Category: finance

CFIUS Broadens Coverage of Cross-Border Biotech Transactions

Summary

The Committee on Foreign Investment in the United States recently broadened its coverage of biotechnology transactions via new regulations that became effective on November 10, 2018. This article provides perspectives about how broadly these new rules will affect the biotech industry. All parties to cross-border transactions involving US biotech businesses, whether mere licensing arrangements or full M&A, should carefully consider all US regulatory implications, including application of the new CFIUS rules, US export controls and related requirements. Parties to pending biotech transactions or contemplating future biotech transactions are well advised to take actions.

In Depth

INTRODUCTION

Recent statutory and regulatory enactments have broadened the scope and jurisdiction of the Committee on Foreign Investment in the United States (CFIUS), including its jurisdiction over transactions in the biotechnology industry. This article provides perspectives about how broadly the new CFIUS regulations, which became effective November 10, 2018, will affect cross-border biotech transactions.

The development and growth of the biotechnology industry has spurred a growing volume of cross-border transactions with US life sciences businesses in recent years, involving early stage research companies as well as large pharmaceutical conglomerates. Foreign parties to cross-border biotech transactions have been active and diverse, involving financial and strategic investors and collaborators from Asia, Europe and other regions. Such transactions take a variety of forms, and can be grouped primarily in the following categories:

  • Controlling investments by foreign entities, such as acquisitions of a majority or more of equity or assets of US biotech companies;
  • Joint ventures between US and foreign entities to which US biotech companies contribute assets and/or intellectual property;
  • Non-controlling investments by foreign entities in US biotech companies with or without outbound licenses and/or options to acquire future equity interests or assets; and
  • Straightforward technology licenses granted by US biotech companies to foreign entities without corresponding equity interests issued in US companies.

How many of the foregoing types of transactions are now subject to the broadened jurisdiction of CFIUS? This On the Subject addresses the effect of recent CFIUS regulations on different types of cross-border biotech transactions.

FIRRMA AND BROADENED JURISDICTION OF CFIUS

CFIUS is a federal interagency committee chaired by the US Treasury Department (Treasury) that is charged with reviewing and addressing any adverse implications for US national security posed by foreign investments in US businesses. For background on the fundamentals of the CFIUS process and recent developments, see here, here and here.

As biotechnology entities generally focus on researching and finding therapeutics and diagnostics for diseases and saving patients’ lives, this industry has spurred very little concern for US national security outside of limited areas of bioterrorism and toxins. CFIUS review procedures were largely irrelevant for parties to cross-border biotech transactions. Under the voluntary CFIUS notification rules, parties to very few biotech transactions involving foreign acquirers notified CFIUS and sought CFIUS’s review and clearance of their deals. This may significantly change with the recent enactment of the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA) in August 2018.

Prior to the enactment of FIRRMA, CFIUS was authorized to review the national security implications of only transactions that could result in control of a US business by a foreign person. FIRRMA expanded the scope of transactions subject to CFIUS’s review to include certain foreign investments in US businesses even in cases where the investment does not result in a controlling interest and imposedmandatory reporting requirements for certain transactions.

On October 10, 2018, Treasury issued new interim rules to implement FIRRMA, establishing a temporary “Pilot Program” that includes a mandatory declaration process. The Pilot Program went into effect on November 10, 2018, and will end no later than March 5, 2020. The interim rules specify 27 industries for focused attention under the Pilot Program, including Nanotechnology (NAICS Code: 541713) and Biotechnology (NAICS Code: 541714), as follows:

Research and Development in Nanotechnology
NAICS Code: 541713

“This U.S. industry comprises establishments primarily engaged in conducting nanotechnology research and experimental development. Nanotechnology research and experimental development involves the study of matter at the nanoscale (i.e., a scale of about 1 to 100 nanometers). This research and development in nanotechnology may result in development of new nanotechnology processes or in prototypes of new or altered materials and/or products that may be reproduced, utilized, or implemented by various industries.”

Such establishments include “Nanobiotechnologies research and experimental development laboratories.”

Research and Development in Biotechnology (except Nanobiotechnology)
NAICS Code: 541714

“This US industry comprises establishments primarily engaged in conducting biotechnology (except nanobiotechnology) research and experimental development. Biotechnology (except nanobiotechnology) research and experimental development involves the study of the use of microorganisms and cellular and biomolecular processes to develop or alter living or non-living materials. This research and development in biotechnology (except nanobiotechnology) may result in development of new biotechnology (except nanobiotechnology) processes or in prototypes of new or genetically-altered products that may be reproduced, utilized, or implemented by various industries.”

The new Pilot Program rules could directly affect parties to multiple cross-border biotech industry transactions, whether they are potential target companies, investors or acquirers. Mandatory, not voluntary, filings with CFIUS will be required for controlling and non-controlling investments that fall within the definition of “Pilot Program Covered Transactions,” and violations of the new rules could result in substantial penalties.

EFFECT ON CROSS-BORDER TRANSACTIONS IN BIOTECH SECTOR

PILOT PROGRAM COVERED TRANSACTIONS

The Pilot Program requires that parties to a “pilot program covered transaction” notify CFIUS of the transaction by either submitting an abbreviated declaration or filing a full written notice.

A “pilot program covered transaction” means either of the following:

1. Any non-controlling investment, direct or indirect, by a foreign person in an unaffiliated “pilot program US business” that affords the foreign person the following (a “pilot program covered investment”):

  • Access to any material nonpublic technical information in the possession of the target US business;
  • Membership or observer rights on the board of directors or equivalent governing body of the US business, or the right to nominate an individual to a position on the board of directors or equivalent governing body of the US business; or
  • Any involvement, other than through voting of shares, in substantive decision-making of the US business regarding the use, development, acquisition or release of critical technology.

As it relates to the biotech sector, the term “pilot program US business” means any US business that produces, designs, tests, manufactures, fabricates or develops one or more “critical technologies” either used in connection with, or designed specifically for use in, the biotechnology industry and/or nanobiotechnology industry. The determining factor is “critical technologies.”

An “unaffiliated” pilot program US business is defined as a “pilot program US business” in which the foreign investor does not directly hold more than 50 percent of outstanding voting interest or have the right to appoint more than half of the members of the board or equivalent governing body.

2. Any transaction by or with any foreign person that could result in foreign control of a “pilot program US business,” including such a transaction carried out through a joint venture.

By contrast, an investment by a foreign person in a US biotech company that does not produce, design, test, manufacture, fabricate or develop one or more “critical technologies” is not a “pilot program covered transaction.”

As it relates to the biotech industry, the term “critical technologies” under the Pilot Program may include:

  • Civilian/military dual-use technologies subject to Export Administration Regulations (EAR) that are relating to national security, chemical and biological weapons proliferation, nuclear nonproliferation or missile technology, excluding, for instance, “EAR99” items (i.e., those not covered by a specific Export Classification Control Number in the EAR);
  • Select agents and toxins; and
  • “Emerging and foundational technologies” controlled pursuant to section 1758 of the Export Control Reform Act of 2018 (the definition of which is forthcoming from the Department of Commerce).

Because most biotech products and technologies are classified as EAR 99 or are not otherwise subject to existing US export license requirements, a US biotech company (not involved with select agents and toxins) would fall under the “pilot program US business” category when one or more technologies such US biotech company produces, designs, tests, manufactures, fabricates or develops are covered in the to-be-released definition of “emerging and foundational technologies,” which are sensitive and innovation technologies not currently subject to export controls but deemed important for US economic security and technological leadership.  Industry observers predict that such definition will likely encompass certain biopharmaceuticals, biomaterials, advanced medical devices, and new vaccines and drugs, because some of these have been the subject of recent economic espionage efforts from groups in select countries such as China and Russia.

The US Commerce Department’s Bureau of Industry and Security (BIS) is expected soon to announce an advance notice of proposed rulemaking, inviting public comments on the development of the scope of such “emerging and foundational technologies.” Interested members of the US biotech industry should monitor and/or participate in this rulemaking procedure, which will define the scope of these new controls. Until new rules defining “emerging and foundational technologies” are issued, many in the biotech industry are expected to take a conservative approach in treating a broad range of biotechnology as potentially within the scope of “emerging and foundational technologies” for CFIUS purposes.

