Tag: Finance

Red States Move to Penalize Companies That Consider Climate Change When Making Investments

A number of conservative-leaning states, particularly those with a significant fossil fuel industry (e.g., Texas, West Virginia), have begun implementing polices and enacting laws that penalize companies which “pull away from the fossil fuel industry.”  Most of these laws focus on precluding state governmental entities, including pension funds, from doing business with companies that have adopted policies that take climate change into account, whether divesting from fossil fuels or simply considering climate change metrics when evaluating investments.

This trend is a troubling development for the American economy.  Irrespective of the merits of the policy, or fossil fuel investments generally, there are now an array of state governments and associated entities, reflecting a significant portion of the economy, that have adopted policies explicitly designed to remove climate change or other similar concerns from consideration when companies decide upon a course of action.  But there are other states (typically coastal “blue” states) that have enacted diametrically opposed policies, including mandatory divestments from fossil fuel investments (e.g., Maine).  This patchwork of contradictory state regulation has created a labyrinth of different concerns for companies to navigate.  And these same companies are also facing pressure from significant institutional investors, such as BlackRock, to consider ESG concerns when making investments.

Likely the most effective way to resolve these inconsistent regulations and guidance, and to alleviate the impact on the American economy, would be for the federal government to issue a clear set of policy guidelines and regulatory requirements.  (Even if these were subject to legal challenge, it would at least set a benchmark and provide general guidance.)  But the SEC, the most likely source of such regulations, has failed to meet its own deadlines for promulgating such regulations, and it is unclear when such guidance will be issued.

In the absence of a clear federal mandate, the contradictory policies adopted by different state governments will only apply additional burdens to companies doing business across multiple state jurisdictions, and by extension, to the economy of the United States.

“Republicans and right-leaning groups fighting climate-conscious policies that target fossil fuel companies are increasingly taking their battle to state capitals. Texas, West Virginia and Oklahoma are among states moving to bar officials from dealing with businesses that are moving to ditch fossil fuels or considering climate change in their own investments. Those steps come as major financial firms and other corporations adopt policies aligned with efforts to reduce greenhouse gas emissions.”

Article By Jacob H. Hupart of Mintz

For more environmental legal news, click here to visit the National Law Review.

©1994-2022 Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. All Rights Reserved.

Crossing the Wires of Energy and Cryptocurrency Policy: U.S. Congress Investigates the Environmental Impact of Crypto Mining

The rapid adoption of cryptocurrency and other popular blockchain applications has captured our global economy’s attention. Even as the value of cryptocurrencies slid from their all-time highs, the promise of these digital assets and the infrastructure being developed to support them has been transformative.

As with most emerging technologies, policymakers are still exploring the best approaches to regulating these new digital assets and business models. Questions about consumer protection, security, and the applicability of existing laws are to be expected; however, the environmental impact of these energy-intensive business practices has prompted considerable study and regulatory activity across the globe, including attention in the United States.

To understand the increasing energy demands associated with major cryptocurrencies – predominantly, Bitcoin and Ethereum – it is important to understand how many cryptocurrencies are generated in the first instance. Many countries, including China, have banned cryptocurrency mining, and, with the United States becoming the largest source of cryptocurrency mining activity, Congress began active investigations and hearings into the energy demands and environmental impacts in January 2022.

Proof of What? Why certain cryptocurrencies create high energy demands. 

Not all cryptocurrencies – or blockchain platforms, for that matter – are created equal in their energy demands. The goal of most major cryptocurrency platforms is to create a decentralized, distributed ledger, meaning that there is no one authority to verify the authenticity of transactions and ensure that assets are not spent twice, for example. There needs to be a trustworthy mechanism – a consensus system – to verify new transactions, add those transactions to the blockchain, and to confirm the creation of new tokens. Bitcoin alone has well over 200,000 transactions per day,[1] so it should not come as a surprise that these platforms take an enormous amount of processing power to maintain.

There are currently two primary ways that network participants lend their processing power, which are framing part of the modern energy policy debates around cryptocurrency. The first form is “proof of work,” which is the original method that Bitcoin and Ethereum 1.0 employ. When a group of transactions (a block) needs to be verified, all of the “mining” computers race to solve a complex math puzzle, and whoever wins gets to add the block to the chain and is rewarded in coins. The competitive nature of proof of work consensus systems has led to substantial increases in computing power provided by institutional cryptocurrency mining operations and, with that, higher energy demands.

The second form is “proof of stake,” which newer platforms like Cardano and ETH2 use, promises to require considerably less energy to operate. With this method, validators “stake” their currency for a chance at verifying new transactions and updating the blockchain. This method rewards long-term investment in a particular blockchain, rather than raw computing power. A validator is picked based on how much currency they have staked and how long it has been staked for. Once the block is verified, other validators must review and accept the data before it’s added to the blockchain. Then, everyone who participated in validating the block is rewarded with coins.

While proof of stake consensus systems are becoming more common, the dominant – and most valuable – cryptocurrencies are still generated through energy-intensive proof of work systems.

Turning out the lights on Crypto: China bans domestic mining and other countries follow.

China has been incredibly influential in the modern cryptocurrency debate around energy use. For several years, China was the cryptocurrency mining capital of the world, providing an average of two-thirds of the world’s processing power dedicated to Bitcoin mining through early 2021.[2] In June 2021, however, China banned all domestic cryptocurrency mining operations, citing the environmental impacts of Bitcoin mining energy demands among its concerns.[3]

As Bitcoin miners fled China, many relocated to neighboring countries, such as Kazakhstan, and the United States became the largest source of mining activity – an estimated 35.1% of global mining power.[4] The surge in Bitcoin mining activity in Kazakhstan has not been without its controversy. Many Kazakhstan-based crypto mining operations are powered by coal plants, and there has been considerable unrest sparked by rising fuel costs.[5]

With some countries experiencing negative impacts from cryptocurrency mining operations, several countries have followed China’s lead in banning cryptocurrencies. According to a 2021 report prepared by the Law Library of Congress, at least eight other countries – Egypt, Iraq, Qatar, Oman, Morocco, Algeria, Tunisia, and Bangladesh – have banned cryptocurrencies.[6] Many other countries have impliedly banned cryptocurrency or cryptocurrency exchanges, as well.[7]

U.S. Congress shines its spotlight on the energy demands of cryptocurrency mining.

Now home to over a third of the global computing power dedicated to mining bitcoin, the United States has turned its attention to domestic miners and their impacts on the environment and local economies.

In June 2021, U.S. policymakers were still predominantly focused on the consumer protection and security concerns raised by digital currencies; however, Senator Elizabeth Warren alluded to her growing concerns about the environmental costs of, particularly, proof of work mining.[8] On December 2, 2021, Senator Warren sent a letter requesting information on the environmental footprint of New York-based Bitcoin miner Greenridge Generation.[9] The letter observed that, “[g]iven the extraordinarily high energy usage and carbon emissions associated with Bitcoin mining, mining operations at Greenridge and other plants raise concerns about their impacts on the global environment, on local ecosystems, and on consumer electricity costs.”[10] Senator Warren’s concerns sparked several rounds of congressional oversight and inquiries into the environmental impacts of, particularly, proof of work cryptocurrencies, over the past month.

Committee Hearing on “Cleaning up Cryptocurrency” begins oversight and investigation into the energy impacts of blockchains.

On January 20, 2022, the U.S. House of Representatives Committee on Energy and Commerce’s Subcommittee on Oversight and Investigations held a hearing, where the externalities of cryptocurrency mining were the focus of the agenda. An early indicator of the Subcommittee’s views on the issue, the title for the hearing was “Cleaning up Cryptocurrency: The Energy Impacts of Blockchains.”[11]

The hearing focused heavily on the amount of energy used to power proof of work cryptocurrency mining. Bitcoin Mining has been widely criticized for the massive amounts of power it consumes – globally, more than 204 terawatt-hours as of January 2022. Although some operations are attempting to utilize renewable energy, the machines executing these algorithms consume enormous amounts of energy primarily sourced from fossil fuels.

The five industry experts testifying before the House Energy and Commerce Oversight Subcommittee had competing views on how regulators should address the energy consumption of cryptocurrencies—with some experts opining that the computational demands were a “feature, not a bug.”[12] Two of the experts – Brian Brooks, CEO of Bitfury Group, and Professor Ari Juels, Faculty member at Cornell Tech – debated the technical merits between proof of work and proof of stake systems, described earlier in this article.[13] Similarly, Gregory Zerzan, an attorney with Jordan Ramis, P.C. who previously held senior positions in the United States Government, encouraged the Subcommittee not to lose sight of the fact that cryptocurrencies are but “one aspect of a larger innovation, blockchain.”[14] Although the viewpoints of the experts varied considerably, there was a clear consensus among the experts: energy-efficient alternatives should guide the path forward.

