State vs. Federal Laws in Cryptocurrency: Blue Sky, or Running in the Red?
by Philip C. Berg, corporate department chairman and privacy and cybersecurity practice chairman, Otterbourg
Philip C. Berg, a longstanding lawyer at New York firm Otterbourg with deep expertise in the cryptocurrency sector, has several thoughts on how regulation of virtual currency should play out in the medium to long term at both the state and federal level. Whether about how federal policy would harmonize state-level regulations or how light-touch regulation would let US investment flourish, in this first installment of a three-part series for BX3 Capital, Berg offers his insights in what tack the SEC may want to consider as cryptocurrency becomes an indelible facet of the investment landscape, as well as how the new Congress may wish to proceed on the legislative front in 2019.
Berg is serving as a legal adviser to Ohio Rep. Warren Davidson, who spearheaded a Congressional roundtable on cryptocurrency in September and is in the process of drafting bills intended to bring regulatory clarity to the burgeoning industry.
In the US we have a dual banking system of both federally chartered and state-chartered banks. In both cases, bank regulation is of a “prudential” nature, in which federal or state regulators actively monitor and regulate the risks engaged in by individual banks, including with respect to safety and soundness standards, capital and liquidity requirements and asset restrictions. The National Banking Act of 1863 (NBA), as amended and interpreted over time, preempts many state-based banking regulations that would otherwise be applicable to federally chartered banks, such as state licensing and registration requirements, and regulation of credit terms and interest rates. Nonetheless, state laws of general application that do not forbid or significantly impair national bank activities are generally not preempted. These include state laws regulating such areas as real estate, crime, torts, and hiring discrimination.
In contrast to the prudential regulation of banks, regulation of U.S. securities markets is generally of a disclosure nature; that is, assuring transparency and avoiding fraud via required disclosure of an issuer’s risks. Generally speaking, the laws and regulations under the Securities Act of 1933 do not substantively regulate the economic terms of securities or how issuers run their business but instead, require transparent and complete disclosure, and in some cases registration.
In addition to federal securities regulation, each state has its own “blue-sky” securities laws, which most states enacted decades prior to the passage of the Securities Act of 1933. It is not hard to imagine why blue-sky laws made sense in the 1920s: charlatans were selling “blue sky” to the residents of far-flung, sparsely populated Western states, and there was no federal law prohibiting such fraudulent activity. Yet in today’s borderless, electronic securities markets, where the Securities and Exchange Commission oversees a robust federal disclosure-based regulatory regime and database, the patchwork of inconsistent and duplicative blue sky laws makes little sense. Nonetheless, because of the reluctance of Congress and the SEC to expressly preempt such state securities regulations, this complex patchwork of required registrations and fees largely remains in place.
Arguments commonly made in favor of federal preemption in a particular area include the creation of a uniform national standard, ease of commerce in markets of a national or global nature, and the concentration of expertise with a single federal regulator. Examples of industries with robust federal preemption include the commercial passenger airline industry (Federal Aviation Administration), the nuclear energy industry (Nuclear Regulatory Commission), and the interstate highway system. Arguments against federal preemption generally include encouragement of policy experimentation, democratic accountability and maintaining the regulator as close as possible to the regulated entities. Examples of areas with robust state regulation are corporate, commercial and contract law, real estate, safety, crime, and education. The healthcare industry is an example of a mixed regime, in which most standards are set on the state level but under HIPAA, the aspects of healthcare most subject to interstate activity — the storage and transmittal of personal healthcare information — are generally subject to exclusive federal standards.
The National Securities Market Improvement Act of 1996 (NSMIA) offers an interesting example of federal preemption, including the first express federal preemption of state blue-sky laws for certain securities offerings, including those under Rule 506 under the Securities Act — but not those under Rules 504 or 505. The SEC was also given the express authority to expand through regulation the types of offerings enjoying federal preemption from state blue sky requirements. To date, however, the SEC has declined to exercise that authority. Since the passage of the NSMIA, 92 percent of all private securities offerings greater than $1 million have been conducted under the more daunting Rule 506, which is exempt from blue-sky registration requirements, and not Rules 504 or 505, which remain subject to blue sky requirements. State anti-fraud provisions still apply to all offerings. This demonstrates the clear preference of securities issuers and investors for certainty and consistency in securities regulation, as they flock to SEC safe harbors that require compliance with only one uniform set of rules, and away from those that require compliance with more than 50 separate sets of rules.