United States: New York State Department Of Financial Services Proposes A "BitLicense" Regulatory Framework For Virtual Currency Businesses

Keywords: New York, Department of Financial Services, BitLicense, virtual currency

The New York State Department of Financial Services (the "NYSDFS") has released a proposed regulatory framework (the "Proposed Rules") for New York virtual currency businesses.¹ The Proposed Rules build upon the NYSDFS' prior activities in the virtual currency space. These activities include a public order in soliciting formal proposals and applications for the establishment of regulated virtual currency exchanges in March 2014, an "Ask Me Anything" Reddit forum by Superintendent Benjamin Lawsky in February 2014, a public hearing with panels of industry participants and subject-matter experts in January 2014 and an inquiry (i.e., request for public comment) in August 2013.

While the Proposed Rules are neither the first regulatory response to virtual currencies nor the final word on the topic, they represent a comprehensive regulatory regime that is likely to have wide-ranging effects on the developing industry. Some of the administrative requirements and business standards set out in the Proposed Rule are similar to those imposed on other types of state licensees (e.g., money transmitters and consumer lenders) and should not present significant concerns. Other provisions, such as the consumer protection disclosure requirements, raise potentially significant concerns, especially if other states were to adopt different or inconsistent requirements.

NYSDFS will be accepting public comments on the Proposed Rules until September 5, 2014. Interested parties should review the Proposed Rules and provide comments to the NYSDFS as this regulatory approach could also serve as a model for other states. A summary of the key provisions of the Proposed Rules is set forth below.

Coverage of the Proposed Rules. The Proposed Rules would apply to business conduct that involves "Virtual Currency," which means any type of digital unit that is used as a medium of exchange or a form of digitally stored value or that is incorporated into payment system technology. Virtual Currency shall be broadly construed to include digital units of exchange that:

• Have a centralized repository or administrator;
• Are decentralized and have no centralized repository or administrator; or
• May be created or obtained by computing or manufacturing effort.

Virtual Currency does not include digital units that are used solely within online gaming platforms with no market or application outside of those gaming platforms. It also does not include digital units that are used exclusively as part of a customer affinity or rewards program and that can be applied solely as payment for purchases with the issuer and/or other designated merchants, but cannot be converted into, or redeemed for, government-issued Fiat Currency.²

Licensing and Supervision. The Proposed Rules would require that any firm engaged in "Virtual Currency Business Activity" obtain a BitLicense from the NYSDFS. The Proposed Rules define engaging in a Virtual Currency Business Activity as:

• Receiving or transmitting Virtual Currency on behalf of customers;
• Securing, storing, holding or maintaining custody or control of Virtual Currency on behalf of customers;
• Buying and selling Virtual Currency as a customer business;
• Performing retail conversion services, including converting or exchanging Virtual Currency into Fiat Currency (and vice versa) or converting two forms of Virtual Currency; or
• Controlling administering or issuing a Virtual Currency.

A BitLicense would not be required for merchants or consumers that utilize Virtual Currency solely for the purchase or sale of goods and services alone. The Proposed Rules also exempt firms that are chartered under the New York Banking Law to conduct exchange services and are approved by NYSDFS to engage in Virtual Currency Business Activity.

Notably, a company would be subject to licensure as a BitLicensee if it engages in the above activities in New York state (i.e., present in the state) or with a New York resident. In light of the global scale and online nature of Virtual Currency, a company could become subject to licensure in New York by inadvertently transacting business with a customer located in the state.

Administrative Requirements

Application Process. To apply for a BitLicense, the prospective licensee would submit a detailed application that contains the following information about the applicant and its Virtual Currency business:

• Basic information about its organization and affiliates, including an illustrative organizational chart showing the applicant's affiliate relationships;
• Management structure, including an organizational chart showing lines of authority and allocation of duties;
• Current financial statements and projected balance sheet and income and expense statement for the coming year;
• A description of the proposed, current and historical business, including products and services provided, online and physical places of business, primary market of operation, projected customer base and specific marketing targets;
• An explanation of the methodologies used to calculate the value of Virtual Currency in Fiat currency; and
• Details of banking arrangements, written policies and procedures and an affidavit describing any administrative, civil or criminal actions against the firm.

