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Expert guests David Gannaway and Frank Weigand join IMS Client Success Advisor and podcast host Adam Bloomberg to discuss how the latest trends in digital asset regulation, cryptocurrency litigation, and tax compliance are shaping US financial markets.

Transcript:

Hello, and welcome to the IMS Insights Podcast. I’m your host, Adam Bloomberg. Today we’re speaking with expert guests David Gannaway and Frank Weigand about how the latest trends in digital asset regulation, cryptocurrency litigation, and tax compliance are shaping US financial markets.

David Gannaway is a principal at Bederson Accountants and Advisors and is a former IRS Criminal Investigation Special Agent with expertise in forensic accounting, litigation support, and tax controversy. Frank Weigand is an experienced general counsel with a strong background in digital assets, securities law, derivatives, and broker-dealer regulation.

Adam Bloomberg:

Thank you, David and Frank, for joining me today. I want to I want to start our discussion with the regulatory environment surrounding digital assets. Frank, why don’t you go ahead and start us off.

Frank Weigand:

Thank you, Adam, and thank you to IMS for inviting me. Today, I’m going to speak about the current regulatory environment for digital assets and companies doing business in this arena. As you probably know, it’s been a very busy week for digital asset regulation, with the SEC suing both Binance and Coinbase in the last few days. Both cases bring charges based on allegations that these firms are operating securities related businesses in an unregistered and therefore illegal manner. I’ll discuss these cases in more detail later. But first, I want to begin my discussion by defining digital assets and giving a brief chronology about how this industry got to where it is today.

I think that when people use the term digital assets, they’re primarily referring to cryptocurrencies, but the digital asset universe is actually much broader than that. In addition to cryptos such as Bitcoin that are viewed by many as a store of value, with some people referring to Bitcoin as digital gold, there are other cryptos called Utility Tokens that are needed to affect certain functionality on the blockchain. Further to this you have cryptos known as Stablecoins, that are designed to trade at a set price normally $1 per coin and venturing outside of the financial realm, certain NFT’s or non-fungible tokens can function as works of art or even as a means to access an experience such as a concert ticket. And lastly, there are even central bank digital currencies which have already been launched in a number of countries and are in the pilot phase elsewhere.

And even further to all of this, digital assets have enabled the growth of an entirely new economic realm called Decentralized Finance, which people refer to as DeFi. But at the end of the day, with all of this new technology, what we really have is something that enables people to transact or interact with one another in new ways. And some of these interactions mirror existing, well-regulated activities, such as the purchase or sale of a security, whereas others can result in something completely new that we haven’t seen before. And when you think about the regulations that are out there, some regulations apply well to this space to the extent it’s mirroring existing processes, but in some instances, it does not match up well and you result in a square peg round whole scenario.

Adam Bloomberg:

Now, could you expand a bit on DeFi and what that means?

Frank Weigand:

Sure, sure. So, as I said, DeFi means Decentralized Finance and it’s an area that’s emerged in the last 5 to 10 years. It’s being developed with the goal of removing central counterparties and large financial institutions from the picture in favor of allowing parties to transact with one another in peer-to-peer exchanges. In these transactions, money and assets can be held in digital wallets and can generally be transferred between parties within minutes. And these capabilities, Adam, are accessible to anyone with an Internet connection. Much of the decentralized finance relies on smart contracts that are self-executing and have the terms of the agreement written directly into the code. Given the utilization of cryptocurrency in DeFi, the two arenas are closely interrelated. Thank you for the question. I think that’s an area that people are still learning a lot about.

Adam Bloomberg:

Can you tell us a little more about relevant regulations?

Frank Weigand:

Because of the different functions of digital assets that I mentioned, there are a range of regulations that are potentially relevant, and these regulations can be at the federal level and also at the state level. And numerous states do have their own local regulations and licensing requirements for conducting digital asset businesses. Unfortunately, we just don’t have the time today to delve into the requirements of each state. But suffice it to say that a thorough jurisdictional analysis is prudent for those interested in conducting business anywhere in the US. From a federal standpoint, I’ll give a high-level overview in cases where cryptocurrencies can be viewed as similar to traditional fiat currency, like the U.S. dollar or euro, those who set up businesses to transact in such cryptocurrencies have been regulated by FinCEN, which is part of the US Treasury Department, and they’re regulated as money services businesses or MSBs. And for context, the most well-known MSB in mainstream financial services is Western Union.