John Belizaire, the founder and CEO of Soluna Computing, said that cryptocurrency mining could further accelerate the transition to renewable energy sources from an energy perspective.[15] Renewables currently suffer from one significant deficiency – intermittency. An example of this challenge is the so-called “duck curve,” which illustrates major differences between the demands for electricity as compared to the amount of renewable energy sources available throughout the day. For example, when the sun is shining, there is significantly more power than consumers need for a few hours per day; however, solar energy does not provide nearly enough energy when demand spikes in the late afternoon and evening.[16] While there has been progress in the development of lithium battery storage – a critical piece in solving the issues mentioned above– for the time being, deploying these batteries at scale is still too expensive.

In addressing gaps in battery storage, Belizaire testified that “Computing is a better battery.”[17] Computing, he states, “is an immediately deployable solution that can allow renewables to scale to their full potential today.”[18] Belizaire highlighted that, unlike other industrial consumers, cryptocurrency miners can turn their systems off when necessary, giving miners the ability to absorb excess energy from a given area’s electrical grid rather than straining it. This ability to start and stop or pause computing processes can increase grid resilience by absorbing excess energy from renewable resources that provide more power than the grid can handle. Brooks shared similar hopes for how Bitcoin mining could help stabilize electric grids, support the viability of renewable energy projects, and drive innovation in computing and cooling technology.[19]

Steve Wright, the former general manager of the Chelan County Public Utility District in Washington, testified that “the portability of cryptocurrency operations could be a benefit in terms of locating operations based on underutilized transmission and distribution capacity availability.”[20] Still, with ambitious goals to expand transmission and increase and integrate large amounts of carbon-free emitting generation, Wright testified that “substantial collaboration and coordination will be necessary to avoid cryptocurrency mining exacerbating an already very difficult problem.”[21]

Congressional Democrats continue the investigation into domestic mining operations and the Cryptomining Industry response.

The January 20, 2022 Hearing made clear that policymakers are doing their due diligence into the impact that the United States could experience as the number of domestic cryptocurrency mining operations increase. Commentary from the Hearing forecasted that scrutinizing the sources and costs of energy used in cryptocurrency mining would be a priority for Democrat members of Congress.

To that end, on January 27, 2022, eight Democrat members of Congress led by Senator Elizabeth Warren “sent letters to six cryptomining companies raising concerns over their extraordinarily high energy uses.”[22] Citing the same concerns raised in her December 2021 letter to Greenridge, Senator Warren and her colleagues observed that “Bitcoin mining’s power consumption has more than tripled from 2019 to 2021, rivaling the energy consumption of Washington state, and of entire countries like Denmark, Chile, and Argentina.”[23] To assist Congress in its investigation, Riot Blockchain, Marathon Digital Holdings, Stronghold Digital Mining, Bitdeer, Bitfury Group, and Bit Digital were all asked for information related to their mining operations, energy consumption, possible impacts on the climate and local environments, and the impact of electricity costs for American consumers.[24] Senator Warren and her colleagues requested written responses by no later than February 10, 2022, so this increased oversight will likely continue.

Even with increased oversight, current trends in crypto mining and renewables could soon make such inquiries a moot point. Amid the heated debate over the environmental impact of cryptocurrencies, miners are increasingly committed to changing the negative reputation that it has built over the years – especially as these operations move to the United States. In November of last year, Houston-based tech company Lancium announced that it raised $150 million to build bitcoin mines across Texas that will run on renewable energy.[25] In 2022, the company plans to launch over 2,000 megawatts of capacity across its multiple sites.[26] Bitcoin mining company Argo Blockchain, a company listed on the London Stock Exchange, secured a $25 million loan to fund its “green” mining operation.[27] The 320-acre site will only use renewable energy, the majority being hydroelectric.[28] This deal is set to transform Argo’s mining capacity and is expected to be completed in the first half of 2022.[29]

Capital Markets also appear to have a growing appetite for the development of green crypto mining. In April of last year, Gryphon Digital Mining raised $14 Million Series A to launch a zero-carbon footprint Bitcoin mining operation powered exclusively by renewables.[30] In a raise that closed in just over two weeks, institutional investors – who were significantly oversubscribed – accounted for over thirty percent of the round.[31]

As congressional, social, and economic pressures grow, it is evident that there is going to be a big focus on the sustainability of Bitcoin mining. As such, we may very well see announcements, like the deals mentioned above, well into 2022 and beyond.

FOOTNOTES

[1] Bitcoin Transactions Per Day, YCharts, https://ycharts.com/indicators/bitcoin_transactions_per_day (last visited Jan. 29, 2022).

[2] Bitcoin Mining Map, Cambridge Centre for Alternative Finance, https://ccaf.io/cbeci/mining_map (last visited Jan. 29, 2022) [“Bitcoin Mining Map”].

[3] Samuel Shen & Andrew Galbraith, China’s ban forces some bitcoin miners to flee overseas, others sell out, Reuters, June 25, 2021, https://www.reuters.com/technology/chinas-ban-forces-some-bitcoin-miners-flee-overseas-others-sell-out-2021-06-25/ (last visited Jan. 29, 2022).

[4] See Bitcoin Mining Map.

[5] Tom Wilson, Bitcoin network power slumps as Kazakhstan crackdown hits crypto miners, Reuters, Jan. 7, 2022, https://www.reuters.com/markets/europe/bitcoin-network-power-slumps-kazakhstan-crackdown-hits-crypto-miners-2022-01-06/ (last visited Jan. 29, 2022).

[6] Regulation of Cryptocurrency Around the World: November 2021 Update, Global Legal Research Directorate, The Law Library of Congress, available at https://tile.loc.gov/storage-services/service/ll/llglrd/2021687419/2021687419.pdf (last visited Jan. 29, 2022).

[7] Id.

[8] Press Release, United States Senate Committee on Banking, Housing, and Urban Affairs, At Hearing, Warren Delivers Remarks on Digital Currencies (June 9, 2021), https://www.banking.senate.gov/newsroom/majority/at-hearing-warren-delivers-remarks-on-digital-currency (last visited Jan. 29, 2022).

[9] Elizabeth Warren, Letter to Greenridge Generation on Crypto, Dec. 2, 2021, available at https://www.warren.senate.gov/imo/media/doc/2021.12.2.%20Letter%20to%20Greenidge%20Generation%20on%20Crypto.pdf (last visited Jan. 29, 2022).

[10] Id. at p.2.

[11] Hearing Notice, United States House Committee on Energy & Commerce, Hearing on “Cleaning Up Cryptocurrency: The Energy Impacts of Blockchains” (Jan. 20, 2022), https://energycommerce.house.gov/committee-activity/hearings/hearing-on-cleaning-up-cryptocurrency-the-energy-impacts-of-blockchains (last visited Jan. 29, 2022) [the “January 20 Hearing”].

[12] January 20 Hearing Testimony. See also Statement of Brian P. Brooks before House Committee (Jan. 20, 2022), available at https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Witness%20Testimony_Brooks_OI_2022.01.20_0.pdf  (last visited Jan. 29, 2022) [the “Brooks Statement”].

[13] See, e.g., Brooks Statement; Statement of Prof. Ari Juels before House Committee (Jan. 20, 2022), available at https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Witness%20Testimony_Juels_OI_2022.01.20.pdf (last visited Jan. 29, 2022) [the “Juels Statement”].

[14] Statement of Gregory Zerzan before House Committee (Jan. 20, 2022), available at https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Witness%20Testimony_Zerzan_OI_2022.01.20.pdf (last visited Jan. 29, 2022).

[15] See, e.g., Statement of John Belizaire before House Committee (Jan. 20, 2022), available at https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Witness%20Testimony_Belizaire_OI_2022.01.20_0.pdf (last visited Jan. 29, 2022) [the “Belizaire Statement”].

[16] Office of Energy Efficiency & Renewable Energy, Confronting the Duck Curve: How to Address Over-Generation of Solar Energy (October 12, 2017)

https://www.energy.gov/eere/articles/confronting-duck-curve-how-address-over-generation-solar-energy (last visited Jan. 29, 2022).

