This monthly bulletin is designed to help companies identify important legal developments governing the use and acceptance of blockchain technology, smart contracts, and digital assets.
While the use cases for blockchain technology are vast, this bulletin focuses on uses of blockchain and smart contracts in the financial services sector. With respect to digital assets, we have organized our approach to this topic by discussing it in terms of traditional asset type or function (although the types and functions may overlap) – that is, digital assets as:
- Securities
- Virtual currencies
- Commodities
- Deposits, accounts, intangibles
- Negotiable instruments
- Electronic chattel paper
- Digitized assets
In addition to reporting on the law and regulation governing blockchain, smart contracts, and digital assets, this bulletin will discuss the legal developments supporting the infrastructure and ecosystems that enable the use and acceptance of these new technologies.
INSIGHTS
SEC fines investment adviser for holding crypto assets outside a qualified custodian
By David Solander
On September 3, the Securities and Exchange Commission (SEC) announced it instituted and settled its first proceedings against an SEC-registered investment adviser for failing to custody crypto assets at a “qualified custodian” as required by Rule 206(a)-4 (the Custody Rule) under the Investment Advisers Act of 1940 (Advisers Act). The limited availability of qualified custodians (generally banks or registered broker-dealers) for custody of crypto assets has long been a concern for the SEC and industry participants, but it appears that the SEC is now actively seeking to require strict compliance with the Custody Rule for crypto assets. Perhaps the tea leaves were there for increased enforcement when the SEC proposed a new asset safeguarding rule to replace the Custody Rule in February 2023, indicating that it believed there were sufficient options in the marketplace for many crypto assets to be held at a qualified custodian.
In the SEC’s order, Galois Capital, a crypto hedge fund management firm, was charged with misleading investors about its redemption practices and a violation of the Custody Rule, as well as compliance deficiencies. It is difficult to determine whether the Custody Rule charge would have been brought by itself in the absence of the other charge for misleading investors. Certainly, the facts in the case increased the likelihood of the Custody Rule charge as Galois’s hedge fund lost approximately half of its assets as a result of the FTX collapse. Galois had been continuously holding fund assets in trading accounts on the FTX platform, which was not a qualified custodian, when FTX collapsed. Galois was fined $225,000 for the violations.
SEC again sets enforcement sights on NFTs
By James Williams
On September 16, the SEC announced it had charged, and simultaneously settled with, Flyfish Club, LLC (Flyfish) for the unregistered offer and sale of the two different versions of a non-fungible token (NFT). More specifically, the SEC’s cease and desist order alleges that, between August 2021 and May 2022, Flyfish publicly sold approximately 1,600 NFTs at two price points. The first price point was for the Flyfish NFT priced at 2.5 ETH (approximately $8,400), and the second price point was for the Omakase NFT priced at 4.25 ETH (approximately $14,300). The offering generated gross proceeds of approximately $14.8 million.
The order charges Flyfish with violating Sections 5(a) and 5(c) of the Securities Act of 1933 by offering and selling these crypto asset securities to the public in an unregistered offering that was not exempt from registration. Without admitting or denying the SEC's findings, Flyfish agreed to a cease-and-desist order, to pay a $750,000 civil penalty, and to comply with certain undertakings.
The order further alleges that:
- The purpose of the NFT offering was to fund the construction and operation of a members-only club, restaurant, and bar called “Flyfish Club,” in New York City
- Ownership of a Flyfish NFT was to be the exclusive means of obtaining membership in the club
- Flyfish principals publicly told prospective purchasers that they could actively profit by buying Flyfish NFTs and reselling them on the secondary market and also passively generate income by “leasing” NFTs to those seeking to dine at the restaurant
Additionally, the SEC alleged that nearly half of the primary purchasers bought more than one NFT “even though they needed only one to become a member of the club” (implying that these excess purchases were for speculation rather than utility) and that the NFTs “almost immediately” began trading on the secondary market after the initial sales, with Flyfish receiving a ten-percent royalty on each secondary sale.
Of note, Commissioners Hester Pierce and Mark Uyeda issued a sharp dissent wherein they stated “Howey is inapt [here] because holders of Flyfish NFTs had a reasonable expectation of obtaining in the future wonderful culinary experiences and other exclusive membership experiences based on the managerial and entrepreneurial efforts of Flyfish and its principals. Might… many purchasers have purchased the NFTs with speculative intent? Sure. … [but] [t]he intent of a buyer cannot transform a non-security into a security.”