In addition, the applicant would be required to provide personal and financial information about each of its directors, principal officers, principal stockholders and principal beneficiaries that would include:

• Detailed biographical information, a background report prepared by an independent investigatory agency and fingerprints;³
• Current financial statements; and
• An affidavit describing any administrative, civil or criminal actions against the firm.

After the application is filed, NYSDFS would investigate the applicant's financial condition and responsibility, financial and business experience, and character and general fitness to ensure that the applicant's Virtual Currency business will be conducted in compliance with the proposed rules. NYSDFS would approve or deny an application within 90 days of its completed filing.

Business Changes. Licensees must obtain NYSDFS approval prior to introducing a new product or service, or before making a material change to an existing product that raises legal or regulatory issues or implicates safety and operational concerns. NYSDFS would also approve a change of control of a licensee, defined in the proposed rules as the power to direct the management and polices of the firm.

Recordkeeping. Licensees must maintain records of their Virtual Currency Business Activity for at least 10 years. These records would include: transactional records (amount, date, time of the transaction, payment instructions, fees and charges, names, account numbers and addresses of all parties to the transactions); a general ledger containing all assets, liabilities, capital, income, expense accounts and profit and loss accounts; bank statements; statements or valuations provided to customers; board of directors meeting minutes; records of compliance with state and federal anti-money laundering laws; and documents relating to the investigation of customer complaints.

Independent NYSDFS Examinations. NYSDFS will have the right to conduct examinations of licensees whenever the superintendent deems necessary—but at least once every two calendar years. These examinations are meant to review the licensee's (or its affiliate's) financial condition, safety and soundness of its business conduct, management polices and compliance with laws and regulation.

Reports and Financial Disclosures. Licensees must submit quarterly financial statements to NYSDFS within 45 days of the close of the fiscal quarter, including a statement of financial condition, financial projections, off-balance sheet items, a chart of accounts and reports of the firm's permissible investments and compliance with financial regulatory requirements.

In addition, a licensee must submit audited annual financial statements. The submission would include an assessment by management of the licensee's compliance with laws and regulations, an opinion of an independent certified public accountant regarding accounting procedures and internal controls and a certification by an officer or director of the licensee of the truthfulness and accuracy of the financial statements.

Business Standards

Each BitLicensee would be required to meet certain internal business conduct standards. To ensure compliance with these standards, each licensee would be required to appoint a compliance officer to maintain and enforce its written compliance policies, including policies with respect to anti-fraud, anti-money laundering, cyber security, privacy and information security.

Capital Requirements and Investment Restrictions. Licensee must maintain such capital as NYSDFS deems sufficient to ensure the financial integrity of the licensee. In determining the minimal amount of capital that must be maintained, the NYSDFS will consider a variety of factors. These include the licensee's:

• Total assets (including the position, size, liquidity, risk exposure and price volatility of each type of asset);
• Total liabilities (including the size and repayment timing of each type of liability);
• Actual and expected volume of virtual currency activity;
• Current regulatory position, including whether the licensee is already licensed or regulated under the Financial Services Law, Banking Law or Insurance Law;
• Amount of leverage;
• Liquidity position; and
• Level of financial protection provided to customers through its trust account or bond.

Additionally, the Proposed Rules would limit the instruments in which a licensee may invest its retained earnings and profits to short-term, US dollar-denominated instruments consisting of money market funds, state or municipal bonds, US government or agency securities and certificates of deposit issued by federally or state-regulated financial institutions.

Custody of Customer Assets. Licensee must hold virtual currency of the same type and amount as any virtual currency owed or obligated to a third party. Licensees would be prohibited from selling, transferring, assigning, lending, hypothecating, pledging or otherwise using or encumbering this virtual currency, or any assets it stores on behalf of another person. Each licensee must maintain a US dollar-denominated bond or trust account for the benefit of its customers in such form and amount as is acceptable to the NYSDFS for the protection of the licensee's customers.

Anti-money Laundering. Licensee must engage in extensive bank-like anti-money laundering procedures, including establishment of an anti-money laundering ("AML") program, performance of an AML risk assessment, currency transaction-like reporting for virtual currency transactions, suspicious activity reporting, customer identification, sanctions screening and enhanced due diligence for foreign entity accounts. The licensee's AML program would need to include a system of internal controls, policies and procedures to ensure compliance with AML requirements and be subject to annual independent testing (internal or external). The customer identification procedures would need to incorporate general know-your-customer elements and screen customers for inclusion on the Office of Foreign Assets Control's Specially Designated Nationals list.

