Sidley Blockchain Bulletin — June 2024

1. Congress Votes on Crypto
2. UCC Minute: Article 12 Presents New Blockchain Opportunities
3. The CFTC Issues First-of-Its-Kind Order Against Crypto Prime Broker for Providing U.S. Customer Access to Digital Assets Derivatives Platforms
4. ICYMI: A Taxonomy and Disclosure Guidelines for Digital Assets

Congress Votes on Crypto

Digital assets have been the subject of numerous congressional hearings over the past few years but little congressional action. That began to change in May 2024, when Congress passed a resolution to overturn the Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 121 (SAB 121), the House of Representatives advanced a comprehensive digital asset market structure bill (FIT21), and a House subcommittee held a hearing on the tokenization of real-world assets.

Resolution to Nullify SAB 121

Despite bipartisan support in both chambers of Congress of a resolution to nullify SAB 121¹, President Joe Biden vetoed the resolution on May 31, 2024, as he previously indicated he would in a Statement of Administration Policy (SAP)². In his statement announcing the veto, Biden stated that the resolution “risks undercutting the SEC’s broader authorities regarding accounting practices” but emphasized that his administration is “eager to work with the Congress to ensure a comprehensive and balanced regulatory framework for digital assets” to “harness the potential benefits and opportunities of crypto-asset innovation.”³

As background, SAB 121 seeks to address perceived risks to publicly traded companies that safeguard digital assets for their customers and requires public companies to record the fair value of user-safeguarded digital assets on their balance sheets.⁴ It has been met with controversy since it was released in March 2022.⁵ Trade associations have conveyed to the SEC, Congress, and the President that SAB 121 deviates from normal accounting treatment of custodied assets as off-balance sheet assets and effectively precludes regulated banking organizations from offering digital asset custody at scale because it treats the assets as if they are owned rather than simply custodied by a banking organization.⁶ SAB 121 has the same effect on broker-dealers as a result of SEC Rule 15c3-1 under the Securities Exchange Act, which treats the on-balance sheet items as nonallowable assets.⁷ Institutions that are forced to record custodied digital assets on balance sheets are subjected to higher capital, liquidity, and other prudential requirements, unlike their nonbank competitors.⁸

Further consideration of the veto message and the resolution in the House of Representatives has been postponed until July 10, 2024.

House Advances FIT21

On May 22, 2024, the House of Representatives passed HR 4769, Financial Innovation and Technology for the 21st Century Act (FIT21).⁹ FIT21 is drafted to make clear when certain activities are subject to oversight by the SEC versus the CFTC, among other things.¹⁰

The version of FIT21 that passed is substantially similar to the version introduced in the House Financial Services and Agriculture committees last year.¹¹ One notable difference, however, is the inclusion of “Title II – Clarity for Assets Offered as Part of an Investment Contract.” Title II excludes from the definition of a “security” in the federal securities laws any digital assets sold or intended to be sold pursuant to an investment contract (provided the asset does not otherwise meet the definition of a security). Several Democrats have been critical of Title II, including SEC Chair Gary Gensler.¹² The White House has openly opposed passage of FIT21 in a SAP (but unlike the SAP concerning SAB 121, this SAP does not mention a presidential veto if passed by Congress).¹³

Nonetheless, FIT21 achieved bipartisan support in the House, passing with a vote of 279 to 136, including 71 Democrats voting in favor of the bill. The bill will next be considered in the Senate; however, there is no projected timetable, and its future remains uncertain.

Congressional Hearing on Tokenization of Real-World Assets

On June 5, 2024, the U.S. House Financial Services Committee’s Subcommittee on Digital Assets, Financial Technology, and Inclusion (Subcommittee) held a hearing entitled, “Next Generation Infrastructure: How Tokenization of Real-World Assets Will Facilitate Efficient Markets.” The committee memorandum on the hearing states that traditional financial institutions are exploring blockchain technology’s benefits for existing markets, such as tokenized bank deposits, private securities, and physical assets, but also notes that existing laws or regulations may create uncertainty.¹⁴

Sidley partner Lilya Tessler testified before the Subcommittee and emphasized that tokenization does not alter an asset’s fundamental nature but enables it to be recorded and transferred digitally.¹⁵ She further explained that this process enhances efficiency, risk mitigation, distribution channels, and liquidity, and allows for programmability using smart contracts. However, she noted that existing regulations and regulatory guidance may lack clarity and flexibility for market participants to fully leverage tokenization’s capabilities, particularly for such intermediaries as broker-dealers and custodians seeking to interact with tokenized securities on the blockchain.¹⁶

Although Representatives and witnesses expressed concern about the ability to mitigate certain risks related to blockchain technology, Subcommittee members from both political parties recognized that tokenization of real-world assets presents potential benefits across different industries and use cases. The Subcommittee is considering two legislative proposals that would require federal regulatory agencies to study and report on tokenization of real-world assets. One bill would direct the CFTC and SEC to assess whether additional guidance or rules are necessary to facilitate the development of tokenized securities and derivatives products, while the other requires the federal banking agencies to report on trends in the use of blockchain to tokenize traditional assets.¹⁷

UCC Minute: Article 12 Presents New Blockchain Opportunities

New amendments to the Uniform Commercial Code (UCC) have been adopted and become effective in several states, including Delaware and California. They await the Governor’s signature in Illinois. Additional state enactments and effective dates are expected in the year ahead. The UCC amendments, which focus on emerging technologies, create new commercial law rules for digital assets, including cryptocurrencies, blockchain tokens, electronic notes, and electronic chattel paper.

