On October 17, 2017, the U.S. Commodity Futures Trading Commission’s (“CFTC”) LabCFTC released a primer on virtual currencies, available here. The primer is an “education tool” that provides an overview of the virtual currency landscape and is “not intended to describe the official policy or position of the CFTC, or to limit the CFTC’s current or future positions or actions.” While the document is largely unrevealing, everyone in the initial coin offering (“ICO”) market should carefully review the risk factors outlined in the document to ensure that they are incorporated into their whitepapers and offering materials.
September 28, 2017
Two months after its Investor Bulletin stating that U.S. securities laws may apply to digital token sales, the Securities Exchange Commission (“SEC”) announced Monday two new initiatives to address cyber-based threats and protect retail investors. The SEC’s press release outlined the creation of the Cyber Unit (“Unit”) and the Retail Strategy Task Force (“RSTF”).
According to the press release, the Unit has been in the planning stages for months, and will focus the Enforcement Division’s substantial cyber-related expertise on targeting cyber-related misconduct, including:
- Market manipulation schemes involving false information spread through electronic and social media
- Hacking to obtain material nonpublic information
- Violations involving distributed ledger technology and initial coin offerings
- Misconduct perpetrated using the dark web
- Intrusions into retail brokerage accounts
- Cyber-related threats to trading platforms and other critical market infrastructure
The Unit seeks to implement an internal cybersecurity risk profile and create a cybersecurity working group in order to enhance the SEC’s ability to detect and investigate cyber threats. The Unit will coordinate information sharing, risk monitoring, and incident response efforts within the SEC. The Unit will be led by Robert A. Cohen, the former co-chief of the SEC’s Market Abuse Unit.Additionally, the RSTF has been established to “develop proactive, targeted initiatives to identify misconduct impacting retail investors.” Using lessons learned from previous cases involving fraud targeting retail investors, along with leveraging data analytics and technology, the RSTF intends to identify large-scale misconduct affecting retail investors.While the stated objective of the RSTF does not specifically mention distributed ledger technology or initial coin offerings, the proliferation of such offerings is likely to draw the attention of the RSTF, specifically for those coins or tokens that would be deemed investment contracts under the “Howey Test,” and that may be considered “securities” for regulatory purposes.
We expect the regulatory scrutiny to continue to increase within the crypto token markets. When considering undertaking an initial coin offering or investing in a crypto token or coin, it is important to conduct appropriate due diligence. Please review Reed Smith’s Client Alerts regarding the jurisdiction of the SEC over initial coin offerings (https://www.reedsmith.com/en/perspectives/2017/07/sec-exercises-jurisdiction-over-initial-coin-offerings), and the CFTC’s enforcement action over fraudulent bitcoin trading (https://sites-reedsmith.vuture.net/24/721/september-2017/cftc-brings-enforcement-action-involving-a-fraudulent-bitcoin-robo-trader.asp?sid=100a3126-a5b4-4296-9f6b-3a4c0ce13649).
On August 3, 2017, the International Swaps and Derivatives Association (“ISDA”) released a whitepaper that considers whether derivative contracts could operate on a blockchain (the “Whitepaper”). The Whitepaper, titled “Smart Contracts and Distributed Ledger – A Legal Perspective,” concludes that many of the provisions of the ISDA Master Agreement and related documentation can be translated into conditional logic and coded into “smart contracts.” While we are still in the early days of distributed ledger technology (“DLT”) and smart contracts, the Whitepaper represents a significant first step towards integrating blockchain into the derivatives market from the leading provider of swaps documentation.
Building on its 2016 whitepaper entitled “The Future of Derivatives Processing and Market Infrastructure”, ISDA explains in this Whitepaper that “[d]erivatives are fertile territory for the application of smart contracts and DLT because their main payments and deliveries are heavily dependent on conditional logic.” It proposes the use of a blockchain to store electronic ISDA Master Agreements. The agreements would contain conditional logic triggers programmed by smart contract code, which would facilitate the automation of certain provisions within swaps documentation. For example, the Whitepaper lists certain “operational” ISDA definitions that embed some form of conditional logic (namely, that upon the occurrence of a specified event at a specified time, a determinative action is required), for example the cash settlement of options transactions.
