On June 14, 2018, the SEC’s Division of Corporation Finance Director, William Hinman, gave a speech titled “Digital Asset Transactions: When Howey Met Gary (Plastic).”  This speech provides additional insight into the SEC’s view as to whether cryptocurrencies and initial coin offerings (“ICOs”) are securities.  Here is a summary:

In his speech, Hinman explains that ICOs typically involve passive investors who purchase tokens in hopes that a promoter builds a successful network.  He posits that the networks involved are rarely functional, and that the token purchase “looks a lot more like a bet on the success of the enterprise and not a purchase of something used to exchange for goods or services on the network.”  These circumstances, combined with token marketing efforts that “are rarely narrowly targeted to token users,” are indicators that an ICO is a securities transaction.

ICO issuers have recently tried to avoid their tokens being classified as securities by labeling them “utility tokens” and arguing that the tokens are for consumptive use.  Hinman directly addresses this practice, stating that labeling something a “utility token” does not prevent it from being a security. While he conceded that tokens by themselves and tokens purchased for consumption only are likely not securities, he emphasized that the “economic substance of the transaction” determines whether a token sale is a securities transaction.  Specifically, the speech focused on the “investment strategy” used, and states that “virtually any assets” can be securities “provided the investor is reasonably expecting profits from the promoter’s efforts.”

To support the above concept that securities can be broadly defined to include an “investment strategy,”  Hinman explains that, as outlined in Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., the Howey test “is not static and does not strictly inhere to the instrument.”  The non-static interpretation of Howey is critical because it indicates that tokens which start as securities can lose that designation over time as a token’s network becomes “sufficiently decentralized.”  Hinman clarified that a security-token loses its status as a security when it becomes decentralized enough that purchasers “no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts,”  noting that, as a system becomes increasingly decentralized, “material information asymmetries recede” and the “ability to identity an issuer or promoter to make the requisite disclosure [required in securities offerings] becomes difficult, and less meaningful.”  This interpretation rewards systems that prioritize decentralization with a shield from securities laws, but creates ambiguity regarding the requirements for a network to become “sufficiently decentralized.”

In light of the above, Hinman finds that Bitcoin and Ethereum’s native token, Ether, are not securities because they are decentralized enough that the efforts of others are not a “key determining factor” in whether an investment in Bitcoin or Ether is successful.  The speech adds that applying the disclosure regime of the federal securities laws to Bitcoin and Ethereum transactions would “add little value”, and that, “[o]ver time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.”

The first two weeks in March 2018 have seen a number of developments with respect to the regulation of cryptocurrencies in the United States.

Regulation of Online Cryptocurrency Trading Platforms

On March 7, 2018, the Securities and Exchange Commission (“SEC”) issued a release addressing the regulation of online trading platforms (or exchanges) on which investors have bought and sold digital assets, including coins or tokens sold in initial coin offerings (“ICOs”).  Consistent with prior SEC articulated positions, the SEC stated that many of these tokens sold in an ICO meet the definition of a “security” and accordingly these trading platforms on which ICO tokens trade should register with the SEC as a national securities exchange or alternative trading system unless exempt from registration.  In its release, the SEC expressed its concern that many of these trading platforms may appear to investors as SEC-regulated exchanges, but are not and do not meet the regulatory and listing standards of a registered exchange. In light of this, in its release, the SEC listed a series of questions that investors should ask before trading assets on an online trading platform.  These include, but are not limited to, asking if:  (i) is the platform registered as a national securities exchange or an ATS with the SEC?; (ii) is there information in FINRA’s BrokerCheck ® about any individuals or firms operating the platform?; (iii) how does the platform select digital assets for trading?; (iv) what are the trading protocols?; (v) how are prices set on the platform?; (vi) how does the platform safeguard users’ trading and personal identifying information?; (vii) what are the platform’s protections against cybersecurity threats, such as hacking or intrusions?; and (viii) does the platform hold users’ assets?  If so, how are these assets safeguarded?  For a complete list of these questions and a copy of this SEC release see SEC Release.