Among other things, the UCC amendments provide additional options for creating and perfecting security interests in digital asset collateral (including margin) and clarity about how to do so. The UCC amendments recognize a new type of asset — a controllable electronic record — within the category of general intangibles.¹⁸ A controllable electronic record is “a record stored in an electronic medium that can be subject to control under Section 12-105.”¹⁹  Under the UCC amendments, secured parties may perfect a security interest in controllable electronic records by filing a proper UCC financing statement or by achieving “control.”²⁰

In addition to providing clarity related to security interests in digital assets, they also provide greater legal certainty for transactions on a blockchain, or transactions involving electronic chattel paper or electronic documents of title. The UCC amendments are intended to be technology neutral and forward thinking, with room to adapt to market developments. This includes providing clearer rules for the issuance of digital securities on a blockchain and contemplating favorable treatment of controllable electronic records, controllable payment intangibles (“payment intangible[s] evidenced by a controllable electronic record that [provide] that the account debtor undertakes to pay the person that has [”control“] of the controllable electronic record”),²¹  and controllable accounts (“account[s] evidenced by a controllable electronic record that provides that the account debtor undertakes to pay the person that has [”control“] of the controllable electric record.”)²² This increased legal clarity removes one of the key hurdles to digitization.

When uniformly adopted, the UCC amendments will create a uniform playing field, providing more certainty for transactions that involve digital assets. However, in the interim, they can hold some surprises for those who are not prepared. And during the transition across states, parties must be especially attentive to which law is in effect to ensure appropriate action under both the amended and pre-amendment versions of the UCC.

Sidley lawyers have been deeply involved in the drafting process for the UCC amendments. We would be happy to discuss in more detail how they apply to you.

The CFTC Issues First-of-Its-Kind Order Against Crypto Prime Broker for Providing U.S. Customer Access to Digital Assets Derivatives Platforms

On May 13, 2024, the CFTC issued a first-of-its-kind order (Order) against Seychelles-based crypto prime broker Falcon Labs, Ltd. (Falcon Labs) for providing U.S. customers access to trading of digital asset derivatives, including futures and swaps, on digital assets derivatives platforms without being registered with the CFTC as a futures commission merchant (FCM) in violation of the Commodity Exchange Act (CEA).

The Order describes that during the relevant period, Falcon Labs acted as a “prime broker” by offering to its institutional customers, including customers located in the United States, a product providing cross-margined, direct access to digital asset exchanges to trade derivatives, including futures and swaps. Notably, the Order calls out as an example of such U.S.-located customers non-U.S. incorporated entities operated and controlled by U.S. based trading firms. The Order explains that in providing such access, Falcon Labs typically submitted its identity verifying information to the digital asset exchanges; however, the exchanges generally did not require, and Falcon Labs did not provide, identity verifying information for its underlying customers.

The Order follows a similar action against Binance in March 2023 for facilitating unregistered trading for U.S. customers, including through prime brokers that opened “sub-accounts” through which U.S.-located customers traded digital asset derivatives on the Binance platform. In the press release announcing the Order, CFTC Director of Enforcement Ian McGinley stated that the action “highlights that the CFTC will not hesitate to charge any entities — exchanges or intermediaries — who are providing customers access to digital asset products and services that require registration but have failed to appropriately register.”

CFTC Commissioner Caroline Pham issued a concurring statement critiquing the extraterritorial application of the CEA in the Order, noting that the U.S.-located test applied by the CFTC “ignore[s] the Commission’s decades of regulations and interpretations” and is an example of “breathtaking overreach” that can burden non-U.S. entities without the benefit of notice-and-comment rulemaking.

Falcon Labs agreed to settle the charges with the CFTC for approximately $1.8 million, reflecting $1,179,008 in disgorgement and a $589,504 civil monetary penalty. The CFTC noted in the Order that it recognized Falcon Labs’ substantial cooperation and remediation in connection with the matter in the form of a reduced civil monetary penalty. This included Falcon Labs’ voluntarily improving its controls for identifying the location of its customers after the CFTC filed its complaint against Binance and off-boarding approximately half of its institutional prime brokerage clients, as well as substantial cooperation with the CFTC’s Division of Enforcement in the investigation. The CFTC stated that it hopes the reduced civil monetary penalty will “encourage other digital asset intermediaries operating unlawfully to come forward and report their activities to the agency.”