PRACTICAL IMPLICATIONS FOR DIFFERENT TYPES OF TRANSACTIONS

Controlling Investments by Foreign Persons

As discussed above, the Pilot Program applies to “any transaction by and with any foreign person that could result in foreign control of any pilot program US business, including such a transaction carried out through a joint venture.” Thus, parties to a controlling investment by a foreign entity in a US biotech company which is a “pilot program US business” are required to submit a declaration to CFIUS.

It is important to note that the CFIUS regulations define “US business,” “control” and “foreign person” very broadly. Such broad definitions could subject even transactions between two non-US entities to the jurisdiction of CFIUS, at least to the extent their venture involves any US business.

CFIUS regulations define a “US business” to include any entity engaged in interstate commerce in the United States, regardless of who owns it or where it is formed or headquartered. This broad definition authorizes CFIUS to review investments by a foreign business (e.g., a Chinese company) in another foreign business (e.g., a German target company) to the extent the deal involves elements of the foreign target company which is engaged in US interstate commerce, such as a US subsidiary or sales office. In other words, an investment or M&A transaction between two non-US biotech companies could be subject to CFIUS review if there are US business activities that will be controlled by the foreign company post-closing.

The CFIUS rules define “control” to mean the power to determine, direct, take, reach or cause decisions regarding important matters of a US business through the ownership of a majority or a “dominant minority” of the voting shares, board representation, proxy voting or contractual arrangements.

Under the CFIUS regulations, the term “foreign person” includes any entity over which a foreign national, foreign government or foreign entity exercises, or has the power to exercise control, (including a foreign-owned US subsidiary or investment fund). In contrast to a US citizen, a US permanent resident visa holder (i.e., green card holder) is a foreign national under the CFIUS regulations. Hence, a company formed as a Delaware corporation or Delaware limited liability company, which is controlled by green card holders, is also a foreign person for CFIUS purposes. An investment by such a Delaware company into a US biotech company will need to be analyzed under the new CFIUS regulations.

The Pilot Program applies to investments by any foreign investor, regardless of the investor’s country, and there are currently no exemptions. FIRRMA provides that CFIUS “may consider” whether a covered transaction involves a country of “special concern” for US national security, and practitioners generally expect CFIUS will consider the countries of foreign investors and will place heightened scrutiny on select countries, particularly if there is government involvement. However, the new regulations themselves do not establish different treatment for different countries, e.g., China, Canada, France or Germany.

Non-Controlling Direct Investments by Foreign Strategic Investors or Foreign Investment Funds

A large number of recent biotech deals take the form of a non-controlling investment, for example, a 5 – 15 percent investment, directly by a foreign strategic investor (e.g., foreign pharmaceutical companies) or by a foreign venture capital or private equity fund in a US biotech business. In some cases, the investment is coupled with, or conditioned upon, a grant by the US biotech business to such foreign strategic investor or its affiliate of an exclusive license of the former’s intellectual property for a particular geographic territory. A typical provision in such investment transactions entitles the investor to serve as, or nominate, a director or observer on the board. Assuming other features of the deal satisfy the new CFIUS regulations, this common transaction term would now trigger a mandatory CFIUS declaration filing whenever such rights are granted to a foreign investor.

Even non-controlling investments with no rights to a board seat or board observer status could be a “pilot program covered investment” subject to the mandatory filing requirement if the investment involves access for the foreign investors to material non-public technological data and scientific findings.  The term “material nonpublic technical information” means “information that is not available in the public domain, and is necessary to design, fabricate, develop, test, produce, or manufacture critical technologies, including process, techniques, or methods,” and does not include “financial information regarding the performance of an entity.” Access to such information is common for biotech investors, precisely because of the need for parties to any biotech deal to focus on the business’s underlying science. For both controlling and non-controlling investments, the ability to undertake careful diligence inquiries into underlying key technologies and scientific findings of biotechnology company targets is critical, especially with respect to the targets that are pre-revenue businesses. When such data and information are not yet patented or published in patent applications or other published scientific literatures, the access by a foreign investor to them in a non-controlling investment would make the transaction fall within the definition of a “pilot program covered investment.”

The CFIUS regulations define the term “investment” to mean the acquisition of equity interests, including not only voting securities, but also contingent equity interests, which are financial instruments or rights that currently do not entitle their holders to voting rights, but are convertible into equity interests with voting rights. For example, if a foreign investor is granted a warrant, option or right of first refusal to obtain additional equity interest in a “pilot program US business,” future exercise of the warrant, option or the right of first refusal should be analyzed to assess whether a declaration must be filed with CFIUS and whether CFIUS might find any US national security implications.

Indirect Investments by Foreign Persons via US Investment Funds

The Pilot Program rules establish an exemption from the mandatory declaration requirement for certain passive investments in US businesses made through investment funds. If a foreign investor makes an investment indirectly through a US-managed investment fund in a “pilot program US business,” such an indirect investment will not constitute a covered transaction under the Pilot Program and will not be subject to CFIUS review, even if it affords the foreign person membership as a limited partner or a seat on an advisory board or investment committee of the fund, provided that the following conditions are satisfied:

  • The fund is managed exclusively by a general partner, managing partner or equivalent who is not the foreign person;
  • The advisory board or investment committee does not have the ability to approve, disapprove or otherwise control (i) investment decisions or (ii) decisions by the general partner (or equivalent) related to entities in which the fund is invested;
  • The foreign person does not otherwise have the ability to control the fund, including authority to (i) approve or control investment decisions; (ii) unilaterally approve or control decisions by the general partner (or equivalent) related to entities in which the fund is invested; or (iii) unilaterally dismiss, select or determine the compensation of the general partner (or equivalent); and
  • The foreign person does not have access to material nonpublic technical information as a result of participation on the advisory board or investment committee.

Private equity funds that have foreign investors, especially foreign sovereign funds, as their limited partners, should carefully review their existing contractual arrangements with their foreign investors, as well as the ownership and control of general partners of such funds, to determine whether this “safe harbor” exemption applies to them.

Follow-On Investments

For any transaction that is not subject to the Pilot Program because it was completed before the effective date of the new rules (November 10, 2018), it is important to note that future investments by the same foreign investor may trigger the Pilot Program’s mandatory declaration requirement and should be reviewed for CFIUS implications earlier than 45 days in advance of such new investment.

CFIUS’s prior approval of a “pilot program covered investment” does not automatically endorse any subsequent “pilot program covered investment” by the same foreign person in the same US business. For example, if a foreign person acquired a 4 percent, non-controlling interest in a US biotech company that is a “pilot program US business” which was cleared by CFIUS, and then subsequently acquires an additional 6 percent non-controlling interest in the same US biotech company and obtains access to material nonpublic technical information, the parties to such follow-on investment would be required to file with CFIUS again.

Outbound License of US Technologies

Under new CFIUS regulations, outbound licensing of only intellectual property or technology by a US business to a foreign person does not fall within CFIUS’s jurisdiction, unless it also involves the acquisition of, or investments in, a US business or unless such license is a disguised acquisition of a US business or all or substantially all of its assets. Note, however, that if such technology is controlled under the EAR, access to such technology by a foreign person may require a US export license under the EAR.

Any contribution by a US critical technology company of both intellectual property and associated support to a foreign person through any type of arrangement (e.g., outbound licensing agreements) are now regulated under enhanced US export controls. Under US export control regulations, an export license is required to be obtained before a “controlled technology” classified in certain export classifications under the EAR is transferred or released to a foreign person. US businesses must carefully determine the export classification of any technology before transferring or releasing (e.g., pursuant to a licensing agreement) such technology to any foreign person.

THE NEW MANDATORY DECLARATION PROCEDURE

Parties to a “pilot program covered transaction” (i.e., the foreign investor and the US business) must submit to CFIUS an abbreviated declaration or, if preferred, file a full written notice (as provided under previous CFIUS rules and procedures). The filing must be made at least 45 days prior to the expected completion date of the transaction, so that CFIUS has an opportunity to review the transaction. The penalty for failing to file can be up to the entire amount of the investment.