Alternatively, to the extent that a cryptocurrency is a security, transactions must be conducted pursuant to the securities regulations or exemptions there from the securities law, as I think most people know, are very expensive and impact upon the initial sale of the security by the issuer, as well as activities of those who make markets operate exchanges or enter into derivative transactions on securities. The next potential categorization of cryptocurrencies could be as a commodity. In this case, the CFTC would have jurisdiction over dealers transacting in derivatives on these products and would also have authority to bring actions against fraudulent actors in the spot markets.

In the banking sector, the Federal Reserve, the Office of the Controller of the Currency, the FDIC, as well as state banking departments, may impose enhanced oversight over banking institutions involving cryptocurrency. This can occur when banks hold these assets on their balance sheet or provide services to companies that themselves are involved in crypto. Lastly, it’s quite possible that the digital asset is neither a currency, a commodity, nor a security, and may have no relationship whatsoever to the US banking system. As an example of this, I think about the NFT that is simply a work of art or as I mentioned, an NFT that functions as a concert ticket. In general, the starting point for regulations of these digital assets will be the regulations that apply to the non-digital version of the same item. And of course, in all of these cases, laws of general applicability such as anti-money laundering and anti-fraud statutes will apply across the board.

Adam Bloomberg:

Can we draw comparisons to other industries to contextualize this?

Frank Weigand:

Good question, Adam. I can’t think of an industry per se, but I think we can draw a comparison between digital asset regulation and how activities on the Internet are regulated. You know, for businesses that’s done online, there’s not one regulator of all aspects of the business conducted, just as there’s not one regulator of all digital assets. So, if you focus on this specific product or activity, then that product or activity should be governed by the relevant regulator or regulators in accordance with their statutory mandates. That’s not to say we aren’t seeing a regulatory land grab in digital assets or even overlapping regulation of the same products due to a clear demarcation of jurisdiction. But theoretically, that’s how it should work.

One other point I should note is that classification from regulatory purposes requires very specific facts and circumstances analysis specific to the particular currency or transaction. On the security side, the leading case regarding whether a financial arrangement constitutes an investment contract and therefore a security is a case called SEC vs Howey. This is a Supreme Court case from 1946 and lays out a four-prong analysis for making such determinations. The case actually dealt with investors who put money into orange groves in Florida, which many argue should not be the applicable standard for classifying digital assets. Nevertheless, it currently is, which is why we’re seeing a call for more specific regulation to apply to the technology as it’s coming into the picture today.

Adam Bloomberg:

Could you draw out a timeline of crypto recent events?

Frank Weigand:

In 2009, digital assets in the current era got their start with Bitcoin, which was launched by an unknown creator, and today there are over 20,000 cryptocurrencies. Notably as well, in 2015, Ethereum was launched which enabled the broad scale of smart contracts which I described earlier, are critical for Decentralized Finance. In addition, over the last decade there were countless ICOs or Initial Coin Offerings, kind of like IPOs, but referring to coins, Initial Coin Offerings through which billions of dollars were raised by creators of digital assets. And many of these offerings were not conducted through regulated means. In addition, throughout this growth period in the U.S., there was no national legislation enacted that would address the nuances of these products. And compounding upon this was the relative inaction by the existing regulators to set guardrails. What that resulted in was businesses setting themselves up pursuant to the patchwork of regulations that I mentioned earlier, often needing to make determinations of how ill-fitting regulation should be applied to the new technology of digital assets and the businesses they would be conducting.

Fast forward more recently to 2022, when a pair of intertwined cryptocurrencies called Terra and Luna suffered an overnight price drop that cost investors billions of dollars and led to the demise of a crypto hedge fund called Three Arrows Capital. This then resulted in significant losses to certain lenders to Three Arrows, namely Blockfi, Celsius, and Voyager. And several months after this, the massive FTX fraud came to light, costing investors billions and also spooking bank depositors at several crypto friendly banks, including Silvergate Bank, Signature Bank, and Silicon Valley Bank, resulting in each of their demises. In reaction to these events, concerns have been raised by elected officials and the reaction of the regulators has been swift and substantial. In recent months, the SEC has shifted from bringing cases against smaller players, which many viewed as a signaling to the market to going after the largest global firms which were presently experiencing in real time with the Coinbase and Binance cases.

I should also note that from a CFTC perspective, in March, the commission brought a civil enforcement action against Binance, alleging that Binance allowed certain US customers to trade on Binance’s digital asset trading platform without Binance first properly registering with the CFTC and also for failing to maintain an effective AML compliance program. The jurisdictional nexus through which the CFTC brought this case was based upon the CFTC’s assertion that certain digital assets traded on Binance are commodities. These included Bitcoin, Ether, Litecoin and certain stablecoins. Critics have argued that the regulators’ approach of bringing individual enforcement actions constitutes regulation by enforcement, and we’ve heard that term used a lot in the context of digital assets with many folks complaining that it’s not the most efficient means of regulating a market and it’s not helpful to a growing ecosystem that is actively seeking regulations that are more fit for purpose.

