Uniform Regulation for Virtual Currency Businesses: Coming to a State Near You

Katherine Cooper is an attorney who focuses on advising financial institutions on legal and regulatory matters in the launch and operation of their businesses. Prior to opening her own practice, she worked in senior roles at NYSE Euronext, Barclays and Citigroup Global Markets.

In this opinion piece, Cooper discusses work ongoing to help standardize virtual currency law across the US, outlining the current state of the model regulation and the questions that need to be solved before it is finalized.

The Uniform Law Commission will vote on its draft uniform virtual currency act at its annual meeting in San Diego on 14th July.

The current draft is the product of as many as six meetings of the act's drafting committee, 14 comment letters from various industry participants and input from the US Treasury Department, the Conference of State Bank Supervisors, authorities from relevant state agencies in California, Texas and Washington and the Federal Reserve Bank of New York.

Although typically the ULC requires a draft uniform act to be voted on and approved at two consecutive annual meetings, the drafting committee has noted the need to act quickly because various state legislatures have bills that would move forward with laws that would regulate virtual currency businesses.

In drafting the US Constitution, the Founders feared a distant and unresponsive national government. As a result, they drafted the Constitution in the late 18th century to reserve to the states' considerable authority over a range of issues. This had its pros and cons.

By the late 19th century, the number of states had more than tripled from the original 13 to 44, and some enterprises had expanded their operations to conduct business across multiple states or even nationally. The quilt-work of inconsistent state laws these interstate enterprises faced proved to be an unnecessary impediment to economic growth.

Accordingly, the ULC was founded in 1892 "to promote uniformity in law through voluntary action of each state government." Since then, the ULC has issued over 300 uniform acts. Some have been very successful in creating a uniform set of laws across the 50 states, the District of Columbia and territories. Adopted by all 50 states, the Uniform Commercial Code is a prime example. It provides a uniform set of laws governing sales contracts, negotiable instruments, bank deposits and collections, letters of credit, documents of title, investment securities and secured transactions.

Accordingly, the ULC's draft Uniform Regulation of Virtual Currency Act, may, in the near future, be the legal framework by which virtual currency businesses will be regulated for years to come.

As many pieces of legislation do, the draft act starts off with a set of definitions.

A couple of these are crucial to determining who is subject to being regulated and who is not. Whether a person is subject to regulation under the act is based on three factors:

The first factor turns on the act’s definition of "virtual currency" which is "a digital representation of value that … is used as a medium of exchange, unit of account, or store of value; and … is not legal tender, whether or not denominated in legal tender" but does not include various software protocols, affinity reward programs and online game tokens.

If what is being dealt with is a "virtual currency," one must turn to the second factor: Is the service being provided a "virtual currency business activity"?

That term includes:

If the first two factors are satisfied, the analysis turns to whether the act provides an applicable exemption. The act contains 16 exemptions that range from being a bank, securities or commodities broker, licensed money transmitter, persons who use virtual currency for personal or household purchases, an attorney providing escrow services, persons who solely mine virtual currency, secured creditors who hold liens over virtual currency to persons who merely provide software and connectivity support services.

Bottom line: If you provide a service that deals in "virtual currency" and constitutes a "virtual currency business activity," but does not qualify for any of the exemptions, the act says you are regulated!

If you are subject to regulation, the act requires you to be licensed with the state whose residents you conduct virtual currency business activity with. To get a license, you need to submit an application in which you must disclose extensive details about the background of the principals of your business, including fingerprints, criminal history, past bankruptcies, current or past lawsuits, enforcement actions or arbitrations.

Prior to being licensed, an applicant is required to post funds, a letter of credit or surety bond with the department administering the act in the amount that the department specifies based on the nature and risks in the applicant’s virtual currency business model.

To ease the administrative hassle of needing to apply for licensure in multiple states, the act includes a reciprocity provision. If you are licensed in state A which has adopted the act, and you wish to do business in state B, and state B has also adopted the Act, then you can apply for a license in state B in streamlined process based on your license in state A.

Once licensed, you must comply with various requirements such as having a minimum net worth or reserves, creating and maintaining required records, making certain disclosures and implementing compliance policies including cybersecurity, business continuity, disaster recovery, anti-fraud, anti-money laundering, and anti-terrorist financing programs. You are subject to be examined by the department for your compliance with these requirements.

Non-compliance with these requirements or engaging in unsafe, deceptive, fraudulent acts or misappropriation of customer property, subjects you to enforcement actions which can result in fines, a revocation or suspension of your license or the issuance of a cease and desist order as well as, where appropriate, the referral of the matter for criminal prosecution.

Two provisions have generated controversy. First, the act mandates the incorporation of Article 8 of the Uniform Commercial Code. Second, the act's exemptions from the licensure and regulation, or provisional licenses, for startups doing de minimis or limited business in the state. These provisions are also known as the "on-ramp" provision.

UCC Article 8 basically does two relevant things. First, it sets up a hierarchy of rights as between, on the one hand, a customer who has a "financial asset" to which the customer has a "security entitlement" being held by a "securities intermediary" and, on the other hand, the creditors of that intermediary.

In the case of the intermediary's insolvency, the customer's property held by the intermediary is generally not subject to the claims of the intermediary's general creditors. In the ensuing bankruptcy litigation, the customer’s property is to be returned to the customer subject to certain limitations. Second, Article 8 provides that, "An action based on an adverse claim to a financial asset, whether framed in conversion, replevin, constructive trust, equitable lien, or other theory, may not be asserted against a person who acquires a security entitlement under Section 8-501 for value and without notice of the adverse claim."

If Article 8 is applied to virtual currency transactions, this means that if you buy a bitcoin and the seller unbeknownst to you, granted a lien on the bitcoin to a creditor, that creditor cannot seek to get the bitcoin from you.