A declaration, at around five pages in anticipated length, is expected to be easier to prepare than the typically much longer joint voluntary notice. CFIUS is preparing to release a declaration form for parties to use. The Pilot Program rules require fairly substantial information in a declaration, including but not limited to the following:

  • Brief description of the nature of the transaction and its structure (e.g., share purchase, merger, asset purchase)
  • The percentage of voting interest acquired;
  • The percentage of economic interest acquired;
  • Whether the “pilot program US business” has multiple classes of ownership;
  • The total transaction value;
  • The expected closing date;
  • All sources of financing for the transactions;
  • A list of the addresses or geographic coordinates of all “locations” of the“pilot program US business,” including “headquarters, facilities, and operating locations”; and
  • A complete organization chart, including information that identifies the name, principal place of business and place of incorporation of the immediate parent, the ultimate parent and each intermediate parent (if any) of each foreign person that is a party to the transaction.

After CFIUS receives a declaration, the CFIUS staff chair will initially assess its completeness and decide whether to accept it as complete. After such acceptance, CFIUS must take action within 30 days. CFIUS may either

  • Request that the parties file a full written notice;
  • Inform the parties that CFIUS cannot complete action on the basis of the declaration (and that the parties may file a full written notice);
  • Initiate a unilateral review of the transaction through an agency notice; or
  • Notify the parties that CFIUS has approved the transaction.

TAKEAWAYS

All parties to cross-border transactions involving US biotech businesses, whether mere licensing arrangements or full M&A, should carefully consider all US regulatory implications, including application of the new CFIUS rules, US export controls and related requirements. Parties to pending biotech transactions or contemplating future biotech transactions are well advised to:

  • Analyze at the outset whether the US businesses’ products and technologies are controlled under the US export control regimes and/or fall within the scope of “critical technologies”;
  • Monitor and participate in the BIS rulemaking procedure for establishing export controls on “emerging” and “foundational” technologies;
  • Determine well in advance of their transactions if the new Pilot Program rules apply, requiring a mandatory declaration filing and review by CFIUS;
  • Establish deal terms and conditions with a full understanding of how the various US requirements apply; and
  • Monitor continuing regulatory developments, as the new CFIUS Pilot Program will be supplanted by final CFIUS regulations to be issued by February 2020.
© 2018 McDermott Will & Emery

Founder’s Stock – a Legal Fiction

In common usage, a founder is an individual who creates or helps create a company, but in legal terms, there is no such thing as a “founder” or “founder’s stock,” only early participants in a company’s organization and ownership of its initial equity capital. Why is this so? Because, for all practical purposes (from a startup’s point of view), there are two types of stock – common stock and preferred stock – and “founders” are just the initial holders of the company’s common stock, usually before any financing, in-licensing, or contribution of assets. It should be noted that common stock and preferred stock can be divided further into subclasses or series (e.g., Class A common stock, or Series B preferred stock) that further differentiate the rights and privileges of the holders, and additional side agreements can be put into place to further restrict or grant rights to a particular holder of equity, but those topics are beyond the scope of this post.

As background, to create a corporation an individual (the incorporator) needs to file a certificate of incorporation with the Secretary of State of the state of organization (e.g., Massachusetts, Delaware, California, New York). Immediately thereafter, the incorporator will execute an organizational action where they will appoint the initial director(s) of the corporation and resign from their position as the incorporator. The director(s) will then have an organizational meeting where the director(s), among other things, will adopt by-laws, appoint officers, and issue stock to the initial stockholders, typically common stock. The price of that stock initially issued is very low and is normally equal to the par value per share (e.g., $0.0001/share) because the company has just been created and does not have any real value at this point in time.  This initial equity is what is referred to as “founder’s stock”.  And founder’s stock can be issued outright or can be subject to a vesting schedule with unvested shares forfeited back to the company in certain circumstances, usually related to termination of employment.

Why does any of this matter? From an organizational standpoint, it doesn’t matter – up until the point that the company contemplates issuing stock to employees, investors, or other individuals or acquiring or licensing assets.  Often the early employees and individuals will either (i) want to receive common stock at the same price that the founder(s) paid or (ii) want to ensure their interests are protected. For more information on the latter, please read A Balanced Approach to Founder’s Equity.

If an individual wants to receive common stock at the same price paid by the founder(s) and the individual is a service provider, the individual will be deemed to have received compensation equal to the difference between the (i) fair market value of the stock received and (ii) the amount paid by the recipient; this amount can become significant depending on the then current value of the company. Note, the founders did not have to deal with this “compensation” issue because when the founders purchased their shares of the company at the organizational meeting, the fair market value of the company’s shares at such time was almost nothing (as the company had yet to conduct any business). To avoid this recognition of income, service providers will typically accept options with a purchase price per share equal to the current fair market value. Options provide the service provider with the ability to receive equity in the future without the initial upfront cost of the equity and the income tax issue does not present itself here because the exercise price of the option equals the current exercise price of the share. It should be noted that options do not provide the option holder with any rights as a stockholder. There are advantages and disadvantages of owning options in comparison to stock, and a discussion of those issues is beyond the scope of this post.  But it’s also worth noting that, if six months or so after the issuance of founder’s stock there have been no activities that have created value (financing, assets, activities, etc.), it may be possible to still fairly conclude that the company is still nearly worthless, and thus still have an opportunity to issue “founder’s stock” to a new key member joining the team.  You should consult your attorney when such matters arise.

 

©1994-2018 Mintz. All Rights Reserved.
This post was written by Michael Bill of Mintz.

Betting Big on Blockchain

Blockchain and sports gambling seem to be a natural fit. Sports gambling has been at the forefront of the news cycle since the U.S. Supreme Court struck down a federal statute that banned states from authorizing sports gambling in Murphy v. NCAA. Since then, New Jersey, Delaware, Mississippi and West Virginia have passed laws allowing wagering on the results of certain sporting events. New York, Pennsylvania and Rhode Island are quickly moving towards the legalization of sports gambling and a number of other states are expected to follow.

Blockchain has already proven to be a reliable partner for online casino gambling. In the past few years, a fruitful relationship between online casino gambling platforms and blockchain technologies has developed. Satoshi Dice, which first gained popularity in 2012, allows users to gamble their cryptocurrency through a blockchain-based, peer-to-peer dice prediction game. Virtue Poker, a ConsenSys-backed, decentralized poker platform, uses blockchain to ensure that casino operators (the “house”) cannot tamper with the integrity of a wager. And ZeroEdgeuses smart contracts and blockchain to eliminate the “house” fee that is typically passed on to gamblers.

Thus, given the opening for sports gambling, it is easy to imagine a relationship forming between sports betting and blockchain technologies. Blockchain may allow casino operators and other entities to reduce transaction fees, speed up payment processing, increase gambler anonymity and flag problematic transactions. Some sports betting entities, such as daily fantasy sports behemoth FanDuel, have already begun exploring such opportunities.

However, even within states that have already legalized sports gambling, there are still a number of factors to consider for those aiming to utilize blockchain technologies within their sports betting platforms. Such considerations include, for example:

  • Licensing: Companies using blockchain technologies will have to work with the licensed casino operators within each state. For example, in New Jersey, online sports betting may only be conducted by a licensed casino/racetrack. Each individual licensee is limited to working with three individually branded websites, each of which must obtain a separate license from the state. Thus, for blockchain to play a role, incumbent casino operators will likely need to understand blockchain and its functionality.

  • Federal Wire Act: The Federal Wire Act effectively prohibits individuals from using the Internet to transmit sports wagers across state lines, even if the casino operator and the bettor are in separate states that each individually allow sports betting. Such a limitation is in conflict with the distributed nature of blockchain networks. However, even if, as some commentators have hypothesized, Murphy re-interpreted the Federal Wire Act to only prohibit interstate sports betting to the extent that sports betting is illegal under the state or local law of any of the transaction’s participants, it remains unclear how this interpretation applies to actors such as node operators or validators on a blockchain network who may be located across any number of states or foreign jurisdictions.