Further to this issue, we’ve seen instances of regulators proposing changes to existing rules in order to sweep in digital asset participants. These proposals include amending the definition of exchange under the 34 Act, which would seem to have the intended effect of bringing many DeFi platforms under SEC jurisdiction. Another example is a proposed change to the definition of custodian under the investment adviser rules. That change would make it more difficult for investment advisors in the traditional finance space to offer digital assets to their clients. And lastly, the banking regulators have been amending capital requirements to make it more onerous and expensive for banks to provide services to crypto clients. In response to these proposals, many comment letters have been submitted to the SEC from those who would instead prefer new rules specifically tailored to digital assets and their particular nuances.         

And I should add that among the most outspoken critics of Chairman Gensler and some of the other SEC commissioners is SEC Commissioner Hester Peirce, who has stated that the SEC’s approach has been focused on solving problems that don’t exist and that the SEC is not allowing room for new technology or new ways of doing business. Consistent with commissioner person’s view, we have seen proposals from members of congress setting out a more thoughtful approach to the regulation of digital assets. Even just this week, the House Agriculture Committee held a hearing centered around 162-page draft bill from representatives Gwen Thompson of Pennsylvania and Patrick McHenry of North Carolina that proposed joint CFTC and SEC responsibility for regulating digital assets. It’s too soon to say what will happen with this bill, but to date, similar efforts have stalled on Capitol Hill because there’s many competing legislative priorities that have tended to push specific digital asset enactments to the sidelines. As a result, the courts may be the more likely source from which clarity or guidance might be forthcoming.

Adam Bloomberg:

Thank you, Frank. We really appreciate your insights into the regulatory atmosphere in the crypto market. Next, we welcome David. Why don’t you address crypto and taxes and what are the tax principles of virtual currency? Maybe let’s start there.

David Gannaway:

One of the things that I want to really hone in on is the Internal Revenue Service. They produce notices and those are really what they call public kind of announcements that you’re talking about, how to interpret a certain tax issue within the Internal Revenue Code, so IRS notice 2014-21 has some very good information. The first thing I want to really look at is what houses traded from an Internal Revenue Service perspective, that virtual currency is a digital representation of value that functions as a unit of account or a store of value. And so, one of the things that’s important here is that in some countries it operates like a real currency, and it’s accepted there. But in the United States, it does not have the recognition of being legal tender here in the in the United States. So virtual currency that, you know, has an equivalent value in real currency or that acts as a substitute for real currency is referred to as a convertible virtual currency.

Bitcoin is one example of a convertible virtual currency that Frank spoke about. Bitcoin can be digitally traded between users and can be purchased or exchanged into the US dollar, euros and any other real or virtual currencies. And so, for federal tax purposes, digital assets are treated as property. And so that’s what Frank was speaking about, how the CFTC considered as a commodity, the IRS is treating digital assets as property. And so there are tax principles that are applied to property transactions regarding these digital assets. But property is the first classification of how the IRS is reviewing and considering these assets. So even though, you know, it’s not treated as currency or treated as legal tender, it’s treated as property, and with this treatment, that means that it’s not generating a foreign currency gain or loss for US federal tax purposes since it’s treated as property, it’s not a currency. Okay. So, if it’s traded there, then it’s not considered for federal tax purposes a foreign currency gain or loss. Okay. If a taxpayer, you know, who receives virtual currency as payment for goods or services must include this in their gross income, and how is it treated from a tax perspective? It’s treated as the fair market value of the virtual currency measured in US dollars at the date that the virtual currency was received. So, for practitioners out there, it’s seems to me the cash method of accounting is going to apply to these type of trading or exchanging the virtual currencies, when it’s a taxable situation, so it’s going to be at the date that the virtual currency was received.

Adam Bloomberg:

David, can you describe the difference between ordinary income and capital gain?