Moreover, the ISDA Definitions booklets could be translated into “a more formal representation that would be tractable by computers” to allow cross-references. Regulators would then be provided with direct access to the data stored on the blockchain. The Whitepaper qualifies that a “consistent, non-ambiguous language” would need to be developed for the drafting of smart legal contracts that lawyers could understand and utilize on a global basis.
The Whitepaper acknowledges that certain “non-operational” aspects of the ISDA documentation, for example clauses predicated on good faith or reasonability, are not suited for translation into formal logic. However, the Whitepaper also proposes that certain subjective provisions could be replaced with determinations by third-party oracles. For example, a third-party oracle could be relied upon to determine if a credit event has occurred with respect to a credit derivatives transaction. If the third-party oracle makes such a determination, then the relevant smart contract provisions would be initiated.
ISDA has also commissioned e-contract opinions from a number of jurisdictions to determine whether ISDA documentation can be executed electronically with e-signatures. In relation to the ISDA netting opinions however, the Whitepaper distinguishes between smart contracts on one hand, and legal contracts on the other. The application of smart contract technology should therefore have little impact on the veracity of the ISDA netting opinions as the opinions apply to the legal contracts that the smart technology sits above, rather than displaces. This is important and illustrates that conditional logic can be over-applied. e.g., to automatically make credit and relationship choices (for example to close-out all outstanding transactions upon the occurrence of an Event of Default where this is not required for the effectiveness of close-out netting or desired under the circumstances).
Moving ISDA documentation to the blockchain could facilitate automated compliance with both the Commodity Futures Trading Commission’s (“CFTC”) swap data reporting and margin requirements in the USA, and European Market Infrastructure Regulation (“EMIR”) reporting requirements in the EU. Day-to-day compliance with the regulations could theoretically be embedded into smart contracts. For example, bank accounts or virtual currency wallets could be linked to the smart contract and automatically exchange variation margin as required. Similarly, the smart contract could be designed to automatically submit swap continuation data and other reports to a swap data repository upon the occurrence of a life cycle event, providing regulators with direct and unencumbered access. Moreover, counterparties would have all of their swap documentation and confirmations stored on the permissioned, private distributed ledger, reducing the volume of records required to be maintained. This would make it much easier for swap counterparties to comply with some of the more onerous requirements imposed by the Dodd-Frank Act, for example.
ISDA’s publication represents another milestone in the ever-growing recognition of the usefulness and ramifications of DLT and smart contracts (see our client alert on Arizona and Nevada’s enactment of bills addressing smart contract enforcement here). With influential bodies such as ISDA standing up and taking note, conditional logic states that this trend is set to continue.
If you have any questions regarding the Whitepaper, please contact Kari S. Larsen, email@example.com, Brett Hillis, firstname.lastname@example.org, Michael S. Selig, email@example.com, or Alex Murawa, firstname.lastname@example.org.
 In its simplest form, a smart contract is a “set of promises, specified in digital form, including protocols within which the parties perform on these promises”, Nick Szabo, Smart Contracts: Building Blocks for Digital Markets, 1996.
 See sections 8.1 and 8.2 ISDA 2002 Equity Derivative Definitions.
 The Whitepaper notes that under the 2014 ISDA Credit Derivatives Definitions, a determination by the Credit Derivatives Determinations Committee that a credit event has occurred would result in an automatic triggering in many cases, subject to certain conditions.
On June 13, 2017, the Illinois Department of Financial and Professional Regulation (“IDFPR”) released guidance outlining its policies with respect to the treatment of digital currencies under the Illinois Transmitters of Money Act (“TOMA”). The guidance document offers a clear distinction between traditional currencies, which it considers “money,” and digital currencies, which it states are not. The guidance will be welcomed by Illinois residents who use and accept digital currencies in commercial transactions.
