State Regulators Want a Piece of the FTX Fallout Too
February 3, 2023
As you are certainly aware, FTX is facing high scrutiny from regulators. Federal authorities have brought both criminal and civil cases against FTX entities, founders, and some employees. They are also investigating related parties and individuals. But state regulators are also getting in on the action. State financial regulators in Texas, California, and New York have been investigating—and even litigating against—Celsius Network, Nexo Group, BlockFi, and Voyager Digital, all large crypto-lending players. The Feds have commandeered most of the headlines—like last week’s “Sam Bankman-Fried Tried to Influence Witness Through Signal, DOJ alleges”—but companies dealing with digital assets would be wise to keep an eye (or two) on state regulators as well.
This alert takes a look at what the states have been up to.
The Texas State Securities Board filed a notice requiring Bankman-Fried, better known as SBF, to appear before an administrative law judge this week, though the proceeding has now been delayed. FTX’s alleged violations of the Texas Securities Act are related to the offer and sale of digital assets that the Board says should be “regulated as securities.” The notice alleges that SBF offered and sold unregistered securities in the Lone Star State without registering as a dealer or agent, and that he withheld material facts about the status of FTX. Texas regulators are also investigating individuals who promoted FTX: “scrutinizing payments received by the celebrities to endorse FTX US, along with what disclosures were made and how accessible they were to retail investors.” Some states may be content to let the federal investigators drive, but Texas, for one, is not taking a backseat to the Feds.
The California Department of Financial Protection and Innovation (DFPI) is also investigating FTX. The DFPI has not disclosed specifics of its investigation, but it previously initiated several enforcement actions against BlockFi, Nexo Group, Celsius, and Voyager Digital, noting that these actions were “part of a larger DFPI effort to investigate companies that offer consumers interest-bearing crypto asset accounts.”
- The DFPI has revoked BlockFi’s California Financing Law License, one day after BlockFi paused all withdrawals from its platform citing “significant exposure to FTX” and affiliated entities.
- The DFPI has joined seven other states’ securities regulators in issuing cease-and-desist orders against Nexo Group in connection with its EARN Interest Product (EIP) accounts. The states allege that Nexo offered investors interest-earning accounts without registering them as securities.
- The DFPI issued a notice to Celsius Lending LLC, stating its intention to revoke Celsius’s California Financing Law lender’s license and suspending its license until the revocation action is resolved. The DFPI’s order claims that Celsius Network and its CEO, Alex Mashinsky, made “material misrepresentations and omissions” when offering crypto interest accounts, understating the risks of depositing digital assets with Celsius.
- The DFPI reached a settlement with Voyager Digital in June for violating “section 25110 of the Corporations Code,” which prohibits the offer or sale of “unqualified, nonexempt securities” in California. The DFPI found that the accounts offered and sold by Voyager were securities under the Corporations Code. Under the terms of the settlement, Voyager was to “desist and refrain” from selling securities in the state.
Neither New York’s Department of Financial Services (NYDFS) nor state Attorney General Letitia James has commented on plans for FTX, but, both before and after the FTX collapse, James filed lawsuits against BlockFi, Nexo, and Celsius for violations of New York’s Martin Act, which we discussed previously.
- In June, James reached a nearly US$1 million settlement with BlockFi for offering unregistered securities.
- Working with a multistate coalition, James sued Nexo Inc. and Nexo Capital Inc in September for operating illegally and defrauding investors, and the coalition obtained a US$24 million settlement last month.
- A few weeks ago, James sued Alex Mashinsky for making false and misleading statements about the Celsius platform to encourage investors to deposit billions of dollars in digital assets.
Surely state regulators are assessing how the FTX collapse has harmed their residents and examining their respective securities, finance, and consumer-protection regulations to see which ones FTX may have violated. Texas being Texas, it has been boldest by already summoning SBF to appear in-person, while California and New York seem to be taking a less public approach. This is not to say that the states won’t collaborate eventually, as in the BlockFi settlement.
What Companies Should do NOW
No matter the resolution of any state or federal investigation, some things are already clear:
- As state legislatures become more active in the digital assets space—in some instances imposing greater burdens on industry participants—make sure your company pays close attention to state legislative proposals and keeps abreast of any new state legal requirements.
- Constantly review your policies and practices to ensure that your company is in compliance with all state and federal regulations and guidelines. That may sound obvious, but if there are regulations and guidelines that you dismissed because you thought they did not apply to your company, take another look.
- Failures in transparency will be judged harshly. A likely goal of all future enforcement will be to increase companies’ transparency, especially regarding how customers’ assets are used. This includes internal processes as well as all marketing and advertising material. Reevaluate your terms of service (TOS), and verify that you are, in fact, doing what you say you’re doing when it comes to holding and transferring altcoins in your possession.
- If your business involves the custody of user funds, consider ways to segregate that function from other parts of your business. Also, ensure that such custody services receive sufficient resources to safeguard customer assets, and avoid any potential conflicts of interest that may undermine the effectiveness of such a custody function.
- Design and implement effective and meaningful internal controls to account accurately for the business’s revenue and expenses and to comply with applicable laws and rules.
- Don’t ignore state laws and rules because you’re focused on the federal authorities. State enforcement actions are a viable threat to companies’ financials and operations—witness the gaudy settlements and operational stoppages we’ve already seen.
O’Melveny will continue to closely monitor the legal issues surrounding the FTX collapse, including state enforcement actions. Please contact the attorneys listed on this article or your O’Melveny counsel to help you navigate this swiftly moving area of practice.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Daniel R. Suvor an O’Melveny partner licensed to practice law in California, William K. Pao, an O’Melveny partner licensed to practice law in California, Sid Mody, an O'Melveny partner licensed to practice law in Texas, AnnaLou Tirol, an O'Melveny partner licensed to practice law in California, and Bill Martin, an O'Melveny counsel licensed to practice law in New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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