Written by: Caleb A. Faulkner

Volume 42 Editor-in-Chief, American Journal of Trial Advocacy

A new challenge recently arose for financial institutions dealing with virtual currencies.[1] The United States Treasury Department has now indicated that laws governing money transmitters will be enforced in regard to Initial Coin Offerings (“ICOs”).[2] Until the present time, such offerings were considered largely unregulated.[3]

A more known form of offering is known as an Initial Public Offering (“IPO”).[4] As defined by Investopedia, an IPO is the initial opportunity for the public at large to purchase a previously private company’s stock.[5] Such offerings are typically implemented by either companies that are less known and are attempting to grow or known companies seeking to make the transition from private ownership to public ownership.[6] “In an IPO, the issuer obtains the assistance of an underwriting firm, which helps determine what type of security to issue, the best offering price, the amount of shares to be issued, and the time to bring it to market.” [7] On the other hand, an ICO (otherwise known as an Initial Public Coin Offering) is a much newer form of offering.[8]

ICOs began in 2014, a few years after “[t]he invention of Bitcoin in 2009 . . . .”[9] As defined by Investopedia, an Initial Coin Offering is “[a]n unregulated means by which funds are raised for a new cryptocurrency venture.”[10] ICOs are often utilized by up-and-coming companies as a way to avoid highly structured “capital-raising process[es] required by venture capitalists or banks.”[11] When an ICO is issued, a portion of the ownership of the cryptocurrency (rather than the company with an IPO) is transferred to investors for either cash (or cash equivalent) or another digital currency, with Bitcoin being a popular choice.[12]

An additional appeal for companies to utilize ICOs is the “advantageous pricing and exposure” offered by ICOs.[13] Another attractive attribute of ICOs is that the “borderless, decentralized nature of public blockchains” allows for the simple and convenient movement of currency to and from different countries.[14] Further, ICOs provide “start-ups and investors alike” with a simpler method through which they can participate in the market.[15]  However, due to the complex nature of ICOs, the ICO market is viewed as a risky market that offers increased advantages for those willing to take the risks.[16] In fact, both “the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC)” have cautioned investors of the dangers of investing in ICOs.[17] The statements were made to further support warnings made by the North American Securities Administrators Association (“NASAA”),[18] in which the SEC commission stated on January 4, 2018 that:

Unfortunately, it is clear that many promoters of ICOs and others participating in the cryptocurrency-related investment markets are not following those laws. The SEC and state securities regulators are pursuing violations, but we again caution you that, if you lose money, there is a substantial risk that out efforts will not result in a recovery of your investment.[19]

While lack of regulations of such currencies have caused problems, some of these problems may soon come to an end.[20]

Enforcement of Existing Regulations

On February 13, 2018, the United States Treasury Department reiterated that “money transmitter rules apply to initial coin offerings.”[21] The development was asserted “[i]n a letter from Drew Maloney, the assistant secretary for legislative affairs for the Financial Crimes Enforcement Network (FinCEN), to U.S. Sen. Ron Wyden, D-Ore., [who is] the ranking member of the Senate Finance Committee.”[22] Maloney, writing on behalf of the United States Treasury Department, first asserted that FinCEN initially indicated, in 2013, “that virtual currency exchangers and administrators are money transmitters and must comply with the BSA and its implementing regulations.”[23] One requirement is that an ICO must “register[] with FinCEN as a [Money Services Business].”[24] Additionally, the issuers of an ICO must “prepar[e] a written AML compliance program that is designed to mitigate risks (including money laundering risks) associated with the entity’s specific business and customer mix, and to ensure compliance with other BSA requirements.”[25] Further, the ICO’s issuance must include the “filing [of] BSA reports, including suspicious activity and currency transaction reports.”[26] Issuers of ICOs must also “keep[] records for certain types of transactions at specific thresholds[] and obtain[] customer identification information sufficient to comply with the AML Program and recordkeeping requirements.”[27] U.S. ICOs must further “comply with all Office of Foreign Assets Control financial sanctions obligations.”[28]