[17] See, e.g., Belizaire Statement, p.4.

[18] Id.

[19] See generally Brooks Statement, pp.8-10.

[20] See, e.g., Statement of Steve Wright before House Committee, p.5 (January 20, 2022) available at https://energycommerce.house.gov/sites/democrats.energycommerce.house.gov/files/documents/Witness%20Testimony_Wright_OI_2022.01.20.pdf (last visited Jan. 29, 2022) [the “Wright Statement”].

[21] Id. p.9.

[22] Press Release, Office of Senator Elizabeth Warren, Warren, Colleagues Press Six Cryptomining Companies on Extraordinarily High Energy Use and Climate Impacts (Jan. 27, 2022), available at https://www.warren.senate.gov/newsroom/press-releases/warren-colleagues-press-six-cryptomining-companies-on-extraordinarily-high-energy-use-and-climate-impacts (last visited Jan. 29, 2022).

[23] Id.

[24] Id.

[25] MacKenzie Sigalos, This Houston Tech Company wants to build renewable energy-run bitcoin mines across Texas CNBC (November 23, 2021), https://www.cnbc.com/2021/11/23/lancium-raises-150-million-for-renewable-run-bitcoin-mines-in-texas.html (last visited Jan 31, 2022).

[26] Id.

[27] Namcios Bitcoin Magazine, Argo blockchain buys Hydro data centers to realize Green Bitcoin Mining Vision, (May 13, 2021), https://www.nasdaq.com/articles/argo-blockchain-buys-hydro-data-centers-to-realize-green-bitcoin-mining-vision-2021-05-13 (last visited Jan 31, 2022).

[28] Id.

[29] Id.

[30] GlobeNewswire News Room, Gryphon Digital Mining raises $14 million to launch bitcoin mining operation with zero carbon footprint, (April 13, 2021), https://www.globenewswire.com/newsrelease/2021/04/13/2209346/0/en/Gryphon-Digital-Mining-Raises-14-Million-to-Launch-Bitcoin-Mining-Operation-with-Zero-Carbon-Footprint.html (last visited Jan 31, 2022).

[31] Id.

Copyright ©2022 Nelson Mullins Riley & Scarborough LLP
For more articles about cryptocurrency, visit the NLR Financial Securities & Banking section.

CFPB to Examine College Lending Practices

On January 20, the CFPB announced that it would begin examining the operations of post-secondary schools that offer private loans directly to students and update its exam procedures to include a new section on institutional student loans.  The CFPB highlights its concern about the student borrower experience in light of alleged past abuses at schools that were previously sued by the CFPB for unfair and abusive practices in connection with their in-house private loan programs.

When examining institutions offering private education loans, in addition to looking at general lending issues, CFPB examiners will be looking at the following areas:

  • Placing enrollment or attendance restrictions on students with loan delinquencies;
  • Withholding transcripts;
  • Accelerating payments;
  • Failing to issue refunds; and
  • Maintaining improper lending relationships

This announcement was accompanied by a brief remark from CFPB Director Chopra:  “Schools that offer students loans to attend their classes have a lot of power over their students’ education and financial future.  It’s time to open up the books on institutional student lending to ensure all students with private student loans are not harmed by illegal practices.”

Putting it Into Practice:  The CFPB’s concern with the experience of student borrowers is in line with a number of enforcement actions pursued by the Bureau against post-secondary schools.  The education loan exam procedures manual is intended for use by Bureau examiners, and is available as a resource to those subject to its exams. These procedures will be incorporated into the Bureau’s general supervision and examination manual.

Article By Moorari Shah, A.J. S. Dhaliwal, and Pouneh Almasi of Sheppard, Mullin, Richter & Hampton LLP

For more financial legal news, click here to visit the National Law Review.

Copyright © 2022, Sheppard Mullin Richter & Hampton LLP.

SEC Rejects Listing of Two Bitcoin ETFs

The SEC rejected two proposals to list and trade shares in two Bitcoin exchange-traded funds (“ETFs”).

The SEC rejected a proposal from NYSE Arca, Inc. (“Arca”) to list and trade shares of the Valkyrie Bitcoin Fund. The SEC also rejected a proposal from CBOE BZX Exchange, Inc. (“BZX”) to list and trade shares of the Kryptoin Bitcoin ETF Trust.

The SEC assessed whether the exchanges (i) had a comprehensive surveillance-sharing agreement with a significant, regulated market, and (ii) could effectively prevent fraudulent and manipulative activity. In the rejected proposals, the SEC noted its concerns over the abilities of the exchanges to adequately meet the requirements under SEA Section 6(b)(5) (“Determination by Commission Requisite to Registration of Applicant as a National Securities Exchange”) in protecting investors and the public interest by preventing fraudulent and manipulative practices.

The SEC rejected Arca’s argument that (i) liquidity, (ii) price arbitrage, and (iii) frameworks to value assets would be sufficient to mitigate potential manipulation.

Similarly, the SEC rejected BZX’s proposal, concluding “that BZX has not established that it has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to bitcoin,” and “that BZX has not established that other means to prevent fraudulent and manipulative acts and practices are sufficient to justify dispensing with the requisite surveillance-sharing agreement.”

As a result, the SEC found that both exchanges had failed to prove that they could meet their burdens under SEA Section 6(b)(5).

© Copyright 2021 Cadwalader, Wickersham & Taft LLP
For more articles on cryptocurrency exchanges, visit the NLR Financial Securities & Banking.

CFPB Solicits Whistleblowers to Strengthen Enforcement of Consumer Financial Protection Laws

In its revamped whistleblower webpage, the CFPB is enlisting the help of whistleblowers to provide tips about the following issues:

  • Any discrimination related to consumer financial products or services or small businesses
  • Any use of artificial intelligence/machine learning models that is based on flawed or incomplete data sets, that uses proxies for race, gender, or other group characteristics, or that impacts particular groups or classes of people more than others;
  • Misleading or deceptive advertising of consumer financial products or services, including mortgages
  • Failure to collect, maintain, and report accurate mortgage loan application and origination data
  • Failure to provide or use accurate consumer reporting information
  • Failure to review mortgage borrowers’ loss mitigation applications in a timely manner
  • Any unfair, deceptive, or abusive act or practice with respect to any consumer financial product or service.

The CFPB has also announced that it seeks tips to help it combat the role of Artificial Intelligence in enabling intentional and unintentional discrimination in decision-making systems.  For example, a recent study of algorithmic mortgage underwriting revealed that Black and Hispanic families have been more likely to be denied a mortgage compared to similarly situated white families.

Proposed CFPB Whistleblower Reward Program

Currently, there is no whistleblower reward program at the CFPB and sanctions collected in CFPB enforcement actions do not qualify for SEC related action whistleblower awards.  In light of the success of the SEC’s Whistleblower Program as an effective tool to protect investors and strengthen capital markets, the CFPB requested that Congress establish a rewards program to strengthen the CFPB’s enforcement of consumer financial protection laws.

In September 2021, Senator Catherine Cortez Masto introduced the Financial Compensation for Consumer Financial Protection Bureau Whistleblowers Act (S. 2775), which would establish a whistleblowers rewards program at the CFPB similar to the SEC Whistleblower Program.  It would authorize the CFPB to reward whistleblowers between 10% to 30% of collected monetary sanctions in a successful enforcement action where the penalty exceeds $1 million.  And in cases involving monetary penalties of less than $1 million, the CFPB would be able to award any single whistleblower 10% of the amount collected or $50,000, whichever is greater.

The Financial Compensation for CFPB Whistleblowers Act is cosponsored by Chairman of the Senate Banking, Housing, and Urban Affairs Committee Senator Sherrod Brown and Senators Dick Durbin, Elizabeth Warren, Jeff Merkley, Richard Blumenthal, and Tina Smith. In the House, Representative Al Green introduced a companion bill (H.R. 5484).

A whistleblower reward program at the CFPB could significantly augment enforcement of consumer financial protection laws, including laws barring unfair, deceptive, or abusive acts and practices.  The CFPB has authority over a broad array of consumer financial products and services, including mortgages, deposit taking, credit cards, loan servicing, check guaranteeing, collection of consumer report data, debt collection associated with consumer financial products and services, real estate settlement, money transmitting, and financial data processing.  In addition, the CFPB is the primary consumer compliance supervisory, enforcement, and rulemaking authority over depository institutions with more than $10 billion in assets.

Hopefully, Congress will act swiftly to enact the Financial Compensation for CFPB Whistleblowers Act.

