New York’s Proposed Regulation of Bitcoin Businesses - Polishing Up or Polishing Off?

by Dorsey & Whitney LLP
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Thousands of commenters on New York’s proposed virtual currency regulations have had mixed reactions. The New York Department of Financial Services (“NYDFS”) recently extended the public comment period until October 21. Comments have ranged from support from those who think the regulations will help legitimize Bitcoin to criticisms regarding intrusiveness, compliance cost, and extraterritorial impact.

In July, the NYDFS released a draft regulatory framework for virtual currency businesses involving New York or New York residents. Benjamin Lawsky, the superintendent of the NYDFS, stated that the intent was to align virtual currency rules with existing regulations for banks and other financial institutions. Lawsky said that the NYDFS “sought to strike an appropriate balance that helps protect consumers and root out illegal activity – without stifling beneficial innovation,” and that setting up a regulatory framework is “vital to the long-term future of the virtual currency industry, as well as the safety and soundness of customer assets.” The proposed rules are available here.

Views on Bitcoin have ranged from it being seen as the next step in the evolution of the global monetary system, as lacking in long-term stability and viability, and as a tool for criminals and money launderers to conduct illicit activity. Perhaps as a result of these competing views, Bitcoin has experienced many recent ups and downs (including the bankruptcy and shutdown of Bitcoin exchanger Mt. Gox). Dramatic fluctuations in the trading value of the bitcoin currency have resulted, ranging from breaking the $1000 threshold in November 2013 to dropping as low as $340 in April 2014, with a value of $503.96 as of August 25, 2014.

The draft New York rules apply to virtual currency, defined as “any type of digital unit that is used as a medium of exchange or a form of digitally stored value or that is incorporated into payment system technology.” Licenses (called “BitLicenses”) would be required for businesses that: (i) receive for transmission or transmit virtual currency on behalf of consumers; (ii) secure, store or maintain custody of virtual currency on behalf of their customers; (iii) exchange virtual currency (i.e., those exchanging virtual currency for fiat currency or other virtual currency); (iv) buy and sell virtual currency as a customer business; and (v) control, administer or issue a virtual currency. The license requirement would not apply to those holding or spending virtual currency on their own behalf, virtual currency miners or businesses that accept virtual currency for payment. Those chartered under New York banking law may apply for exemptions.

Potential licensees would have to pass background checks, and once licensed, some of the requirements would include:

  • Maintaining a bond or trust account in U.S. dollars and holding virtual currency of the same type and amount as virtual currency owed or obligated to a third party;
  • Providing customer receipts upon completion of any transaction which include contact information for the business, transaction details, fees and charges, any applicable exchange rate, a statement of the liability of the licensee for non-delivery or delayed delivery and a statement of refund policy;
  • Providing written customer complaint policies and procedures;
  • Making clear and conspicuous disclosures about potential risks associated with virtual currencies;
  • Following anti-money laundering requirements, the main components of which are: (i) maintaining information for all virtual currency transactions; (ii) verifying accountholders, including verifying customer identity at account opening, maintaining records of verification information and complying with enhanced due diligence requirements for certain customers and accounts; and (iii) reporting suspicious fraud and illicit activity, including monitoring for transactions that may signify illegal or criminal activity;
  • Maintaining a cyber-security program designed to identify risks, detect system intrusions and breaches and respond to any breaches or disruptions;
  • Being subject to NYDFS examinations at least every two years; maintaining books and records including transaction information, bank statements and compliance records; and submitting quarterly and annual financial statements; and
  • Meeting capital requirements.

Critics of the proposed rules say they are too intrusive and financially rigid and note that the proposed rules cover businesses not presently subject to federal regulation, such as online wallet companies. Patrick Muck, general counsel for the Bitcoin Foundation, has opined that the scope of the rules effectively “ropes in the whole industry” and would “set New York up as a quasi-federal regulator for the entire Bitcoin industry.”

Supporters, including many within the Bitcoin industry, see the rules as a positive development. Nick Spanos, cofounder of NYC Bitcoin Center, notes that, although emerging businesses may find the rules to be costly and onerous and prompt them to go to other states, such rules may provide Bitcoin with accountability, commenting “[i]f you’re going to take people’s money and hold it as a third party, you should be scrutinized.”

New York is not the only state to take action recently regarding virtual currencies. In June, California approved a bill which legalized alternative and digital currencies for purchasing goods and transmitting payments. Specifically, the bill clarified that current law banning the issuance or circulation of anything but lawful money of the United States does not prohibit the issuance and use of “alternative” currency, including digital currency and “points” with monetary value. The bill’s author, Assemblyman Roger Dickinson, stated that it “is impractical to ignore the growing use of cash alternatives.” Analysis of the California bill is available here.

On the federal level, there have not been many developments since earlier this year, when the Financial Crimes Enforcement Network (“FinCEN”) and the Internal Revenue Service (“IRS”) each issued guidance regarding virtual currency. In March, the IRS issued Notice 2014-21 which noted that virtual currency is treated as property for U.S. federal tax purposes. Among the impacts of this Notice are that: (i) wages paid using virtual currency are taxable to the employee and must be reported by an employer on a Form W-2; (ii) virtual currency payments are subject to information reporting to the same extent as any other payment made in property; and (iii) the character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A copy of the Notice is available here.

In January, FinCEN released two rulings regarding virtual currency miners and investors, serving to interpret guidance released last year which stated that virtual currency exchangers and administrators are considered money services businesses (“MSBs”), and specifically as money transmitters, subject to registration requirements and anti-money laundering regulations. The first ruling provides that individuals creating or mining virtual currency solely for their own benefit are not considered MSBs. The second ruling provides that a company purchasing and selling virtual currency as an investment exclusively for its own benefit will not be considered an MSB. A press release regarding these rulings is available here.

Outside of the regulatory context, the NYDFS’s draft rules were followed the next day by an announcement by Dell that it would accept bitcoins for purchases on its website, joining major businesses such as Overstock, DISH Network and Expedia in accepting bitcoins. Online merchant Gyft.com also accepts bitcoins for the purchase of gift cards from major retailers such as Amazon, Target, CVS and Zappos. Other recent Bitcoin developments include Apple’s lifting of its ban on Bitcoin-trading apps in its App Store, Google’s updating of its search engine to display Bitcoin prices and conversions, following Microsoft’s Bing and Yahoo! Finance in offering similar features, and rumors that Braintree, a popular payment processor used by websites and mobile apps owned by Ebay/PayPal, is in talks to begin accepting bitcoins.

In both the legal and business contexts, the volatility of bitcoins remains high. It remains to be seen how New York’s foray into regulating the Bitcoin universe will impact it.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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