While the laws had already applied to ICOs for several years, the laws were not viewed as any that would actually be enforced.[29] Maloney went on to inform Wyden that if ICOs “involve[] an offering or sale of securities or derivatives, certain participants in the ICO could fall under the authority of the SEC, which regulates brokers and dealers in securities, or under the authority of the CFTC, which regulates merchants and brokers in commodities.”[30] In situations where this is the case, ICOs would have to comply with “the AML/CFT requirements imposed by SEC or CFTC regulations . . . .”[31] In short, the U.S. “Treasury [Department] expects businesses involved in ICOs to meet the BSA obligations that apply to them.”[32]

The Bank Secrecy Act (“BSA”) “requires businesses to keep records and file reports that are determined to have a high degree of usefulness in criminal, tax, and regulatory matters.”[33]

These records are then “used by law enforcement agencies, both domestic and international, to identify, detect and deter money laundering whether it is in furtherance of a criminal enterprise, terrorism, tax evasion or other unlawful activity.”[34]

Additionally, the Anti-Money Laundering rules (“AML”) are “impending regulations” of “the Bank Secrecy Act.”[35] “The purpose of the AML rules is to help detect and report suspicious activity including the predicate offenses to money laundering and terrorist financing, such as securities fraud and market manipulation.”[36]  Standard requirements of “an AML compliance program” mandate that:

1. The program has to be approved in writing by a senior manager.
2. It must be reasonably designed to ensure the firm detects and reports suspicious activity.
3. It must be reasonably designed to achieve compliance with the AML rules, including, among others, having a risk-based customer identification program (CIP) that enables the firm to form a reasonable belief that it knows the true identity of its customers.
4. It must be independently tested to ensure proper implementation of the program.
5. Each FINRA member firm must submit contact information for its AML Compliance Officer through the FINRA Contact System (FCS).
6. Ongoing training must be provided to appropriate personnel.[37]

Furthermore, Investopedia defines “Combating the Financing of Terrorism (CFT) [as a process that] involves investigating, analyzing, deterring and preventing sources of funding for activities intended to achieve political, religious or ideological goals through violence and the threat of violence against civilians.”[38] In order to battle possible avenues of terrorist financing, law enforcement pursues “the source of the funds that support terrorist activities . . . [in order] to prevent some of those activities from occurring.”  The financial aspects of the problem are combatted by “law enforcement . . . detecting suspicious financial transactions and tracking down all the individuals and organizations involved in those transactions.”[39]

CFT objectives lead to the examination of the financial activities of various organizations and entities.[40] The regulations that a particular ICO must comply with depends on the nature of the ICO.[41] While the regulations do require a substantial amount of records and rigorous review, the regulations are in place to protect the interests of investors, issuers, and U.S. interests as a whole.[42]

Conclusion

Maloney’s statements simply indicate that ICOs will no longer enjoy the unregulated and unstructured elements that have, until now, attracted many issuers.[43] Regulations that technically have applied to ICOs since ICOs were created will now be enforced, while in the past the regulations were not truly and completely enforced.[44]

Commentator Peter Van Valkenburgh classified Maloney’s letter as “a highly consequential interpretation.”[45] In fact, based on Maloney’s letter, the issuers of an ICO “involving U.S. residents . . .” who does not “register with FinCEN as a money transmitter [or] perform the associated compliance KYC/AML obligations[] can be charged under a federal felony criminal statute, 18 U.S.C. § 1960, with unlicensed money transmission.”[46] Conviction of this statute can carry five years of imprisonment.[47]  Further, “employees of, and investors in, the business that sold the tokens” are exposed to criminal liability.”[48]

The effect of Maloney’s letter on the market of Initial Coin Offerings has yet to be seen. It is evident that all participants involved in ICOs that do not comply with the governing regulations will be exposed to the possibility of prosecution.[49] Further, it is clear that the ICOs will now have to comply with regulations that ICOs have mostly been ignoring. While the enforcement of such regulations will create more time, effort, and expenses for issuers of ICOs, investors can be confident that their investment is safer and more regulated than it once was.