David Gannaway:

Well, ordinary income is going to be a situation where a business, let’s just make it simple, let’s say it’s a car dealer. And a car dealer sells a car for X thousands of dollars. The car dealer may accept a virtual currency as payment for the purchase of that car. If they do, that’s been handled and going to be considered income to their business. So that would be considered ordinary income because it’s a sale of a good or service. And here is an inventory item from the car dealer to an outside customer like myself. And so that would be that $20,000 in my example, here are the $20,000 and how they agreed to the purchase price. And then the dealers receive Bitcoin or whatever other digital virtual currency, then that’s going to be reported as gross income on the individual’s tax return or on the car dealer’s tax return in this situation. So the other situation would be if it’s capital gain, would be considered like it’s property. So there if you made a personal investment, if you purchased X number of coins, bitcoins, virtual currency in the like one of the things you look at is how did you acquire that property? Was it acquired from, you know, already taxed income? And if you made that investment, it’s no different than purchasing stocks or bonds. So, at that point in time, that’s when you would say that you’ve taken, you know, currency out of your individual bank account to go and purchase this type of property. Then you hold it and let’s say you purchased it for $10,000 today, you held it for six months and you sold it, exchanged it for $20,000, then you would have a short-term capital gain transaction because you’re holding it as a personal investment versus being received in a trade or business.

So again, the distinction is between personal investment and whether it is received or delivered as a part of your trade or business. And one of the things that, like I mentioned there, the purchase, that’s the basis that you have to determine whether you have gain or loss. So, it’s no different than any other type of transaction. You know, a purchase of X, Y, Z stock on the through the stock market today, you purchased it on June the 8th. You obtain a thousand shares for $20,000. That’s your basis in the virtual currency that you have at that point in time. And then whether you have a gain or loss is what you end up selling it for. Whether it’s 6 months from now or long term would be, as we all know, more than twelve months. So that’s how you how the transactions are disguised or not disguised but determined between ordinary income and capital gain.

So one of the things that you have to look there is to make sure that that basis is correct and keep track of that so that you’re able to, if reported on your income tax return and then B, if there is an audit that comes later, a year and a half later after you file your return, you’re able to support how you determine what the basis was at the time that you acquired it versus when you sold it, and then the time period of when you purchased it versus when you sold it gives the determination whether it’s a short term or long term capital gain.

Adam Bloomberg:

Does a taxpayer have a gain or loss upon exchange of a virtual currency or other property?

David Gannaway:

Yes, they can have the gain or loss when they hold the property as an investment. So that’s the main characterization and the main difference is whether it’s being received in a trade or business or if you own it personally and hold it for investment purposes. One of the things that you want to look at as well is whether, you know, sometimes you may have enough, and I’ve seen this on a couple of cases where companies may pay their employees with virtual currency. And so that is treated as, you know, subject to employment taxes, just like if someone received a check from the company or direct deposit into their, you know, the person, the employee’s bank account and so the company in this situation would be required to treat them since they’re an employee, treat them as even though they’re paying them with the virtual currency, they’re supposed to properly report that and include that and file a W-2 form, withhold the proper amount of taxes reported on forms 941 and pay over the amounts due to the to the IRS and to the state regarding the, you know, the income that’s been paid to your employees for, you know, the services that they’ve performed.

And then likewise, on the other side of this, you have situations where if you’re using virtual currency to pay a contractor, someone that’s not an employee, then this type of situation is going to be required to submit a Form 1099, which all the practitioners are aware of that if you have an independent contractor who has provided services or not an employee, if they’ve been paid more than $600 at the time of the services that were provided, then this will be reported on a Form 1099 and submitted to the local contractor, whether it’s the plumber or the electrician that may have come in and did work for your business, or in that way there all the 1099 are still going to be reported. So, from a standpoint of obtaining the correct information from the vendor that’s providing services, you need to make sure you have the invoice, the proper employee identification number or the Social Security number of the person that provided the services for you, if that’s your business. So that a Form 1099 can be submitted to the individual at the end of the year, then properly claimed on your income tax return.

Adam Bloomberg:

Does virtual currency paid by an employer as remuneration for services constitute wages or employment tax purposes?

David Gannaway:

The IRS, I don’t know if this term is something new for a few out there in the audience. The IRS, when they’re investigating potential issues like the like the virtual currency here and then there was a several cases years ago that I worked on when I was still with the service, that there was a John Doe summons. And what that means is that there are times when the IRS now investigates violations of potential violations of internal revenue laws. But, you know, people or groups of them have, you know, a common type of identity and what they are, it’s a type of scheme that may be undertaken. One of them was several l years ago we did a John Doe summons to the major credit card companies because there was individuals living in the United States that were United States citizens, but they had credit cards based outside the United States. And they were using unreported income to prepay those credit card expenses. And the statements were not being mailed back to the United States. There was no linkage to the United States through those credit cards. And so that was something the IRS issued a John Doe summons to the credit card companies to obtain all of the clients that they had that were U.S. citizens, U.S. persons that had these types of accounts.

