December 15, 2022
This is a busy time of year for a lot of reasons.
There are the holidays, of course, but this is also a great time to take stock of the year that was and to do some crystal ball-gazing into the future. So this week’s issue does a bit of “looking back” at 2022 and “looking ahead” to 2023, including a look at the FTX situation that will likely feature prominently in the weeks and months to come.
Mentioned several times as we’re looking back and looking ahead is sustainability, and along those lines, we’re excited to welcome ESG finance and investment partner Sukhvir Basran to Cadwalader. Sukhvir is based in London and has established a global profile as a market-leading ESG attorney.
But even with the anticipation of the new year, there are still very important developments in the news every day − none more prominent than continued and intensified discussion around crypto asset regulation. My colleagues Philip Khinda and Kendra Wharton take a look at important new SEC guidance following recent developments.
This will be our final issue of 2022. Thank you for your loyal readership over the past year, and we hope we were able to provide some helpful insights and analysis. We’ll aim to do more of the same in 2023.
Happy holidays, all.
Daniel Meade
Editor, Cabinet News and Views
On December 13, the U.S. Attorney’s Office for the Southern District of New York (the “U.S. Attorney’s Office”), the U.S. Securities and Exchange Commission (the “SEC”), and the U.S. Commodity Futures Trading Commission (the “CFTC”) announced parallel criminal and civil actions (here, here and here) against FTX co-founder and former CEO Sam Bankman-Fried. The charges were made public the morning after the U.S. Attorney tweeted that Bankman-Fried had been arrested by Bahamian authorities at the request of the U.S. government.
Criminal Charges
A federal grand jury indicted Bankman-Fried on December 8, charging him in eight separate counts. The charges include conspiracies to commit wire fraud, commodities fraud, securities fraud, money laundering and federal campaign finance violations.
According to the indictment, Bankman-Fried perpetrated a multi-year scheme to defraud FTX customers by diverting billions of dollars of their crypto assets to his crypto trading firm, Alameda Research. Bankman-Fried is also alleged to have defrauded Alameda’s lenders and equity investors in FTX by concealing his misuse of customer crypto, some of which are alleged to be the true source of millions of dollars in political contributions.
Bankman-Fried is being held without bail in the Bahamas pending the filing of a formal extradition request. An extradition process is usually lengthy, and it might be many months before Bankman-Fried can be prosecuted in a U.S. court. At a hearing on December 13, Bankman-Fried indicated that he plans to fight extradition at this time, but he may ultimately waive that right and agree to be transferred to the U.S. to begin judicial proceedings. Bankman-Fried’s appearance in the U.S. may also be delayed if Bahamian authorities pursue charges under Bahamian law.
In addition to the possibility of a lengthy prison sentence, Bankman-Fried faces potential asset forfeiture of any property derived from the proceeds of his alleged crimes.
SEC Allegations
The SEC’s complaint, filed in the U.S. District Court for the Southern District of New York, alleges that Bankman-Fried defrauded equity investors in FTX by misrepresenting that FTX was a safe, responsible crypto asset trading platform. For example, the SEC alleges that Bankman-Fried repeatedly told prospective investors that FTX had sophisticated risk management controls in place to protect customer assets, and that those assets were safe and secure, but his statements were false and misleading because he had exempted Alameda from the risk management measures and was diverting billions in crypto assets to prop up Alameda’s operations. The SEC alleges that these and other actions amounted to securities fraud in violation of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder.
The SEC is seeking a permanent injunction against Bankman-Fried, disgorgement of ill-gotten gains, civil money penalties, an officer and director bar, and an order prohibiting Bankman-Fried from participating in any future offer or sale of securities (including crypto asset securities).
CFTC Allegations
Unlike the criminal and SEC actions, the CFTC’s complaint alleges multiple federal violations by Bankman-Fried, as well as FTX Trading and Alameda Research. The CFTC’s complaint is very similar to those filed by the DOJ and the SEC; however, the scope of the complaint and the legal authorities relied by the CFTC are materially different.
- First, the CFTC asserted that virtual currencies, such as Bitcoin, Ether and Tether, are recognized as “commodities” as defined in Section 1a(9) of the Commodity Exchange Act of 1936 (the “CEA”) and CFTC regulations thereunder.
- Second, the CFTC charged that FTX’s actions materially impacted the trading of crypto assets, as well as certain futures contracts on these assets that are traded on registered derivative commodity exchanges.
- Third, the CFTC alleged that FTX’s asset transfers to Alameda constituted fraud and that FTX engaged in fraudulent misstatements of material fact and material omissions “in connection with contracts of sale of commodities in interstate commerce” in violation of Section 6c(1), and CFTC regulations Section 180.1(a)(1), (2) and (3), thus triggering CFTC’s general antifraud enforcement jurisdiction in connection with commodities generally.