Money Transmitter Rules Apply to Initial Coin Offerings

In a letter published March 6, 2018 by the Financial Crimes Enforcement Network (“FinCEN”), which had previously been sent on February 13, 2018 to Senator Ron Wyden of the Senate Committee on Finance, FinCEN reiterated that in combatting the financing of terrorism (“CFT”) and illicit financing of criminal activity, the Bank Secrecy Act (“BSA”) and anti-money laundering (“AML”) laws and regulations applied to virtual currency exchanges and administrators that are based in the United States or that do business in whole or substantial part in the United States. These would include “a developer that sells convertible virtual currency, including in the form of … ICO coins or tokens, in exchange for another type of value that substitutes for currency….” FinCEN indicated that these exchanges and administrators would be considered a money transmitter who would have to be register with FinCEN as a money service business (“MSB”) with an established written AML compliance program designed to mitigate money laundering risks. These AML/CFT compliance programs would include filing of BSA suspicious activity and currency reports, maintaining records for certain transactions over some monetary threshold and obtaining customer identification information. The letter also clarified that in the case of an ICO that is structured as a sale of a security or derivative, the participants in the ICO could be subject to regulation by the SEC or the Commodity Futures and Trading Commission (“CFTC”).  In such cases, the SEC or CFTC AML/CFT requirements would apply.  Companies and exchanges involved in ICOs should consult legal counsel to clarify and satisfy their respective AML/CFT obligations.

U.S. District Court  Rules that the CFTC has Authority to Regulate Cryptocurrencies Not Involving Derivatives

In a Memorandum and Decision of the United States District Court for the Eastern District of New York, issued on March 8, 2018, Judge Jack Weinstein issued a ruling as to the authority of the CFTC to prosecute a fraud case that it had brought against Patrick Kerry McDonnell, the operator of a cryptocurrency business.  Defendant McDonnell was alleged to have “operated a deceptive and fraudulent virtual currency scheme” whereby his company solicited investments from investors to assist them in purchasing and trading Bitcoin and Litecoin, but instead misappropriated their funds.  In his ruling, Judge Weinstein, after discussing the definition of a commodity under the Commodity Exchange Act (“CEA”) and relying, in part, on a 2015 CFTC administrative ruling that cryptocurrencies were commodities, held that “virtual currencies can be regulated by CFTC as a commodity,” and that, in the absence of federal rules, the CEA permitted the CFTC in a fraud case to exercise its jurisdiction over cryptocurrencies that did not directly involve the sale of futures or derivative contracts.

Judge Weinstein ruled that the CFTC could proceed prosecuting the case against the defendant and granted a preliminary injunction barring the defendant from further engagement in cryptocurrency investments as the case continues. For a copy of the case, see CFTC v. McDonnell.

As a result of the well-publicized scandals involving LIBOR rate manipulation, British regulators announced plans in July 2017 to phase-out LIBOR by 2021 and replace it with a more reliable benchmark.  In addition to other markets, the LIBOR phase-out will have a broad impact on the $4 trillion syndicated loan market, including currently existing loan documents that extend past 2021.  Specifically, in the case of loan documents that reference a LIBOR rate and automatically fall back to prime or base rate if LIBOR is unavailable, the permanent phase-out of LIBOR will likely lead to the imposition of a higher interest rate if this fallback language is not amended.  However, because LIBOR’s replacement has not yet been determined and the phase-out is at least three years away, it is probably premature at this time for borrowers to proactively seek amendments to their credit agreements.  That being said, there are a few steps that borrowers can take now to be prepared.

BACKGROUND

The London Interbank Offered Rate (LIBOR) has been the global borrowing interest rate benchmark for nearly 50 years.  Many borrowers pay interest under their credit agreements based upon a LIBOR interest rate, which is typically defined first by reference to the screen rate published by ICE Benchmark Administration Limited (IBA), and then to an alternative reference source if the screen rate is unavailable.  Although the LIBOR rate is intended to represent the rate of interest at which major banks in London actually loan funds to each other, the financial crisis liquidity in the LIBOR market has dropped significantly to the point where more than 70% of 3-month LIBOR submissions are based on the judgment of the submitting bank as opposed to actual transactions.  Due to this lack of liquidity and the negative publicity surrounding the LIBOR scandal, the United Kingdom Financial Conduct Authority (FCA), which has regulated LIBOR since April 2013, urged the phase-out of LIBOR by the end of 2021 and a transition to an alternative reference rate based on market transactions.