---

[1] Jason Tashea, US Treasury says money transmitter rules apply to initial coin offerings, ABA Journal (Mar. 8, 2018, 7:30 AM), http://www.abajournal.com/news/article/u.s._treasury_says_money_transmitter_rules_apply_to_initial_coin_offerings.

[2] Id.

[3] Investopedia, Initial Coin Offering (ICO), https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp (last visited Apr. 1, 2018).

[4] Investopedia, Initial Public Offering- IPO, https://www.investopedia.com/terms/i/ipo.asp (last visited Apr. 1, 2018).

[5] Id.

[6] Id.

[7] Id.

[8] Investopedia, supra note 3.

[9] Raja Palaniappan, Initial Coin Offerings Explained, Origin Markets (July 21, 2017), https://originmarkets.com/initial-coin-offerings-explained/.

[10] Investopedia, Initial Coin Offering (ICO), https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp (last visited Apr. 1, 2018).

[11] Id.

[12] Id.

[13] Palaniappan, supra note 9.

[14] Id.

[15] Id.

[16] Id.

[17] Francine McKenna, SEC, CFTC warn of risk of virtual currencies and initial coin offerings, MarketWatch (Jan. 7, 2018, 11:40 AM), https://www.marketwatch.com/story/sec-cftc-warn-of-risk-of-virtual-currencies-and-initial-coin-offerings-2018-01-04.

[18] Id.

[19] U.S. Securities and Exchange Commission, Statement on NASAA’s Message to Investors about ICOs (Jan. 4, 2018), https://www.sec.gov/news/public-statement/statement-clayton-stein-piwowar-010418.

[20] See id. (warning investors of the risks associated with ICOs); see also Tashea, supra note 2 (stating that “money transmitter rules apply to initial coin offerings”).

[21] Tashea, supra note 1.

[22] Id.

[23]Drew Maloney, Letter to U.S. Senator Ron Wyden, Department of the Treasury 1, 1-2 (2018), https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-center.pdf.

[24] Id. at 2.

[25] Id.

[26] Id.

[27] Id.

[28] Id.

[29] Drew Maloney, Letter to U.S. Senator Ron Wyden, Department of the Treasury 1, 2 (2018), https://coincenter.org/files/2018-03/fincen-ico-letter-march-2018-coin-center.pdf.; see Investopedia, Initial Coin Offering (ICO), https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp (last visited Apr. 1, 2018) (defining an ICO as “[a]n unregulated means by which funds are raised for a new cryptocurrency venture”).

[30] Maloney, supra note 23, at 3.

[31] Id.

[32] Id.

[33] Bank Secrecy Act, IRS (Aug. 6, 2017), https://www.irs.gov/businesses/small-businesses-self-employed/bank-secrecy-act.

[34] Id.

[35] Anti-Money Laundering, Financial Industry Regulatory Authority (2018), https://www.finra.org/industry/aml.

[36] Id.

[37] Id.

[38] Investopedia, Combatting the Financing of Terrorism (CFT),  https://www.investopedia.com/terms/c/combating-financing-terrorism-cft.asp (last visited Apr. 1, 2018).

[39] Id.

[40] Id.

[41] Peter Van Valkenburgh, FinCEN raises major licensing problem for ICOs in a new letter to Congress, Hot Takes (Mar. 6, 2018) https://coincenter.org/link/fincen-raises-major-licensing-problem-for-icos-in-new-letter-to-congress.

[42] Tashea, supra note 1, at 1-3.

[43] Id. at 1-3.

[44] Id. at 1-2; see Investopedia, Initial Coin Offering (ICO), https://www.investopedia.com/terms/i/initial-coin-offering-ico.asp (last visited Apr. 1, 2018) (describing ICOs as “unregulated”).

[45] Peter Van Valkenburgh, supra note 41.

[46] Id.

[47] Id.

[48] Id.

[49] Id.