Notably, the CFTC made clear that FTX’s U.S. CFTC-registered platforms (“FTX US Derivatives”) (formerly known as “LedgerX”) were registered with and fully regulated by the CFTC as a designated contract market, a derivatives clearing organization and swap execution facility, that “maintained separate bank accounts which segregated and accounted for customer funds at all relevant times.” Accordingly, the U.S. platforms are not within the scope of this complaint.
Final Thoughts
Despite recent focus on whether many crypto assets can be regulated under the federal securities laws or the CEA, the criminal and civil actions announced on December 13 do not require any finding that crypto assets listed by FTX were securities or commodity derivatives (such as futures, options or swaps). Rather, they focus on time-tested legal theories of fraud. However, the U.S. Attorney’s Office, the SEC and the CFTC have indicated that investigations into other possible misconduct are still ongoing.
In the wake of mounting crypto bankruptcies and federal investigations into the alleged misappropriation of crypto assets, among other possible wrongdoing by market participants, the U.S. Securities and Exchange Commission’s Division of Corporation Finance announced new guidance on December 8 for public company disclosures about the impact of these and other developments.
While the news cycle is currently focused on the arrest of FTX co-founder and former CEO Sam Bankman-Fried, public companies, funds and other institutions with federal disclosure obligations must be mindful of the heightened scrutiny they will receive in the coming months. Many public companies, in particular, may be obligated under the federal securities laws to provide disclosures in their upcoming annual or quarterly filings relating to the impacts of widespread financial distress across the crypto asset markets. Even those facing indirect counterparty risks may be required to make meaningful disclosures.
In its December 8 guidance, the Division of Corporation Finance released a sample letter describing several considerations that public companies should keep in mind as they prepare their disclosures. The Division advised companies to evaluate their disclosures, including Risk Factors and Management’s Discussion & Analysis of Financial Condition and Results of Operations, with a view toward providing specific, tailored disclosures about the material impacts of crypto asset market developments.
Among other considerations, the sample letter indicates issuers should carefully evaluate their disclosures of:
- impacts from the price volatility of crypto assets;
- impacts from the bankruptcies of FTX, Voyager, Celsius Network, BlockFi, and other market participants, including whether the business has any material assets that may not be recovered or may otherwise be lost or misappropriated;
- direct or indirect exposure to other counterparties, customers, custodians, or other participants in crypto asset markets known to have experienced insolvency or excessive redemptions, have crypto assets that are unaccounted for, or have experienced material corporate compliance failures;
- if the company holds crypto assets, whether the crypto assets serve as collateral for any loan, margin, rehypothecation, or other similar activities;
- changes to company processes in light of crypto market developments, including steps taken to safeguard crypto assets, and implementation of policies and procedures designed to prevent commingling of assets, self-dealing and other potential conflicts of interest;
- risk management gaps identified by the company’s board or management in light of crypto market conditions, as well as changes made to address those gaps;
- reputational harm the company may face in light of recent disruption in the crypto asset markets; and
- potential impacts of regulatory developments, including pending crypto legislation or regulation.
The sample letter follows an announcement by the Division of Corporation Finance in September that it was adding a dedicated Office of Crypto Assets to its Disclosure Review Program. The new office focuses resources and expertise to address the unique and evolving disclosure issues relating to crypto assets. The Office of Crypto Assets will be ready and willing to refer matters to the Division of Enforcement when it finds that companies failed to provide investors meaningful disclosures about the material impacts of crypto asset market conditions.
As we are coming to a close on 2022, we’re taking a look back at some of the important developments of 2022 and what lies ahead for 2023.
Looking Back at 2022
As past readers may have seen me say before, there’s a saying in Washington that personnel is policy. In 2022, we at least have more certainty on who the personnel is, and therefore some better educated guesses about what policy may be in 2023. On the personnel front, in 2022, we saw Michael Barr confirmed as Vice Chair of Supervision at the Federal Reserve Board (“FRB”), and Martin Gruenberg nominated to be permanent Chair of the Federal Deposit Insurance Corporation (“FDIC”). We also saw nominations of Travis Hill and Jonathan McKernan as the Republicans on the FDIC Board. If confirmed, the FDIC would have all five seats filled for the first time in a long while. The Federal Reserve Board also has its full contingent of seven members for the first time in recent memory as well, with Jerome Powell and Lael Brainard being confirmed as Chair and Vice Chair, respectively, this year as well. Presuming Acting Chair Gruenberg is confirmed as FDIC Chair, the only acting principal at the federal prudential banking agencies is Acting Comptroller of the Currency Michael Hsu. While President Biden may very well nominate someone (possibly including Mr. Hsu) to be confirmed as Comptroller, the National Bank Act permits an acting Comptroller to stay at the pleasure of the Secretary of the Treasury.
