the ledgerare reflected and copied to all participants in a matter of seconds orminutes. Underlying the distributed ledger technology is the blockchain,which is the technology that underlies bitcoin.

Blockchain?

Blockchains are one form of distributed ledger technology.The structure of the blockchain makes it distinct from otherkinds of distributed ledgers as data on a blockchain isgrouped together and organized in blocks. The blocks arethen linked to one another and secured using cryptography.

A blockchain is essentially a continuously growing list ofrecords. Its append-only structure only allows data to beadded to the database: altering or deleting previouslyentered data on earlier blocks is impossible.

Cryptocurrency?

Cryptocurrency is a form of digitalmoney that is designed to besecure and, in many cases,anonymous. In other words, it isjust another form of paymentthat can be exchanged for goodsand services.

Many companies have issuedtheir own currencies, often calledtokens, and these can be tradedspecifically for the good or servicethat the company provides.

Think of them as you wouldarcade tokens or casino chips.You’ll need to exchange realcurrency for the cryptocurrencyto access the good or service.

ICO?

An Initial Coin Offering, also commonly referred to as an ICO, is a fundraising

mechanism in which new projects sell their underlying crypto tokens in exchange for

bitcoin and ether.

ICOs, token pre-sales, and similar sales of blockchain-based coins and tokens are

quickly becoming an important fundraising option for many

early-stage companies.

ICO?

Even though an ICO raises funds, the "coins" are not currency. Instead, the coinsor tokens purchased in an initial coin offering can be used to transfer value withinthe new coin's ecosystem, or to other cryptocurrencies' ecosystems.

Not unlike a Kickstarter campaign, an ICO usually sets a minimum goal for afundraise and a period of time to reach that goal.

If the requirements are met, then the tokens are distributed and can be used forthe purchase and use of certain products developed by the start-up.

Individuals choose to invest in ICOs typically because they believe that the tokenswill have value either in and of themselves as currency (e.g., Bitcoin) or becausethe tokens will have value on the platform to be created (e.g., Ethereum)

Imagine that a friend is building a casino and asks you to invest. In exchange,you get chips that can be used at the casino’s tables once it’s finished. Nowimagine that the value of the chips isn’t fixed, and will instead fluctuatedepending on the popularity of the casino, the number of other gamblers andthe regulatory environment for casinos. Oh, and instead of a friend, imagine it’sa stranger on the internet who might be using a fake name, who might notactually know how to build a casino, and whom you probably can’t sue forfraud if he steals your money and uses it to buy a Porsche instead. That’s anI.C.O.

– Kevin Roose, The New York Times

SEC Enforcement and Regulation

SEC enforcement and regulation

SEC Enforcement and Regulation

The DAO Report

• The most formal guidance is an investigative report issued

by the SEC on July 25, 2017, where the SEC analyzed

one specific set of tokens issued by an unincorporated

organization The DAO. While the SEC took no position on

the status of tokens generally, its analysis is consistent

with the framework used by the SEC and courts in other

contexts since Congress enacted the first federal

securities laws in the wake of the Great Depression.

An Investment Contract and the Howey Test

SEC v. W.J. Howey Co., 328 U.S. 293, 298-300 (1946): Whendetermining whether it will regulate something that might be asecurity, the SEC is governed by the courts’ application of a four-part test often called the Howey test. This test examines whetherthe potential investment contract involves (1) investment ofmoney (2) in a common enterprise (3) with an expectation ofprofit that comes (4) solely from the efforts of others. The thirdand fourth prong are often analyzed together.

SAFT?

Simple Agreement For Future Tokens

“ICOs, these things can transform. They may start their life as a security from a capital-raising perspective but then at some point (…) turn into a commodity.” CFTC Commissioner Brian Quintenz.

