Dinsmore & Shohl LLP
  June 23, 2022 - Louisville, Kentucky

Senators Gillibrand and Lummis Seek to Regulate Digital Assets
  by David A. Lopez-Kurtz

Regulation brings uniformity and security, which may feel anathema to the fundamental premise of distributed ledger technology (specifically blockchain and the nascent crypto industry blockchain technology allows) – a world that needs neither trust nor centralized authority. Nevertheless, two U.S. senators are pushing to reconcile these seemingly contrary positions and priorities.

On June 7, 2022, Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) published a nearly 70-page draft of their landmark legislation providing clarity on the regulatory status of blockchain-based crypto assets. Dubbed the “Lummis-Gillibrand Responsible Financial Innovation Act,” the bipartisan bill seeks to regulate the digital assets industry in a crypto-friendly manner.

The act prefaces its eight sections with a mission statement: “to provide for responsible financial innovation and to bring digital assets within the regulatory perimeter.” This regulatory perimeter includes standards on taxation, securities, commodities, consumer protection, payment, banking, and interagency coordination. Below summarizes each section’s most notable features.

Definitions

Lummis-Gillibrand begins by establishing a legal framework for prominent digital terms, the first step in creating uniformity and coherence in the digital realm. Below are a few key definitions.

Taxation of Digital Assets and Retirement Plans

In calculating an individual’s taxable gross income, the act first provides a de minimis exclusion of up to $200 from gains or losses of personal virtual currency transactions.

Additionally, holders of cryptocurrency may place their tokens into a retirement account, an investment on which the comptroller general has been mandated to produce a study.

Brokers. Next, the act clarifies that duties of digital asset brokers are similar to those of traditional brokers. More specifically, individuals are not deemed brokers if they are solely engaged in:

DAOs. Lummis-Gillibrand also sheds light on the classification of decentralized autonomous organizations (DAO), or blockchain-hosted communities. DAOs are defined in the legislation as an organization which utilizes smart contracts to effectuate collective action for a business and is governed primarily by a distributed basis.

Under the act, not only are DAOs by default deemed businesses entities which are not disregarded entities, but DAOs must also be properly incorporated or organized under the laws of a state or foreign jurisdiction.

This emphasizes the significance of state statutes on DAO incorporation. Delaware, for example, has always enjoyed a heavy amount of incorporation in its state over others due to its permissive fiduciary duties laws. A similar competition could emerge among the states to make their DAO laws more permissive and inviting than the rest.

The Future. Looking forward, the act designates the secretary of the Treasury (or the secretary’s delegate) with the duty to adopt enforcement rules for the above regulations and to determine guidance on:

Securities Innovation

The next section provides long-awaited clarification on the identity crisis of digital assets.

Ancillary Assets. Ancillary assets in compliance with U.S. Securities and Exchange Commission (SEC) disclosures are considered commodities. Under the bill, an ancillary asset is an intangible asset provided to a person in connection with the purchase and sale of a security through an investment contract, as defined by the Howey test. This may include a digital asset that is used to facilitate the governance of a distributed ledger technology network or DAO.

Finally, an ancillary asset would not include any asset that provides a holder with any of the following rights in a business entity:

The establishment of this new asset class resolves some of the jurisdictional tension between the SEC and Commodities Future Trading Commission (CFTC) that has been growing as quickly as the digital space.

Foreign Private Issuer. Here, a foreign private issuer means a foreign issuer other than a foreign government, excluding those:

Disclosures. Ancillary assets issuers who (i) provide daily aggregated assets totaling over $5,000,000, and (ii) derive their value primarily from the managerial efforts of others must file semiannual public disclosures with the SEC. These disclosures would include information regarding the issuer, the ancillary assets, and various technical details. The act provides further guidance on how the assets should be calculated.

As for ongoing compliance, the disclosures would be revisited on an annual basis. If the project (i) lost trading volume below the $5,000,0000 threshold, or (ii) became sufficiently decentralized so that its value no longer primarily derived from managerial efforts, then disclosures would be deemed unnecessary.

The disclosure and compliance rules also offer insight on the classification of ancillary assets as securities or commodities. Ancillary asset issuers who make the appropriate SEC disclosures are deemed to have assets that are commodities. There is room in the act, however, for a court to determine that there is no basis for an asset to be a commodity.

The Future. Finally, the legislation mandates the SEC to issue guidance on a variety of securities issues, including access control of digital users’ private key. An access control mandate will be beneficial for many cryptocurrencies. Millions of Bitcoin, for example, have been lost due to forgotten or misplaced private keys.