Protection for CFPB Whistleblowers

Although Congress did not establish a whistleblower reward program when it created the CFPB, it included a strong whistleblower protection provision in the Consumer Financial Protection Act of 2010 (CFPA).  The anti-retaliation provision of the Consumer Financial Protection Act provides a cause of action for corporate whistleblowers who suffer retaliation for raising concerns about potential violations of rules or regulations of the CFPC.

Workers Protected by the CFPA Anti-Retaliation Law

The term “covered employee” means “any individual performing tasks related to the offering or provision of a consumer financial product or service.”  The CFPA defines a “consumer financial product or service” to include “a wide variety of financial products or services offered or provided for use by consumers primarily for personal, family, or household purposes, and certain financial products or services that are delivered, offered, or provided in connection with a consumer financial product or service . . . Examples of these include . .. residential mortgage origination, lending, brokerage and servicing, and related products and services such as mortgage loan modification and foreclosure relief; student loans; payday loans; and other financial services such as debt collection, credit reporting, credit cards and related activities, money transmitting, check cashing and related activities, prepaid cards, and debt relief services.”

Scope of Protected Whistleblowing About Consumer Financial Protection Violations

The CFPA protects disclosures made to an employer, to the CFPB or any State, local, or Federal, government authority or law enforcement agency concerning any act or omission that the employee reasonably believes to be a violation of any CFPB regulation or any other consumer financial protection law that the Bureau enforces. This includes several federal laws regulating “unfair, deceptive, or abusive practices . . . related to the provision of consumer financial products or services.”

Some of the matters the CFPB regulates include:

  • kickbacks paid to mortgage issuers or insurers;
  • deceptive advertising;
  • discriminatory lending practices, including a violation of the Equal Credit Opportunity Act (“ECOA”);
  • excessive fees;
  • any false, deceptive, or misleading representation or means in connection with the collection of any debt; and
  • debt collection activities that violate the Fair Debt Collection Practices Act (FDCPA).

Some of the consumer financial protection laws that the CFPB enforces include:

  • Real Estate Settlement Procedures Act;
  • Home Mortgage Disclosure Act;
  • Equal Credit Opportunity Act;
  • Truth in Lending Act;
  • Truth in Savings Act;
  • Fair Credit Billing Act;
  • Fair Credit Reporting Act;
  • Electronic Fund Transfer Act;
  • Consumer Leasing Act;
  • Fair Debt Collection Practices Act;
  • Home Owners Protection Act; and
  • Secure and Fair Enforcement for Mortgage Licensing Act

Reasonable Belief Standard in Banking Whistleblower Retaliation Cases

The CFPA whistleblower protection law employs a reasonable belief standard.  As long as the plaintiff’s belief is reasonable, the whistleblower is protected, even if the whistleblower makes a mistake of law or fact about the underlying violation of a law or regulation under the CFPB’s jurisdiction.

Prohibited Retaliation

The CFPA anti-retaliation law proscribes a broad range of adverse employment actions, including terminating, “intimidating, threatening, restraining, coercing, blacklisting or disciplining, any covered employee or any authorized representative of covered employees” because of the employee’s protected whistleblowing.

Proving CFPA Whistleblower Retaliation

To prevail in a CFPA whistleblower retaliation claim, the whistleblower need only prove that his or her protected conduct was a contributing factor in the adverse employment action, i.e., that the protected activity, alone or in combination with other factors, affected in some way the outcome of the employer’s decision.

Where the employer takes the adverse employment action “shortly after” learning about the protected activity, courts may infer a causal connection between the two.  Van Asdale v. Int’l Game Tech., 577 F.3d 989, 1001 (9th Cir. 2009).

Filing a CFPA Financial Whistleblower Retaliation Claim

CFPA complaints are filed with OSHA, and the statute of limitations is 180 days from the date when the alleged violation occurs, which is the date on which the retaliatory decision has been both made and communicated to the whistleblower.

The complaint need not be in any particular form and can be filed orally with OSHA. A CFPA complaint need not meet the stringent pleading requirements that apply in federal court, and instead the administrative complaint “simply alerts OSHA to the existence of the alleged retaliation and the complainant’s desire that OSHA investigate the complaint.” If the complaint alleges each element of a CFPA whistleblower retaliation claim and the employer does not show by clear and convincing that it would have taken the same action in the absence of the alleged protected activity, OSHA will conduct an investigation.

OSHA investigates CFPA complaints to determine whether there is reasonable cause to believe that protected activity was a contributing factor in the alleged adverse action.  If OSHA finds a violation, it can order reinstatement of the whistleblower and other relief.

Article By Jason Zuckerman of Zuckerman Law

For more financial legal news, click here to visit the National Law Review.

© 2021 Zuckerman Law

In the Coming ‘Metaverse’, There May Be Excitement but There Certainly Will Be Legal Issues

The concept of the “metaverse” has garnered much press coverage of late, addressing such topics as the new appetite for metaverse investment opportunities, a recent virtual land boom, or just the promise of it all, where “crypto, gaming and capitalism collide.”  The term “metaverse,” which comes from Neal Stephenson’s 1992 science fiction novel “Snow Crash,” is generally used to refer to the development of virtual reality (VR) and augmented reality (AR) technologies, featuring a mashup of massive multiplayer gaming, virtual worlds, virtual workspaces, and remote education to create a decentralized wonderland and collaborative space. The grand concept is that the metaverse will be the next iteration of the mobile internet and a major part of both digital and real life.

Don’t feel like going out tonight in the real world? Why not stay “in” and catch a show or meet people/avatars/smart bots in the metaverse?

As currently conceived, the metaverse, “Web 3.0,” would feature a synchronous environment giving users a seamless experience across different realms, even if such discrete areas of the virtual world are operated by different developers. It would boast its own economy where users and their avatars interact socially and use digital assets based in both virtual and actual reality, a place where commerce would presumably be heavily based in decentralized finance, DeFi. No single company or platform would operate the metaverse, but rather, it would be administered by many entities in a decentralized manner (presumably on some open source metaverse OS) and work across multiple computing platforms. At the outset, the metaverse would look like a virtual world featuring enhanced experiences interfaced via VR headsets, mobile devices, gaming consoles and haptic gear that makes you “feel” virtual things. Later, the contours of the metaverse would be shaped by user preferences, monetary opportunities and incremental innovations by developers building on what came before.

In short, the vision is that multiple companies, developers and creators will come together to create one metaverse (as opposed to proprietary, closed platforms) and have it evolve into an embodied mobile internet, one that is open and interoperable and would include many facets of life (i.e., work, social interactions, entertainment) in one hybrid space.

In order for the metaverse to become a reality, that is, successfully link current gaming and communications platforms with other new technologies into a massive new online destination – many obstacles will have to be overcome, even beyond the hardware, software and integration issues. The legal issues stand out, front and center. Indeed, the concept of the metaverse presents a law school final exam’s worth of legal questions to sort out.  Meanwhile, we are still trying to resolve the myriad of legal issues presented by “Web 2.0,” the Internet we know it today. Adding the metaverse to the picture will certainly make things even more complicated.

At the heart of it is the question of what legal underpinnings we need for the metaverse infrastructure – an infrastructure that will allow disparate developers and studios, e-commerce marketplaces, platforms and service providers to all coexist within one virtual world.  To make it even more interesting, it is envisioned to be an interoperable, seamless experience for shoppers, gamers, social media users or just curious internet-goers armed with wallets full of crypto to spend and virtual assets to flaunt.  Currently, we have some well-established web platforms that are closed digital communities and some emerging ones that are open, each with varying business models that will have to be adapted, in some way, to the metaverse. Simply put, the greater the immersive experience and features and interactions, the more complex the related legal issues will be.