And so here’s what the, you know, the IRS did this type of situation several years ago in the case involving Coinbase. And that was one of the first times that goes all the way back to 2000. And I think it was 2016 was when the IRS utilized a John Doe summons to go to Coinbase to obtain all of the clients that had been used to, you know, all the clients that the Coinbase had then bought, sold, sent or received cryptocurrency of at least $20,000 value in the years 2013 through 2015. And so based on this information, the IRS sent out what they said were 10,000 compliance letters to taxpayers advising them of their failure to properly report cryptocurrency transactions. And so that’s one of the things too, that we’ve talked about is, you know, if you may recognize or remember now, that on the tax returns as of 2019, individual income tax returns, there’s a block now that says, have you been involved in or had any transactions with cryptocurrency?

Adam Bloomberg:

Frank, anything to add on Coinbase?

Frank Weigand:

Sure, happy to. And you know, I think some of the themes that you’re raising are consistent with what I’ve been talking about in the security side, which is that, you know, those transacting in digital assets or cryptocurrencies will have their actions accounted for, right? Whether it’s from a tax perspective or a securities or commodities perspective. With respect to Coinbase, though, from a regulatory standpoint, I mean, Coinbase is situation on the security side is interesting because they’ve asked the SEC for guidance numerous times. The SEC has not given them guidance and Chair Gensler has stated his belief that the US securities regulations are clear tokens on the Coinbase platform are securities and that the SEC is bringing the most recent case which, which, you know, was announced earlier this week squarely under the existing regulations. And by doing so, the SEC is protecting US investors. And you know, some additional context with respect to the SEC and of Coinbase related case is a case actually that was settled last week also premised upon the assertion that certain tokens on the Coinbase platform were securities. That case did not involve Coinbase itself as a party, but rather was brought against former Coinbase employee and his brother, alleging that they traded in 25 crypto assets ahead of those assets being listed on the exchange. And this is important because when a token is added as a listing on Coinbase, it tends to trade up from a price standpoint. So, in his job at Coinbase, one of the brothers was privy to information on which coins were going to be listed before they were. He had that information, he shared it with others and people traded it ahead of the listings.

The SEC brought their case against the brothers, claiming that some of these tokens were securities and therefore is a violation of securities laws. On the same facts, the Department of Justice brought a non-securities wire fraud case against the two gentleman defendants. They were prosecuted under those wire fraud charges, as I mentioned, but the Department of Justice, interestingly, did not bring securities related claims in that case, or securities related charges in that case. And pursuant to the individual settlement with the SEC, they actually were not able to challenge the facts that the SEC brought to bear. In other words, there is no analysis from a securities law perspective that the SEC needed to produce in order to show that the tokens were securities. So, commenters in that case pointed out that the SEC was bringing a case against defendants that really were not, you know, deep pocketed enough to bring on bring a robust defense with respect to the charges and analyzing whether or not the securities or the tokens themselves were securities. Now, in the case just this week that we see against Coinbase, I don’t think that will be an issue here. Coinbase has indicated its intention to vigorously defend itself, and we know that it’s resourced enough to mount a very vigorous defense there.

Adam Bloomberg:

So David, you had a few more things to talk about related to the kind of the latest criminal prosecutions involving currency or virtual currency. Do you want to expand on that a little more?

David Gannaway:

Yes, please. Thank you, Adam. And there’s several cases that have been like Binance was just brought this past week by the SEC, FTX, I’m sure everyone has heard of that, Crypsee, there’s another case that, these three are under either the other end or under indictment or there’s allegations brought by the SEC in these type of cases. And what I want to do is not really go into each one of them specifically, but kind of go over what the general purpose is or the general charges that have been brought in these type of cases or allegations at this point in time. So they’re not they’re not criminal convictions. So, they’re just allegations made. Charges that have been brought or consist of tax evasion, wire fraud and money laundering. And then the money laundering leads to asset forfeiture in the in the potential end of these cases. But most of these all three of these consistently say that the owners and the main individuals are these companies misled the investors. They sent funds to related companies that they had control over and then used the money for their own personal benefit. And so that’s the basic type of situation that happens, whether it’s a Ponzi scheme from a made off situation, there’s been misleading of information. You’re saying that you’re going to do this type of transaction, or you provided this information for someone to rely on and the facts aren’t the same. And then you’ve they’ve created fictitious companies and they’ve moved money. And basically, the shareholders or the owners have, you know, lost maybe all their life savings or many, many of their savings from participating or conducting, you know, and trusting these types of situations. And so, again, these are allegations at this point in time, but that is kind of the consistency of them, that the funds, the investor funds, investors have been misled, investor funds have been diverted, and that went to the personal benefit of the main principals in these types of cases.

