Category Archives — BitLicense

‘BitLicense Refugees’: ShapeShift, Kraken Talk Escape from New York

If you wanted to hear red-meat rhetoric about New York State’s regulatory approach, a fireside chat Tuesday between two of the cryptocurrency industry’s most outspoken leaders delivered.

For example, the audience at Consensus 2018 in New York City cheered when ShapeShift CEO Erik Voorhees invoked a local icon to make the case that the state’s BitLicense was a case of regulatory overreach.

Here we are two miles from the Statue of Liberty and you cannot sell CryptoKitties in the state without that license. That’s the absurdity of what’s happened here,” he said.

And Jesse Powell, the CEO of Kraken, got some laughs at the expense of former New York Attorney General Eric Schneiderman.

When Scheniderman’s office sent a request for information to Kraken (along with several other exchanges) earlier this year – three years after his company stopped doing business in New York – it felt like “a slap in the face,” Powell said.

But then “it turns out this asshole actually slapped people in the face,” he quipped, referring to the allegations of physical abuse that forced Schneiderman to resign shortly afterward.

Yet between these zingers and applause lines about the BitLicense – which both executives blame for driving their companies out of state – there were subtler points made. The conversation highlighted the challenges facing both the industry and regulators worldwide as governments come to terms with the ramifications of cryptocurrency.

Powell, for example, pointed out the tension between anti-money-laundering regulations and customer privacy protections. In the case of the BitLicense, he said, Kraken would have had to “disclose all the information about our entire global client base to the state of New York.”

That was not only distasteful, Powell said, but “potentially illegal” under the privacy laws of other countries.

“To service New York today, what we’d have to do is create a special purpose entity just to service New York and completely firewall off” all the exchange’s other users to protect their privacy, he said.

Alternative models

Widening the lens, Powell contended that the U.S. “has really failed” by leaving it up to local regulators to figure out how to deal with cryptocurrencies.

“In others parts of the world, it’s an issue that’s being taken seriously by heads of state – presidents, prime ministers. It’s not something that’s relegated to individual regulators at a state level,” he said. “It should be treated as a national economic and national security issue, maybe even an international issue.”

Powell cited Japan’s Virtual Currency Act as an example of “reasonable” regulation. Although the law is “not perfect,” he said, “we’re already seeing an explosion of business in Japan” as a result of the clarity it brought.

Voorhees, however, held up a different U.S. state as an example of how to do things right: Wyoming, which recently passed a package of five blockchain-related laws.

The two most important ones, in his view, were a law that excludes tokens from being automatically categorized as securities, and another that excludes digital asset companies from being automatically classified as money transmitters.

“That’s the model people should be looking at, they’ve done it the best,” Voorhees said.

And despite using the phrase “statist oppression” early in the conversation to describe his feelings about New York when the BitLicense was created, Voorhees later clarified that he thinks regulators generally have good intentions.

But their aims can be met today by means other than imposing bureaucratic, bank-style regulations on businesses that want to be nothing like traditional financial institutions, he argued.

“The crypto industry and regulators can find common ground in realizing that this incredible new technology can achieve many of the noble goals of the regulators such as protecting consumers,” Voorhees said.

Regulatory hopscotch

Ultimately, though, the two executives depicted cryptocurrency as a highly mobile activity that can easily relocate when any jurisdiction starts to appear heavy-handed.

Powell said Kraken’s main office is located in San Francisco only as a convenience because that’s where he lived when he started the company. Crypto businesses can basically pick up and move anywhere in the world they want to be, he said.

And users need not always move to another place, use a VPN to mask their IP address or even break the law to get around restrictions; Powell shared a tip for New York residents who feel deprived because of the way the BitLicense has limited their cryptocurrency trading options.

“If you’re here stuck in New York and you can’t trade how you want to trade, set up a Wyoming LLC and you can trade through that and have your business trade for you,” he said.

Further limiting regulators’ power, Powell said, the rise of decentralized exchanges will give users even more alternatives.

“If they can’t do what they want on Kraken they’re doing to do it on a decentralized exchange,” he said.

And Voorhees said “regulatory hopscotch” by exchanges and other businesses that move from one country to another is only a symptom of a broader phenomenon that won’t easily be resolved.

He concluded:

“Bitcoin basically broke down the borders of how value moves across humanity. There is no way that an invention like that doesn’t run straight into the jaws of regulations. And that conflict is going to be one of the great themes of my lifetime.”

Photo via Wolfie Zhao for CoinDesk. Left to right: CoinDesk research director Nolan Bauerle, Jesse Powell and Erik Voorhees. 

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Contortions for Compliance: Life Under New York’s BitLicense

Sarah H. Brennan, a corporate and securities attorney, leads the blockchain technology, cryptocurrency and digital assets practice team at Lippes Mathias Wexler Friedman LLP.

In June 2015, in a race to be a first mover in the space, the New York Department of Financial Services (DFS) enacted the BitLicense regulatory framework, a licensing regime that covers substantially all “virtual currency business activity” to the extent it touches New York or its residents.

