June 2022

Digital Assets Regulation - The Lummis-Gillibrand Responsible Financial Innovation Act

In the wake of Biden’s recent Executive Order on Ensuring Responsible Development of Digital Assets and the increasing acceptance of the promises and functionality of digital assets by governments around the world, the U.S. legislature has taken steps toward finally embracing and regulating digital assets and cryptocurrencies.

On June 7, 2022, Sen. Cynthia Lummis (R-Wyo.) and Sen. Kirsten Gillibrand (D-N.Y.) introduced a new bipartisan bill, The Lummis-Gillibrand Responsible Financial Innovation Act, that would create the regulatory framework in regulating digital assets and cryptocurrencies. First announced in March 2022, the proposed bill addresses a myriad of issues that have caused tensions between institutions, investors, and regulators alike.

In a joint press release, Sen. Lummis declared, “The Responsible Financial Innovation Act, a bipartisan framework that I crafted in conjunction with Senator Kirsten Gillibrand, creates regulatory clarity for agencies charged with supervising digital asset markets, provides a strong, tailored regulatory framework for stablecoins, and integrates digital assets into our existing tax and banking laws.” Echoing this enthusiasm, Sen. Gillibrand added, “Importantly, the Lummis-Gillibrand framework will provide clarity to both industry and regulators, while also maintaining the flexibility to account for the ongoing evolution of the digital assets market.”

Please see below important portions of the proposed bill, which has already garnered widespread bipartisan support as well as support from blockchain and cryptocurrency stakeholders, such as Blockchain Association and Coinbase.¹

Definitions

The proposed bill provides a number of definitions, which have long been absent, often misunderstood, or used inconsistently, at best. Among others, the proposed bill defines the following terms:

• Ancillary asset: an intangible, fungible asset that is offered, sold, or otherwise provided to a person in connection with the purchase and sale of a security through an arrangement or scheme that constitutes an investment contract.

• Digital asset: a natively electronic asset that (i) confers economic, proprietary, or access rights or powers; and (ii) is recorded using cryptographically secured distributed ledger technology or any similar analogue. Digital assets include virtual currency, ancillary assets, payment stablecoins; and other securities and commodities.

• Digital asset exchange: a centralized or decentralized platform which facilitates the transfer of digital assets.

• Digital asset intermediary: includes (i) a person who holds a license, registration, or other similar authorization² that may conduct market activities relating in digital assets, or a person who is required by law to hold such a license, registration or other similar authorization; and (ii) a person who holds a license, registration, or other similar authorization under State or Federal law that issues a payment stablecoin, or person who is required by law to hold such a license, registration or other similar authorization.

• Distributed ledger technology: technology that enables the operation and use of a ledger that (i) is shared across a set of distributed nodes that participate in a network and store a complete or partial replica of the ledger; (ii) is synchronized between the nodes; (iii) has data appended to the ledger by following the specified consensus mechanism of the ledger; (iv) may be accessible to anyone or restricted to a subset of participants; and (v) may require participants to have authorization to perform certain actions or require no authorization.

• Payment stablecoin: a digital asset that is (i) redeemable, on demand, on a one-to-one basis for instruments denominated in United States dollars and defined as legal tender (excluding digital assets defined as legal tender under the laws of a foreign country); (ii) issued by a business entity; (iii) accompanied by a statement from the issuer that the asset is redeemable; (iv) backed by one or more financial assets (excluding other digital assets); and (v) intended to be used as a medium of exchange.

• Security: the term “security” has the broad meaning given the term in section 3(a) of the Securities Exchange Act of 1934 (see below for greater detail).

• Smart contract: computer code deployed to a distributed ledger technology network that executes an instruction based on the occurrence or nonoccurrence of specified conditions, or any similar analogue, which may include taking possession or control of a digital asset and transferring the  asset or issuing executable instructions for these actions.

• Virtual currency: means a digital asset that (i) is used primarily as a medium of exchange, unit of account, store of value, or any combination of such functions;  (ii) is not legal tender; and (iii) does not derive value from or is backed by an underlying financial asset (except other digital assets). This may also include a digital asset that (i) is accompanied  by a statement from the issuer that a denominated or pegged value will be maintained and (ii) be available upon redemption from the issuer or other identified person, based solely on a smart contract.