So, you know, there was another case that that was just sentenced not too long ago, about a year or so ago called Crypto ICO, which Frank mentioned, you know, the ICO with those individuals, there was 13,000 investors that they misled, and it was $24 million dollars and they pled guilty and they were sentenced to eight years in prison. So, you know, even though there’s some I mean, a lack of understanding is not the proper term, but it’s all brand, It’s all new. It’s not just, you know, a Ponzi scheme that’s been going on for 50 years. But the IRS, the US Attorney’s office, the FBI, who are all working on these cases, the SEC, are all bringing the core type of transactions in a call. And the admissions or overt acts is basically misleading investors and then diverting the funds for their own personal benefit. So, they’ve used, you know, different types of schemes to go along like that. One of the things that the IRS, and I know that the current chief of IRS criminal investigation back a few months ago, late last year, made the announcement that they have, you know, probably a few hundred cases that are in their inventory that they are about to recommend prosecution or cases will be, you know, brought indictments will be returned regarding, you know, tax evasion, money laundering and the like. So IRS criminal investigation is really taking the lead, along with the US attorney’s office and the FBI agents to work on these types of cases. And so, I think you’re going to see more over the next few months from the IRS, because they’re out there really working on these types of cases because of the financial impact that it has. And then also to try to seize to seize assets. And so that’s something that the IRS also did. They started in in ‘21. There was a kind of internal operation where they, you know, devoted resources to it. They brought in outside vendors to help them understand and do the data analytics and analyze the blockchain to identify potential individuals and type of transactions that should be under investigation because it’s, you know, the type of transaction, the way they have done has raised some red flags. So that’s kind of their starting point now from 2021 is to really make a focus on this type of potential noncompliance. So, you’re going to start seeing more cases come out, I believe in the near future, from the IRS and obviously from the US attorney’s office and the FBI when they when the cases are made, along with the SEC and the CFTC. So, there’s I think there’s a joint you know, each one of them is kind of taking their own piece of it.

Adam Bloomberg:

Thank you, David. That’s an excellent analysis here. Frank, I know you touched it a little bit there, but would you like to talk a little more about some recent cases?

Frank Weigand:

Sure. You know, I think we’ve covered Coinbase pretty thoroughly. I’d also mentioned another large-scale case that people are focused on, which is SEC vs Ripple in this case, which is before the Southern District of New York. The SEC is alleging that XRP, which is a cryptocurrency issued by Ripple, through, which the company raised significant sums of money, is a security. And here again, the question of securities classification presents itself. And many are watching this case because it’s been progressing for months already, so it might reasonably be expected to reach resolution, you know, ahead of the new cases just being brought. Of course, that being said, the facts and circumstances of each case are unique unto themselves and will drive the decision in each of those respective cases. However, broad or novel concepts could potentially be addressed in one case that influences other cases. And one topic that I’m personally interested in is whether a potential argument that crypto tokens might be classified as a security upon issuance, but once traded in the secondary market, might be a non-security. So can they change their classification over the course of time? That outcome would clearly contrast with the existing securities markets. However, you know, digital assets are not like traditional securities, as we’ve discussed, nor are the companies that issue these entirely similar to operating companies that typically issue equity and debt in the capital markets. And new regulations to address these differences or new rulings by courts would be helpful from, you know, in my opinion, it’d be interesting to see if the courts do take up these topics and are able to provide some guidance to the market.

And then just shifting gears and David mentioned, but I want to touch on some cases related to FTX, not specifically the bankruptcy, but there were some suits brought against investors who put money into the fund, or I should say, private equity funds too, that invested client money into FTX, namely Sequoia, Thoma Bravo, and Paradigm. And the case against them alleges that they invested their client funds in FTX without proper due diligence, and that these private equity firms also inappropriately participated in propping up FTX’s valuation by actively bolstering FTX’s public relations campaign. So, we’ll see how that case and how that case is resolved. In addition, along similar lines, individual celebrity promoter promoters such as Larry David and Tom Brady are being sued for improperly touting FTX in Super Bowl advertisements in 2022. I think folks who watch the Super Bowl will remember the plethora of crypto ads that that we saw during the breaks in action. There were just so many I can’t I don’t actually have a count on how many there were, but it was quite notable. And the specific claim against Larry David and Tom Brady is that they violated Florida state laws prohibiting unfair business practices by essentially touting a company that wound up to be nothing more than a Ponzi scheme. So, a lot is happening here, a lot of different touch points, Adam, that come out of these cases. And you know, to echo David’s point, everything here is very much evolving at this stage.