In terms of the policy we have seen in 2022, all three agencies have issued proposed guidance on the management of financial risks related to climate and crypto. The FDIC finalized its 2‑basis point increase in base deposit insurance rates. This year showed a return to a preference for interagency agreement. The climate and crypto guidance noted above demonstrate an intent to provide consistent, if not uniform guidance on those topics, and the most notable interagency action may be the interagency release of a Community Reinvestment Act proposed rule in May.
Looking Ahead to 2023
Looking ahead to 2023, many of the topics of proposals in 2022 likely will become the final rules of 2023. Just last week, we noted Vice Chair Barr’s speech at the American Enterprise Institute on Bank Capital. As 2022 turns to 2023, we will likely see the results of Vice Chair Barr’s holistic review of the capital rules, and likely (hopefully?) see an interagency proposal on the U.S. version of the Basel III endgame (aka Basel IV) rules. Reading the tea leaves laid out in Mr. Barr’s speech, it’s likely that capital levels will be going up.
Given the continuing turmoil in the cryptocurrency market (see this week’s article by my colleagues on SEC and CFTC actions with regard to FTX), it’s become more likely that Congress will do something to at least clarify jurisdiction among the market regulators and possibly legislate on stable coin rules.
As noted above, we will likely see final rules or guidance from the banking agencies on rules they proposed in 2022. Look for a final rule (or possibly a re-proposal) from the three agencies on the Community Reinvestment Act. There will likely be further guidance on climate and crypto activities. If the FRB doesn’t finish before the end of 2022 (which is still a possibility), we will likely see a final rule from the FRB on rules to implement the LIBOR Act. Although the FRB finalized its Guidelines on access to Federal Reserve master accounts in 2022, the issue will likely continue to see developments in 2023, as litigation on the matter continues. Finally, speaking of litigation, since the Consumer Financial Protection Board (“CFPB”) is a bureau of the FRB, I’ll squeeze a big CFPB matter into our 2023 future gazing. It seems likely that the Supreme Court will hear an appeal of the Fifth Circuit Decision finding the way the CFPB is funded through the FRB to be unconstitutional. Any decision on the constitutionality of the CFPB could very well be the biggest banking law story of 2023.
On December 14, Senators Elizabeth Warren (D-Mass.) and Roger Marshall (R-Kan.) introduced in the U.S. Senate a new bipartisan bill, titled "Digital Asset Anti-Money Laundering Act of 2022" (the “Bill”), intended to curb the use of digital assets for money laundering and to counter the financing of terrorism. This is a very narrow bill and is not intended to supplant previously proposed legislation on digital assets by Senators Stabenow/Boozman or Lummis/Gillibrand, and does not address the Commodity Futures Trading Commission (“CFTC”)/Securities and Exchange Commission (“SEC”) jurisdictional reach over digital assets.
The Bill defines the terms: digital assets, digital asset kiosk, digital asset mixer and privacy coin, and directs the Financial Crimes Enforcement Network (“FinCEN”) to promulgate rules “classifying custodial and unhosted wallet providers, cryptocurrency miners, validators, or other nodes who may act to validate or secure third-party transactions, independent network participants, including MEV searchers, and other validators with control over network protocols as money service businesses.”
Further, FinCEN is directed to implement rules requiring reporting of all transactions by U.S. persons in digital assets in value over $10,000 through accounts outside the United States. The Bill also requires the U.S. Treasury to promulgate rules prohibiting financial institutions from “handling, using, or transacting business with digital assets” entities using anonymity-enhancing technologies.
The Bill directs the Treasury, SEC and CFTC to establish a “risk-focused examination and review process” to assess the adequacy of anti-money laundering and anti-terrorist prevention programs, including suspicious activity reporting.
Finally, the Bill requires operators of digital assets kiosks and the ATMs to ascertain the identity of all their customers and users.
The reach of this Bill is very broad, requiring, first, existing financial institutions and, second, digital assets infrastructure providers to play a critical role in preventing domestic and international money laundering and financing of the terrorist activities through the use of digital assets, such as crypto currencies Iike Bitcoin, Ether, or Tether.
Many of the digital assets infrastructure providers, such as FTX, are based outside of the U.S. but offer their services to U.S. persons. If this Bill had been enacted before the collapse of FTX, most if not all of FTX’s non-U.S. transactions with U.S. participants would have been reportable to and transparent for the FinCEN, Treasury, SEC, and CFTC.
This Bill is likely the first of many to be introduced (or re-introduced) in the aftermath of the FTX’s collapse in November 2022.