The SAFT framework seeks to solve this uncertainty for both investors and issuer. If tokens are sold with the believe that they will be a utility / commodity in the future, a SAFT contract can be created as a security sold to accredited investors. This agreement is ensuring investors the delivery of tokens once a functioning network or application has been developed and tokens can be used on it. The bet that issuers and investors of a SAFT are making is that the SEC or the courts will determine that the tokens are not securities at this later point, while they might have been classified as such during the ICO because there was no fully functional network (= no use value) yet.

How does SAFT work?

The developers themselves can also sell tokens to the public at this point.

Once the network’s basic functionality exists, the developer creates the tokens and delivers them to the investors, who can sell tokens to the public on the open market to realize their profit.

The developer uses the money to develop the network. Still no pre-functional tokens are issued.

The developer into a written agreement, called a SAFT, with accredited investors. The SAFT calls for investors to pay money to the developer in exchange for a right to tokens once the network is completed. The developers don’t

issue any pre-functional tokens at this stage, but they do file the required forms with the SEC.

SAFT Pros and Cons

• Through the two-step process, the SAFTframework is bringing a financing structureand standard for token financing that fitswith the stage and intent of the companies.If properly executed, a token sale can permitusers to participate financially in thatcreation and growth without taking onsignificant risk.

• Only wealthy individuals and institutionalbuyers, not the proverbial mom-and-popinvestors, would bear the risk of the projectfailing, while consumer protectionregulations would still apply if the finalproduct turns out to be defective.

• Also, many blockchain projects, originallybased in the U.S., have made the difficultdecision to relocate the project to non-U.S.jurisdictions. The SAFT framework enablesprojects to have more clarity regarding thesethree bodies of law. This might lead to morecompanies remaining within the USjurisdiction.

• The SEC still hasn’t confirmed that this two-stepframework actually works as intended.

• The SAFT doesn’t achieve much for tokens that arethemselves securities. Using a SAFT won’t make asecurities token any less of a security. It only works forutility tokens.

• It won’t aid even utility tokens where purchasersremain reliant on the efforts of others for theirexpectation of profit after the token is in circulation.

• The SAFT framework is focused on bodies of USfederal law and not generally applicable worldwide,although it can be beneficial in regards to USregulation it can very well be deemed as an illegalpractice in other jurisdictions, potentially excludingmany international contributions.

• The SAFT approach excludes the general public fromparticipation, as only accredited investors couldparticipate in the first part of token sale.

SEC

ENFORCEMENT

What do we know about the subpoenas that have been continuously issues since Fall 2017?

What did we learn (or did not learn) from Munchee, Inc.?

Going after attorneys?

Statement on Potentially Unlawful Online Platforms for Trading Digital Assets

Fraud and Ponzi schemes

IRS

Recent IRS-related cryptocurency developments

IRS-RELATED CRYPTO DEVELOPMENTS OVER THE PAST

SIX MONTHS

IRS

• IRS issued guidance on tax treatment of transactions using virtual currencies

• Explained that virtual currency is treated as property for federal tax purposes and must

be reported in U.S. dollars

NOVEMBER 14, 2017

IRS

• Federal court in the Northern District of California ordered Coinbase to give the

IRS requested transaction information on approximately 13,000 of its users after

Coinbase refused to comply with a summons from the IRS a year earlier.

• Court ordered Coinbase to produce only the taxpayer identification number; name;

birthdate; address; records of account activity, including transaction logs; and all periodic

statements of account or invoices (or the equivalent) for accounts subject to the

narrowed summons.

NOVEMBER 29, 2017

IRS

• Trump Tax Bill announced that in 2018 the exchange of one cryptocurrency for

another can no longer be claimed as a tax free exchange under Tax Code §1031.

DECEMBER 22, 2017

IRS

• IRS announces new whistleblower policy: if the cryptocurrency reported was

used for an illegal purpose, like a fraud scheme, and the IRS seizes the

actual cryptocurrency, the whistleblower will receive between 15 and 30 percent

of the seized virtual currency

JANUARY 12, 2018

IRS

• Bloomberg reported that the IRS assembled a team of investigators for

international crime investigations as well as for finding tax evaders who use

cryptocurrency

FEBRUARY 8, 2018

IRS

• IRS sent out a news release reminding taxpayers to report virtual currency

transactions on their income tax returns (and noting that it did not forget about

the previous years).