STATUTORY AND AGENCY DEVELOPMENTS
FEDERAL DEVELOPMENTS
FTC
FTC reports data showing losses from bitcoin ATM scams. On September 3, the Federal Trade Commission (FTC) announced the release of new data showing a “massive increase” in the amount of money consumers report losing to scammers involving bitcoin ATM machines. The FTC asserts that the amounts lost increased nearly tenfold between 2020 and 2023 to over $110 million. According to the FTC, the majority of reported scams result from either government impersonation, business impersonation, or tech support scams.
FBI
FBI warns of North Korea targeting crypto industry. On September 3, the Federal Bureau of Investigation (FBI) warned that North Korea is aggressively targeting the crypto industry by conducting “highly tailored, difficult-to-detect social engineering campaigns against employees of decentralized finance (DeFi), cryptocurrency, and similar businesses to deploy malware and steal company cryptocurrency.” The announcement includes a description of the tactics used, indicators of such activity, and mitigation measures.
FBI publishes 2023 crypto fraud report. On September 9, the FBI announced publication of its Cryptocurrency Fraud Report for 2023. The announcement asserts that, “In 2023, the FBI’s Internet Crime Complaint Center received more than 69,000 complaints from the public regarding cyber-enabled crime and financial fraud involving the use of cryptocurrency, with over $5.6 billion in reported losses.” In addition to providing complaint statistics, the report offers guidance for cryptocurrency scheme victims.
CFPB
CFPB issues advisory on video game payments and virtual currencies. On August 28, the Consumer Financial Protection Bureau (CFPB) issued an advisory statement on video game payments, including the use of virtual currencies in such online games, stating that video game companies use design tricks and in-game currencies “to conceal the real costs of transactions in game.” Additionally, the advisory warns that “[m]any games use gambling-like design tricks to hide the odds and encourage compulsive spending.” The CFPB recommends that consumers use gift cards to limit spending, use available parental controls, and opt out of third party sharing of data.
ENFORCEMENT ACTIONS AND LITIGATION
FEDERAL
Securities
SEC settles with DeFi protocol. On September 18, the SEC announced settled charges against Rari Capital, Inc., a DeFi protocol, and its co-founders, Jai Bhavnani, Jack Lipstone, and David Lucid, for allegedly misleading investors and engaging in unregistered broker activity in connection with the operation of two blockchain-based investment platforms that, at their peak, collectively held crypto assets worth more than $1 billion. Rari Capital also settled SEC charges that it conducted unregistered offerings of three securities tied to those platforms. In a separate order, Rari Capital Infrastructure LLC, which took over operations from Rari Capital in 2022, settled charges that it engaged in unregistered securities offerings and unregistered broker activity.
According to the SEC’s complaint, Rari Capital offered two investment products, Earn pools and Fuse pools, which functioned like crypto asset investment funds, allowing investors to deposit crypto assets in lending pools, either managed by Rari (Earn) or user-created (Fuse), and earn returns from their investments. The SEC’s complaint alleges that investors in the pools received a token representing their interest in the pools and the right to receive profits earned by the pools. Certain Earn pool investors also received a governance token, called the Rari Governance Token (RGT). By selling interests in these pools and RGT, the complaint alleges, Rari Capital conducted unregistered offers and sales of securities.
Furthermore, the SEC’s complaint alleges that Rari Capital and its co-founders falsely told investors that the Earn pools would automatically and autonomously rebalance their crypto assets into the highest yield-generating opportunities available when, in reality, the rebalancing mechanism often required manual input, which Rari Capital sometimes failed to initiate. The SEC also alleges that Rari Capital and its co-founders misleadingly touted the high annual percentage yield that investors would earn, but they failed to account for various fees and, ultimately, a significant percentage of Earn pool investors lost money on their investments.
To settle the Commission’s charges, Rari Capital and the three co-founders, without admitting or denying the SEC’s allegations, consented to the entry of final judgments ordering various forms of relief, including permanent injunctions, conduct-based injunctions, civil penalties, disgorgement with prejudgment interest, and equitable officer-and-director bars against the co-founders for a period of five years. The settlements are subject to court approval.