Cyber Security. Licensees must implement a cyber security program that performs a set of core functions, including: identifying internal and external cyber risks; protecting systems from unauthorized access or malicious acts; detecting systems intrusions and data breaches; and responding and recovering from any breaches, disruptions, or unauthorized use of systems. Licensee would also need to designate a Chief Information Security Officer to oversee the cyber security program, annually audit the integrity of the licensee's systems and submit the resulting audit report to NYSDFS. The annual audit would need to include penetration testing and an independent third party source code review of any internally developed software.

Business Continuity and Disaster Recovery. Licensees would be required to establish and maintain a business continuity and disaster recovery ("BCDR") plan to ensure the licensee's ongoing functioning and viability during an emergency or other disruption. In addition to identification of internal resources, the creation of procedures for the maintenance of back-up facilities, systems and infrastructure, and the provision for sufficient data back-ups, a licensee would be required to annually test its BCDR plan using independent personnel (internal or external).

Advertising and Marketing. Licensees would be restricted from advertising their products, services or activities in New York or to New York residents without including the name of the licensee and a notice confirming proper licensure in New York. Further, in all advertising and marketing materials, licensees would be prohibited from providing false, misleading or deceptive representations or omissions. Licensees must maintain copies of all advertisements for examination by the NYSDFS.

Disclosure of Risks Associated with Virtual Currency. Licensees must clearly disclose to consumers the potential risks associated with its products. Necessary disclosures include the following: that Virtual Currency is not legal tender, is not backed by the government and that Virtual Currency accounts are not subject to FDIC or SIPC protections; that transactions in Virtual Currency are generally irreversible and losses due to fraudulent or accidental transactions may not be recoverable; that the volatility of the price of Virtual Currency relative to Fiat Currency may result in significant loss or tax liability over a short period of time; and that the nature of Virtual Currency may lead to an increased risk of fraud or cyber attack.

Disclosure of Transaction Terms and Conditions. Licensees must disclose terms and conditions associated with their products before entering into an initial transaction with a customer. These disclosures would need to include, at a minimum: the amount of the transaction; any fees, expenses and charges borne by the customer, including applicable exchange rates; the type and nature of the Virtual Currency transaction; and such other disclosures as are customarily given in connection with a transaction of this nature.

Virtual Currency Receipts. Upon completion of any transaction, each licensee must provide each customer a receipt containing the following information: (i) the name and contact information of the licensee, including a telephone number established to answer questions and register complaints; (ii) the type, value, date and precise time of the transaction; (iii) the fee charged; (iv) the exchange rate, if applicable; (v) a statement of the liability of the licensee for non-delivery or delayed delivery; and (vi) a statement of the licensee's refund policy.

Prevention of Fraud. Customers who are victims of fraud will be entitled to seek compensation from any trust account, bond or insurance policy maintained by the licensee. In an effort to prevent fraud, licensees must establish and maintain a written anti-fraud policy that would include, at a minimum: the identification and assessment of fraud-related risk areas; procedures and controls providing protections against identified risks; and the allocation of responsibility for monitoring risks. Notably, licensees would not be required to refund or reimburse customer's losses or reverse transactions if there is an occurrence of fraudulent activity.

Consumer Complaints. Licensees must establish and maintain written policies and procedures to resolve consumer complaints in a fair and timely manner. In accordance with this requirement, each licensee would need to provide consumers with its mailing address, email address and telephone number for the receipt of complaints. Licensees would also be required to direct consumers to the NYSDFS if they wish to bring a complaint to the Department's attention

Originally published August 6, 2014

Footnotes

* The firm wishes to thank Corey A. Ciorciari and Micah D. Stein, summer associates in our Washington DC office, who contributed to the drafting of this legal update.

1. Regulation of the Conduct of Virtual Currency Businesses, 2014-29 N.Y. St. Reg. 14 (proposed July 23, 2014), available at http://docs.dos.ny.gov/info/register/2014/july23/pdf/rulemaking.pdf.

2. Fiat Currency is defined as government-issued currency that is designated as legal tender in its country of issuance through a government decree, regulation or law.

3. The Proposed Rules would also require the submission of fingerprints for each employee of the licensee.

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