MARCH 23, 2018

OTHER ISSUES

IRS

• Per Notice 2014-21, Bitcoins earned through mining were gross income at the

time earned (different from, for example, gold which is not income when mined,

but when used).

BITCOIN EARNED THROUGH MINING

IRS

• What happens when there is an update to the currency software or the

blockchain and some miners do not agree to the changes and continue using the

old software or the old blockchain.

HARD FORK

Stefan Savic

Stefan Savic is a partner at ShipkevichPLLC. He represents clients in all stages oflitigation and alternative disputeresolution proceedings. Stefan’s litigationpractice focuses on commercial litigationin federal and state courts in varioussubject matters ranging from civil RICOclaims to misappropriation of tradesecrets, unfair competition, and breachesof fiduciary duties.

While Stefan’s work focuses heavily on civillitigation, he also assists businesses inavoiding costly litigation by assuring thatclients have safeguards in place at allstages of business management.

CFTC / Money Transmission / FinCEN

Who knew there is also…

▪ U.S. CFTC

▪ Money Transmitter Laws

▪ FinCEN

CFTC

CFTC Jurisdiction

▪ The Commodity Exchange Act (“CEA”) grants the CFTC exclusive jurisdiction over trading of futures.

▪ The Dodd-Frank Act (Title VII) amended the CEA to expand the CFTC’s jurisdiction to include swaps.

Key Definitions:

• Futures contract: an agreement to purchase or sell a commodity for delivery in the future (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfill the contract at the specified price; (3) that is used to assume or short price risk; and (4) that may be satisfied by the delivery or offset.

• Forward contract: A cash transaction common in many industries, including commodity merchandising, in which a commercial buyer and seller agree upon delivery of a specified quality and quantity of goods at a specified future date. Terms may be more 'personalized' than is the case with standardized futures contracts (i.e., delivery time and amount are as determined betweenseller and buyer). A price may be agreed upon in advance, or there may be agreement that the price will be determined at the time of delivery.

• Swap: a derivative contract through which two parties exchange financial instruments.

• Commodity: includes, among other things, "all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in."

CFTC Jurisdiction

▪ Broad definition of the term “commodity.”

▪ CFTC vs Coinflip.

▪ Swaps may be traded on a Swap Execution Facility (SEF) or a

Designated Contract Market (DCM).

▪ SEFs: Eligible Contract Participants (ECPs).

▪ A financial institution, insurance company, registered investment company,

commodity pool, and pension plans with assets in excess of USD 5 million and

entities with assets in excess of USD 10 million:

▪ A governmental entity;

▪ An individual who has invested on discretionary basis in excess of USD 10 million

▪ DCMs: retail consumers and ECPs.

CFTC Jurisdiction

▪ Jurisdiction over any agreement, contract or transaction in any

commodity:

▪ (i) entered with, or offered to a person that is not an ECP or eligible commercial

entity; and

▪ (ii) entered into, or offered on leveraged or margined basis, or financed by the

offeror, the counterparty, or a person acting in concert with the offeror or

counterparty on a similar basis.

▪ No Jurisdiction over spot transactions

▪ transactions for immediate delivery (t+2);

▪ for cryptocurrency that results in actual delivery within 28-days (CFTC issued

proposed interpretation on virtual currency “actual delivery” on December 15, 2017).

CFTC vs Coinflip

• Coinflip operated an online facility named Derivabit, offering to connect buyers and sellers of Bitcoin option contracts.

• On September 17, 2015, CFTC filed its first action against an unregistered bitcoin options trading platform (coinflip) for operating a facility for the trading or processing of swaps without being registered as a swap execution facility or designated contract market.

• CFTC asserted jurisdiction under section 1a(9) with reference to Board of Trade of City of Chicago v. SEC, 677 F. 2d 1137, 1142 (7th Cir. 1982).