  • Taxation: While blockchain applications may be able to facilitate trust-minimized peer-to-peer sports betting, there would need to be proper safeguards in place to ensure that each sports bet is properly taxed. In New Jersey, the state charges 13% for online wagers run by casinos and 14.25% for online wagers run by racetracks. While blockchain may enable bettors to avoid the “house” fee, it cannot circumvent state taxation on sports betting. It will be interesting to see if taxing authorities encourage the use of blockchain, on the theory that they, as a “supernode” on the network, could have a window into all winnings. This could potentially result in more complete and efficient tax collections.

  • Anti-Money Laundering: Currently, casino operators must comply with certain federal and state regulatory schemes that aim to prevent money laundering. Given that anti-money laundering laws will be a primary concern as legalized sports gambling proliferates, companies utilizing blockchain technologies must be able to comply with the Bank Secrecy Act and similar state anti-money laundering laws. However, it is also worth noting that blockchain technologies may be able to aid in preventing money laundering and other illicit financial transactions (e.g., through real-time tracking of suspicious betting patterns).

  • Congress & Further Legislation: The Supreme Court was clear that Congress may regulate sports gambling directly if it elects to do so. While the decentralized nature of blockchain technology is typically deemed to be one of its strengths, lawmakers may be wary of the lack of accountability that blockchain-based platforms may present. As a result, it is possible that Congress or individual states could enact additional legislation that impedes the proliferation of blockchain-based sports betting.

© 2018 Proskauer Rose LLP.
This post was written by Brett Schwab of Proskauer Rose LLP.

CMS Proposes to Overhaul the Medicare Shared Savings Program

On August 9, 2018, the Centers for Medicare and Medicaid Services (CMS) issued a proposed rule to overhaul the Medicare Shared Savings Program (MSSP). The proposal, titled “Pathways to Success,” would make significant changes to the accountable care organization (ACO) model at the heart of the program. The proposed changes include a restructuring of the current ACO risk tracks, updating spending benchmarks, increased ACO flexibility to provide care, as well as changes to the electronic health records requirements for ACO practitioners.

Background

There are currently 561 Shared Savings Program ACOs serving over 10.5 million Medicare fee-for-service (FFS) beneficiaries. Under the MSSP, ACOs are assessed based on quality and outcome measures, and by comparing their overall health care spending to a historical benchmark. ACOs receive a share of any savings under the historical benchmark if they meet the quality performance requirements.

Currently, the MSSP allows ACOs to participate in one of three “tracks.” Track 1 is a “one-sided” model, meaning that participating ACOs share in their savings, but are not required to pay back spending over the historical benchmark. Track 2 and Track 3 are “two-sided” models, meaning that participating ACOs share in a larger portion of any savings under their benchmark, but may also be required to share losses if spending exceeds the benchmark. Currently, the vast majority of ACOs participate in Track 1.

Restructuring the Tracks

CMS proposes retiring Track 1 and Track 2, creating a BASIC track, and renaming Track 3 the ENHANCED Track. CMS describes the BASIC track as a “glide path” that will help ACOs transition to higher levels of risk and potential reward.  To that end, the BASIC track contains five levels that ACOs would transition through over the course of a five year contract period, spending a maximum of one year at each level. The first two years would involve upside-only risk, with a transition to increasing levels of financial risk in the remaining three years. Current Track 1 ACOs will be limited to one-year of upside-only participation before taking on downside risk. This is a substantial acceleration from the current Track 1 Model, which permits ACOs to avoid downside risk for up to six years.

Finally, the proposed rule draws a distinction between low revenue ACOs and high revenue ACOs. Low revenue ACOs (typically composed of rural ACOs and physician practices) would be permitted to spend two 5-year contract periods on the BASIC track. High revenue ACOs (typically composed of hospitals) would be permitted only one 5-year contract period on the Basic track.

Source: Proposed Rule: Medicare Program; Medicare Shared Savings Program; Accountable Care Organizations–Pathways to Success

Updating the Historical Spending Benchmarks

Every year, an ACO’s spending is comparing to its historical benchmark to determine the ACO’s participation in any shared savings or losses. Under the proposed rule, the benchmark methodology will incorporate regional FFS expenditures beginning in the first contract period. Also, the historical benchmark will be rebased at the beginning of each 5-year contract period. Adjustments to the benchmark related to regional expenditures will be capped at 5% of the national Medicare FFS per capita expenditure. According to CMS, these changes will improve the predictability of historical benchmark setting and increase the opportunity for ACOs to achieve savings against the historical benchmark.

Expanding ACO Flexibility in Beneficiary Care

The proposed rule contains several changes to the MSSP aimed at increasing the flexibility of ACOs to provide cost-effective care to their assigned beneficiaries. For example, to support the ACO’s coordination of care across health care settings, ACOs will be eligible to receive payment for telehealth services furnished to prospectively assigned beneficiaries even when they would otherwise be prohibited based on geographic prerequisites. The proposed rule also expands the Skilled Nursing Facility (SNF) 3-Day Rule Waiver to all ACOs in two-sided models. This waiver permits Medicare coverage of certain SNF services that are not preceded by a qualifying 3-day inpatient hospital stay.

Finally, the proposed rule permits ACOs in two-sided models to reward beneficiaries with incentive payments of up to $20 for primary care services received from ACO professionals, Federally Qualified Health Centers, or Rural Health Clinics.

Changing Electronic Health Record Requirements

Currently, one of the quality measures for which ACOs are assessed relates to the percentage of participating primary care providers that successfully demonstrate meaningful use of an electronic health records system for each year of participation in the program. The proposed rule eliminates this measure. Instead, CMS proposes to adopt an “interoperability criterion” that assesses the use of certified electronic health record technology for initial program participation and as part of each ACO’s annual certification of compliance with program requirements.

Commentary

CMS’s proposal is not surprising in light of CMS Administrator Seema Verma’s recent comments about upside-only ACOs. At an American Hospital Association annual membership meeting this past spring, Administrator Verma is quoted as saying:

[T]he majority of ACOs, while receiving many waivers of federal rules and requirements, have yet to move to any downside risk.  And even more concerning, these ACOs are increasing Medicare spending, and the presence of these ‘upside-only’ tracks may be encouraging consolidation in the market place, reducing competition and choice for our beneficiaries.  While we understand that systems need time to adjust, our system cannot afford to continue with models that are not producing results.

Though the rule is only a proposal at this time, the above comments illustrate that CMS is serious about requiring providers to be more financially accountable for the care of their patients. And the agency is clear-eyed about the short-term impact of the proposal, estimating that more than 100 ACOs will exit the MSSP over the next 10 years if the proposal is finalized.  The agency nevertheless believes that the new program would be attractive to providers due to its simplicity (as compared to the current program) and the new opportunity it offers clinicians to qualify as participating in an Advanced Alternative Payment Model (APM) when they reach year 5 of the BASIC track. APMs are an important concept under the Quality Payment Program (QPP) that was ushered in by the Medicare Access and CHIP Reauthorization Act of 2015. Clinicians participating in an Advanced APM are exempt from reporting under the QPP’s Merit-based Incentive Payment System (MIPS) and are eligible for certain financial incentives. The fates of the MSSP and the QPP are thus intertwined, and the co-evolution of the programs is at a critical stage, especially in light of CMS’s July release of a proposed rule modifying the QPP. We will continue to report on the developments of both of these programs.

 

©1994-2018 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

Treasury Releases Report on Nonbank Institutions, Fintech, and Innovation

On July 31, 2018, the U.S. Department of the Treasury released a reportidentifying numerous recommendations intended to promote constructive activities by nonbank financial institutions, embrace financial technology (“fintech”), and encourage innovation.

This is the fourth and final report issued by Treasury pursuant to Executive Order 13772, which established certain Core Principles designed to inform the manner in which the Trump Administration regulates the U.S. financial system.  Among other things, the Core Principles include:  (i) empower Americans to make independent financial decisions and informed choices; (ii) prevent taxpayer-funded bailouts; (iii) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis; (iv) make regulation efficient, effective, and appropriately tailored; and (v) restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.