Digital Asset as a Commodity, Not a Security
 
There is an ongoing litany of litigation and debate over whether a digital asset is a security under U.S. law. The term “security” is defined in Section 2(a)(1) of the Securities Act of 1933 (the "Securities Act"), Section 3(a)(10) of the Securities Exchange Act of 1934, Section 2(a)(36) of the Investment Company Act of 1940, and Section 202(a)(18) of the Investment Advisers Act of 1940, whereby securities encompass instruments such as stocks, bonds, and what are commonly known as “investment contracts.”³

In SEC v. W. J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100 (1946), the Supreme Court highlighted that “[t]he term ‘investment contract’ is undefined by the Securities Act or by relevant legislative reports.” Noting that the term appeared in many state blue sky laws in existence prior to the adoption of the federal statute and that the term had been broadly construed by state courts, the Supreme Court proceeded to define an investment contract as “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” Id. 298–99. Since the landmark decision of Howey, the courts have continued to use and expand upon Howey tests to determine whether a particular transaction is an investment contract and thus a security.⁴

Now, a legislative first, the bill delineates the difference between digital assets as commodities and securities by contemplating the rights and obligations granted pursuant to the issuance of those digital assets. In essence, the proposed bill seeks to codify judicial precedents determined by the Howey tests, whereby an ancillary asset issued pursuant to an investment contract does not necessarily create a security.

Specifically, subject to certain periodic disclosure and compliance requirements, the proposed bill expressly provides that if an issuer issues a security through an arrangement or scheme that constitutes an investment contract, an ancillary asset provided directly or indirectly by the issuer shall be presumed to be a commodity rather than a security. However, the proposed bill explicitly excludes from its definition of an ancillary asset certain rights granted by a business entity, such as (i) debt or equity interest in that entity; (ii) liquidation rights with respect to that entity; (iii) entitlement to an interest or dividend payment from that entity; (iv) a profit or revenue share in that entity derived solely from the entrepreneurial or managerial efforts of others; and (v) any other financial interest in that entity. The proposed bill also states that if a court determines at the conclusion of a legal proceeding there is not a substantial basis for the presumption that the ancillary asset at issue is a commodity, then the court shall find and the ancillary asset shall be deemed a security. Therefore, the ways in which and financials terms upon which digital assets are issued are critical.

CFTC Jurisdiction over Digital Asset Transactions

If implemented, the proposed bill would make several amendments and additions to the Commodity Exchange Act, thereby granting the Commodity Futures Trading Commission (CFTC) exclusive jurisdiction over any agreement, contract, or transaction involving a contract of sale of a digital asset in interstate commerce, including ancillary assets. However, the Securities and Exchange Commission (SEC) would continue to retain jurisdiction over (i) specified periodic reporting requirements made by an issuer which provided the holder of the security with an ancillary asset, and (ii) the security that constitutes an investment contract.⁵ It is also imperative to note that the proposed bill expressly provides that the CFTC would only retain jurisdiction over an agreement, contract, or transaction involving a contract of sale of a digital asset that is fungible, meaning that the CFTC would not retain jurisdiction over non-fungible tokens (NFTs) and other unique digital assets.

Digital Asset Exchanges

The proposed bill would also make several amendments and additions to the Commodity Exchange Act, whereby registered digital asset exchanges may make available digital assets available for trading so long as the digital asset is not readily susceptible to manipulation.

To register and maintain registration, a digital asset exchange must comply with certain core principles set out in the proposed bill and requirements that the CFTC would impose via the CFTC’s rulemaking powers. These core principles include but are not limited to compliance with digital asset exchange rules, digital assets that are not readily susceptible to manipulation, and system safeguards.