CFTC vs Bitfinex

• CFTC vs Bitfinex; CFTC Docket No. 16-19 (June 2, 2016)– On June 2, 2016, the CFTC issued an Order filing and simultaneously settling

charges against BFXNA Inc. d/b/a Bitfinex, alleging that, from April 2013 to at least

February 2016, Bitfinex offered illegal off-exchange financed retail commodity

transactions in various cryptocurrencies, including Bitcoin, while failing to register as

a Futures Commission Merchant, a requirement of the Commodity Exchange Act.

– The Order required Bitfinex to pay a $75,000 civil penalty and to cease and desist

from further violations of the CEA.

– The Order found that Bitfinex allowed users to borrow funds from other users on the

platform in order to trade Bitcoins on a leveraged, margined, or financed basis.

– By offering to enter into, executing, and/or confirming the execution of off-exchange

financed retail commodity transactions, Bitfinex violated Section 4(a) of the CEA

which requires that these transactions be conducted on a designated contract

market or derivatives transaction execution facility.

– The Order further found that Bitfinex accepted orders and received funds in

connection with retail commodity transactions without being registered with the

CFTC as an FCM.

LabCFTC

• October 17, 2017 issued a report on virtual currencies (titled: A CFTC

Primer on Virtual Currencies) that provided a sample of potential use

cases on virtual currencies:

– Store of Value – Like precious metals, many virtual currencies are a “non-yielding” asset (meaning they do not pay dividends or interest), but they may be more fungible, divisible, and portable – Limited or finite supply of virtual currencies may contrast with ‘real’ (fiat) currencies.

– Trading in virtual currencies may result in capital gains or losses. Note that trading in virtual currencies may involve significant speculation and volatility risk.

– Payments and Transactions – Some merchants and online stores are accepting virtual currencies in exchange for physical and digital goods (i.e., payments) – Some public Blockchain systems rely on the payment of fees in virtual currency form in order to power the network and underlying transactions.

– Transfer / Move Money – Domestic and international money transfer (e.g., remittances) in order to increase efficiencies and potentially reduce related fees.

LabCFTC

LIST OF PROHIBITED ACTIVITIES

• Price manipulation of a virtual currency traded in interstate commerce.

• Pre-arranged or wash trading in an exchange traded virtual currency swap or

futures contract.

• A virtual currency futures or option contract or swap traded on a domestic

platform or facility that has not registered with the CFTC as a SEF or DCM.

• Certain schemes involving virtual currency marketed to retail customers, such

as off-exchange financed commodity transactions with person who fail to

register with the CFTC.

LabCFTC

• There is no inconsistency between the SEC’s analysis and the CFTC’s

determination that virtual currencies are commodities and that virtual

tokens may be commodities or derivatives contracts depending on the

particular facts and circumstances.

– The CFTC looks beyond form and considers the actual substance and purpose of

an activity when applying the federal commodities laws and CFTC Regulations.

CFTC Enforcement

• Sep 24, 2015 , the CFTC brought an action against a registered bitcoin/dollar exchange (TeraExchange), alleging that the company had failed to enforce the Commission’s prohibition on wash trading.

• The Order found that TeraExcange offered for trading on its SEF a non-deliverable forward contract based on the relative value of the U.S. Dollar and Bitcoin.

• Specifically, on October 8, 2014, two authorized participants on TeraExchange’s Swap Execution Facility entered into two transactions to in the Bitcoin Swap. While this was a pre-arranged wash sale to test their system, TeraExchange issued a press release announcing the transactions, creating the impression of actual trading interest in the Bitcoin Swap.

• This violated the CFTC rules prohibiting certain types of trade practices on the SEF, including wash trading and prearranged trading.

