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On Friday, May 5, 2023, New York Attorney General Letitia James (“AG”) announced sweeping legislation to regulate the cryptoasset industry. The bill’s purported intent is to “protect customers and investors in digital assets from fraudulent practices, eliminate conflicts of interest and increase transparency.” The Office of the New York Attorney General (“OAG”) said in its press release that it will submit the bill to the State Senate and Assembly during the 2023 legislative session.
Per the press release, the impetus for the legislation is the “lac[k] of robust regulations” that have led to rampant fraud and dysfunction which are the “hallmarks of cryptocurrency.”
The draft legislation is comprehensive and includes, among other things, provisions requiring stablecoin issuers to hold a highly constrained set of reserves (inadvertently, it appears, excluding bank deposits) at a 1:1 ratio. Persons acting as newly defined “digital asset brokers” and “digital asset investment advisors” are required to comply with state and federal KYC/AML rules (otherwise applicable only to “financial institutions”), and “digital asset issuers”, and “digital asset marketplaces,” as well as digital asset brokers and digital asset investment advisers, are required to make public quarterly financial statements and independent annual audits. The bill also includes several rules to regulate a class of crypto enthusiasts which it refers to as “digital asset influencers,” making it illegal, among other things, for them to merely “widely circulate” a posting the “encourages” investment in a digital asset they may own a modest amount of without first registering with the State and disclosing their ownership interest, compensation, or both, among many, many other things.
Significantly, the legislation would make it illegal for a person or affiliate to act as more than one of these service providers: digital asset issuer, digital asset broker, digital asset marketplace, and digital asset investment adviser. This is dramatically at odds with how both centralized and decentralized crypto exchanges operate today. The legislation also prohibits digital asset brokers and their affiliates from trading on their own account, unless an exception is made in the rules or regulations adopted under the legislation.
In addition, the legislation requires issuers of digital assets to publish and distribute a prospectus that contains prescribed information, including, all related material information about the issuer and the digital asset. Moreover, the digital asset marketplace (crypto exchange) is required to verify that the digital asset’s software code is consistent with the issuer’s disclosure in the prospectus, among many other requirements and restrictions.
This draft legislation is the NYAG’s latest effort to assert control over the crypto industry. In March 2023, the AG filed a lawsuit against the KuCoinKCS crypto exchange for failing to register as a securities and commodities broker-dealer, among other things. That lawsuit drew (negative) attention due largely to its claim that the crypto asset, “ether” is a security. (Notably, not even the Securities and Exchange Commission (“SEC”) Chair Gary Gensler was willing to characterize ether as a security during a hearing before the House Financial Services Committee a couple of weeks ago.)
The New York legislation is similarly heavy handed. Although the bill does not attempt to label crypto assets as “securities,” it would handle crypto-related activities in a manner that is even more exacting than how the law requires treatment of securities-related activities. Early feedback from participants in the crypto asset community suggests that the bill is a dramatic overreach that seeks to indirectly create a comprehensive framework that would throttle the crypto industry.
In crafting the bill, the OAG appears to subject the crypto industry to least favored nation status, borrowing requirements from disparate regulatory frameworks. For example, the bill grafts various federal securities regulations, such as capital requirements, onto the draft law. Moreover, any violation of the law would be deemed to constitute fraud.
One prominent New York attorney who asked that his name be withheld is concerned about the power that the bill vests in the NYAG who would have broad authority under the bill to adopt new rules and unilaterally implement listing standards for digital assets. He explains, “the bill would effectively render the NYAG the czar of the digital economy insofar as it touches New York in any way. This may be appealing to the AG, but beyond that, not so much.”
According to some, these efforts could backfire. They say that the NYAG is methodically pushing the crypto industry out of New York. If the bill were to become law, crypto businesses would exit the State until Congress enacts preemptive federal legislation, and only return once a single set of sensible rules apply nationwide. The same attorney concurs, warning that “as drafted, the bill would have the effect of making New York a no-go zone for centralized and decentralized exchanges.”
Political observers also see this as an encroachment on the authority of the New York State Department of Financial Services (“DFS”), the regulator in New York State responsible for the crypto sector under New York’s “BitLicense” regime. DFS gets short shrift in the bill, and it is unclear whether they were consulted in the bill’s preparation. (Despite the OAG’s press release featuring quotes from 25 different policymakers and others in New York State, there is not one quote given to anyone currently in the DFS).
“New York is an effective global regulator with respect to the securities and banking industries when it acts interstitially, that is, when federal regulators fail to act and the New York AG or the DFS takes action pursuant to state law that has global impact because of New York’s unique status a global financial center,” says Daniel Alter, a partner at Abrams Fensterman LLP in New York who specializes in FinTech regulation. “It is one thing for a state attorney general to be a regulatory gadfly within a national regulatory structure. But currently, there is no national regulatory framework for cryptoassets,” Alter stresses. “New York has no federal backstop in that financial sector against which to leverage its power.”
There are some who believe that with this legislation, Attorney General James is trying to create a Martin Act for cryptocurrency. The Martin Act is a New York State law empowering the attorney general to investigate and prosecute securities fraud. Under the law, the attorney general can issue subpoenas and otherwise investigate misconduct in securities without having to bring an enforcement action. This legislation incorporates by reference certain of these investigative tools, thus effectively expanding the Martin Act to cover cryptoassets.
But critics think that Attorney General James has it backwards. First you need the national framework for crypto regulation, and then you layer on top of that the types of powers that the Martin Act grants.
Frequent commentor on the regulation of the crypto asset space, Lewis Cohen, co-founder of DLx Law, noted that “this bill reads more like a holiday wish list cobbled together by outside consultants seeking simply to prevent otherwise law-abiding New York State businesses from utilizing crypto assets, rather than a genuine attempt to provide a thoughtful regulatory framework that would enable innovation in New York State while providing practical protections crypto asset users are actually calling for. Similar to the “Red Scare” of the 1950s which used a few dramatic examples of seditious activity to whip up broad anxiety in order to achieve otherwise unacceptable political outcomes, this bill references genuine issues (the collapse of the Terra/Luna platform and the bankruptcies of FTX and Celsius) in an attempt to impose what would be a highly unpopular functional ban on crypto activity within the State.”
Perhaps the best thing that can come of this is that it catalyzes Congress to act. “No act of Congress has yet to create a national framework,” says Alter. New York should keep its powder dry until then.”
Recent industry events, such as the failure of centralized cryptoasset lenders like Celsius, and the spectacular implosion of FTX, demonstrate that there are areas of weakness in the cryptoasset industry that are appropriate for regulators to respond to. However, top heavy regulation of the type proposed in the bill may cause more harm than good, by penalizing compliant actors, such as the existing DFS-licensed cryptoasset exchanges by making their business models illegal, and making it more difficult for every-day New Yorkers to participate in the digital economy.
Author’s Note: The opinions herein are my own and do not reflect the opinions or position of the Global Blockchain Business Council.
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