Treasury’s lengthy report contains over 80 recommendations, which are summarized in an appendix to the report.  The recommendations generally fall into four categories:  (i) adapting regulatory approaches to promote the efficient and responsible aggregation, sharing, and use of consumer financial data and the development of key competitive technologies; (ii) aligning the regulatory environment to combat unnecessary regulatory fragmentation and account for new fintech business models; (iii) updating a range of activity-specific regulations to accommodate technological advances and products and services offered by nonbank firms; and (iv) facilitating experimentation in the financial sector.

Some notable recommendations include:

Embracing Digitization, Data, and Technology

  • TCPA Revisions: Recommending that Congress and the Federal Communications Commission amend or provide guidance on the Telephone Consumer Protection Act to address unwanted calls and revocation of consent.

  • Consumer Access to Financial Data: Recommending that the Bureau of Consumer Financial Protection (“BCFP”) develop best practices or principles-based rules to promote consumer access to financial data through data aggregators and other third parties.

  • Data Aggregation: Recommending that various agencies eliminate legal and regulatory uncertainties so that data aggregators can move away from screen scraping to more secure and efficient methods of access.

  • Data Security and Breach Notification:  Recommending that Congress enact a federal data security and breach notification law to protect consumer financial data and notify consumers of a breach in a timely manner, with uniform national standards that preempt state laws.

  • Digital Legal Identity:  Recommending efforts by financial regulators and the Office of Management and Budget to enhance public-private partnerships that facilitate the adoption of trustworthy digital legal identity products and services and support full implementation of a U.S. government federated digital identity system.

  • Cloud Technologies, Artificial Intelligence, and Financial Services:  Recommending that regulators modernize regulations and guidance to avoid imposing obstacles on the use of cloud computing, artificial intelligence, and machine learning technologies in financial services, and to provide greater regulatory clarity that would enable further testing and responsible deployment of these technologies by financial services firms as these technologies evolve.

Aligning the Regulatory Framework to Promote Innovation

  • Harmonization of State Licensing Laws:  Encouraging efforts by state regulators to develop a more unified licensing regime, particularly for money transmission and lending, and to coordinate supervisory processes across the states, and recommending Congressional action if meaningful harmonization is not achieved within three years.

  • OCC Fintech Charter:  Recommending that the Office of the Comptroller of the Currency move forward with a special purpose national bank charter for fintech companies.

  • Bank-Nonbank Partnerships:  Recommending banking regulators tailor and clarify regulatory guidance regarding bank partnerships with nonbank firms.

Updating Activity-Specific Regulations

  • Codification of “Valid When Made” and True Lender Doctrines:  Recommending that Congress codify the “valid when made” doctrine and the legal status of a bank as the “true lender” of loans it originates but then places with a nonbank partner, and that federal banking regulators use their authorities to affirm these doctrines.

  • Encouraging Small-Dollar Lending:  Recommending that the BCFP rescind its Small-Dollar Lending Rule and that federal and state financial regulators encourage sustainable and responsible short-term, small-dollar installment lending by banks.

  • Adoption of Debt Collection Rules:  Recommending that the BCFP promulgate regulations under the Fair Debt Collection Practices Act to establish federal standards governing third-party debt collection, including standards that address the reasonable use of digital communications in debt collection activities.

  • Promote Experimentation with New Credit Models and Data:  Recommending that regulators support and provide clarity to enable the testing and experimentation of newer credit models and data sources by banks and nonbank financial firms.

  • Regulation of Credit Bureaus:  Recommending that the Federal Trade Commission and other relevant regulators take necessary actions to protect consumer data held by credit reporting agencies and that Congress assess whether further authority is needed in this area.

  • Regulation of Payments:  Recommending that the Federal Reserve act to facilitate a faster payments system, as well as changes to the BCFP’s remittance transfer rule.

Enabling the Policy Environment

  • Regulatory Sandboxes:  Recommending that federal and state regulators design a unified system to provide expedited regulatory relief and permit meaningful experimentation for innovative financial products, services, and processes, essentially creating a “regulatory sandbox.”

  • Technology Research Projects:  Recommending that Congress authorize financial regulators to undertake research and development and proof-of-concept technology partnerships with the private sector.

  • Cybersecurity and Operational Risks:  Recommending that financial regulators consider cybersecurity and other operational risks as new technologies are implemented, firms become increasingly interconnected, and consumer data are shared among a growing number of third parties.

© 2018 Covington & Burling LLP

Bank Deregulation Bill Becomes Law: Economic Growth, Regulatory Relief, and Consumer Protection Act

On May 24, President Trump signed into law the most significant banking legislation since the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in 2010.  The bill – named the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “Act”) – passed its final legislative hurdle earlier this week when it was approved by the U.S. House of Representatives.  Identical legislation passed the U.S. Senate last March on a bipartisan basis.

The Act makes targeted, but not sweeping, changes to several key areas of Dodd-Frank, with the principal beneficiaries of most provisions being smaller, non-complex banking organizations.

Below is a summary of several key changes:

  • Higher SIFI Threshold – The controversial $50 billion asset threshold under Dodd-Frank is now $250 billion, affecting about two dozen bank holding companies. Under Section 165 of Dodd-Frank, bank holding companies with at least $50 billion in total consolidated assets were subjected to enhanced prudential standards.  Under the Act, the enhanced prudential standards under Section 165 no longer apply to bank holding companies below $100 billion, effective immediately.  Bank holding companies with total consolidated assets of between $100 billion and $250 billion will be exempted from such standards starting in November 2019, although the Federal Reserve retains the authority to apply the standards to any such company if it deems appropriate for purposes of U.S. financial stability or to promote the safety and soundness of the particular firm.

The increase in the Section 165 threshold does not eliminate the $50 billion threshold used in other areas of regulation and supervision, such as the Office of the Comptroller of the Currency’s (“OCC”) “heightened standards,” the “living will” regulations adopted by the Federal Deposit Insurance Corporation (“FDIC”) for insured depository institutions or the Federal Reserve’s capital plan rule pursuant to which it administers the CCAR process.  However, it is expected that the federal banking agencies may reconsider the appropriateness of using the $50 billion asset threshold elsewhere.

The increase in this threshold is especially important because it may spark renewed interest in M&A opportunities among regional banks that have carefully managed growth to avoid crossing $50 billion or that have otherwise been reluctant to pursue transactions in light of the significant regulatory scrutiny that has accompanied applications by large acquirors.

  • Volcker Rule – The Volcker Rule is amended so that it no longer applies to an insured depository institution that has, and is not controlled by a company that has, (i) less than $10 billion in total consolidated assets and (ii) total trading assets and trading liabilities that are not more than 5% of total consolidated assets. All other banking entities, however, remain subject to the Volcker Rule.  The other change to the Volcker Rule relates to the name-sharing restriction under the asset management exemption, which the Act modifies slightly by easing the prohibition on banking entities sharing the same name with a covered fund for marketing or other purposes.  Going forward, a covered fund may share the same name as a banking entity that is the investment adviser to the covered fund as long as the word “bank” is not used in the name and the investment adviser is not itself (and does not share the same name as) an insured depository institution, a company that controls an insured depository institution or a company that is treated as a bank holding company.  This change allows separately branded investment managers within a bank holding company structure to restore using the manager’s name on its advised funds.

The Act represents only the first set of changes to the Volcker Rule.  The federal banking agencies are expected to release a proposal the week of May 28 to revise aspects of the regulations first adopted in late 2013.

  • “Off-Ramp” Relief for Qualifying Community Banks – A depository institution or depository institution holding company with less than $10 billion in total consolidated assets will constitute a “qualifying community bank” under the Act. The benefit of such a designation is that the institution will be exempt from generally applicable capital and leverage requirements, provided the institution complies with a leverage ratio of between 8% and 10%.  The federal banking agencies must develop this ratio and establish procedures for the treatment of a qualifying community bank that fails to comply.  The regulators have the authority to determine that a depository institution or depository institution holding company is not a qualifying community bank based on the institution’s risk profile.