The uncertainty surrounding LIBOR’s fate is twofold.  First, although the FCA has encouraged the phase-out of LIBOR, it has stressed that the phase-out is not mandatory and, further, that the IBA may continue to produce LIBOR rates after 2021 if it chooses to do so.  Because of this, some commentators believe that LIBOR may continue to be quoted well beyond 2021 side-by-side with LIBOR’s replacement.  Second, the FCA has put the burden of finding LIBOR’s replacement primarily on market participants, who have not yet settled on an alternative rate.  The front runners at this point appear to be the Broad Treasury Financing Rate (BTFR) in the U.S., and the Sterling Overnight Index Average (SONIA) in the U.K., each of which is being considered as a replacement rate in the derivatives market.  However, neither of these rates are ready replacements for LIBOR in the lending market because (i) each is an overnight rate as opposed to LIBOR, which is quoted for seven borrowing periods ranging from overnight to one year, and (ii) each is based on past transactions (i.e., each is “backward looking”) as opposed to LIBOR, which is a stated rate for a forward-looking term.

WHAT BORROWERS CAN DO TO PREPARE

The first thing borrowers can do is review their existing credit agreements to see how the interest rate is determined if LIBOR no longer exists.  Although some credit agreements, such as the LSTA and LMA models, contain provisions that fall back to a waterfall of alternative reference rates if LIBOR is unavailable, such as a reference bank rate (i.e., an average of quotes of rates in the wholesale markets), the lenders’ cost of funds, or an alternative rate, many do not contain any fallback other than to simply default to base or prime rate loans.  As these rates are historically higher than the LIBOR rate, they can lead to the borrower incurring a significantly higher interest expense than it anticipated at the time the borrower entered into the loan.  However, even if a borrower is faced with a potential rate increase, given the uncertainty of both the timing of LIBOR’s phase-out and the replacement for the LIBOR rate, it is probably premature for it to approach its lender seeking an amendment.

If a borrower sees a potential issue with its LIBOR fallback language, it should closely monitor the marketplace to determine when and if it needs to take action.  Given the magnitude that LIBOR’s phase-out will have on the loan market, it is highly unlikely that the market will not do all that it can well in advance of the phase-out to effectuate a smooth transition to an alternative standard.  In particular, it is likely that LIBOR’s replacement will be determined well in advance of 2021 so borrowers can assess the impact on their credit agreements and be prepared to take appropriate action (e.g., seeking an amendment or prepaying the loan).  Further, it is also likely that the FCA will have signaled whether it will continue to quote LIBOR after the phase-out and, if so, for how long.  Depending on the length of time FCA continues to do so, borrowers with loans that mature past 2021 may be able to avoid amending their agreements entirely.  Finally, by the time the phase-out is implemented, the market will have likely settled on a standard for appropriate LIBOR fallback language, which should then be much easier to incorporate into existing loan documents than starting from scratch.  In short, although the temptation as a borrower may be to get ahead of the potential problem by proactively seeking an amendment, the best course of action is to monitor the situation and take a wait-and-see approach. One caveat to this is the situation where a borrower is already in the process of amending its credit agreement for other reasons, in which case it may as well amend the LIBOR fallback provision since the marginal cost of doing so is minimal.

 

Not too long ago, technology was considered a “vertical” market filled with companies that met the needs of the “technology” industry (think Microsoft, Dell, Cisco, Intel, and IBM).  However, technological products and services have evolved to the point of serving a “horizontal” market, having become an important aspect of many different types of businesses across a wide variety of industries and sectors (think fintech, healthtech, cleantech, autotech, edtech, etc.) and, by extension, M&A transactions.

For example, deals in the media industry increasingly are focused on the digital media aspects, particularly given the decline in demand for print media.  Likewise, parties to acquisitions in the financial services industry often pay close attention to the protection of proprietary investment strategies, data protection, trade names, and customized software.  Even manufacturers and other traditionally “non-tech” companies are leaning on technology more and more in order to streamline their business processes, manage and analyze data better, and to protect themselves from cyber-attacks.

This trend towards a “horizontal” market only looks to accelerate as technology becomes more and more embedded in businesses of all stripes, as presaged by the $13.7 billion purchase of Whole Foods by Amazon.com Inc. this year.  Similarly, private equity interest in tech and tech-enabled businesses has grown in recent years, particularly for more “stable” businesses such as software companies that generate recurring revenue or that serve other businesses.

Given the growing proportion of M&A deals that are considered to be “tech” deals (even where non-technology companies are involved), middle market businesses of all kinds that are evaluating the possibility of a sale or, conversely, looking for potential targets to acquire cannot afford to overlook the importance of technology as a key asset.