Contemplating the metaverse, these are just a few of the legal issues that come to mind:

  • Personal Data, Privacy and Cybersecurity – Privacy and data security lawyers are already challenged with addressing the global concerns presented by varying international approaches to privacy and growing threats to data security. If the metaverse fulfills the hype and develops into a 3D web-based hub for our day-to-day lives, the volume of data that will be collected will be exponentially greater than the reams of data already collected, and the threats to that data will expand as well. Questions to consider will include:
    • Data and privacy – What’s collected? How sensitive is it? Who owns or controls it? The sharing of data will be the cornerstone of a seamless, interoperable environment where users and their digital personas and assets will be usable and tradeable across the different arenas of the metaverse.  How will the collection, sharing and use of such data be regulated?  What laws will govern the collection of data across the metaverse? The laws of a particular state?  Applicable federal privacy laws? The GDPR or other international regulations? Will there be a single overarching “privacy policy” governing the metaverse under a user and merchant agreement, or will there be varying policies depending on which realm of the metaverse you are in? Could some developers create a more “privacy-focused” experience or would the personal data of avatars necessarily flow freely in every realm? How will children’s privacy be handled and will there be “roped off,” adults-only spaces that require further authentication to enter? Will the concepts that we talk about today – “personal information” or “personally identifiable information” – carry over to a world where the scope of available information expands exponentially as activities are tracked across the metaverse?
    • Cybersecurity: How will cybersecurity be managed in the metaverse? What requirements will apply with respect to keeping data secure? How will regulation or site policies evolve to address deep fakes, avatar impersonation, trolling, stolen biometric data, digital wallet hacks and all of the other cyberthreats that we already face today and are likely to be exacerbated in the metaverse? What laws will apply and how will the various players collaborate in addressing this issue?
  • Technology Infrastructure: The metaverse will be a robust computing-intensive experience, highlighting the importance of strong contractual agreements concerning cloud computing, IoT, web hosting, and APIs, as well as software licenses and hardware agreements, and technology service agreements with developers, providers and platform operators involved in the metaverse stack. Performance commitments and service levels will take on heightened importance in light of the real-time interactions that users will expect. What is a meaningful remedy for a service level failure when the metaverse (or a part of the metaverse) freezes? A credit or other traditional remedy?  Lawyers and technologists will have to think creatively to find appropriate and practical approaches to this issue.  And while SaaS and other “as a service” arrangements will grow in importance, perhaps the entire process will spawn MaaS, or “Metaverse as a Service.”
  • Open Source – Open source, already ubiquitous, promises to play a huge role in metaverse development by allowing developers to improve on what has come before. Whether or not the obligations of common open source licenses will be triggered will depend on the technical details of implementation. It is also possible that new open source licenses will be created to contemplate development for the metaverse.
  • Quantum Computing – Quantum computing has dramatically increased the capabilities of computers and is likely to continue to do over the coming years. It will certainly be one of the technologies deployed to provide the computing speed to allow the metaverse to function. However, with the awesome power of quantum computing comes threats to certain legacy protections we use today. Passwords and traditional security protocols may be meaningless (requiring the development of post-quantum cryptography that is secure against both quantum and traditional computers). With raw, unchecked quantum computing power, the metaverse may be subject to manipulation and misuse. Regulation of quantum computing, as applied to the metaverse and elsewhere, may be needed.
  • Antitrust: Collaboration is a key to the success of the metaverse, as it is, by definition, a multi-tenant environment. Of course collaboration amongst competitors may invoke antitrust concerns. Also, to the extent that larger technology companies may be perceived as leveraging their position to assert unfair control in any virtual world, there may be additional concerns.
  • Intellectual Property Issues: A host of IP issues will certainly arise, including infringement, licensing (and breaches thereof), IP protection and anti-piracy efforts, patent issues, joint ownership concerns, safe harbors, potential formation of patent cross-licensing organizations (which also may invoke antitrust concerns), trademark and advertising issues, and entertaining new brand licensing opportunities. The scope of content and technology licenses will have to be delicately negotiated with forethought to the potential breadth of the metaverse (e.g., it’s easy to limit a licensee’s rights based on territory, for example, but what about for a virtual world with no borders or some borders that haven’t been drawn yet?). Rightsholders must also determine their particular tolerance level for unauthorized digital goods or creations. One can envision a need for a DMCA-like safe harbor and takedown process for the metaverse. Also, akin to the litigation that sprouted from the use of athletes’ or celebrities’ likenesses (and their tattoos) in videogames, it’s likely that IP issues and rights of publicity disputes will go way up as people’s virtual avatars take on commercial value in ways that their real human selves never did.
  • Content Moderation. Section 230 of the Communications Decency Act (CDA) has been the target of bipartisan criticism for several years now, yet it remains in effect despite its application in some distasteful ways. How will the CDA be applied to the metaverse, where the exchange of third party content is likely to be even more robust than what we see today on social media?  How will “bad actors” be treated, and what does an account termination look like in the metaverse? Much like the legal issues surrounding offensive content present on today’s social media platforms, and barring a change in the law, the same kinds of issues surrounding user-generated content will persist and the same defenses under Section 230 of the Communications Decency Act will be raised.
  • Blockchain, DAOs, Smart Contract and Digital Assets: Since the metaverse is planned as a single forum with disparate operators and users, the use of a blockchain (or blockchains) would seem to be one solution to act as a trusted, immutable ledger of virtual goods, in-world currencies and identity authentication, particularly when interactions may be somewhat anonymous or between individuals who may or may not trust each other and in the absence of a centralized clearinghouse or administrator for transactions. The use of smart contracts may be pervasive in the metaverse.  Investors or developers may also decide that DAOs (decentralized autonomous organizations) can be useful to crowdsource and fund opportunities within that environment as well.  Overall, a decentralized metaverse with its own discrete economy would feature the creation, sale and holding of sovereign digital assets (and their free use, display and exchange using blockchain-based payment networks within the metaverse). This would presumably give NFTs a role beyond mere digital collectibles and investment opportunities as well as a role for other forms of digital currency (e.g., cryptocurrency, utility tokens, stablecoins, e-money, virtual “in game” money as found in some videogames, or a system of micropayments for virtual goods, services or experiences).  How else will our avatars be able to build a new virtual wardrobe for what is to come?

With this shift to blockchain-based economic structures comes the potential regulatory issues behind digital currencies. How will securities laws view digital assets that retain and form value in the metaverse?  Also, as in life today, visitors to the metaverse must be wary of digital currency schemes and meme coin scams, with regulators not too far behind policing the fraudsters and unlawful actors that will seek opportunities in the metaverse. While regulators and lawmakers are struggling to keep up with the current crop of issues, and despite any progress they may make in that regard, many open issues will remain and new issues will be of concern as digital tokens and currency (and the contracts underlying them) take on new relevance in a virtual world.

Big ideas are always exciting. Watching the metaverse come together is no different, particularly as it all is happening alongside additional innovations surrounding the web, blockchain and cryptocurrency (and, more than likely, updated laws and regulations). However, it’s still early. And we’ll have to see if the current vision of the metaverse will translate into long-term, concrete commercial and civic-minded opportunities for businesses, service providers, developers and individual artists and creators.  Ultimately, these parties will need to sort through many legal issues, both novel and commonplace, before creating and participating in a new virtual world concept that goes beyond the massive multi-user videogame platforms and virtual worlds we have today.

Article By Jeffrey D. Neuburger of Proskauer Rose LLP. Co-authored by  Jonathan Mollod.

For more legal news regarding data privacy and cybersecurity, click here to visit the National Law Review.

© 2021 Proskauer Rose LLP.

Don’t Use “Build Back Better” to Sabotage the False Claims Act

Congress is on the verge of setting a dangerous precedent.  As part of the Build Back Better Act, it has added two provisions equivalent to a “get out of jail free card” for Big Banks that violate federal law when they hand out billions in federal mortgage-related benefits.   The two provisions create exemptions to False Claims Act liability by creating blanket immunity from liability when banks fail to exercise due diligence, violate FHA housing regulations, or even directly violate federal laws such as the Truth in Lending Act.

It is obvious why banks want to have their federally sponsored mortgage practices immunized from exposure to the False Claims Act (“FCA”).  The FCA works remarkably well and is widely recognized as “the most powerful tool the American people have to protect the government from fraud.”   The law has directly recovered over $64.450 billion in sanctions from fraudsters since Congress modernized it in 1986.  During the debates on the massive trillion-dollar infrastructure laws enacted or debated this year, corporate lobbyists have been extremely active in successfully preventing Congress from adding any new anti-fraud measures to protect taxpayers from fraud.  As part of these efforts, they targeted the False Claims Act as enemy #1 and already have blocked one key amendment needed to close some weaknesses in that law.

With the Build Back Better Act, these corporate lobbyists have taken their opposition to effective anti-fraud laws to a higher level.  Instead of trying to repeal the FCA, they are simply exempting Big Banks from liability under that law in two new programs.  It is obvious why the Big Banks want the exemption from FCA liability.  As a result of illegal or irresponsible lending and foreclosure practices, such as those that fueled the 2008 financial collapse, banks have had to pay billions in sanctions to the United States.