  • Stress Testing – The Act provides relief from stress testing for certain banking organizations. Notably, bank holding companies with total consolidated assets of between $10 billion and $250 billion will no longer need to conduct company-run stress tests.  Bank holding companies with more than $250 billion in assets and nonbank companies deemed systemically important still need to conduct company-run stress tests, but are permitted to do so on a “periodic” basis rather than the previously required semi-annual cycle.  As for supervisory stress tests, which are conducted by the Federal Reserve, bank holding companies with less than $100 billion are no longer subject to such stress tests.  Bank holding companies with total consolidated assets between $100 billion and $250 billion are subject to supervisory stress tests on a periodic basis, while such firms with $250 billion or more in total consolidated assets and nonbank companies designated as systemically important remain subject to annual supervisory stress tests.

  • Risk Committees and Credit Exposure Reports – The Act raises the asset threshold that triggers the need for publicly-traded bank holding companies to establish a board-level risk committee, from $10 billion to $50 billion. In addition, the Act amends Dodd-Frank’s requirement that bank holding companies with at least $50 billion in assets and nonbank companies designated as systemically important submit credit exposure reports.  Instead, the Act authorizes, but does not mandate, the Federal Reserve to receive reports from these firms, but with respect to bank holding companies, only those with more than $250 billion in assets are within scope.

  • Exam Cycle and Call Report Relief for Smaller Institutions – The Act increases the asset threshold for insured depository institutions to qualify for an 18-month on-site examination cycle from $1 billion to $3 billion. The Act also directs the federal banking agencies to adopt short-form call reports for the first and third calendar quarters for insured depository institutions with less than $5 billion in total consolidated assets and that meet such other criteria as the agencies determine appropriate.

  • Small BHC and SLHC Policy Statement – The asset threshold for the application of the Federal Reserve’s Small Bank Holding Company and Savings and Loan Holding Company Policy Statement is raised from $1 billion to $3 billion. As a result, those institutions with less than $3 billion in consolidated assets are not subject to consolidated capital requirements and have the benefit of less restrictive debt-to-equity limitations.

  • Flexibility for Federal Thrifts to Operate as National Banks – Federal savings associations with total consolidated assets of $20 billion or less (as of December 31, 2017) may elect to be subject to the same rights, privileges, duties, restrictions, penalties, liabilities, conditions and limitations that apply to a national bank, without having to convert their charters. As a result, institutions that make the election would be exempt from certain restrictions unique to savings associations, including asset-based limitations applicable to commercial and consumer loans, unsecured constructions loans, and non-residential real property loans.  To make an election, a federal savings association must provide 60 days’ prior written notice to the OCC.

  • “Ability to Repay” Safe Harbor for Smaller Institutions – The Act provides a safe harbor from the “ability to repay” requirement under the Truth in Lending Act (“TILA”) for mortgage loans originated and retained in portfolio by an insured depository institution or insured credit union that has, together with its affiliates, less than $10 billion in total consolidated assets. However, mortgage loans that have interest-only, negative amortization or certain other features do not qualify for this ability-to-repay relief.

  • Capital Treatment for HVCRE Exposures – The Act eases the treatment for certain “high-volatility commercial real estate” (“HVCRE”) loans under U.S. Basel III capital rules. HVCRE exposures had been assigned a 150% risk-weight under the U.S. standardized approach, but the Act now restricts this higher risk-weight to those exposures that constitute acquisition, development and construction (“ADC”) loans meeting a new “HVCRE ADC loan” definition.  Various loans are excluded from HVCRE ADC loan definition, including loans to finance the acquisition, development or construction of one- to four-family residential properties, community development project loans, and loans secured by agricultural land.  In addition, loans to acquire, refinance or improve income-producing properties and commercial real estate projects that meet certain loan-to-value ratios are also excluded from the new HVCRE ADC loan definition.

  • Reciprocal Deposits – The Act excludes deposits received under a reciprocal deposit placement network from the scope of the FDIC’s brokered deposit rules if the agent institution’s total amount of reciprocal deposits does not exceed either $5 billion or 20% of the institution’s total liabilities. The exclusion applies generally to a bank that has a composite condition of outstanding or good and is well capitalized, but it may be relied upon by a bank that has been downgraded or ceases to be well capitalized if the amount of reciprocal deposits it holds does not exceed the average of its total reciprocal deposits over the four quarters preceding its rating or capital downgrade.

  • PACE Financing – The Act requires the Consumer Financial Protection Bureau (“CFPB”) to issue ability-to-repay rules under TILA to cover Property Assessed Clean Energy (“PACE”) financing. The Act defines such financing to include a loan that covers the costs of home improvements and which results in a tax assessment on the consumer’s real property.  In developing these regulations, the CFPB must consult with state and local governments and PACE bond-issuing authorities.

  • Protections for Student Borrowers – The Act provides protections for student loan borrowers in situations involving the death of the borrower or cosigner and those seeking to “rehabilitate” their student loans. In particular, the Act amends TILA to prohibit a private education loan creditor from declaring a default or accelerating the debt of the student obligator solely on the basis of the death or bankruptcy of a cosigner.  In addition, in the case of the death of the borrower, the holder of a private education loan must release any cosigner within a “reasonable timeframe” after receiving notice of the borrower’s death.  The Act also amends the Fair Credit Reporting Act by allowing a borrower to request that a financial institution remove a reported default on a private education loan from a consumer credit report if the institution offers and the borrower successfully completes a loan rehabilitation program.  The program, which must be approved by the institution’s federal banking regulator, must require that the borrower make consecutive on-time monthly payments in a number that, in the institution’s assessment, demonstrates a “renewed ability and willingness to repay the loan.”

  • Immunity from Suit for Disclosure of Financial Exploitation of Senior Citizens – The Act shields financial institutions and certain of their personnel from civil or administrative liability in connection with reports of suspected exploitation of senior citizens. The reports must be made in good faith and with reasonable care to a law enforcement agency or certain other designated agencies, including the federal banking agencies.  Personnel covered by the immunity (which include compliance personnel and their supervisors, as well as registered representatives, insurance producers and investment advisors) must have received training in elder care abuse by the financial institution or a third party selected by the institution.

  • Mortgage Relief – The Act contains a number of provisions easing certain residential mortgage requirements, especially with respect to such loans made by smaller institutions. The Act amends the Home Mortgage Disclosure Act to exempt from specified public disclosure requirements depository institutions and credit unions that originate, on an annual basis, fewer than a specified number of closed-end mortgages or open-end lines of credit.  The Act revises the Federal Credit Union Act to allow a credit union to extend a member business loan with respect to a one- to four-family dwelling, regardless of whether the dwelling is the member’s primary residence.  The Act also amends the S.A.F.E. Mortgage Licensing Act of 2008 to allow loan originators that meet specified requirements to continue, for a limited time, to originate loans after moving: (i) from one state to another, or (ii) from a depository institution to a non-depository institution.  Further, the Act exempts from certain escrow requirements a residential mortgage loan held by a depository institution or credit union that: (i) has assets of $10 billion or less, (ii) originated 1,000 or fewer mortgages in the preceding year, and (iii) meets other specified requirements.

  • Liquidity Coverage Ratio – The Act directs the federal banking agencies to amend their liquidity coverage ratio requirements to permit certain municipal obligations to be treated as higher quality “level 2B” liquid assets if they are investment grade, liquid and readily marketable.

  • Custodial Bank Capital Relief – The Act requires the agencies to exclude, for purposes of calculating a custodial bank’s supplementary leverage ratio, funds of a custodial bank that are deposited with a central bank. The amount of such funds may not exceed the total value of deposits of the custodial bank linked to fiduciary or custodial and safekeeping accounts.

  • Fair Credit Reporting Act – The Fair Credit Reporting Act is amended to increase the length of time a consumer reporting agency must include a fraud alert in a consumer’s file. The Act also: (i) requires a consumer reporting agency to provide a consumer with free “credit freezes” and to notify a consumer of their availability, (ii) establishes provisions related to the placement and removal of these credit freezes and (iii) creates requirements related to the protection of the credit records of minors.

