Preemption of inconsistent state laws

In these days of hyper-partisan politics, any bill with sponsors from both sides of the aisle deserves attention. Now there is one that is particularly important in the cryptographic space. The eighth. In March 2021, Representative Warren Davidson introduced the Taxonomy Act of 2021 as a token. He was sponsored by Ted Budd, Darren Soto, Scott Perry and Josh Gotheimer.

Token Taxonomy Legal Terms 2021

Among other things, the bill would exempt digital tokens from the definition of a security and eliminate inconsistent government regulations. Cryptoassets must meet certain requirements to qualify as digital tokens under the law:

  • First, the unit must be created either as a result of a revision to the proposed transactions, under creation rules that cannot be changed by one or more persons under common control, or as an initial distribution of numerical units that would otherwise be created under one of the first two options.
  • Second, the assets must have a transaction history recorded in a distributed ledger or data structure for which consensus is reached through a mathematically verifiable process.
  • Third, once a consensus has been reached, the record of the transaction must be capable of withstanding modification by one or more persons under common control.
  • Fourth, the interest must be transferred in homogeneous transactions and fifth, it must not be a traditional financial interest in a company or partnership.

Davidson said the bill is intended to make regulations clearer. Moreover, he suggested in an interview that if the law had been passed earlier, it could have prevented enforcement actions such as the Securities and Exchange Commission (SEC) lawsuit against Ripple Labs. This commentary takes a closer look at how law can actually play a role with respect to certain forms of cryptography.

How will bitcoin evolve?

As almost everyone in the cryptocurrency world probably knows, bitcoin (BTC) is only released through mining transactions. In other words, it is created in response to the validation of proposed transactions, thus satisfying the first of the requirements for a digital token. Moreover, the transaction history is maintained on the blockchain, which satisfies the second of the above requirements.

The whole process is structured in such a way that it resists modification or change unless there is a consensus within the large decentralized community. The entire Bitcoin network was set up as a peer-to-peer network, although there are now many exchanges that facilitate data transfer. Finally, bitcoin is not affiliated with any business or corporation and does not represent any ownership or right to a share of the proceeds.

Given these facts, bitcoin will undoubtedly become a digital token. Thus, under the new definition proposed in the bill, the concept of bitcoin would be excluded from the definition of a security. In addition, under Section 2(d) of the Act, state securities laws relating to the registration or imposition of restrictions on assets would not apply to Bitcoin, with the only caveat that the states would retain the authority to regulate and enforce actions based on fraud or deceit.

Since the SEC has already exempted bitcoin from the federal securities laws, this would not change the federal requirements. Nevertheless, it would create a unified system of government in which bitcoin as a security is excluded from regulation except in the case of fraud claims.

Will Ripple XRP become a digital token?

However, it is not entirely accurate to assume that all cryptographic assets will qualify as digital tokens under the Act. Think XRP Ripple (and the SEC’s ongoing lawsuit against the company and its executives). For those not familiar with Ripple and XRP: In December 2012, Ripple’s XRP settlement was completed and the computer code set a firm bid of 100 billion XRP. At launch, 80 billion of these tokens were given to Ripple, while the remaining 20 billion XRP went to the founding group.

According to the SEC’s complaint, between 2013 and 2014 Ripple worked to create a market for XRP by distributing about 12.5 billion XRP through bounty programs that paid programmers to report problems in the XRP ledger code. From 2014 through the third quarter of 2020, the company sold approximately 8.8 billion XRP on the market and through institutional sales, raising approximately $1.38 billion to fund its operations. At this time, resales were also taking place, including XRP resales, which were previously common among the company’s founders. So is XRP a digital token and therefore exempt from regulation as a security under the Act?

Looks like it: Securities and Exchange Commission v. Ripple: Foreseeable but undesirable developments

The first requirement is in fact the biggest challenge for XRP. The bill provides three options for the first part of the test, but it is not clear whether XRP meets any of them. Since all tokens were released at launch, there is no argument that the XRP is created in response to the validation or collection of proposed transactions.

Furthermore, given that all tokens were issued at launch, it is clear that Ripple or those who control the company may have changed the terms under which XRP would be released. This leaves the argument that there was an initial distribution of numerical units that would otherwise have occurred in either of the first two alternatives, and it is doubtful that this occurred. XRP was never made to mine, and Ripple certainly had the ability to retain control of the assets since it owned the vast majority of them. This gives the impression that XRP is not really a digital token, even though the facts can be disputed.

It should be noted that the law also provides a very limited exception for any digital entity, a much broader term that includes any representation of economic, property or access rights stored in a machine-readable format. The exemption applies to anyone who acted reasonably and in good faith in the belief that the digital medium was a digital token. However, it applies only if, within 90 days of notifying the SEC that it has determined that the interest is a security, all reasonable efforts have been made to terminate the sale and return all unused proceeds to the customers. Apparently, Ripple has refused to go down that road while fighting the SEC’s current enforcement action in court.