On May 17, 2017, Commodity Futures Trading Commission (“CFTC”) Acting Chairman J. Christopher Giancarlo announced an “important step forward” in bringing the CFTC’s regulations into the “digital world of the 21st century.” The CFTC’s new FinTech initiative, LabCFTC, will facilitate cooperation between the CFTC and FinTech innovators.
Acting Chairman Giancarlo stated that the primary aims of the initiative are: (1) to provide greater regulatory certainty to the industry; and (2) to identify and utilize emerging technologies that can better enable the CFTC to regulate the commodities markets. Given the breadth of the “commodity” definition, numerous potential FinTech initiatives, such as those related to clearing, digital currencies, transaction settlement, etc., may fall under CFTC jurisdiction. Often the regulations are new and potentially costly and burdensome for FinTech startups, so any guidance and certainty from the CFTC should be very welcomed by the industry.
The initiative’s two core components are GuidePoint and CFTC 2.0. GuidePoint will provide a direct point of contact to FinTech innovators to engage with the CFTC, discuss compliance issues, and obtain guidance. GuidePoint will have its own suite in the CFTC’s New York office. Acting Chairman Giancarlo clarified that CFTC will not be entering the business of providing legal advice to market participants but it will help innovators better understand relevant regulations and the CFTC’s policies. LabCFTC will not have its own independent decision making authority, but can offer some guidance to industry members. The CFTC website will have a new portal that persons can use to reach out with such questions and concerns. CFTC 2.0 is a FinTech/RegTech innovation lab that will better enable the CFTC to understand new financial technologies and identify useful applications.
In a speech announcing the initiative, Acting Chairman Giancarlo expressed his hope that “LabCFTC and its engagement with technology innovators will assist the CFTC in prioritizing efforts to modernize its regulatory mission.”
If you have any questions regarding LabCFTC or wish to contact the CFTC via GuidePoint, please contact Kari S. Larsen (email@example.com) or Michael S. Selig (firstname.lastname@example.org).
On April 26, 2017, the Conference of State Bank Supervisors (“CSBS”), the trade association that represents state banking regulators, initiated a lawsuit against the Office of the Comptroller of the Currency (“OCC”) in the U.S. District Court for the District of Columbia. The lawsuit seeks declaratory and injunctive relief to prevent the OCC from moving forward with its proposal for granting special-purpose national bank charters to fintech companies.
Following the trend of regulators across the globe, the United Nations Office for Project Services’ (“UNOPS”) issued a request for information regarding the application of blockchain technologies on April 24, 2017. The UNOPS has formed a blockchain group within the United Nations to analyze the possible applicability of blockchain technologies to the international assistance area. The Request for Information explains that the UNOPS seeks “information widely from the industry of blockchain space and to identify potential partners / suppliers for the future work in the area of international, humanitarian, development or peacekeeping assistance.”
On March 23, 2017, the European Commission (“EC”) published a Consultation Document entitled “FinTech: A More Competitive and Innovative European Financial Sector.” The Consultation Document seeks comments regarding the development and regulation of novel financial technologies, including distributed ledger technology (“DLT” or “blockchain”), cloud computing, and artificial intelligence (“AI”). The EC hopes to obtain feedback from both financial services providers and consumers that will assist it in developing an appropriate regulatory framework for FinTech. It explains, in the Consultation Document, that “appropriate policies on important issues, such as access to technology, data standardisation and security, personal data protection and data management, need to be put in place,” to account for new innovative financial technologies.
In the ongoing skirmishes between card networks and merchants in the surcharge world, the U.S. Supreme Court has just issued a significant ruling on a novel theory. Merchants in the State of New York sought to charge consumers higher fees for purchases made by credit cards. New York state law contains a prohibition on the imposition of surcharges in such instances. The law states that merchants may not “impose a surcharge on a holder who elects to use a credit card in lieu of payment by cash, check or similar means.” N.Y. Gen. Bus. Law §581. The law is similar to a prohibition on surcharging credit card use that the major card networks had previously imposed on merchants, but which was challenged as a violation of the anti-trust laws and consequently, has not been in effect for some time. The merchants had argued that the law prohibits free speech by regulating how they communicate the surcharge to their customers. The merchants used the “single tag” method, in which the cash price appears on the item; consumers were advised that the surcharge amount is in addition to the amount on the price tag. The merchants are not prohibited from discounting prices for payment by cash.