Two words explain why the FCA is “the most powerful tool” protecting taxpayers from fraud:  Whistleblowers and sanctions.  If you accept federal taxpayer monies, you are required to spend that money according to your contractual agreement or the law.  The FCA’s first secret weapon is whistleblowers.  The law encourages whistleblowers, known as qui tam “relators,” to report violations of the FCA.  Whistleblowers disclosures trigger the overwhelming majority of FCA cases, and the law incentivizes employees to risk their careers to serve the public interest. The second secret weapon is how you prove liability.  Second, when an institution accepts federal monies (such as banks that operate various federally sponsored loan programs), liability can attach if the institution acts in “deliberate ignorance of the truth” when spending federal dollars.  Similarly, if payments are made with “reckless disregard of the truth,” liability can attach.  In other words, corporations (including banks) that accept federal money must ensure that these monies are spent as required by law, regulation, or contract.  Safeguards must be in place to prevent fraud.  If a bank does not have adequate compliance programs to protect against fraud, it cannot plead ignorance when the law is broken and taxpayers are ripped off.

These two key elements of the False Claims Act are precisely what the banking lobby is attempting to undermine through the Build Back Better Act.  The tactics employed by the Big Banks are somewhat devious.  They are doing an end-run around the False Claims Act by exempting themselves from having to engage in any due diligence when spending billions in federal dollars.  The banks are seeking to add language to the Build Back Better Act that will immunize themselves from liability under the False Claims Act when they make payments in “reckless disregard” to the legality of those payments.  The immunities they are seeking legalize “deliberate ignorance” in the use of taxpayer money, in complete defiance of the False Claims Act. Thus, whistleblowers who report these frauds will be stripped of protections they have under the False Claims Act, and the federal government will have no effective way to recover damages from these frauds.

What language in the Build Back Better Act creates an exemption to False Claims Act liability?

Two highly technical provisions are deeply buried within the 2135 pages of the Build Back Better Act’s legislative text. The provisions are sections 40201 and 40202 of the Build Back Better Act.  These two sections establish helpful programs that will provide needed financial support to first-generation homebuyers.  Section 40201(d)(5) would provide $10 billion in down payment assistance. Section 40202(f) would give an interest rate reduction on new FHA 20-year mortgage products to first-time homeowners with a potential value of $60 billion.  But the banking lobby has corrupted these otherwise well-meaning programs. The exemptions obtained by the banks are incubators for massive fraud.  It permits the Big Banks to escape any liability when they abuse the generosity of taxpayers and dole out billions to unqualified individuals.

How do the exemptions work?  To qualify for these taxpayer-financed benefits, an applicant simply has to “attest” that they are first-time/first-generation homebuyers.  That would be the end of the inquiry a bank would need to approve making a payment from the billions allocated in these two programs. Anyone could simply stroll into a bank and “attest” to being such a first-time homebuyer and would thereafter qualify for the federal benefits.  The banks would not be required to do any diligence of their own to confirm the borrower’s eligibility.  Willful ignorance would be legalized.  Reckless disregard in the handling of taxpayer monies would be permitted under this law.  Safeguards, such as requiring banks to adhere to the Truth in Lending Act, which requires verification of a borrower’s statements, would not apply.

Under Sections 40201(d)(5) and 40202(f), banks will not be held liable once they are lied to, even if the bank has reason to know that the borrower is not eligible for the federal payout.  Banks can spend taxpayer money even if the information on an applicant’s loan application directly contradicts the borrower’s attestation that they are a first-time homeowner.  Given the lack of any compliance standards, the temptation to engage in fraud in these programs will be overwhelming.

Permitting banks to escape liability under the False Claims Act opens the door to paying billions of dollars in benefits to unqualified persons.  Such payments rip off the taxpayers and severely hurt all honest first-generation homebuyers denied benefits.  For every fraudster who benefits from this program, an honest homebuyer will be left in the cold due to the reckless disregard of the banks.

Congress should never use a back-door procedure to undermine the False Claim Act, as it sets a dangerous precedent.  It is a devious way to undermine America’s “most effective” anti-fraud law.  Instead of undermining the False Claims Act by granting immunities to Big Banks, Congress should be strengthening anti-fraud laws to protect the taxpayers and ensure that the trillions of dollars spent on COVID-19 relief programs and infrastructure improvement are lawfully spent in the public interest.

Copyright Kohn, Kohn & Colapinto, LLP 2021. All Rights Reserved.
For more articles about banking and finance, visit the NLR Financial, Securities & Banking section.

OFAC Reaffirms Focus on Virtual Currency With Updated Sanctions Law Guidance

On October 15, 2021, the US Department of the Treasury’s Office of Foreign Asset Control (OFAC) announced updated guidance for virtual currency companies in meeting their obligations under US sanctions laws. On the same day, OFAC also issued guidance clarifying various cryptocurrency-related definitions.

Coming on the heels of the Anti-Money Laundering Act of 2020—and in the context of the Biden administration’s effort to crackdown on ransomware attacks—the recent guidance is the latest indication that regulators are increasingly focusing on virtual currency and blockchain. In light of these developments, virtual currency market participants and service providers should ensure they are meeting their respective sanctions obligations by employing a “risk-based” anti-money laundering and sanctions compliance program.

This update highlights the government’s continued movement toward subjecting the virtual currency industry to the same requirements, scrutiny and consequences in cases of noncompliance as applicable to traditional financial institutions.

IN DEPTH

The release of OFAC’s Sanctions Compliance Guidance for the Virtual Currency Industry indicates an increasing expectation for diligence as it has now made clear on several occasions that sanctions compliance “obligations are the same” for virtual currency companies who must employ an unspecified “risk-based” program (See: OFAC Consolidated Frequently asked Questions 560). OFAC published it with the stated goal of “help[ing] the virtual currency industry prevent exploitation by sanctioned persons and other illicit actors.”

With this release, OFAC also provided some answers and updates to two of its published sets of “Frequently Asked Questions.”

FAQ UPDATES (FAQ 559 AND 546)

All are required to comply with the US sanctions compliance program, including persons and entities in the virtual currency and blockchain community. OFAC has said time and again that a “risk-based” program is required but that “there is no single compliance program or solution suitable for all circumstances” (See: FAQ 560). While market participants and service providers in the virtual currency industry must all comply, the risk of violating US sanctions are most acute for certain key service providers, such as cryptocurrency exchanges and over-the-counter (OTC) desks that facilitate large volumes of virtual currency transactions.

OFAC previously used the term “digital currency” when it issued its first FAQ and guidance on the subject (FAQ 560), which stated that sanctions compliance is applicable to “digital currency” and that OFAC “may include as identifiers on the [Specially Designated Nationals and Blocked Persons] SDN List specific digital currency addresses associated with blocked persons.” Subsequently, OFAC placed certain digital currency addresses on the SDN List as identifiers.

While OFAC previously used the term “digital currency,” in more recent FAQs and guidance, it has used a combination of the terms “digital currency” and “virtual currency” without defining those terms until it released FAQ 559.

In FAQ 559, OFAC defines “virtual currency” as “a digital representation of value that functions as (i) a medium of exchange; (ii) a unit of account; and/or (iii) a store of value; and is neither issued nor granted by any jurisdiction.” This is a broad definition but likely encompasses most assets, which are commonly referred to as “cryptocurrency” or “tokens,” as most of these assets may be considered as “mediums of exchange.”

OFAC also defines “digital currency” as “sovereign cryptocurrency, virtual currency (non-fiat), and a digital representation of fiat currency.” This definition appears to be an obvious effort by OFAC to make clear that its definitions include virtual currencies issued or backed by foreign governments and stablecoins.

The reference to “sovereign cryptocurrency” is focused on cryptocurrency issued by foreign governments, such as Venezuela. This is not the first time OFAC has focused on sovereign cryptocurrency. It ascribed the use of sovereign backed cryptocurrencies as a high-risk vector for US sanctions circumvention. Executive Order (EO) 13827, which was issued on March 19, 2018, explicitly stated:

In light of recent actions taken by the Maduro regime to attempt to circumvent U.S. sanctions by issuing a digital currency in a process that Venezuela’s democratically elected National Assembly has denounced as unlawful, hereby order as follows: Section 1. (a) All transactions related to, provision of financing for, and other dealings in, by a United States person or within the United States, and digital currency, digital coin, or digital token, that was issued by, for, or on behalf of the Government of Venezuela on or after January 9, 2018, are prohibited as of the effective date of this order.