Commodities Innovation

Transactions Jurisdiction. Crypto assets and the digital space are no longer the Wild West, as the act assigns the CFTC exclusive jurisdiction over retail digital asset transactions. These transactions do not include securities or ancillary assets (which are left to the SEC), but rather the trade of digital assets in the retail market, as laid out in the Digital Commodities Act. Another jurisdictional limitation includes the sale of non-fungible assets, such as NFTs.

A financial institution with digital assets activities need not register as a commission merchant, however, if it:

Security. In an effort to maximize security of digital assets transactions, the legislation also permits merchants to hold consumers’ assets and for trading facilities to register with the CFTC as a digital asset exchange.

The Future. While the CFTC has exclusive jurisdiction over a portion of the digital asset space, it must still collaborate with the SEC to ensure the two organizations do not issue conflicting or overlapping rules. Consultation topics must relate to rules regarding:

Consumer Protection

Providers and Consumers. Section five sets responsibilities to providers of digital assets to establish protection on both sides of a transaction. Disclosures include:

Payments Innovation

Section six addresses the systematic risks of stablecoins and references the Republic of China’s growing presence in the crypto space.

Liquid Assets. In pursuit of consumer protection, the act mandates payment stablecoin issuers maintain a 100 percent high-quality liquid assets reserve. Issuers must also comply with a series of public disclosures and reporting procedures related to their payment stablecoin. Finally, issuers must be prepared to issue legal tender on demand of the consumers in exchange for their payment stablecoin.

Republic of China. In a brief response to China’s developmental digital yuan, Lummis-Gillibrand mandates the creation of standards and guidelines for adequate security measures on government devices.

The Future. The legislation next establishes the Innovation Laboratory, nestled within the Treasury Department’s Financial Crimes Enforcement Network. The Innovation Laboratory’s mission is to conduct pilot projects for supervision of financial technology and promote dialogue between the digital and financial industries.

Banking Innovation

Federal Reserve Act Amendment. Lummis-Gillibrand first requires the Federal Reserve banks to make a segregated balance account available to depository institutions.

12 U.S. Code § 27 Amendments. The Certificate of Authority to Commence Banking U.S. Code is the next to receive modifications under the act. The most notable prohibits a depository institution from engaging in maturity transformation or facilitating consumer lending through third parties.

Payment Stablecoins. Next, Lummis-Gillibrand mandates that to issue a payment stablecoin, a depository institution must submit an application before the Federal Reserve System or a Federal Reserve bank. These applications must be reviewed in a timely manner. Additionally, the comptroller of the currency is tasked to develop a simplified capital framework for issuance of a payment stablecoin.

Routing Numbers. The act then directs the Federal Reserve System to assume responsibility for issuing routing transit numbers to depository institutions.

Standards. Joining the growing list of amended standards is that of digital asset examination and custody standards. The former mandates adoption of digital asset activity examination standards and the latter codifies common asset custody principles for depository institutions.

Reputation Risk. The next section requires a Federal banking agency to provide a valid reason before terminating a customer account. The notice and reporting must comply with the act’s detailed standards.

Future. Finally, the act assigns the Federal Financial Institutions Examination Council (FFIEC), the SEC, and the CFTC, in consultation with the Financial Crimes Enforcement Network (FINCEN), the final say on digital assets’ banking activities. The Federal Reserve System must also submit a study regarding the effect of distributed ledger technology on risk reduction for depository institutions.

Interagency Coordination

Cooperation. Recognizing the jurisdictional confusion of the cryptospace, the legislation ends by laying a foundation for future cooperation and uniformity. In general, the act establishes a timeline for interpretive guidance issued by federal financial agencies. The guidance contains the mandate of uniform standards among states. This will likely spur action into states that have yet to adopt major digital assets legislation. 

Conclusion

This act has not yet been voted on or passed. Nevertheless, its implications are significant and it seems to confirm that extensive (and hopefully coherent) regulation is on the horizon for the crypto industry.

As always, Dinsmore attorneys remain available to counsel market participants on matters relating to blockchain technology, digital assets, and their regulatory framework.

(This alert was prepared with the assistance of Alexandria Labaro who is currently a summer associate with Dinsmore & Shohl and not yet admitted to practice.)




Read full article at: https://www.dinsmore.com/publications/senators-gillibrand-and-lummis-seek-to-regulate-digital-assets/