While this analysis and the results do not disappoint everyone in the crypto community, as some have long argued that XRP is not a true crypto asset anyway, it is a clear indication that this law does not create a free pass for all crypto offerings. This won’t be the end of the road for Ripple either, as it can always argue that XRP is not an investment contract under the Hoey test.

Are Facebook’s stables digital tokens?

Another illustrative example may also be of interest in understanding how this bill would work if passed. Take a look at Facebook’s first offer. On the 18th. June 2019, Facebook announced in a white paper that it actively plans to launch a cryptocurrency called Libra in 2020. The entire proposal has been renamed and updated, but the language of the original white paper is discussed here.

The scale was conceived by Facebook and designed as a stable asset whose value is tied to a basket of bank deposits and short-term government securities for a group of historically stable global currencies. It would be managed by the Libra Association, a Swiss non-profit organization.

Weight was set up as a grouping of various organizations from around the world, including Facebook, and major investors such as Mastercard, Visa, eBay and PayPal. The original plan was for about 100 members to contribute $10 million each by the association’s target date. In return, the members of the association will have the right to control the development of the balance, the actual reserves and even the rules for managing the balance. A group of 100 members can also act as a validation node for the property.

The scales were not allowed to be disassembled, but had to be delivered according to the specifications of the weight association. The White Paper also describes a system that would allow the association to modify the operation of the system and, in particular, to establish rules for the issuance of assets. Although the association consists of a relatively large number of different members with their own objectives and interests, they act through the association, which is itself a single legal entity. This means that the Libra token (in its original form) would not meet the definition of a digital token according to the law.

Does this mean Libra is a guardian? As with XRP, the answer is not necessary. The next step would be to determine if it is an investment contract. Depending on the club’s decision to issue the coin and whether it was revalued (which seems unlikely, since it was assumed that the coin was pegged to fiat currencies as a stablemate), the Libra coin may or may not have been an investment contract. The determination should be based on the same Howey test that would have been developed to clarify the law.

Supplement

Excluding digital tokens from the definition of a security means that the SEC retains no authority to regulate fraud related to transactions involving these shares, leaving the bulk of enforcement to entities like the Commodity Futures Trading Commission. While the CFTC has tried to act against those who commit fraud or deception in the crypto spot markets (when it comes to crypto spot trades and not futures or other derivatives), it does not have the resources that the SEC has.

For example, the CFTC just announced its first enforcement action related to a pump-and-dump scheme, while the SEC’s list of past enforcement actions related to cryptocurrencies includes a number of market manipulation complaints, in addition to complaints against John McAfee, who is the subject of the CFTC’s most recent actions.

This difference is partly due to the relative size of the two agencies. The SEC’s 2021 budget justification plan provides for support of $1.895 billion. By contrast, the CFTC’s 2021 budget request was relatively modest: $304 million. Therefore, it is not necessarily wise or prudent to comply with the TCRC’s anti-fraud laws.

Furthermore, it is clear that the proposed definition of a digital token is likely to be much simpler than the Howey test, but it will not necessarily replace that analysis in all cases.

Does the law of token taxonomy provide more clarity? Absolutely. Preferences for inconsistent state laws could be particularly useful in this regard. Does it offer security in all cases? No, but that’s not necessarily a bad thing. Is the law a good idea? Unfortunately, probably not. The provision of a predetermined exception for the registration of digital tokens may be supported. Excluding them from the definition of security is probably not possible in today’s environment where fraud remains a major problem.

The views, thoughts and opinions expressed herein are those of the author and do not necessarily reflect or represent those of Cointelegraph.

Carol Goforth is Clayton N. Little Professor of Law at the University of Arkansas School of Law in Fayetteville. Little Chair in Law at the University of Arkansas School of Law, Fayetteville.

The opinions expressed are solely those of the author and do not necessarily reflect those of the University or its affiliates. This article is intended for general information purposes and is not intended to be, nor should it be construed as, legal advice.

frequently asked questions

What does preempt state law mean?

Preemption occurs when a higher level of government (state or federal), through legislation or regulation, overrides or limits the authority of a lower level in a particular area. Express preference exists when a statute contains a preference clause or other expressly preferential language.

Can state law take precedence over federal law?

The Supremacy Clause of the Constitution provides that federal law is the supreme law of the land, regardless of whether a state law conflicts with it. This language is the basis for the doctrine of federal preemption, under which federal laws take precedence over conflicting state laws.

What is a conflict option?

Conflict avoidance occurs when state law conflicts with existing federal law to such an extent that it is materially impossible to comply with both laws, or when state law becomes an impediment to the accomplishment and fulfillment of all congressional purposes.20 State law is not conflict avoidant law.

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