For example, a digital asset exchange would be required to establish and enforce (i) compliance with any rule established by the digital asset exchange, including but not limited to its terms and conditions of the trades traded or processed on or through the digital asset exchange; (ii) trading, trade processing, and participation rules that will deter abuses and have the capacity to detect, investigate and enforce those rules; and (iii) rules governing the operation of the digital asset exchange, including rules specifying trading procedures to be used in entering and executing orders traded or posted on the digital asset exchange. Importantly, a digital asset exchange must prevent the trading of a digital asset, if it is reasonably likely that the transaction history of the digital asset can be materially or fraudulently altered by one or more persons. Relatedly, the proposed bill would require a digital asset exchange to (i) establish and maintain risk management program to identify and mitigate source of operational and security risk; (ii) adopt emergency procedures, backup facilities, and a disaster recovery plan; and (iii) periodically perform tests with respect to continuity of trades and reporting.

Recognition of Decentralized Autonomous Organizations (DAOs)

The proposed bill would formally recognize DAOs as legal entities subject to taxation. In particular, the proposed bill would recognize a DAO as an organization that (i) utilizes smart contracts to carry out collective actions for a business, commercial, charitable, or similar entity; (ii) achieves governance primarily through a distributed basis; and (iii) is properly incorporated or organized under the laws of a State or foreign jurisdiction as a DAO, cooperative, foundation or any similar entity.

Cybersecurity Standards for Digital Asset Intermediaries

The proposed bill would direct the CFTC and SEC, in collaboration with the Secretary of the Treasury and Director of the National Institute of Standards and Technology (NIST), to develop robust guidance with respect to cybersecurity measures and practices for digital asset intermediaries. In particular, the proposed bill would direct the CFTC and SEC to develop guidance regarding (i) internal governance of cybersecurity; (ii) security operations, including but not limited to threat identification, incident response, and mitigation; (iii) risk identification and measurement; (iv) risk mitigation via policies, procedures, controls, change management, and third party relationships; and (v) penetration testing and independent audits.

Implementation of Effective Tax Guidance

The proposed bills would direct the Secretary of the Treasury to adopt tax guidance with respect to various activity involving digital assets, such as (i) classification of forks, airdrops, and similar subsidiary value; (ii) merchant acceptance of digital assets and the tax treatment of payments and receipts; (iii) treatment of digital asset mining and staking, including mining and staking rewards; (iv) allowance of charitable contributions of digital assets greater than $5,000; and (v) characterization of payment stablecoins.

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The recent introduction of the Lummis-Gillibrand Responsible Financial Innovation Act should further signal to investors and businesses alike that cryptocurrencies and digital assets have become ripe for long-term investments and, consequently, imminent regulation.

Let us work with you to optimize your goals and operations by forecasting and developing a plan to mitigate regulatory and legal risks involving cryptocurrencies and digital assets.

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^1.  https://www.lummis.senate.gov/wp-content/uploads/Statements-of-Support-RFIA-FINAL.pdf  

^2. See, e.g., the Commodity Exchange Act (7 U.S.C. 1 et seq.), the 18 Securities Act of 1933 (15 U.S.C. 77a et seq.), the Corporation of Foreign Bondholders 19 Act, 1933 (15 U.S.C. 77bb et seq.), the Trust Indenture Act of 1939 (15 U.S.C. 77aaa 20 et seq.), the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.), the Securities 21 Investor Protection Act of 1970 (15 U.S.C. 78aaa et seq.), the Investment Company 22 Act of 1940 (15 U.S.C. 80a–1 et seq.), the Investment Advisers Act of 1940 (15 U.S.C. 23 80b–1), and the Omnibus Small Business Capital Formation Act of 1980 (15 U.S.C. 24 80c)

^3. Securities Act, Section 2(a)(1), 15 U.S.C. § 77b(a)(1).

^4. See, e.g., United Hous. Found., Inc. v. Forman, 421 U.S. 837, 851–52, 95 S.Ct. 2051, 44 L.Ed.2d 621 (1975); State v. Hawaii Market, 52 Haw. 642, 485 P.2d 105 (1971).

^5.  See section 2(a)(1) of the Securities 24 Act of 1933 (15 U.S.C. 77b(a)(1)).

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