On March 19, 2018, OFAC issued FAQs 564, 565 and 566, which were specifically focused on Venezuela issued cryptocurrencies, stating that “petro” and “petro gold” are considered a “digital currency, digital coin, or digital token” subject to EO 13827. While OFAC has not issued specific FAQs or guidance on other sovereign backed cryptocurrencies, it may be concerned that a series of countries have stated publicly that they plan to test and launch sovereign backed securities, including Russia, Iran, China, Japan, England, Sweden, Australia, the Netherlands, Singapore and India. With the release if its most recent FAQs, OFAC is reaffirming that it views sovereign cryptocurrencies as highly risky and well within the scope of US sanctions programs.

The reference to a “digital representation of fiat currency” appears to be a reference to “stablecoins.” In theory, stablecoins are each worth a specified value in fiat currency (usually one USD each). Most stablecoins were touted as being completely backed by fiat currency stored in segregated bank accounts. The viability and safety of stablecoins, however, has recently been called into question. One of the biggest players in the stablecoin industry is Tether, who was recently fined $41 million by the US Commodities Futures Trading Commission for failing to have the appropriate fiat reserves backing its highly popular stablecoin US Dollar Token (USDT). OFAC appears to have taken notice and states in its FAQ that “digital representations of fiat currency” are covered by its regulations and FAQs.

FAQ 646 provides some guidance on how cryptocurrency exchanges and other service providers should implement a “block” on virtual currency. Any US persons (or persons subject to US jurisdiction), including financial institutions, are required under US sanctions programs to “block” assets, which requires freezing assets and notifying OFAC within 10 days. (See: 31 C.F.R. § 501.603 (b)(1)(i).) FAQ 646 makes clear that “blocking” obligations applies to virtual currency and also indicates that OFAC expects cryptocurrency exchanges and other service providers be required to “block” the virtual currency at issue and freeze all other virtual currency wallets “in which a blocked person has an interest.”

Depending on the strength of the anti-money laundering/know-your-customer (AML/KYC) policies employed, it will likely prove difficult for cryptocurrency exchanges and other service providers to be sure that they have identified all associated virtual currency wallets in which a “blocked person has an interest.” It is possible that a cryptocurrency exchange could onboard a customer who complied with an appropriate risk-based AML/KYC policy and, unbeknownst to the cryptocurrency exchange, a blocked person “has an interest” in one of the virtual currency wallets. It remains to be seen how OFAC will employ this “has an interest” standard and whether it will take any cryptocurrency exchanges or other service providers to task for not blocking virtual currency wallets in which a blocked person “has an interest.” It is important for cryptocurrency exchanges or other service providers to implement an appropriate risk-based AML/KYC policy to defend any inquiries from OFAC as to whether it has complied with the various US sanctions programs, including by having the ability to identify other virtual currency wallets in which a blocked person “has an interest.”

UPDATED SANCTIONS COMPLIANCE GUIDANCE

OFAC’s recent framework for OFAC Compliance Commitments outlines five essential components for a virtual currency operator’s sanctions compliance program. These components generally track those applicable to more traditional financial institutions and include:

  1. Senior management should ensure that adequate resources are devoted to the support of compliance, that a competent sanctions compliance officer is appointed and that adequate independence is granted to the compliance unit to carry out their role.
  2. An operative risk assessment should be fashioned to reflect the unique exposure of the company. OFAC maintains both a public use sanctions list and a free search tool for that list which should be employed to identify and prevent sanctioned individuals and entities from accessing the company’s services.
  3. Internal controls must be put in place that address the unique risks recognized by the company’s risk assessment. OFAC does not have a specific software or hardware requirement regarding internal controls.
    1. Although OFAC does not specify required internal controls, it does provide recommended best practices. These include geolocation tools with IP address blocking controls, KYC procedures for both individuals and entities, transaction monitoring and investigation software that can review historically identified bad actors, the implementation of remedial measures upon internal discovery of weakness in sanction compliance, sanction screening and establishing risk indicators or red flags that require additional scrutiny when triggered.
    2. Additionally, information should be obtained upon the formation of each new customer relationship. A formal due diligence plan should be in place and operated sufficiently to alert the service provider to possible sanctions-related alarms. Customer data should be maintained and updated through the lifecycle of that customer relationship.
  4. To ensure an entity’s sanctions compliance program is effective and efficient, that entity should regularly test their compliance against independent objective testing and auditing functions.
  5. Proper training must be provided to a company’s workforce. For a company’s sanctions compliance program to be effective, its workforce must be properly outfitted with the hard and soft skills required to execute its compliance program. Although training programs may vary, OFAC training should be provided annually for all employees.

KEY TAKEAWAYS

As noted in OFAC’s press release issued simultaneously with the updated FAQ’s, “[t]hese actions are a part of the Biden Administration’s focused, integrated effort to counter the ransomware threat.” The Biden administration’s increased focus on regulatory and enforcement action in the virtual currency space highlights the importance for market participants and service providers to implement a robust compliance program. Cryptocurrency exchanges and other service providers must take special care in drafting and implementing their respective AML/KYC policies and in ensuring the existence of risk-based AML and sanctions compliance programs, which includes a periodic training program. When responding to inquiries from OFAC or other regulators, it will be critical to have documented evidence of the implementation of a risk-based AML/KYC program and proof that employees have been appropriately trained on all applicable policies, including a sanctions compliance policy.

Article By Joseph B. Evans, Edward B. Diskant, and Alexandra C. Scheibe of McDermott Will & Emery.

Ethan Heller, a law clerk in the firm’s New York office, also contributed to this article.

© 2021 McDermott Will & Emery
For the latest in Financial, Securities, and Banking legal news, read more at the National Law Review.

New Report Highlights Need for Coordinated and Consistent U.S. Policy to Address Possible Impacts to Financial Stability Due to Climate Change

“Climate change is an emerging threat to the financial stability of the United States.” So begins a recently issued Financial Stability Oversight Council (FSOC) Report, identifying climate change as a financial risk and threat to U.S. financial stability and highlighting a need for coordinated, stable, and clearly communicated policy objectives and actions in order to avoid a disorderly transition to a net-zero economy.

The FSOC’s members are the top regulators of the financial system in the United States, including the heads of the Federal Reserve, the Securities and Exchange Commission (SEC), and the Consumer Financial Protection Bureau. Their charge is to identify risks facing the country’s financial system and respond to them. This new Report supports steps being taken by various financial regulators in the U.S.

The Report suggests four steps necessary to facilitate an orderly transition to a net-zero economy.

  1. Regulators must develop and use better tools to help policymakers. “Council members recognize that the need for better data and tools cannot justify inaction, as climate-related financial risks will become more acute if not addressed promptly.” The FSOC Report highlights the tool of scenario analysis, “a forward-looking projection of risk outcomes that provides a structured approach for considering potential future risks associated with climate change.” The FSOC recommends the use of sector- and economy-wide scenario analysis as particularly important because of the interrelated and unpredictable development of climate impacts and technologies necessary to address them. Each of these technologies may have an unexpected impact on a part of the economy.
  2. Climate-related financial risk data and methodologies for filling gaps must be addressed.  The FSOC Report noted that its members lacked the ability to effectively access and use data that may be present in the financial system. The FSOC Report also noted potential risks to lenders, insurers, infrastructure, and fund managers caused by physical and transitional risks of climate change and the need to develop tools to better understand those risks.
  3. As has been highlighted by the environmental, social, and governance (ESG) movement, disclosure by companies of their climate-related risks is a key piece of data not only for investors but also for regulators and policymakers. Disclosure regimes that promote comparable, consistent, or decision-useful data and impacts of climate change are necessary, according to the Report, and also regimes that cover both public and private entities. The Report highlights various ongoing discussions on this topic, including possible regulations by the SEC.
  4. To assess and mitigate climate-related risks on the financial system, methods of analyzing the interrelated aspects of climate change are necessary. The Report details the developing thoughts around scenario analysis as a tool to help predict the many aspects of climate change on the financial system but notes that clearly defined objectives and planning are essential for decision-useful analysis.

A Flurry of CFTC Actions Shock the Cryptocurrency Industry

The Commodity Futures Trading Commission (CFTC) sent shockwaves across the cryptocurrency industry when it issued a $1.25 million settlement order with Kraken, one of the industry’s largest market participants. The next day, the CFTC announced that it had charged each of 14 entities for offering cryptocurrency derivatives and margin trading without registering as a futures commission merchant (FCM). While the CFTC has issued regulatory guidance in the past and engaged in some regulatory enforcement activities, it has now established itself as a key regulator of the industry along with the US Securities and Exchange Commission (SEC), the US Department of Justice (DOJ) and the US Department of the Treasury (Treasury). Market participants should be aware that the CFTC will continue to take a more active role in regulation and enforcement of commodities and derivatives transactions moving forward.

