By Marina Fyrigou-Koulouri and Alexandra Levin Kramer
During the last two weeks, ending January 19, 2018, the blockchain industry faced the following legal and regulatory challenges globally and particularly in the United States.
On January 18, 2018, the Commodity Futures Trading Commission (the “CFTC”) filed two civil enforcement actions, both in the U.S. District Court for the Eastern District of New York, alleging a “fraudulent virtual currency scheme” in each case.
The first lawsuit, filed against Dillon Michael Dean and his company, The Entrepreneurs Headquarters Limited (collectively, the “Defendants”), alleges that the Defendants have engaged in a “fraudulent scheme,” by “solicit[ing] at least $1.1 million worth of Bitcoin from more than 600 members of the public to participate in a pooled investment vehicle for trading commodity interests.” Specifically, according to the complaint, the Defendants, who never registered with the CFTC, were promising high profit returns and, instead of “convert[ing] customer funds…from Bitcoin to fiat currency to invest in binary options contracts, as promised, [they] misappropriated their customers’ funds,” in various ways including practices used in a Ponzi scheme. Additionally, the Defendants allegedly invented a “hacking incident” in order to support their fraud, which the CFTC claims never occurred.
Accordingly, the CFTC alleges violations of the Commodity Exchange Act (the “CEA”) with respect to fraud and failure to register as a commodity pool operator and it seeks, inter alia, a permanent injunction, disgorgement of “all benefits received from acts or practices that constitute violations,” “full restitution” to defrauded persons as well as a “civil monetary penalty.”
The second lawsuit, against Patrick Kerry and his company CabbageTech, Corp. d/b/a Coin Drop Markets (collectively, the “Defendants”) also includes allegations of “a deceptive and fraudulent virtual currency scheme.” The Complaint claims that the Defendants, who also never registered with the CFTC, fraudulently induced investors “to send money and virtual currencies…in exchange for purported virtual currency trading advice,” but as soon as they obtained the funds, they stopped all communication, even shutting down their website and social media, and also “misappropriated the funds.”
In this complaint as well, the CFTC alleges CEA violations based on “fraud by deceptive device or contrivance,” and requests similar reliefs as in the first case.
Following these cases, the Securities and Exchange Commission (the “SEC”) Co-Enforcement Directors Stephanie Avakian and Steven Peikin and the CFTC Director James McDonald issued a joint statement stating that in cases of market fraud, “- 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.”
On January 5, 2018, the SEC suspended trading in the securities of Hong Kong-based UBI Blockchain Internet from 9:30 a.m. EST on January 8, 2018, until 11:59 p.m. EST, on January 22, 2018. The suspension was ordered pursuant to Section 12(k) of the Securities Act of 1934 and was based on “unexplained market activity.” Indeed, according to the SEC release, “[t]he Commission temporarily suspended trading in the securities of UBIA because of (i) questions regarding the accuracy of assertions, since at least September 2017, by UBIA in filings with the Commission regarding the company’s business operations; and (ii) concerns about recent, unusual and unexplained market activity in the company’s Class A common stock since at least November 2017.”
On January 12, 2018, the U.S. Treasury Secretary Steven Mnuchin announced that the Financial Stability Oversight Council has initiated a working group for cryptocurrencies. Mnuchin additionally stated: “We are very focused on cryptocurrencies,” and “[w]e want to make sure that bad people cannot use these currencies to do bad things.”
On January 19, 2018, the Enforcement Section of the Massachusetts Securities Division (the “MSD”) filed an administrative complaint against Kirill Bensonoff and his Cayman Islands company, Caviar, (collectively, the “Respondents”) alleging violations of state securities laws due to the offering and selling of unregistered securities. The Respondents conducted a token sale (“TS”) distributing Caviar tokens “purportedly to finance the creation of a pooled investment fund with hedged exposure to crypto-assets and real estate debt.” The MSD alleges that the Caviar tokens are securities and, therefore, the Respondents violated the relevant laws by failing to comply with the registration requirement or classify as an exception.
