On October 18, 2021, New York Attorney General Letitia James announced that the New York State Office of the Attorney General (OAG) ordered two crypto-lending platforms to cease operations within or from New York State (NYS) or with New York users, and announced investigation into three other platforms. The company names were not released.
James cited violation of New York General Business Law Article 23-A §352, part of NYS legislation otherwise known as the “Martin Act,” which requires commodity broker-dealers, salespersons, and others who deal in certain virtual currencies to register in New York.
Background on the New York Blue Sky Law
Various state securities laws that preceded the federal regime established under the Securities Act of 1933 (Securities Act) and the Securities and Exchange Act of 1934 sought to protect investors from “speculative schemes which have no more basis than so many feet of 'blue sky’," and were thus colloquially dubbed “blue sky laws.”
Originally passed in 1921, New York’s blue-sky legislation, dubbed the Martin Act, provides the NYS attorney general with broad powers to investigate and prosecute suspected securities fraud. The Martin Act is largely considered the strictest of the securities laws, in part because it does not require the OAG to prove scienter, the intent to defraud, or damages from the fraud. Among other powers, the Martin Act also permits the attorney general to commence confidential or public investigations, civil or criminal proceedings, grants broad subpoena powers, and the ability to confer immunity.
Use of the Martin Act since inception has been contingent on the priorities of the AG at any given time, technological innovation and changes in the capital markets ecosystem, and the prominence of New York City and Wall Street as the centers of finance in the US. NYS has at times stepped in when the federal regulators did not initiate action. The result are various instances in which NYS, not the federal regulatory bodies, led significant change in the industry. The Martin Act gained prominence in the early 2000s when then-AG Eliot Spitzer prosecuted conflicts of interest related to research reports at Merrill Lynch. The case led to settlements and reforms in several other investment banking houses. It was later used by AG Eric Schneiderman during his tenure to target fraudulent practices and disclosures related to trading in dark pools, resulting in settlements in early 2016.
B.(Not) Out of the Blue Sky: Recent Actions Against Crypto-Lending Platforms
AG James is now using the OAG’s broad powers to target the virtual currency industry. In July 2020, the OAG successfully exercised its authority under the Martin Act in the digital assets space In re Letitia James v. iFinex Inc., which upheld the AG’s authority to investigate virtual currency platforms. In addition to $18.5 million in penalties and termination of operations within New York, the iFinex case resulted in mandating various disclosure requirements, setting expectations for other virtual currency platforms operating in the state. On February 17, 2021, the same day the iFinex settlement was signed, AG James announced it was suing Coinseed, Inc., a mobile phone application that functioned as a virtual currency trading platform, and its founder and CEO and CFO, for operating an unregistered commodities broker-dealer, selling unregistered securities, and making false and misleading disclosures about the fees charged to users and the experience of those managing the company.
Following the iFinex settlement and Coinseed announcement, in March 2021 the OAG published an Industry Alert that warned investment advisors, commodity broker-dealers, and salespersons dealing in virtual currencies in NYS must register with OAG unless they qualify for an exemption. The recent action that mandated two platforms cease operating in or from New York or with New York users, and compelled an expansive amount of information and documentation from three others, indicates that the OAG will continue to pursue unregistered virtual currency platforms.
Why is This Significant?
Of critical interest to the digital asset industry is the broad reading the OAG applies to the definition of “security” and “commodity” in the Act. The OAG’s October announcement specifically states that, “[T]he nature and function of the most common virtual currency lending products or services demonstrate that they fall squarely within any of several categories of ‘security’ under the Martin Act," thus requiring such platforms to register with the OAG if providing services within NYS or to New Yorkers.
The Securities and Exchange Commission (SEC) has not made the same sweeping statement, but rather considers certain virtual currencies “investment contracts,” which are “securities” pursuant to the Securities Act of 1933 (Securities Act). It is not clear yet whether the SEC considers that all virtual currency platforms meet the SEC registration requirements, and therefore come under its jurisdiction. Federal courts have upheld the Commodity Futures Trading Commission’s determination that virtual currencies are commodities under the Commodity Exchange Act (CEA). The iFinex case makes clear, however, that commodities are defined more narrowly under the CEA than the Martin Act. This broader application requires virtual currency platforms to consider whether their products could be considered “commodity contracts” pursuant to the Martin Act, and whether they must register as a commodities broker-dealer at the state level, even if they have concluded that registration is not required at the federal level.
Virtual currency lending platforms are on notice. Such entities operating in New York, or offering services to New Yorkers, that have not yet registered should review the recent actions and determine whether they must register or if they qualify for an exemption. Entities operating outside of NYS that would otherwise qualify for registration should ensure policies, procedures, and controls are designed to detect and prevent users from NYS from accessing their platforms.
Additionally, it is critical for virtual currency platforms, wherever located, to review their disclosures and ensure they are transparently and accurately disclosing the risks related to the products and services they offer.
How Guidehouse can Help
Guidehouse’s team of experts can help virtual currency lending platforms assess their compliance programs and enhance policies, procedures, controls, and technology as needed. Guidehouse has been at the forefront working with digital asset platforms as new products and technologies become increasingly widespread. Its areas of relevant expertise include the following:
Vendor sourcing and governance
Guidehouse is well-equipped to assess your specific circumstances and offer advice and solutions for responding to heightened regulatory requirements.