New York Gets Tough on Virtual Currency

Going forward, it looks like crypto companies that make it in New York will be able to make it anywhere. All over, at the state and federal level and internationally, turmoil in the crypto industry is leading to increased scrutiny. In New York, home of the comprehensive (some would say onerous) BitLicense, cryptocurrency mining has been partially banned and the New York State Department of Financial Services (DFS) is adding more rules for crypto companies to follow. It’s not all whips and chains, however, as a short leash has been granted to support the industry as discussed below.

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90-Day Crypto Banking

On December 15, 2022, DFS published industry guidance pertaining to New York-registered banks approved to conduct virtual currency business (such banks are generally exempt from the BitLicense regulation). The guidance explains that if a bank received prior approval to engage in crypto activities that “does not constitute general consent for [such NY bank] to engage in other types of virtual currency-related activity.”

Instead, the DFS now expressly requires NY banks to seek approval from DFS within 90 days before “commencing any new or significantly different virtual currency-related activity.” Notably, DFS approval may be required even for crypto activity performed by a third party engaged by a NY bank. 

If the DFS informs the bank that formal approval of the proposed activity is required, the bank will have to prepare a written submission, which must set forth the following:

  • a business plan,
  • legal/regulatory analysis, and
  • a summary of the applicable risk management and corporate governance frameworks, consumer protection procedures and financials.

DFS Nixes Crypto Commingling

On January 23, 2023, the DFS also issued guidance for BitLicensed companies and limited purpose trust companies that provide crypto custodial services. The guidance requires crypto custodians to separately account for and segregate customer crypto from the custodian’s own assets. Though, omnibus wallets (i.e., that hold crypto of multiple customers) are permitted so long as certain conditions are met, such as the custodian maintains a clear internal audit trail to identify each customer’s assets.

In addition, and apparently in direct response to the FTX/Alameda fiasco, New York now expressly only permits crypto custodians to take possession of crypto for the limited purpose of carrying out custody and safekeeping services. Custodians cannot use crypto for the custodian’s own use, e.g., using it to secure or guarantee an obligation of the custodian.

Crypto custodians also must disclose to their customers, among other things, (i) how it segregates and accounts for customer crypto, (ii) the property interest the customer retains in the assets and (iii) how the custodian can use the assets while they are in its possession.

More State Regulations Coming

In the coming months, DFS and perhaps even New York lawmakers may be working on more rules and regulations for crypto companies to follow.

Perhaps a sign of tough love, New York may also be taking steps to support the industry. For example, a new bill has been introduced that would allow state agencies “accept crypto for payments related to taxes, rent, fines, penalties, interest, and so on through agreements with individuals and groups." 

Across the Hudson, another state is looking to clamp down on crypto. The proposed “Digital Asset and Blockchain Technology Act” is currently working its way through the New Jersey Senate. The Blockchain Association recently criticized the bill, asserting it “would effectively outlaw all of the crypto businesses that are currently thriving in the Garden State” is so overly broad that “even airline miles could be prohibited from being offered to New Jersey residents.”

Another Crypto Clawback Waive Crashes

In other crypto news, and as discussed in our prior article on crypto clawbacks, the tide of lawsuits seeking to clawback crypto is rolling and picking up steam. Last month, Alameda (FTX’s trading arm) filed a preference action against bankrupt lender Voyager Digital, to claw back $446 million in funds transferred to Voyager prior to Alameda's own bankruptcy filing. Interestingly, Alameda describes Voyager as a “feeder fund” and alleges that it “solicited retail investors and invested their money with little to no due diligence in cryptocurrency investment funds like Alameda and Three Arrows Capital.” Alameda further asserts the automatic stay doesn’t apply because the at-issue transfers were made after the filing of Voyager’s bankruptcy.

Looking Ahead

Political crypto clawbacks may be next. That is, FTX has demanded that the political figures and groups that received donations from Sam Bankman-Fried and other FTX leaders return the funds by the end of this month. If any donations are not returned, we can expect to see legal action to follow.

Also, a broader trend for participants to be mindful of is litigation against backers of crypto firms, such as the class action recently filed against Sequoia Capital related to FTX. There, the plaintiffs claim that Sequoia’s involvement and public statements legitimized FTX’s operations, which induced plaintiffs to transact business with FTX. Key issues regarding investor duties and the reasonableness of diligence may be decided, with implications beyond crypto to other markets. In particular, the District Court may weigh in on the scenario where a party sues arguing that they relied on the truth and accuracy of statements or diligence of others. For example, the analysis may apply to investors in ESG funds claiming against fund managers who relied on a target’s representation that turned out to be false or a cannabis REIT subject to claims by its investors for misrepresentations made by the REIT’s tenant, which allegedly should have been discovered.  

Adam Levy,  an attorney in the Insolvency + Finance Group at Davis+Gilbert, contributed to this post.

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