CFTC Enforcement

• January 16, 2018, the CFTC brought action against My Big Coin Pay and associated individuals solicited customers to buy “My Big Coin,” a virtual currency supposedly backed by gold, actively traded worldwide, and associated with payment services such as MasterCard for fraud after misappropriation of millions of dollar of funds– The action alleged that Defendants fraudulently solicited My Big Coin customers in the United States by making

false and misleading claims and omissions about the currency’s value, usage, trade status, and that it was backed by gold.

– The currency website contained numerous solicitation materials, trade data, and other materials misrepresenting that the currency was actively traded on several exchanges, misrepresenting the daily trading price (even though no actual price existed because it was not trading), misrepresenting it was backed by gold, and misrepresenting that the company had partnered with Mastercard.

– However, the trading results were fraudulent, and any payouts to customers were derived from funds fraudulently obtained from other clients, akin to a ponzi scheme.

• January, 18, 2018, the CFTC filed 2 lawsuits in federal court arising from alleged fraud schemes involving virtual currencies. – In one case, the CFTC alleged that Dillon Michael Dean from Colorado and his company, Entrepreneurs

Headquarters Limited, collected more than $1.1 million in bitcoin from over 600 people as part of a pooled investment vehicle for trading commodity interests. The pool was said to invest in binary options contracts, according to the complaint. However, the CFTC alleged that the defendants misappropriated the funds

– In the second case, Patrick Kerry McDonnell from New York and the company CabbageTech, were sued by the CFTC for allegedly absconding with customers' digital assets after McDonnell branded himself as a cryptocurrency investment expert with trading advice that could result in highly attractive returns on investment but cut off all communications with customers after they sent him money and cryptocurrencies for his advisory services

CFTC Enforcement

• Commodity Futures Trading Commission v. Patrick K. McDonnell, and CabbageTech, Corp. d/b/a Coin Drop Markets(1:18-cv-00361)– Defendants Patrick McDonnell and CabbageTech, Corp d/b/a Coin Drop Markets were charged with

operating a fraudulent virtual currency scheme which alleged to provide virtual currency trading advice and virtual currency purchases and trading, and for misappropriating investor funds.

– Customers paid defendants for membership of virtual currency trading groups purported to provide profits of up to 300% per week. Services were advertised through websites and Twitter. However, after receiving membership payment or currency investments, defendants deleted their social media accounts and websites, and provided minimal if any virtual currency trading advice, and never achieved a return on investment for customers.

– The primary issue was whether the CFTC had standing to sue defendants for alleged violations of the CEA.

• Judge Weinstein ruled that– Virtual currencies fall well-within the CEA’s definition of “commodities”;– The CFTC has “standing to exercise its enforcement power over fraud to virtual currencies sold in

interstate commerce.”

What the CFTC said

“When market participants engage in fraud under the guise of offering digital instruments — whether characterized as virtual currencies, coins, tokens, or the like – the SEC and the CFTC will look beyond form, examine the substance of the activity and prosecute violations of the federal securities and commodities laws. The Divisions of Enforcement for the SEC and CFTC will continue to address violations and bring actions to stop and prevent fraud in the offer and sale of digital instruments.”- SEC Co-Enforcement Directors Stephanie Avakian and Steven Peikin and CFTC Enforcement Director James McDonald.

What the CFTC said

• “Everyone that trades these products needs to know that there is no federal oversight over these platforms”- CFTC Commissioner Brian Quintenz.

• “Virtual currencies mark a paradigm shift in how we think about payments, traditional financial processes, and engaging in economic activity. Ignoring these developments will not make them go away, nor is it a responsible regulatory response.”- CFTC Chairman Christopher Giancarlo.

What the CFTC said

• "We don't have oversight authority... "That's kind of a hole in the law, a lack of jurisdiction.”- Commissioner Quintenz said in regards to action against unregistered ICOs.

• “I want to reiterate my previously stated emphasis that market participants should take note that the relatively nascent underlying cash markets and exchanges for bitcoin remain largely unregulated markets over which the CFTC has limited statutory authority. Investors should be aware of the potentially high level of volatility and risk in these markets.” CFTC Chairman Christopher Giancarlo.

