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By Richard Hill
Companies looking to introduce new digital currencies into the marketplace may have to brace for scrutiny from a new source—the CFTC.
The agency Oct. 17 said virtual “tokens” used in initial coin offerings can come under Commodity Futures Trading Commission oversight. The tokens, which are sold through the offerings, known as ICOs, “may be commodities or derivatives contracts, depending on the particular facts and circumstances,” the agency said.
The statement—included in a primer on virtual currencies — is the agency’s first of its kind and a signal that entities that decide their offerings don’t involve securities and are free of SEC scrutiny may have a different regulator to worry about.
“There’s now this whole other regulatory scheme that may come to bear,” Reuben Grinberg, a Davis Polk & Wardwell LLP attorney told Bloomberg Law prior to the CFTC announcement. “Folks have been saying, `My ICO isn’t a security, I’m in the clear, I don’t have to worry about it.’” he said. Grinberg advises established and emerging financial technology companies.
The CFTC “is putting the market on notice that these things can also fall within their jurisdiction,” Jeff Bandman, former CFTC fin tech director, told Bloomberg Law. “This confirms that they’re paying attention and they’re trying to provide clarity to the market about their jurisdiction,” according to Bandman, now with the New York consulting firm Bandman Advisors.
An ICO is the sale of virtual coins or tokens often used as a means to raise capital by startup companies involved in digital technology. The Securities and Exchange Commission earlier this year said some ICOs can be considered securities and come under that agency’s scrutiny. “There is no inconsistency between the SEC’s analysis and the CFTC’s determination” from 2015 that virtual currencies are commodities, the CFTC said.
The CFTC is “explaining both the extent and limits” of its jurisdiction, Bandman said. It doesn’t appear to be saying “every ICO under the sun” falls within its authority. Rather, the agency is explaining the statutory basis on which it does have jurisdiction, Bandman said.
Following its first-ever antifraud enforcement action last month for activities involving virtual currency, CFTC Enforcement Director James McDonald said that the agency would continue “aggressively and assertively” rooting bad actors out of the industry.
Several derivatives attorneys interpreted that as a signal that the CFTC would begin looking at ICOs and virtual currency exchangers, which facilitate investors trading digital currency such as bitcoin for other cryptocurrency or for sovereign currency.
Non-securities ICOs—those in which the tokens being introduced are not considered securities and so don’t come under SEC oversight—are notorious for having sloppy disclosures and other problems, said Grinberg.
Because of the relatively young nature of the ICO and exchange businesses, issuers may not be aware of all the regulatory possibilities. “People might not have realized that they were getting into a commodity business,” Dan Berkovitz, co-head of Wilmer Cutler Pickering Hale and Dorr LLP’s Futures and Derivatives Group, told Bloomberg Law prior to the CFTC’s statement. “All of a sudden, it’s an area where the CFTC is vigilant. It’s an awareness that people need to have.”
Issuers often structure their ICOs to avoid the SEC’s jurisdiction, said Allison Baker Shealy, a former CFTC trial attorney now at Shulman Rogers Gandal Pordy & Ecker, P.A., Potomac, Md., who also spoke before the announcement. “For people trying to do it right, the CFTC should be on their radar now” too, she said.
Los Angeles attorney Brian Klein, who has represented fintech startups in regulatory matters, said there are a number of defenses attorneys could use to counter a CFTC action involving virtual currency. “The scope of what a commodity is in this area has not been subject to a court challenge,” Klein, a Baker Marquart LLP partner, told Bloomberg Law. “No doubt as they start bringing enforcement actions, it will be. It’s just a matter of time.”
Joseph Moreno, Cadwalader, Wickersham & Taft LLP, New York, agreed that the CFTC’s authority hasn’t been tested in the virtual currency realm. However, mounting a defense based on jurisdiction or authority, while possible, would be “an uphill battle,” he said. The CFTC’s antifraud rule “has withstood scrutiny in other contexts,” including cases involving manipulation, spoofing, and insider trading, said Moreno, who handles securities matters and has written about ICOs. Moreno and Klein both spoke before the CFTC announcement.
Meanwhile, exchangers and their employees should have other considerations, Massari and Grinberg said, including being vulnerable to insider-trading and control-person issues.
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