The State of New York’s position was that the law regulates the actions of the merchants. The District Court found in favor of the merchant’s free speech argument, however, the Second Circuit vacated that judgment and instructed the District Court to dismiss the case. In the view of the Second Circuit the law did not violate the merchants’ right of free speech under the First Amendment. The U.S. Supreme Court determined that the law does regulate speech and remanded the case to the Second Circuit for a determination of whether the law violates the First Amendment.
The free speech concept argued in this case, that the law prohibits the merchants from communicating the surcharge to their customers, marks a novel Constitutional argument. The outcome may be the final resolution of this long running pricing battle. Other states have similar prohibitions on surcharging so the decision could reverberate outside of the Second Circuit. We will be following developments very closely.
To read the entirety of the Reed Smith client alert, visit reedsmith.com.
On Friday, in a decision certain to please the business community as well as the Chair and new majority of the Federal Communications Committee, the D.C. Circuit struck down parts of the FCC’s October 30, 2014 Order, 29 F.C.C. Rcd. 13998 (FCC 14-164), requiring that solicited faxes (those sent with consent of the recipient) must contain opt-out notices in order to avoid violating the TCPA. See Bais Yaakov of Spring Valley, et al v. FCC (No. 14-1234). In a 2-1 decision, the majority held that the FCC lacked authority under the statute to regulate solicited faxes. The D.C. Circuit thus limits liability under the TCPA to just unsolicited fax advertisements, as its plain language states.
This ruling vindicates the two Republican FCC Commissioners, now Agency Chair Ajit Pai and Commissioner Michael O’Reilly, both of whom dissented in 2014 when the Commission’s fax Order was adopted. The ruling should also moot pending lawsuits based solely on the absence of an opt-out notice in faxes sent with the recipient’s express permission or invitation.
One caution is worth noting though. The decision does not eliminate the need to honor opt-out requests, thus creating a potential issue of fact for litigants. On the one hand, this should make it much harder for plaintiffs’ attorneys to succeed at class certification because whether any particular person opted out of receiving faxes is an individualized factual issue. On the other hand, however, it becomes harder for a defendant to refute a claim that a particular plaintiff revoked his or her consent before receiving an allegedly offending fax.
Under the FCC’s 2014 Order, onerous as the requirement to include an opt-out notice in every fax was, the business community had certainty as to what was required in communicating with customers or potential customers by fax. Now, it is incumbent on businesses to review their existing procedures or implement new procedures to defend against allegations that they have ignored or mishandled attempts by consumers to withdraw consent.
It is also worth pointing out that Bais Yaakov was argued before a three judge panel consisting of D.C. Circuit Judges Brett Kavanaugh and Nina Pillard, and Senior Circuit Judge Raymond Randolph on November 8, 2016. Oral argument in the all-important TCPA case ACA International, et al. v. FCC, also before the D.C. Circuit, was argued a few weeks earlier, on October 19, 2016, before Judges Pillard, Sri Srinivasan, and Harry Edwards. Now that Bais Yaakov has been decided, one can assume that decision in ACA cannot be far behind, and with it more certainty with respect to the definition of an “automatic telephone dialing system” and — hopefully — some much needed, practical relief, such as in the case of reassigned telephone numbers.
Before one starts uncorking the champagne, however, it is worth noting that Judge Pillard, the only judge on both the panel that heard Bais Yaakov and the panel that heard ACA, was the lone dissenter in the just decided fax case. In her dissent, Judge Pillard focused on consumer harm and the need to address what she referred to as “a fusillade of annoying and unstoppable advertisements.” In her view, Congress expressly delegated authority to the FCC to implement a prohibition on unsolicited fax advertisements, and the opt-out notice requirement gave practical effect to that ban.
In any event, it shouldn’t be long now until we see how Judge Pillard and the rest of the D.C. Circuit’s ACA panel weighs in on this ever-evolving area of the law.