Adam Bloomberg:

I remember the Super Bowl and those ads were all over the place. With fraud in the industry, how could an investor verify the solvency and business practices of a digital asset company?

David Gannaway:

Well, I think first thing, as we’ve pretty well established, that you need to have buyer beware for sure, investor beware, and all of those type of things lead me to, first thing I would do is if you were going to invest, you know, a significant amount of money, I think it would go and have a business lawyer review any of the documents you’re able to obtain. Also, how did you become aware of this one opportunity? Did you receive a phone call? Did you go to a convention in X, you know, city? And they were touting this type of potential investment. So, all of those things are kind of, you know, red flags for, you know, it’s not something that is potentially on the up and up. And also one of the things, too, is that you should ask for, you know, financial statements, operating type agreements, any of this, the ownership agreements, shareholder agreements to look at those financial statements and the balance sheets and so forth to see what the, you know, who is it that’s preparing that? Is it an actual audited financial statement by an independent, a regional or large Big 4 accounting firm? That’s something that you least have some the potential independence there. Or is it on, you know, four corners of a piece of paper that could have been drafted by whoever was trying to sell you this investment? So that would be one of the things I would want to look for any steps you can from an independent standpoint that has reviewed the information that’s being provided to you. And again, you want to look at what’s the, you know, the dynamics of when you purchase and what do you want to do when if you’re wanting to sell, how long does it take for you to recover or receive the money? Some of those transactions may wait, you know, two weeks, a month before you can receive your money.

All those different type of things that are not normal in a normal type of transaction where funds should be available to provide you if you’re ready to sell. And that’s, I think, what Frank had mentioned before. All those banks have got to a position where they weren’t liquid because of all the funds that were gone. So, I think he’s got to really concentrate on doing your own due diligence and understanding how you’ve arrived at this opportunity. And does it make sense? And I think the most one of those things is, you know, speak with someone like again, not to promote Frank, but you need to speak with an attorney that you would then outside, of your own passion to say I really want to get in on this, I’m going to really chase this because I think this is the next way for me to make X, whatever, thousands of dollars, millions of dollars. Just take a deep breath about it, pause it, go, and really run it by someone else that has some independent view here that can give you some good, strong, you know, business advice.

Adam Bloomberg:

Okay. Well, let’s promote Frank then. This next question’s for you here. What’s going on in other countries that’s likely to affect US digital currency market and maybe how it’s regulated?

Frank Weigand:

Great question. If I can pick it apart a little bit. There’s a lot going on outside of the US Whether or not it will affect us is a question from a regulatory standpoint. I think some people say what’s going on abroad will affect the US because it will suck some of our, you know, technologists and people who are advancing in this space out of the US to avoid US jurisdiction, but that’s probably a bit of field with respect to the question that you’re asking. So, on the positive side, in the in the EU, there’s recently new legislation enacted called the Markets in Crypto Assets or MICA for short. MICA is focused on investor protection, increasing transparency and putting in place a comprehensive framework for issuers and service providers in the digital asset space. They address utility tokens, asset referencing tokens and stable coins, and they’re trying to fill gaps that exist in current regulations that don’t look at this technology use. So some of this square peg round hole issues that are currently existing in the US, at least in the EU, they’ve noted that in their own regulation, they’re trying to improve upon it.

Similarly, in Hong Kong, there’s a new licensing regime for virtual asset trading platform operators. So think about that as exchanges or clearinghouses. This regime seeks to capture all the dimensions of the public’s interface with virtual assets providing for investor protection and market integrity while managing key risks. If it’s focused on let me read these off here virtual asset trading platform operators, virtual asset fund managers, intermediaries dealing or advising on virtual assets and intermediaries distributing virtual asset related products. Maybe it actually dovetails with what David was saying about how to be sure about a crypto investment or a crypto company, at least in Hong Kong, to the extent that, you know, if one is being touted or marketed through one of these regulated firms, perhaps that can be helpful to investors there because there is a sense of a credibility and control going through a regulated provider there.                           

Adam Bloomberg:

David and Frank, this is for both of you. What about concerns that digital assets facilitate money laundering or potential nefarious activities? And David, why don’t, why don’t you go first?

David Gannaway:

That’s a good question, Adam, thank you.

Adam Bloomberg:

Big softball for you.