Coinbase strongly objects to the act's mandate that UCC Article 8 law be applied to virtual currency businesses. In its view, a simpler full-backing, permissible investment obligations regime is preferable. It notes that states which already regulate virtual currency businesses employ a permissible investments approach. That approach requires licensees to hold in trust for customers virtual currency in like kind quantity and equivalent market value to the virtual currency held in a customer’s account.

Coinbase argues that incorporating Article 8 law would invoke "a distinct body of law not well-developed in our field, will complicate future application of prevailing consumer financial protection laws that may come to bear on retail virtual currency businesses and does not appear to enhance the fundamental obligations Coinbase and similar licensees already owe to their customers."

In further discussions with drafting committee members, Coinbase also articulated a concern with placing a commercial law provision in a statute focused on regulation.

To address Coinbase’s concerns, the Drafting Committee held a conference call on Thursday, 29th June. There was a general consensus to support a compromise – that being to remove the provision in the act mandating the application of UCC Article 8 law to virtual currencies, and propose a separate, stand-alone commercial law uniform act that mandates the application of Article 8 law.

The drafting committee was conscious of the fact that virtual currency businesses are developing and evolving rapidly. As a significant area of technological innovation, the drafting committee wanted, on the one hand, not to stifle new, start-up enterprises with the imposition of extensive regulation, while, on the other hand, having in place some customer protections.

The result of their attempt to balance these concerns was an "on-ramp" to becoming fully regulated. The on-ramp consists of a complete exemption from licensure and regulation for businesses conducting $5,000 or less on an annual basis in virtual currency business with residents of the state.

For businesses conducting over $5,000, but less than $35,000, on an annual basis with residents of the state, the act provides for a provisional registration process. Although labelled "provisional," the registration process requires of provisional registrants much of what is required of fully licensed businesses, such as having a minimum net worth or reserves, and having the same suite of policies and procedures.

A number of commenters felt that these on-ramp provisions did not reflect the consensus at the last drafting meeting. They felt that the dollar thresholds should be more nuanced based on the type of virtual currency business activity involved. For long term custodial activities, they thought the threshold should be lower, but for short-term transactional activities the threshold should be higher.

In their view, the de minimis exemption should be set at $5,000 or less for long-term custodial activities, but for short-term transactional activity the threshold should be $15,000. For the provisional registration, they argue that for long-term custodial activity the threshold should be $35,000 but for short-term transactional activity the threshold should be $100,000.

In addition, some noted that the provisional registration process was complicated and did not require all that much less than the requirements for full-fledged registered firms.

I agree with the drafting committee’s approach to incorporate UCC Article 8 law and with the critics on the committee's on-ramp thresholds.

Applying UCC Article 8 solves a significant commercial law problem with virtual currencies under US law. As others have noted, without agreements in place treating virtual currency as a financial asset under Article 8, virtual currency falls into UCC Article 9's general intangibles bucket.

As such, if Sally, an owner of virtual currency gives a security interest in "all of her assets" to a lender, Len, Len need only file financing statements in the appropriate jurisdiction(s) to perfect his security interest. If Sally sells her virtual currency in such a scenario to a buyer, Bob, Bob takes the virtual security subject to Len's lien.

In other words, Len can assert his claim against the virtual currency, now owned by Bob that he bought from Sally. The bottom line is buying virtual currency without doing lien searches against the seller is like buying a house without doing a title search. This is frequently impossible to do. Even worse, Bob the buyer needs to worry whether the seller that Sally bought the bitcoins from, Susie, had granted a security interest to another lender, Lester. Lester can asset a claim against the bitcoins now owned by Bob if Susie defaults on the debt she owes to Lester.

Mandating the application of UCC Article 8 law solves this problem. The buyer of what is defined as a "security entitlement" in Article 8 takes it free and clear of the liens on the seller’s assets. Coinbase's concern that mandating UCC Article 8 law invokes "a distinct body of law not well-developed in our field" overlooks the fact that the application of any other body of law, such as bailment law, is not well-developed either.

Virtual currency is simply too new for there to be much case law to have developed. The advantage of Article 8 is it is uniform is across the 50 states whereas other bodies of law such as the common law of bailment are not. So as applied in other contexts, UCC Article 8 is better developed than the alternatives.

One of the downsides of the compromise of putting the mandate of Article 8 law to virtual currencies into a separate uniform act is that act will not be recommended to the states until 2018, a year after the regulatory act. It opens the door to a lack of uniformity across the states as some states may adopt one, but not both, acts and delays the solution to the risk buyers of virtual currency wear of facing adverse claims from their sellers’ creditors. I think it is a missed opportunity to not mandate the application of Article 8 law in the "regulatory" act going to the full ULC on 14th July.

Regarding the on-ramp, the critics have good points. There should be different thresholds for different activities. The dollar value of short-term transactional activity is likely to add up faster than long-term custodial activities while posing less of a threat to customer protection. Custody always poses the threat of embezzlement, which can easily lead to the total loss of customer funds, while misconduct in exchanging virtual currencies poses the risks of mis-pricing or front-running abuses.

Although these are bad, they usually do not lead to the complete loss of customer funds – rather the risk is more likely limited to the customer getting a worse price than they should have. Given the different levels of risk involved, the act should set the thresholds for exemption and provisional registration at different amounts based on the activity involved.

In just a few weeks, the ULC will be voting on a uniform law that could set the framework for the regulation of virtual currencies in the US for years to come. Regulation is coming to, if not to your state, a state near you.

Disclosure: CoinDesk is a subsidiary of Digital Currency Group, which has an ownership stake in CoinBase. 

US dollar image via Shutterstock