The CFTC alleged that each of the defendants were acting as an unregistered FCM. Under Section 1a(28)(a) of the Commodity Exchange Act (the Act), 7 U.S.C. § 1(a)(28)(A), an FCM is any “individual, association, partnership, or trust that is engaged in soliciting or accepting orders for the purchase or sale of a commodity for future delivery; a security futures product; a swap . . . any commodity option authorized under section 6c of this title; or any leverage transaction authorized under section 23 of this title.” In order to be considered an FCM, that entity must also “accept[] money, securities, or property (or extends credit in lieu thereof) to margin, guarantee, or secure any trades or contracts that result or may result therefrom.” (See: 7 U.S.C. § 1(a)(28)(A)(II).) 7 U.S.C. § 6d(1), requires FCMs to be registered with the CFTC.

IN DEPTH

THE KRAKEN SETTLEMENT

On September 28, 2021, the CFTC issued an order, filing and settling charges against respondent Payward Ventures, Inc. d/b/a Kraken for offering margined retail commodity transactions in cryptocurrency—including Bitcoin—and failing to register as an FCM. Kraken is required to pay a $1.25 million civil monetary penalty and to cease and desist from further violations of the Act. The CFTC stated that, “This action is part of the CFTC’s broader effort to protect U.S. customers.”

The CFTC’s order finds that from approximately June 2020 to July 2021, Kraken violated Section 4(a) of the Act, 7 U.S.C. § 6(a)(2018) by offering to enter into, entering into, executing and/or confirming the execution of off-exchange retail commodity transactions with US customers who were not eligible contract participants or eligible commercial entities. The CFTC also found that Kraken operated as an unregistered FCM in violation of Section 4d(a)(1) of the Act, 7 U.S.C. § 6d(a)(1) (2018). According to the order, Kraken served as the sole margin provider and maintained physical and/or constructive custody of all assets purchased using margins for the duration of a customer’s open margined position.

Margined transactions worked as follows: The customer opened an individual account at Kraken and deposited cryptocurrency or fiat currency into the account. The customer then initiated a trade by selecting (1) the trading pair they wished to trade, (2) a purchase or sale transaction and (3) a margin option. All trades were placed on Kraken’s central limit order book and executed individually for each customer. If a customer purchased an asset using margin, Kraken supplied the cryptocurrency or national currency to pay the seller for the asset. If a customer sold an asset using margin, Kraken supplied the cryptocurrency or national currency due to the buyer. Trading on margin allowed the customer to establish a position but also created an obligation for the customer to repay Kraken at the time the margined position was closed. The customer’s position remained open until they submitted a closing trade, they repaid the margin or Kraken initiated a forced liquidation based on the occurrence of certain triggering events, including limitations on the duration of an open margin position and pre-set margin thresholds. Kraken required customers to exit their positions and repay the assets received to trade on margin within 28 days, however, customers could not transfer assets away from Kraken until satisfying their repayment obligation. If repayment was not made within 28 days, Kraken could unilaterally force the margin position to be liquidated or could also initiate a forced liquidation if the value of the collateral dipped below a certain threshold percentage of the total outstanding margin. As a result, actual delivery of the purchased assets failed to occur.

The CFTC asserted that these transactions were unlawful because they were required to take place on a designated contract market. Additionally, by soliciting and accepting orders for, and entering into, retail commodity transactions with customers and accepting money or property (or extending credit in lieu thereof) to margin these transactions, Kraken was operating as an unregistered FCM.

Coinciding with the release of the enforcement action against Kraken, CFTC Commissioner Dawn D. Sump issued a “concurring statement.” In it, she appeared to be calling upon the CFTC to adopt more specific rules governing the products that are the subject of the enforcement action. Commissioner Sump seemed to indicate that it would be helpful to cryptocurrency market participants if the CFTC clarified its position on the applicability of the Act, as well as registration requirements. The CFTC will likely issue guidance or rules to clarify its position on which cryptocurrency-related products trigger registration requirements.

CFTC CHARGES 14 CRYPTOCURRENCY ENTITIES

On September 29, 2021, the CFTC issued a press release and 14 complaints against cryptocurrency trading platforms. The CFTC is seeking a sanction “directing [the cryptocurrency platforms] to cease and desist from violating the provisions of the Act set forth herein.” Each of the platforms have 20 days to respond.

All of the complaints are somewhat similar in that the CFTC alleges that each of the cryptocurrency platforms “from at least May 2021 and through the present” have offered services to the public “including soliciting or accepting orders for binary options that are based off the value of a variety of assets including commodities such as foreign currencies and cryptocurrencies including Bitcoin, and accepting and holding customer money in connection with those purchases of binary options.”

The CFTC has taken the position that “binary options that are based on the price of an underlying commodity like forex or cryptocurrency are swaps and commodity options as used in the definition of an FCM.” (The CFTC has previously taken the position that Bitcoin and Ethereum constitute “commodities,” doing so in public statements and enforcement actions.) In a prominent enforcement action previously filed by the CFTC in the United States District Court for the Eastern District of New York, the court held that “virtual currency may be regulated by the CFTC as a commodity” and that it “falls well-within the common definition of ‘commodity’ as well as the CEA’s definition of commodities.” (See: CFTC v. McDonnell, et al., 287 F. Supp. 3d 213, 228 (E.D.N.Y. Mar. 6, 2018); CFTC v. McDonnell, et al., No. 18-cv-461, ECF No. 172 (E.D.N.Y. Aug. 23, 2018).) In the action the CFTC filed against BitMEX in October of 2020, it alleged that “digital assets, such as bitcoin, ether, and litecoin are ‘commodities’ as defined under Section 1a(9) of the Act, 7 U.S.C. § 1a(9). (See: CFTC v. HDR Global Trading Limited, et al., No. 20-cv-8132, ECF 1, ¶ 23 (S.D.N.Y. Oct. 1, 2020).)

The CFTC has previously taken the position that Bitcoin, Ethereum and Litecoin are considered commodities. However, in these recently filed complaints, the CFTC did not appear to limit the cryptocurrencies that would be considered “commodities” to just Bitcoin, Ethereum and Litecoin. Instead, the CFTC broadly referred to “commodities such as foreign currencies and cryptocurrencies including Bitcoin.” It remains to be seen which of the hundreds of cryptocurrencies on the market will be considered “commodities,” but it appears that the CFTC is not limiting its jurisdiction to just three. It is also an open question as to whether there are certain cryptocurrencies or cryptocurrency referencing financial products that the SEC and CFTC will determine are subject to the overlapping jurisdiction of both regulators, similar to mixed swaps under the derivatives rules.

The CFTC also singled out two of these cryptocurrency platforms, alleging that they issued false statements to the effect that it “is a registered FCM and RFED with the CFTC and member of the NFA.” The CFTC noted that neither of these entities were ever registered with the National Futures Association (NFA) and one of the NFA ID numbers listed “identifies an individual who was once registered with the CFTC but has been deceased since 2009.”

WHAT’S NEXT

While the SEC, Treasury and DOJ are often considered the most prominent federal regulators in the cryptocurrency space, this recent sweep by the CFTC is not the first time it has flexed its muscles. The CFTC went to trial and won in 2018, accusing an individual of operating a boiler room. In October 2020, the CFTC filed a case against popular cryptocurrency exchange BitMEX for failing to register as an FCM, among other counts. However, unlike those one-off enforcement actions, the recent actions targeting multiple market participants within two days is a big step forward for the CFTC. Cryptocurrency derivative trading has been rising in popularity over the last few years and it is unsurprising that the CFTC is taking a more active enforcement role.

It is expected that regulatory activity within the cryptocurrency space will increase from all US regulators, including the CFTC, SEC, Treasury and the Office of the Comptroller of the Currency, especially as cryptocurrency products are increasingly classified as financial products subject to regulation. While the CFTC and other regulators have issued some regulatory guidance, regulators appear to be taking a “regulatory guidance by enforcement action” strategy. Market participants will need to thoughtfully consider all relevant regulatory regimes in order to determine what compliance activities are necessary. As we describe, multiple classifications are possible.

© 2021 McDermott Will & Emery
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