ICYMI: A Taxonomy and Disclosure Guidelines for Digital Assets

On March 6, 2024, the CFTC Global Markets Advisory Committee (GMAC), an advisory committee comprising financial market infrastructures, market participants, end users, service providers, and regulators, recommended that the CFTC adopt a proposed “digital asset taxonomy” (Taxonomy). The Taxonomy aims to “set out a consistent language for participants in the digital asset ecosystem” and “enable effective regulatory understanding.”²³

The Taxonomy defines digital assets by building on UCC Article 12’s definition of a “controllable electronic record”²⁴ and characterizes different types of digital assets by looking at six features pertaining to the asset: (1) how the asset is issued and by whom, (2) how the asset holds value, (3) what rights the asset confers, (4) fungibility of the asset, (5) redeemability of the asset, and (6) whether the asset is a “digital native” (like bitcoin) or represents an asset that can be recorded using other systems, such as tokenized real-world assets.

Importantly, the Taxonomy recognizes that digital assets may serve a variety of functions and uses and that “when those assets have the characteristics of regulated instruments … a specific regulatory framework may already apply, and … it is unnecessary to look beyond the existing classification for the regulated instrument.” The Taxonomy provides that digital assets should not be classified by virtue of being recorded on a blockchain, as this “is inconsistent with how financial instruments (and non-financial instruments) today are classified and could have unintended consequences for the application of market regulations.”²⁵

Regardless of regulatory classification, material information about digital assets should be available to purchasers and users of that asset. For blockchain “native” digital assets in particular, existing disclosure frameworks may be both over- and underinclusive of material information specific to such digital assets. A working group of legal academics and practitioners, including Sidley lawyers, recently proposed guidelines designed to identify and elicit the disclosure of material information for these types of digital assets.²⁶ This version of the proposed disclosure guidelines, available below, is intended to start a dialogue. If you would like to provide feedback, please contact one of the blockchain industry groups listed in the proposal.

¹ H.J.Res.109, Providing for congressional disapproval under Chapter 8 of Title 5, United States Code, of the rule submitted by the Securities and Exchange Commission relating to “Staff Accounting Bulletin No. 121,” 118th Congress (2023–24).

² Executive Office of the President, May 8, 2024, Statement of Administrative Policy.

³ President Biden, A Message to the House of Representatives on the President’s Veto of H.J.Res. 109 (May 31, 2024).

⁴ See Sidley Update, The SEC Has Crypto in Its Crosshairs (Again) (April 8, 2022).

⁵ See, e.g., Brandon Milhorn, Conference of State Bank Supervisors, Comment Letter on SEC’s Staff Accounting Bulletin 121 (Feb. 28, 2024).

⁶American Bankers Association, Bank Policy Institute BPI, Financial Services Forum, and Securities Industry and Financial Markets Association, Letter to President Biden re: “Staff Accounting Bulletin No. 121” (H.J. Res. 109) (May 31, 2024).

⁷ Id.

⁸ Id.

⁹ HR 4763, Financial Innovation and Technology for the 21st Century Act, 118th Congress (2023–24).

¹⁰ See Paul Tierno, Eva Su, Congressional Research Service IN12223; see also Sidley Update, U.S. Congressional Leaders Introduce Two Landmark Bills to Create a Digital Assets Regulatory Scheme (July 25, 2023).

¹¹ The House Committee on Rules has made available blacklines against the introduced versions at https://rules.house.gov/bill/118/hr-4763.

¹² Chair Gary Gensler, May 22, 2024, Statement on the Financial Innovation and Technology for the 21st Century Act.

¹³ Executive Office of the President, May 22, 2024, Statement of Administrative Policy.

¹⁴ Memorandum to Members of the Committee on Financial Services from Digital Assets, Financial Technology, and Inclusion Subcommittee Staff (May 31, 2024).

¹⁵ Congressional Transcripts, House Financial Services Subcommittee on Digital Assets, Financial Technology, and Inclusion Holds Hearing on Next Generation Infrastructure (Jun. 05, 2024).

¹⁶ Id.

¹⁷ See HR _____, To Require the Commodity Futures Trading Commission and the Securities and Exchange Commission to conduct a study to assess whether additional guidance or rules are necessary to facilitate the development of tokenized securities and derivatives products, and for other purposes, and HR 8464, the Tokenization Report Act of 2024.

¹⁸ Amended Model UCC § 9-102(42) (defining general intangible as “any personal property ... [including] controllable electronic records, payment intangibles, and software”).

¹⁹ Amended Model UCC § 12-102(a)(1).

²⁰ See Amended Model UCC § 12-105.

²¹ Amended Model UCC § 9-102(27B).

²² Amended Model UCC § 9-102(27A).

²³ Recommendations to the Commodity Futures Trading Commission Global Markets Advisory Committee by the Digital Asset Markets Subcommittee (Recommendations) (March 6, 2024).

²⁴ UCC 12-102(a)(1).

²⁵ Recommendations, at p. 2.

²⁶ Proposed U.S. Disclosure Guidelines for a Particular Category of Tokens.

Knowledge Management Lawyer Daniel Engoren contributed to this Sidley Update.