Namely, any business engaging in virtual currency business activity involving New York State or persons that reside, are located, have a place of business, or are conducting business in New York must apply for the BitLicense, with no grace periods or de minimis exceptions.

To the extent a business makes it through the licensing process and receives a BitLicense, as a whopping four businesses have to date (in addition to two companies who undertook the application process and received trust charters), the BitLicense imposes significant operational burdens, requiring robust compliance policies and processes with respect to anti-fraud, anti-money-laundering, cybersecurity, privacy and information security, among other requirements.

As such, the BitLicense has prompted flight from New York by larger players such as Bitfinex and Shapeshift and has had a chilling effect on others acting in an abundance of caution.

For those of us who remain in New York because we happen to live here, there is a widespread sense of confusion as to the scope of activities which fall under the purview of the regulations given: their vague wording, requirements that seem positioned toward financial institutions and the lack of formal guidance in the wake of the enactment of the regulations.

In all, uncertainty as to the reach of the licensing requirement has left many companies with three options: avoid doing business in New York entirely, attempt to structure a business around the law, or engage in potential or outright non-compliance with the law.

Based on the fact that DFS has received so few applicants to date, and has only five rejected applications on file, one could infer that many are electing non-compliance.

Case studies

Drone Energy and Travel by Token are two Empire State-based clients of mine running very different businesses, but with the common concern of operating in line with best practices.

These businesses, in addition to complying with applicable foreign, federal and state regulatory regimes (existing and as they develop), are expending a significant amount of time and energy to structure around the BitLicense.

For example, Drone Energy has a patented solution and an innovative business model designed around mining cryptocurrency. While it would be helpful for this exemption to have been explicit in the text of the BitLicense regulations, DFS has indicated in public comments that mining activities are categorically outside the scope of the law.

However, the business will at some point look to exit to U.S. dollars without tripping into the definition of “virtual currency business activities.” This has been limiting as we have discussed various potential business models but something our client is able and willing to work around.

The other client, Travel by Token (TBT), is an early-stage start-up that uses an AirBnB/timeshare hybrid model for vacation stays, providing token holders access to vacation properties purchased and held by the company for the exclusive use of token holders at below-market prices.

As the token is in the development stage, we are in the clear to develop the underlying software in New York State under the BitLicense regulations. But the company will need to leave the state before commencing a token offering and hazarding being deemed to be “controlling, administering, [and/]or issuing a Virtual Currency” under Section 200.2(q)(5) of the BitLicense regulations.

While providing a viable path forward, structuring business plans and transactions to avoid the BitLicense is not a small or inexpensive undertaking.

For an example of how regulations interact, given the developments in securities laws over the course of December alone, in order to conduct a utility token offering (whether for Travel by Token or for another New York State-based client) we are considering the following as a potential workaround to the BitLicense as it interacts with applicable securities laws:

  • Structuring an initial offering as a 506(c)-compliant Simple Agreement for Future Tokens (SAFT) offering, using a third-party service provider to verify accredited investors and for AML/KYC compliance, to the extent we do initial raises in New York because the SAFT, while squarely an investment contract subject to securities laws, should not trip the BitLicense as no tokens are issued;
  • Use funds raised in SAFT offering to continue to develop the token and move the business out-of-state and/or build out the organizational structure and form an affiliate to conduct the offering in a friendlier jurisdiction;
  • Subsequent to reorganizing the business, in the next iteration of funding, through a token offering:
    • At the time of the token offering, we would evaluate the state of securities laws with respect to whether utility tokens that are immediately usable in exchange for a service or product constitute securities in the eyes of the Securities and Exchange Commission and/or state regulators. This would inform us as to whether there is a need to comply with securities laws in the larger offering. However, even if we take the position that a token is not a security based on the Howey test, we would likely expend the effort to produce offering materials with robust securities law type disclosures;
    • We would, absent DFS guidance, plan to block New York State residents (and any others in jurisdictions that give rise to compliance concerns) from participating because, taking a conservative approach, all issuers will likely need a BitLicense to conduct any sort of token offering if based in the state or offering to state residents.

The above process only relates to fundraising and is based on the current state of the law as we understand it (literally) today.

New York passed the BitLicense regulations in a regulatory vacuum and now state and federal laws are catching up to it, oftentimes with less-than-stellar coordination between regulators, causing a compliance nightmare.

Next steps

Absent a successful challenge to the BitLicense regulations in court, and short of the DFS (or the state legislature) reworking the rules in line with the Uniform Law Commission framework, it would be helpful for the DFS to issue more expansive guidance than the bare-bones FAQs posted on its website.

We will also learn the limits of the law the hard way – through enforcement actions, though there have been none to date.

However, further clarification (in whatever form it takes) should provide comfort in the space and limit further exits as well as complex structuring exercises.

Contortion image via Shutterstock

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