SEC settles with eToro crypto trading platform. On September 12, the SEC announced that eToro USA LLC has agreed to pay $1.5 million to settle charges claiming that it operated an unregistered broker and unregistered clearing agency in connection with its trading platform that facilitated buying and selling certain crypto assets. The SEC’s order finds that, since at least 2020, eToro operated as a broker and clearing agency by providing US customers the ability, through eToro’s online trading platform, to trade crypto assets being offered and sold as securities, but eToro did not comply with the registration provisions of the federal securities laws.
eToro publicly announced that, going forward, subject to the provisions of the SEC’s order, the only crypto assets that US customers will be able to trade on the company’s platform will be bitcoin, bitcoin cash, and Ether. eToro will provide its customers with functionality to sell all other crypto assets for only 180 days after the issuance of the SEC’s order.
Without admitting or denying the SEC’s findings, eToro agreed to the entry of a cease-and-desist order, to pay a penalty of $1.5 million, and, within 187 days of the order, to liquidate any crypto assets being offered and sold as securities that eToro is unable to transfer to its customers, and return the proceeds to the respective customers.
Federal Court denies motion to dismiss SEC allegations against Kraken. On August 23, the US District Court for the Northern District of California denied the motion to dismiss filed by Payward, Inc. and Payward Ventures (dba Kraken) in a lawsuit filed by the SEC alleging that Kraken operates as a broker, dealer, exchange, and clearing agency for crypto asset securities without proper registration. The court found that “the SEC has plausibly alleged that at least some of the cryptocurrency transactions that Kraken facilitates on its network constitute investment contracts, and therefore securities, and are accordingly subject to securities laws.”
Commodities
CFTC issues order against Uniswap for illegal digital asset derivatives trading. On September 4, the Commodity Futures Trading Commission (CFTC) announced it issued an order filing and settling charges against Universal Navigation Inc. (dba Uniswap Labs) for illegally offering leveraged or margined retail commodity transactions in digital assets via a decentralized digital asset trading protocol. The CFTC found that Uniswap helped develop and deploy a decentralized digital asset trading protocol that offered trading in digital assets, including some leveraged tokens and margined commodity transactions, to non-eligible contract participants without registering with the CFTC as a contract market. The order requires Uniswap to pay a $175,000 civil monetary penalty and to cease and desist from violating the Commodity Exchange Act (CEA). The order acknowledges Uniswap Labs’ substantial cooperation, resulting in a reduced civil monetary penalty.
Commissioners Caroline Pham and Summer Mersinger each filed dissenting statements. Commissioner Pham asserted that a lack of evidence describing the terms and/or characteristics of the “Leveraged Tokens” made it impossible to perform an appropriate product legal analysis to determine whether the tokens are a CFTC-jurisdictional product, and, therefore, whether the CFTC has the authority to bring the enforcement action and whether a violation of the CEA or CFTC regulations occurred. Commissioner Mersinger denounced the CFTC’s “enforcement-first” approach instead of providing guidance or notice-and-comment rulemaking.
STATE
Virtual currency
California court upholds daily transaction limit for crypto kiosks. On September 4, the California Department of Financial Protection and Innovation (DFPI) announced that the Superior Court for Los Angeles County upheld the state Digital Financial Assets Law’s consumer protections for users of crypto asset kiosks, or bitcoin ATMs. The plaintiff alleged that the $1,000 per customer per day crypto kiosk withdrawal limit in the Digital Financial Assets Law was unreasonable and exceeded the authority of the state legislature. In response to the DFPI’s demurrer, the Court entered a judgment of dismissal in favor of the DFPI and dismissed the complaint in its entirety with prejudice.
Money laundering
Federal Reserve Board enters into consent order against Texas bank for AML/BSA violations. On September 4, the Federal Reserve Board announced entry of a consent cease-and-desist order with United Texas Bank in connection with an examination of the bank that identified significant deficiencies, including in connection with virtual currency customers relating to anti-money laundering (AML) and Bank Secrecy Act (BSA) violations. In addition to other requirements, the consent order requires the Bank to submit revised programs acceptable to the supervisors for BSA/AML compliance, customer due diligence, suspicious activity monitoring and reporting, and OFAC compliance.
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