High-level legal concerns often revolve around the target’s ownership or right to use key technological assets, as well as the level of protection and ability to transfer the same.  This includes making sure that all owned intellectual property of the business is properly registered with the USPTO or copyright office in the name of the appropriate entity, and that all renewals and maintenance fees have been paid.  Additionally, acquirers should check that employees and, particularly, key independent contractors of the target have assigned their rights in and to all key intellectual properties to the target.  Inbound licenses that are material to the business, as well as revenue generating outbound licenses, should be reviewed to determine assignability.  It goes without saying that it is critical to ascertain whether the target has any existing or suspected infringement claims, as well as any security interests or encumbrances affecting its key technology assets.

Further, to the extent key technologies are held within a joint venture between the target and a third party, an acquirer should consider whether its business model would allow it to “step into the shoes” of the target vis a vis the joint venture versus the extent to which the acquirer could readily extract the technological assets and/or wind-down the joint venture.

The takeaway here is when engaging in M&A transactions – whether in the middle market or otherwise – ignore technology at your peril.  Those companies (even “non-tech” ones) that can demonstrate a strong command of their technological assets should increase their attractiveness as targets as we move into the future.  Conversely, acquirers that understand their own technology “gaps,” can quickly assess the target’s key technological assets and grasp how such assets will improve the integrated business post-closing will be better positioned to focus their due diligence efforts, minimize indemnification risks, and ultimately achieve the intended synergies.

New York entrepreneurs in the virtual currency space must be careful to follow New York’s licensing requirements enacted under Financial Services Law Sections 102, 104, 201, 206, 301, 302, 309, and 408. Under the new regulations issued by the New York State Department of Financial Services, a business that engages in “Virtual Currency Business Activity” must be licensed by the New York State Department of Financial Services.  A business is engaged in Virtual Currency Business Activity if it:

  1. receives virtual currency for transmissions or transmits virtual currency;
  2. stores, holds, or maintains custody or control of virtual currency on behalf of others;
  3. buys and sells virtual currency;
  4. exchanges or converts something of value, into virtual currencies; or
  5. controls, administers, or issues a virtual currency.

However, businesses chartered under New York Banking Law and “approved by the superintendent to engage in Virtual Currency Business Activity,” as well as “merchants and consumers” that use virtual currencies for investment purposes or to buy and sell goods or services are exempt from the licensing requirement.

The license application fee to register as a business engaged in Virtual Currency Business Activity is $5,000.00 and is nonrefundable.  The application must include:

  1. the exact name of the applicant, including any doing business as name;
  2. a list of all of the applicant’s affiliates and an organization chart illustrating the relationship among the applicant and such affiliates;
  3. a list of, and detailed biographical information for, each individual applicant and each director, principal officer, principal stockholder, and principal beneficiary of the applicant;
  4. a background report prepared by an independent investigatory agency for each individual applicant, and each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable;
  5. for each individual applicant; for each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable; and for all individuals to be employed by the applicant who have access to any customer funds, whether denominated in fiat currency or virtual currency: (i) a set of completed fingerprints, or a receipt indicating the vendor (which vendor must be acceptable to the superintendent) at which, and the date when, the fingerprints were taken, for submission to the State Division of Criminal Justice Services and the Federal Bureau of Investigation; (ii) if applicable, such processing fees as prescribed by the superintendent; and (iii) two portrait-style photographs of the individuals measuring not more than two inches by two inches;
  6. an organization chart of the applicant and its management structure;
  7. a current financial statement for the applicant and each principal officer, principal stockholder, and principal beneficiary of the applicant, as applicable, and a projected balance sheet and income statement for the following year of the applicant’s operation;
  8. a description of the proposed, current, and historical business of the applicant;
  9. details of all banking arrangements;
  10. all written policies and procedures required by, or related to, the requirements of this part;
  11. an affidavit describing any pending or threatened administrative, civil, or criminal action, litigation, or proceeding before any governmental agency, court, or arbitration tribunal against the applicant or any of its directors, principal officers, principal stockholders, and principal beneficiaries, as applicable;
  12. verification from the New York State Department of Taxation and Finance that the applicant is compliant with all New York State tax obligations in a form acceptable to the superintendent;
  13. if applicable, a copy of any insurance policies maintained for the benefit of the applicant, its directors or officers, or its customers; and
  14. an explanation of the methodology used to calculate the value of virtual currency in fiat currency; and

Businesses operating in the virtual currency space, that are not exempt from these new regulations, must ensure that they comply with these new licensing requirements. Businesses interested in pursuing a New York virtual currency license should consult with legal counsel.