David Gannaway:

Thank you. Yes. Well, let’s think about it from two perspectives. One from the I’m going to classify them into two different areas. One would be illegal funds that may be obtained from selling drugs. What’s to say that there’s illegal proceeds from selling drugs and now they need to be able to try to make those or may use this type of digital asset to be able to help legitimize and launder the money so that when it comes back to them, it looks like a legitimate transaction. So you have the illegal side of how they take the proceeds from the sale of narcotics and convert them into this digital assets based to then move it to offshore, move it outside the United States, to then be able to obtain it in a different country or different way. So you’ve got the legal side of business. Again, it’s hard to believe that where you had the drugs that you can try to funnel that cash into the banking system, into then into the digital currency space and then move it however, wherever and it’s like water, that’s what we used to call it when you’re in money laundering. It’s just water, just wherever the water could go is how the creativity of somebody that’s laundering money can come up with this. You know, again, you still have to have someone else to be able to help you be a part of that transaction to help launder the money.

Now, I’m going to turn it to the other side is you had the cases that we’ve spoken about, those are what I’m going to call, even though it’s illegal processes because the owners of these businesses, the Binance and the Crypsee and those, when they have misled the investors, if they have sent them an email, they’ve provided them documents through email. There’s been a wire transfer of funds to get the transaction started. Those are what’s called the predicate acts for money laundering. And so, what happens there is once the government is able to prove and show that the individuals lied to the investors, they did it through mail or wire type of transactions, that’s the predicate act to be able to say that now that the money has been originated or made available to the owners of these crypto and digital companies, now they start conducting transactions with it, then that’s when money laundering kicks in from a standpoint, and I’m trying to break the difference between the two of not being illegal sources of funds coming in versus misleading individual investors who have provided maybe some of their legitimate hard-earned money or there may be some people that have unreported income from their operations that they’re trying to get into this investment, which then has been taken to mislead the investors and do the things that we’ve talked about where they’ve created fictitious companies and the investor ends up being, you know, losing, being ripped off and walking away with nothing in this situation. So that’s the money laundering side from the cases that we’ve spoken about today.

Adam Bloomberg:

And Frank, anything to add to that?

Frank Weigand:

No, I think David’s exactly right with respect to, you know, folks who want to launder money and have nefarious purposes in mind. In my experience with the clients that I’ve dealt with, people are more interested now in having robust AML compliance programs, right? They see digital assets as ill-legitimate means of transacting, and they want to comply across the board, including from an AML perspective.

Adam Bloomberg:

Frank, you mentioned that Coinbase had asked the SEC for guidance numerous times, but the SEC didn’t provide it. Can you explain a little bit more about this?

Frank Weigand:

Sure. And there are a lot of examples where Coinbase, you know, informally, has asked for guidance, they’ve published articles, they publish white papers. But I think, you know, the most obvious example would be that last year, at some point in the summer of 2022, Coinbase actually filed a formal petition with the SEC asking them to propose and adopt rules that would govern the regulation of securities laid out 50 questions to help the SEC. It was really, you know, nicely packaged and teed up for the commission. Months and months and months went by. No response from the SEC and quite recently Coinbase took action into their own hands and saw it issued a writ of mandamus to compel an SEC’s response to the Coinbase request. To this, the SEC actually responded to the writ, seeking to dismiss it, saying that there’s no timeline under which the SEC could be compelled to issue rules and that, you know, the request by Coinbase or any other member of the public. So, you know, the SEC is pretty clear on the fact that they’re not interested in providing the type of guidance that Coinbase has been asking for.

Adam Bloomberg:

Frank, this is to you again.

Frank Weigand:

Okay.

Adam Bloomberg:

Tokens might be classified as securities. Why is that a problem for them?

Frank Weigand:

Okay. I mean, under existing securities regulations, I think the problem is that, you know, the tokens don’t match up with what I mentioned earlier with traditional, and the issuers of these tokens are not operating companies as such. So, it’s difficult for periodic reporting, it’s difficult for boards in this structure and so on and so forth. And rather than go through all of the issues that are problematic and don’t fit, I think I would point out the fact that the SEC has shown themselves to be nimble in the past where certain securities don’t match up with the 33 and 34 act like asset backed securities or reits or master limited partnerships, the SEC has come up with alternative means of regulation to fit those securities, and it’s not clear why they can’t do the same thing here.

Adam Bloomberg:

Well, this has been a fascinating and very relevant topic. Thank you both for joining me today and I look forward to gaining additional insights on digital asset regulation and the related litigation. Thank you very much.

David Gannaway:

Thank you, Adam. Thank you, Frank.

Frank Weigand:

Thank you, David. Thank you, Adam. Thanks, everyone.


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National Law Review, Volume XIII, Number 196