Importantly, although Respondents claim that they had limited their TS, as sales of Caviar tokens to U.S. and Cayman Islands investors were not permitted, and they purportedly delegated to a third party the screening out of such persons, the MSD found that the relevant procedures were “inadequate” as the Respondents promoted the TS through “general solicitation,” and, according to the complaint, at least two U.S. residents participated in the TS. In fact, an MSD investigator created a profile using a cartoon character name and a passport image found online and was still able to participate in the TS. Additionally, the complaint alleges that Bensonoff formed a Cayman Islands company “in an acknowledged attempt to avoid jurisdiction of U.S. securities regulators.”
Accordingly, the complaint requests, inter alia, that the Respondents cease and desist from any further unlawful conduct as well as rescission to all investors, sanctions, and remedies for the public interest and an administrative fine.
On January 4, 2018, the Texas State Securities Board (the “TSSB”) issued an Emergency Cease and Desist Order against BitConnect. BitConnect, an England-based company, is “an open source all in one [b]itcoin and crypto community platform designed to provide multiple investment opportunities.” The TSSB action followed the company’s announcement of launching a TS in the U.S. on January 9, 2018. The TSSB found that investments in BitConnect are securities and, therefore, the company is violating “the Texas Securities Act by offering securities for sale in Texas at a time when the securities are not registered with the Securities Commissioner” as well as “by offering securities for sale in Texas without being registered.” Additionally, the TSSB claimed that BitConnect engaged in fraudulent conduct and misleading statements, which “threaten immediate and irreparable public harm.” According to the order, BitConnect has 31 days to request a hearing after receiving service of the order.
On January 9, 2018, the Securities Division of the North Carolina Department of Secretary of State also initiated a cease-and-desist order against BitConnect claiming violations of the North Carolina Securities Act. Indeed, the order claims, similarly to the TSSB order, that the BitConnect investments are “securities” under the state’s securities laws and, therefore, BitConnect is “is violating … [them] by offering securities for sale in North Carolina that are not registered with the Administrator, not exempted from registration, and not notice filed as would be the case with securities covered under federal law” as well as “by offering securities while it, BitConnect, is not registered with the Administrator.” Again the order alleges harmful misconduct and misleading statements. BitConnect may request a hearing or submit any responsive pleading within 30 days of the receipt of service.
On January 16, 2018, following these proceedings, the company announced on a website post that it is closing the Bitconnect lending and exchange platform and returning any active loan to all community members’ wallets. As the company team stated: “We have received two Cease and Desist letters, one from the Texas State Securities Board, and one from the North Carolina Secretary of State Securities Division. These actions have become a hindrance for the legal continuation of the platform.”
On January 16, 2018, a bill was submitted in the Colorado Senate proposing the use of blockchain technology for state records in order “to protect state records containing trusted sensitive and confidential information from criminal, unauthorized, or inadvertent manipulation or theft.”
According to the bill, citizens often need to go in person to state agencies in order to modify official registries since, even today, “some records exist only in paper form.” The use of blockchain technology, however, “may offer transformative improvements to data security, accountability, transparency, and safety across dispersed state departments and jurisdictions” by “provid[ing] the capability of openly traceable transactions while maintaining the privacy of each person performing the transactions.”
On January 3, 2018, Senator Clarkson introduces a bill in the Vermont Senate proposing “strategies relating to blockchain, cryptocurrency, and financial technology in order to: promote regulatory efficiency; enable business organizational and governance structures that may expand opportunities in financial technology; and promote education and adoption of financial technology in the public and private sectors.” Among other things, the bill proposes the creation of “Digital Currency Limited Liability Companies,” which “may provide for its governance, in whole or in part, though the technological architecture of the system.” According to the bill, such digital currency limited liability companies “shall maintain a physical presence within the State or conduct some or all of its activities within this State, or both.” They shall pay to the State “in the form of its digital currency a transaction tax equivalent to $0.01” whenever a unit of currency is mined, created, sold or transferred but they will be “exempt from taxes otherwise applicable.”
On January 8, 2018, a lawmaker in Florida submitted a bill relating to information technology and aiming to establish a legal recognition for blockchain data storage and smart contracts. Notably, the bill states that “[a] contract may not be denied legal effect or enforceability solely because 1. [a]n electronic record was used in the formation of the contract [and] 2. [t]he contract contains a smart contract term.” Additionally, “the use of blockchain technology to secure information while engaged in interstate or foreign commerce does not affect the rights of ownership or use held by the owner of such information unless the terms of the transaction expressly provide for the transfer of such rights.”