  • Cyber Threat Report – Within one year of enactment, the Secretary of the Treasury must submit a report to Congress on the risks of cyber threats to U.S. financial institutions and capital markets. The report must include: (i) an assessment of the material risks of cyber threats, (ii) the impact and potential effects of material cyber attacks, (iii) an analysis of how the federal banking agencies and the Securities and Exchange Commission are addressing these material risks and (iv) a recommendation of whether additional legal authorities or resources are needed to adequately assess and address the identified risks.

Apart from the changes in the thresholds for banks with assets above $100 billion, most of the Act’s provisions are effective immediately.

 

© Copyright 2018 Cadwalader, Wickersham & Taft LLP
Read more news on banks at the National Law Review’s Finance Practice Group Page.

Can I Secure a Loan with Bitcoin? Part I

Each day seems to bring another story about Bitcoin, Ethereum, Litecoin, or another virtual currency. If virtual currencies continue to grow in popularity, it’s only a matter of time before borrowers offer to pledge virtual currency as collateral for loans.  This article does not advise lenders on whether they should secure loans with virtual currency, but instead it focuses on whether a lender can use the familiar tools of Article 9 of the Uniform Commercial Code (“UCC”) to create and perfect a security interest in bitcoin.  (In this article, “bitcoin” is used as a generic term for all virtual currencies.)

Article 9 Basics

Article 9 allows a creditor to create a security interest in personal property. The owner of the property grants the creditor a security interest through a written security agreement. The security agreement creates the security interest between the secured party and the debtor. The secured party must then “perfect” the security interest to obtain lien priority over third parties and to protect its secured status should the debtor file bankruptcy.

Security interests are perfected in different ways depending on the type of collateral. Article 9 divides personal property into different categories, such as goods, equipment, inventory, accounts, money, and intangibles. The primary ways to perfect a security interest are (1) filing, with the appropriate filing agency, a UCC-1 financing statement containing a sufficient description of the collateral, (2) possession, or (3) control.

Bitcoin and Blockchain

Virtual currencies are electronic representations of value that may not have an equivalent value in a real government-backed currency. They can be used as a payment system, or digital currency, without an intermediary like a bank or credit card company. While virtual currencies can function like real currencies in certain transactions, and certain virtual currencies can be exchanged into real currencies, a virtual currency itself does not have legal tender status. Virtual currency is virtual—there is no bitcoin equivalent to a quarter or dollar bill.

Bitcoin operates on a protocol that uses distributed-ledger technology. This technology is called the blockchain. The blockchain eliminates the need for intermediaries such as banks. Unlike a dollar, which is interchangeable, each bitcoin is unique. The blockchain records all bitcoin transactions to prevent someone from re-spending the same bitcoin over and over.

Suppose you wanted to transfer cash to a friend. You could transfer funds from your bank account to her bank account. The banks act as intermediaries. Suppose you wanted to transfer cash to that same friend without a middle man. The only way to do that is meet her and hand over the cash. This exchange many not be practical for many reasons. You might live far from each other. Even if you’re near each other, you might not want to travel around town with a briefcase full of cash. Bitcoin and blockchain technology allow the transfer of cash directly and digitally without a middle man.

The blockchain is both transparent and opaque. It is transparent as to the ownership chain of every bitcoin.  In this way, it is easier to “trace” a bitcoin than to trace cash.  But the blockchain presently does not show liens on bitcoin.  So a secured party can confirm if a borrower owns bitcoin, but not if the borrower or a previous owner encumbered the bitcoin.

Is Bitcoin Money?

At first glance, bitcoin would seem to fall in the category of “money.” Article 9 defines money as a medium of exchange authorized or adopted by a domestic or foreign government. No government has adopted bitcoin as a medium of exchange. Dollars, euros, and pounds meet the definition of money—bitcoin does not. Therefore, bitcoin does not meet the definition of money. And a secured party perfects its security interest in money by physical possession, but because bitcoin is virtual, physical possession is impossible.

Is Bitcoin a Deposit Account?

A deposit account is a demand, time, savings, passbook, or similar account maintained with a bank. With a traditional deposit account, the secured party perfects its security interest by having “control” over that account. This is usually accomplished when the debtor, the debtor’s bank, and the secured party execute a deposit account control agreement. If the debtor defaults, the secured party can direct the debtor’s bank to transfer the funds from the account.

Bitcoin often is stored in a digital wallet with an exchange like Coinbase. The wallet is access-restricted by private keys or passwords, but that wallet is not a deposit account. The bitcoin itself is held by its owner on the blockchain, which is decentralized. Unlike a deposit account, there is no intermediary like a bank. With no intermediary, there is no way to establish “control” over the bitcoin. Consequently, bitcoin does not meet the definition of a deposit account.

Bitcoin is (Probably) a General Intangible

By process of elimination, bitcoin should be treated as a general intangible. A general intangible is personal property that does not fall into any other Article 9 category. A lender perfects a security interest in general intangibles by filing a UCC-1 financing statement. In North Carolina, you file it with the Secretary of State.

Although we can categorize bitcoin as a general intangible for Article 9 purposes, and create and perfect a security interest accordingly, several issues arise that question the overall effectiveness of that security interest. For starters, a security interest in general intangibles follows the sale, license, or other disposition of the collateral, unless the secured party consents to the transfer free of its security interest, the obligations secured by the security interest have been satisfied, or the security interest has otherwise terminated.

This is a problem for the lender wanting a first-priority lien on the bitcoin. Before approaching the lender, the borrower may have granted a secured party a security interest in bitcoin, or granted a security interest in “all assets whether now owned or acquired later” and then acquired bitcoin. In both instances, the bitcoin is encumbered by the security interest. The lender could not confirm prior liens without searching UCC-1 filings in all 50 states (and even that might not catch international liens).

Even if a secured party acquires a senior lien in bitcoin, that party still has the problem of lack of control over the bitcoin. Without control, bitcoin collateral is susceptible to unauthorized transfers. Even if a borrower has an account at an online currency exchange like Coinbase—which allows you to exchange bitcoin into traditional money—the exchange may be unwilling to sign a tri-party control agreement to restrict the debtor’s ability to exchange the bitcoin. Upon default, without the debtor’s cooperation, it will be difficult or impossible to enforce, take possession, and liquidate the bitcoin.

Conclusion

Putting aside its value and volatility, the intrinsically unique nature of bitcoin makes it an imperfect and problematic form of collateral under Article 9. Part II of this article will discuss the pros and cons of using Article 8 of the UCC to create and perfect a security interest in bitcoin. Article 8 has the potential to be a safer and more reliable solution for these transactions.

© 2018 Ward and Smith, P.A.. All Rights Reserved.

This post was written by Lance P. Martin of Ward and Smith, P.A.

               

State of Washington Enacts Student Loan Servicing Law

Washington has become the latest state to impose a licensing requirement on student loan servicers. Yesterday, Governor Jay Inslee signed  SB 6029, which establishes a “student loan bill of rights,” similar to the bills that have been enacted in California, Connecticut, the District of Columbia, and Illinois.

The law’s requirements include the following:

