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NYAG’s Warning to Crypto Businesses Muddies Regulatory Waters; Compliance Requirements Remain Elusive | Sheppard Mullin Richter & Hampton LLP

New York’s chief law enforcement agency recently squandered an opportunity to bring much needed guidance to the digital assets space.  On October 18, 2021, the Office of New York Attorney General, Letitia James (“NYAG”), issued a press release warning New York businesses that offer interest-bearing accounts to customers depositing virtual currency without having registered under New York General Business Law § 352, et seq. (the “Martin Act”) are breaking the law.

The Martin Act establishes the regulatory framework businesses must follow when trading securities and commodities within the State of New York.  The press release cites a list of instruments set forth in the Martin Act that qualify as securities, the trading of which would require registration under the statute.  The release goes on to state that the “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.”  However, the release also fails to identify specifically the aforementioned categories of ‘security,’ noting that the statutory list is “not exhaustive,” and the statutory definition of security is to “be given a broad reading.”  The NYAG’s warning follows on the heels of action in the digital assets space taken by various other state and federal regulators.  In the last two months, the U.S. Securities Exchange Commission (“SEC”) and Blue Sky authorities in Alabama, Kentucky, New Jersey, and Texas have taken aim at businesses offering interest on customers’ virtual currency deposits, arguing that such offerings constitute unregistered securities trading.

The NYAG press release emphasizes that the NYAG stands ready to take action against what it calls “high-risk virtual currency schemes,” revealing that the NYAG already has issued two cease-and-desist letters and three information request letters in furtherance of its crackdown on unregistered businesses, providing a redacted example of each letter.  The cease-and-desist letter provides additional information regarding the NYAG’s legal position and directs the recipient to cease all unlawful activity or explain why the NYAG should not take further action.  The information request letter inquires as to the recipient’s virtual currency deposit operations.

Though the NYAG’s press release, cease-and-desist letter, and information request letter (collectively, the “Release”) are long on tough talk, they are short on the type of meaningful analysis that an innovative industry thirsting for guidance has been seeking for more than half a decade.  New York’s opening salvo lacks the definitional clarity, factual context, and legal rationale necessary for crypto companies to make informed decisions regarding their operations.

The Release focuses on activities relating to “virtual currencies” but does not define the term or direct readers to a governing legal definition.  In recent years, courts and regulators have notoriously grappled with the proper classification of various types of digital assets as currencies, securities, commodities, or some other instrument.  Making no reference to this lively debate and instead resorting to the generic concept of “virtual currency,” the Release fails to advance the dialogue and provide industry players with concrete guidance they can use in determining whether their products fall within the NYAG warning’s ambit.  Scare tactics? Yes. But little concrete guidance on what, specifically, companies should be scared of.

The Release also provides little in the way of factual detail regarding the problematic products at issue, except to state that they offer a return on virtual currency deposits and “claim to deliver those returns by, among other things, trading with, or further lending those virtual assets.”  The Release’s legal rationale is similarly lacking.  For instance, the cease-and-desist letter asserts that these products constitute “securities under the Martin Act because they promise a rate of return to investors, and deliver that return by (for instance) [REDACTED] trading with, or further lending or hypothecating, those virtual assets,” citing two cases in support of this position: All Seasons Resorts v. Abrams, 68 N.Y.2d 81, 87 (1986); People v. Van Zandt, 43 Misc. 3d 563, 569 (Sup. Ct., Bx. Cnty. 2014).  However, the Release lists these case captions without applying the law to the facts, leaving readers to infer potential legal theories.  In All Seasons, the NY court held that campground memberships did not constitute securities based on an analysis that considered whether the instruments fell within the Martin Act’s enumerated or catch-all security definitions.  In Van Zandt, the NY court assessed on a case-by-case basis whether multiple financial instruments, which bore varying degrees of resemblance to the crypto instruments targeted by the Release, constituted securities.  The Release’s failure to apply the cited law to novel facts represents another missed opportunity by the regulator to provide clarifying guidance.  Without the specificity, compliance feels a bit like a crap shoot – introducing a level of uncertainty that most law-abiding companies would like to avoid.

The NYAG’s Release does not arise in a vacuum.  Vigorous debates in recent years regarding the proper classification of various digital assets have yielded valuable fruit.  By relying upon the general, undefined concept of “virtual currency” without offering factual and legal context that would allow industry players to discern precisely what digital assets the warning targets, the Release does little to advance the conversation and help companies ensure that their business practices comply with the law.  Though the NYAG seems poised to go to market with enforcement actions targeting these novel instruments, the Release misses a valuable opportunity to provide an industry experiencing growing pains with actionable guidance that would promote responsible innovation.  Without such guidance, frustration may mark the relationship between New York regulators and digital asset businesses for the foreseeable future.