On January 9, 2018, a bill was introduced to the Arizona Senate aiming to permit the use of bitcoin and other cryptocurrencies for tax payments. According to the text, “a payment gateway, such as bitcoin or other cryptocurrency, using electronic peer-to-peer systems. the department shall convert cryptocurrency payments to united states dollars at the prevailing rate within twenty-four hours after receipt and shall credit the taxpayer's account with the converted dollar amount.”
On January 3, 2018, three bills were introduced to the Nebraska Legislature concerning blockchain and digital currencies.
The first one is related to “financial crimes” and proposes the amendment of the current money-laundering statutes by including provisions for cryptocurrencies as well as the adoption of the Nebraska Virtual Currency Money Laundering Act.
The second refers to “political subdivisions” and aims “to prohibit cities and villages from taxing or otherwise regulating the use of distributed technology.”
Finally, the third relates to “electronic records and transactions” and proposes the amendment of existing statutes “to authorize and define smart contacts [and] to authorize use of distributed ledger technology in the Electronic Notary Public Act and the Uniform Electronic Transactions Act for purposes of digital and electronic signatures.”
On January 10, 2018, a new bill was submitted to the Tennessee House of Representatives proposing an amendment to the Tennessee Code concerning electronic transactions and specifically recognizing blockchain signatures. The bill includes similar language as the bills in Florida and Nebraska.
On January 13, 2018, Bank of Indonesia issued a press release stating that “virtual currencies, including bitcoin, are not recognized as a legitimate instrument of payment, therefore not allowed to be used for payment in Indonesia.” Additionally, the release argues that virtual currencies are highly risky and present certain risks such as speculator behavior, volatility, lack of asset backing and bubble risks as well as illicit practices like money laundering and terrorism financing.
O January 8, 2018, Korea’s Financial Services Commission issued a statement announcing that the Korea Financial Intelligence Unit and the Financial Supervisory Service will begin bank inspections over cryptocurrency trading accounts. Due to their “anonymity” and “non-face-to-face transaction,” there is a high risk that cryptocurrencies will be used for money laundering purposes. According to the release, “[t]he inspectors will look into whether the banks comply with their anti-money laundering (AML) obligations in their transactions with cryptocurrency exchanges; and whether they have in place appropriate measures to verify their customers’ identification in regard with cryptocurrency trading.”
Additionally, the Bank of Korea launched a cryptocurrency task force “to study virtual currency and its effect on a conventional financial system.”
On January 9, 2018, the Securities Commission of Malaysia issued a cease-and-desist order against Copy Cash Foundation (the “Foundation”) concerning the Foundation’s planned TS on January 10, 2018. “The directive was issued by the SC following its inquiry after it found that there is a reasonable likelihood that disclosures in CopyCash Foundation’s white paper and representations to potential investors will contravene relevant requirements under securities laws.”
On January 1, 2018, the Secretary of the National Security and Defense Council of Ukraine, Oleksandr Turchynov, stated that the country has been paying close attention to the development of cryptocurrencies. Accordingly, the National Cybersecurity Coordination Center ordered the launch of “a working group” with representatives of the National Bank of Ukraine, the Ministry of Finance of Ukraine, the National Securities and Stock Market Commission of Ukraine and other sovereign bodies in order “to develop legal proposals for regulating this issue; to define the state regulator and the order of functioning of the cryptocurrencies market; to establish the order of monitoring transactions with the use of cryptography and identification of subjects of cryptocurrency transactions; as well as to set up the procedure for taxation of income from transactions using cryptocurrencies in accordance with the requirements of Ukrainian legislation.”
Additionally, in the same statement, it is announced that the National Bank of Ukraine is examining the introduction of “its own cryptocurrency.”
Please contact Alexandra Levin Kramer, the Chair of CKR Law’s Blockchain Technology & Digital Currency practice group if you have any questions. She can be reached at email@example.com or +1 (212) 259-7300.
 https://nebraskalegislature.gov/FloorDocs/105/PDF/Intro/LB691.pdf, https://nebraskalegislature.gov/FloorDocs/105/PDF/Intro/LB694.pdf, https://nebraskalegislature.gov/FloorDocs/105/PDF/Intro/LB695.pdf