  • Creation of Advocate Role: The law creates the position of “Advocate” within the Washington Student Achievement Council to assist student education loan borrowers with student loans. This role is analogous to that of “ombudsman” under proposed and enacted servicing bills in other states.  One of the Advocate’s roles is to receive and review borrower complaints, and refer servicing-related complaints to either the state’s Department of Financial Institutions (“DFI”) or the Attorney General’s Office, depending on which office has jurisdiction. The Advocate is also tasked with:
    • Compiling information on borrower complaints;
    • Providing information to stakeholders;
    • Analyzing laws, rules, and policies;
    • Assessing annually the number of residents with federal student education loans who have applied for, received, or are waiting for loan forgiveness;
    • Providing information on the Advocate’s availability to borrowers, institutions of higher education, and others;
    • Assisting borrowers in applying for forgiveness or discharge of student education loans, including communicating with student education loan servicers to resolve complaints, or any other necessary actions; and
    • Establishing a borrower education course by 10/1/20.
  • Licensing of Servicers: SB 6029 requires servicers to obtain a license from the DFI. There are various exemptions from licensing for certain types of entities and programs (trade, technical, vocational, or apprentice programs; postsecondary schools that service their own student loans; persons servicing five or fewer student loans; and federal, state, and local government entities servicing loans that they originated), although such servicers would still need to comply with the statute’s substantive requirements even if they are not licensed.
  • Servicer Responsibilities: All servicers, except those entirely exempt from the statute, are subject to various obligations. Among other things, servicers must:
    • Provide, free of charge, information about repayment options and contact information for the Advocate ;
    • Provide borrowers with information about fees assessed and amounts received and credited;
    • Maintain written and electronic loan records;
    • Respond to borrower requests for certain information within 15 days;
    • Notify a borrower when acquiring or transferring servicing rights; and
    • Provide borrowers with disclosures relating to the possible effects of refinancing student loans.
  • Modification Servicer Responsibilities: The bill imposes a number of requirements on third-parties providing student education loan modification services, including mandates that such persons: not charge or receive money until their services have been performed; not charge fees that are in excess of what is customary; and immediately inform a borrower in writing if a modification, refinancing, consolidation, or other such change is not possible.
  • Requirements for Educational Institutions: Institutions of higher education are required to send borrower notices regarding financial aid.
  • Fees: The bill also calls for the establishment, by rule, of fees sufficient to cover the costs of administering the program created by the bill.
  • Bank Exemption: The statute provides for a complete exemption for “any person doing business under, and as permitted by, any law of this state or of the United States relating to banks, savings banks, trust companies, savings and loan or building and loan associations, or credit unions.” Notably, this exemption does not expressly cover state banks chartered in other states.

As we recently noted, bills like  SB 6029 are being introduced in legislatures across the country at an increasing rate, and we are continuing to track the progress of these proposals as they move through various statehouses.

Hopefully the torrent of such proposals will soon be reduced to a trickle, now that the U.S. Department of Education has formally weighed in on this trend, issuing an interpretation emphasizing that the Higher Education Act, federal regulations, and applicable federal contracts preempt laws like SB 6209 that purport to regulate federal student loan servicers.

 

Copyright © by Ballard Spahr LLP 2018
This post was written by Jeremy C. Sairsingh of Ballard Spahr LLP.

               

The Unique Quandaries Faced in Recovering International Cryptocurrency Frauds

Cryptocurrency itself is a string of computer-generated code.  This line of code is accessed by an owner’s unique passcode secret private key.  Each owner’s cryptocurrency is kept in their “Virtual Wallet”. Virtual wallets are similarly anonymous as are the virtual currency balances. The transfer of cryptocurrency is based upon the block chain protocol, a public decentralized ledger that identifies transactions by a digital code with no link to a person or place.

Practically, there is no public record of virtual currency transfers.  Other than the debtor’s own testimony, a creditor would not know where to begin searching for evidence of virtual currency purchases or transactions. There is no way for a creditor to identify either the owner or location of a transferee’s cryptocurrency address. In some cases, the debtor could honestly state that he does not know the identity of the individual who received his cryptocurrency transfers.

For asset protection purposes, a cryptocurrency account currently functions similarly to offshore banking prior to the IRS’s crackdown of anonymous personal foreign accounts.  Today, it is almost impossible for U.S. citizens to establish an anonymous bank account, or any type of bank account, outside of the U.S. With the advent of Bitcoin, a U.S. citizen can open and maintain a financial account that has creditor protection features similar to an offshore bank account in that the Bitcoin account is anonymous and can be maintained outside the geographical jurisdiction of domestic courts. Since block chains are decentralized, they are not subject to any central authority (such as a bank or other financial institution) that might be legally compelled to provide a court with access or control over assets in its possession. Without the complete private key, no court or legal authority can manipulate ownership of a block chain asset.

At the moment, creditors face obstacles of identifying potential defendants and the international nature of the transaction.  Properly selected offshore fiduciaries holding accounts are unlikely to become subject to the jurisdiction of a court where a defendant may be sued.  Absent jurisdictional authority, a court is powerless to compel the fiduciary to turn over assets. Similarly, a US court could try to compel the party to turn over the account or information about the transaction. The court’s contempt powers could be used to coerce compliance. Arrest and incarceration can be utilized. See In Re Lawrence, 279 F.3d 1294,1300 (11th Cir. 2002); FTC v. Affordable Media Inc., 129 F.3d 1228, 1229 (9thCir. 1999). But, on cruel and unusual punishment grounds, incarceration cannot be imposed forever. If the asset is more important than personal freedom, a court’s power of compliance is limited.

There are two equitable remedies that exist under English common law which could be flexibly applied to these evolving transactions. One existing remedy is the equitable pre-trial discovery device known as a Norwich Pharmacal order requiring third parties to disclose information to potentially identify the wrongdoer, to trace funds and to assist prospective plaintiffs in determining whether a cause of action exists.  (There are five states in the U.S. that also allow for pretrial discovery to identify the wrongdoing.)  Norwich orders, being a flexible tool of equity, could assist in claims involving cryptocurrency transactions.  It may be possible that identification information might come from “know your customer” information given a bitcoin exchange.  Proceedings could be constituted as “the bitcoin holder with the public key number…”  However, the hurdle still exists to identify the wrongdoer.

The second equitable remedy is injunctive relief.  Courts have granted world-wide injunctions, particularly when the impugned conduct is occurring online and globally, such as the internet.  InGoogle Inc. v. Equustete, 2017 SC 34, the Supreme Court of Canada recently held that injunctive relief can be ordered against somebody who is not a party to the underling lawsuit, even if that third party is not guilty of wrongdoing.  Google was ordered to stop displaying search results globally for any Data Link websites.  “The problem in this case, is occurring online and globally.  The internet has no borders; its natural habitat is global.  The only way to ensure interlocutory injunction (order) attain its objection was to have it apply where Google operates – globally.”  Thus, if the third party to the block chain transaction can be identified, there may be a remedy to discover information and wrongdoing.

Therefore, courts will need to apply not only new remedies, but expand existing ones.  While the identities of the buyer and seller are encrypted, a transaction record is maintained on the public ledger. In the future, anti-money laundering laws and cryptocurrency exchanges may require the collection of personal data of customers. Until then, the challenge of recovery will require creativity and experience.

 

© Horwood Marcus & Berk Chartered 2018.
This post was written by Eric (Rick) S. Rein from Horwood Marcus & Berk Chartered.

Climate Change and Trends in Global Finance

On December 12, French President Emmanuel Macron, joined by President of the World Bank Group, Jim Yong Kim and the Secretary-General of the United Nations, António Guterres, hosted the One Planet Summit highlighting public and private finance in support of climate action. The summit’s focus centered on addressing the fight against climate change and ensuring that climate issues are central to the finance sector.

The summit’s most notable event was perhaps the announcement that insurance giant Axa would be dumping investments in and ending insurance for controversial U.S. oil pipelines, quadrupling its divestment from coal businesses, and increasing its green investments fivefold by 2020. Axa’s plans echo those of BNP Paribas, who, in mid-October, announced that it would terminate business with companies whose principal activities involve exploration, distribution, marketing, or trading of oil and gas from shale or oil sands. The bank also ceased financing projects that are primarily involved in the transportation or export of oil and gas. These moves themselves follow controversy over the Dakota Access pipeline in the U.S. from mid-March that resulted in ING’s $2.5 billion divestment in the loan that financed the pipeline.

These measures prefigure what might be a more conspicuous trend of large institutional investors moving more rapidly away from fossil fuel investments and into green investments. In mid-December, the World Bank said it would end all financial support for oil and gas exploration by 2019. Around the same time, New York Governor Andrew Cuomo revealed a plan for the state’s common retirement fund, with over $200 billion in assets, to cease all new investments in entities with significant fossil-fuel related activities and to completely decarbonize its portfolio. Recently, HSBC pledged $100 billion to be spent on sustainable finance and investment over the next eight years in an effort to address climate change. Additionally, JP Morgan Chase committed $200 billion to similar clean-minded investments, Macquarie acquired the UK’s Green Investment Bank, and Deutsche Bank and Credit Agricole both made exits from coal lending. As the landscape of global finance shifts, it will be important to monitor how funds, banks, and insurers address the issues related to climate change.

 

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