• With regard to tokens distributed through ICOs, "The CFTC cannot issue any requirements to employees regarding legal financial transactions beyond those currently enumerated in the CEA…Broadly speaking, Initial Coin Offerings do not fall under the CFTC's jurisdiction.”- CFTC director for the office of public affairs Erica Richardson.

What the CFTC said

“There is no inconsistency between the SEC’s analysis and the CFTC’s determination that virtual currencies are commodities and that virtual tokens may be commodities or derivatives contracts depending on the particular facts and circumstances.” – A CFTC Primer on Virtual Currencies

“The CFTC looks beyond form and considers the actual substance and purpose of an activity when applying the federal commodities laws and CFTC regulation.” - A CFTC Primer on Virtual Currencies

CFTC Needs to Clarify

What remains unclear…

- Is the CFTC going to opine on utility tokens?

- Is the CFTC going to regulate / require registration of unlicensed ICOs /

token exchanges?

- Will the CFTC require registration of crypto brokers as FCMs?

- Will the CFTC treat leveraged crypto similar to over-the-counter retail

foreign exchange transactions?

Money Transmitter Laws

• Every state besides Montana requires money transmitters to satisfy requirements to be licensed as a money transmitter.

• Some states exempt virtual currency from definition as a money transmitter.

– In April, 3014, Texas became the first state to exempt the exchange of virtual currency from money transmission licensing requirements.

– In December 2017, the Texas State Securities Board brought enforcement actions against five digital currency related businesses, holding that the investments tied to cryptocurrency constituted as securities under the Texas Securities Act.

Money Transmitter Laws

• High-Level ICO / Token Sales Money Transmitter Analysis:

– Licensing required (or likely to regulate): AL, CT, HI, NY, VT, and WA.

– License not required (or unlikely to regulate): CA, ID, IL, KS, LA, MD, MO, MT, NH, NC, TN, TX and WI.

– Still unclear: AK, AZ, AR, CO, DC, DE, FL, GA, IN, IA, KY, ME, MA, MI, MN, MS, NE, NV, NJ, NM, ND, OH, OK, OR, PA, RI, SC, SD, UT, WV, WY.

FinCEN

• 2013: FinCEN stated that it has jurisdiction over cryptocurrency businesses as money transmitters.

– FinCEN determined that the Bank Secrecy Act applies to administrators or exchanges of virtual currency and must in turn register as money service businesses.

FinCEN

• 2018: on March 6th FinCEN published a letter to U.S. Sen. Ron Wyden (D – Oregon) asserting that cryptocurrency exchanges are typically money transmitters and must register with FinCEN: - company with the Bank Secrecy Act; perform KYC and AML. According to FinCEN: – “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 money service business. An exchange that sells ICO or tokens, or exchanges them for other virtual currency, fiat currency, or other value that substitutes for currency would typically also be a money transmitter.”

– “FinCEN is closely working with the SEC and CFTC to clarify and enforce AML/CFT obligations of business engaged in ICOs activities that implicate the regulatory authorities of these agencies.”

Felix Shipkevich

Felix concentrates on futures, commodities, and derivatives regulatory, transactional, and enforcement matters. He performs transactional work for Futures Commissions Merchants (FCMs), Retail Foreign Exchange Dealers (RFEDs), Introducing Brokers (IBs), Commodity Pool Operators (CPOs), Commodity Trading Advisors (CTAs), Swap Dealers (SDs), and Swap Execution Facilities (SEFs).

His practice also includes enforcement defense litigation and regulatory investigations of FinTech companies. Felix is regularly involved with both national and cross-border financial services regulatory issues including representing clients investigated by regulatory bodies such as the U.S. CFTC and National Futures Association.

Felix is also a Special Professor of Law at Hofstra University School of Law.

Shipkevich PLLC65 Broadway, Suite 508

New York, NY 10006

+1 212 252 3003

www.shipkevich.com

Felix Shipkevich

fs@shipkevich.com

Stefan Savic

ssavic@shipkevich.com