Introduction to AB 39: A Game Changer for Digital Assets in California The digital assets landscape in California just changed in a big way. On October 13th, 2023, Governor Gavin Newsom signed into law Assembly Bill 39, known as the Digital Financial Assets Law. This groundbreaking legislation provides a comprehensive framework for companies seeking to engage with digital financial assets like cryptocurrencies and NFTs in the Golden State. For businesses interested in entering the Web3 space, the implications of AB 39 will be far-reaching. From crypto exchanges to NFT marketplaces, companies now have a clearer pathway to secure licenses from the Department of Financial Protection & Innovation (the "Department") and comply with regulations around digital asset activities. But make no mistake - the licensing process will still be rigorous. Keep reading as we dive into the key provisions of AB 39 and what they mean for businesses like yours. Who is Covered and Who is Exempt? In summary, the law provides broad authority to regulate commercial digital asset activities conducted by any person, including entities, with or on behalf of California residents, while exempting certain persons and transactions in the public interest. Having cast the net widely, let’s now look at who is exempted from the “covered person” definition: - Exempt entities include government agencies, insured banks and credit unions, licensed trust companies, merchants accepting digital assets as payment, and attorneys/title companies providing escrow services. - Also exempt are persons contributing connectivity/computing power to networks, providing data/security services to digital asset businesses, using digital assets for personal purposes, or with annual business below $50,000. - The commissioner can exempt by order or regulation any person or transaction if it's in the public interest and regulation is unnecessary. - The list of exemptions is subject to change. Exemptions will be listed on the commissioner's website. The commissioner can amend or rescind exemptions. - The law does not apply to activities like investing or obtaining digital assets for personal use, testing with one's own funds, operating as a registered securities broker-dealer or clearing agency, or enforcing a security interest in digital assets. California ❤s NY A notable provision of the new law, Section 3205(a), allows the Department to grant a conditional license to an applicant who holds or maintains a license to conduct virtual currency business activity in the state of New York pursuant to Part 200 of Title 23 of the New York Code of Rules and Regulations (the “BitLicense” regulation) or a license to conduct a virtual currency business under the limited purpose trust company provisions of the New York Banking Law, provided the license was issued or approved no later than January 1, 2023. Section 3205(b) provides that the commissioner may issue such conditional license to an applicant holding either the BitLicense or the limited purpose trust license for virtual currency business if the applicant has paid the applicable fees and complies with the requirements of Section 3219, provided that all of the following conditions are met: (1) The applicant has supplied all fingerprints required under Section 3219. (2) The applicant meets all other requirements for licensure. (3) Notwithstanding the commissioner’s reasonable efforts, the commissioner has been unable to complete the criminal history investigations required by Section 3219 with reasonable speed. The Fluid Nature of Security Deposits Licensees are required to maintain a surety bond or deposits in a trust account at an approved bank or credit union in the State of California to protect against any possible consumer claims. While no specific amount is set out, the amount of the security must cover claims for a period determined by the department, including additional time after the licensee ceases operations. Security is payable to the state to cover claims against the licensee for their digital asset business activities involving residents. Only the department may recover and process claims and individual claimants cannot recover directly against the security. Ongoing Responsibilities for Licensed Entities Once licensed, companies become subject to extensive oversight including examinations, capital requirements, security deposits, recordkeeping duties, and enforcement actions for violations. However, prudent exemptions apply to certain entities like government agencies, merchants accepting digital assets as payments, and persons using digital assets for personal purposes. Overall, the new law strikes a balance between allowing innovative digital asset applications to flourish in California while ensuring strong consumer protections. By establishing clear licensing criteria and regulatory expectations, AB 39 provides a pathway for serious players in this emerging industry to thrive. How We Can Help: Navigating AB 39’s Complex Landscape If you are planning to apply for a license under the Digital Financial Assets Law, contact our law firm today to schedule a consultation. Our attorneys have expertise in financial services and emerging technologies and can provide invaluable assistance with crafting your license application and preparing for the rigorous vetting process. Our end goal isn't just regulatory compliance - it's to help your innovative ideas thrive in this rapidly developing market. Coming up: We will dig further into the details of AB 39 in future posts, and in particular, examine some of the finer points of license applications such as transfer of “control” in licensees and notifying the Department when there are changes proposed in the activities of the licensee. Exciting stuff you will not want to miss! The views expressed herein are solely those of the author. They should not be construed as legal advice, and the suitability of any such matters discussed for a particular transaction should not be assumed without the advice of legal counsel. Any reference to a company or product is solely for illustrative and informational purposes and is not an endorsement or recommendation of such a company or product. None of the opinions expressed herein should be construed as investment advice. As is regularly stated in writings that are crypto-related, DYOR (Do Your Own Research)! Russell Murphy is a founder of lex[array]'s Emerging Companies and Venture Capital practice based in Silicon Valley. Russell brings over thirty years of experience working in private practice and as outside general counsel. He started his career in the Corporate Securities and Financial Institutions practice of a prominent Southern California law firm. Russell supports clients across a broad range of transactions, and he has a focus on the intersection of law, business technology, and data, providing transaction counseling and strategic advice to multidisciplinary founder teams.
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Imagine yourself, as a trusted advisor assisting a client in selling a company, speaking with a new prospective buyer. They have told you they want to send a letter of intent with an attractive offer to acquire your client. However, there's just one thing: the buyer company uses blockchain (aka "distributed ledger") recordkeeping, decentralized finance, and smart contracts in transactions as much as possible, and they would like to conduct this acquisition using these capabilities. Are you prepared to respond knowledgeably to this request?
Cryptocurrencies, decentralized finance applications, and smart contracts are all part of the category of "Web 3.0" technology innovations that we think will rapidly change how people do business. The cryptocurrency phenomenon is still relatively new, but already the combined value of the top 10 cryptocurrencies is, as of this writing, currently valued at $2 trillion. [i] One exchange has predicted that in 2025 the value of all cryptocurrencies will be $3 trillion. [ii] You might be noticing more frequent media reports that national, state and local government entities, international banking firms, and global investment funds are all building cryptocurrency capabilities. Decentralization is a central tenet of Web 3.0 and is promoted by proponents to eliminate the need for banks and traditional payment systems; however, the reality is more likely that the institutions will adapt to these technologies and thus help facilitate the adoption of a much broader global audience. To participate in Web 3.0 M&A transactions, professionals need to understand how these capabilities alter our traditional way of managing a transaction. Advantages of smart contracts and cryptocurrency-based corporate transactions will be nearly immediate execution of transactions upon satisfaction of specified conditions written into smart contract code, all recorded to an immutable ledger, with full transparency to the participants. Preparation of M&A documents involving Web 3.0 technologies will require careful attention to the use of new nomenclature in drafting terms and conditions and the mechanics of closing transactions. Perhaps you will soon be expected to understand how executable code can be merged with a text-based document.[iii] We expect these methods to become commonplace over time and make permanent changes in our respective professional practices. Let's look at some of the ways Web 3.0 will start to show up in the M&A process. Payment and form of consideration. If it hasn't happened already, I predict that in 2022, an M&A transaction will use cryptocurrency as the specified consideration to be paid. It is hard to argue that the Bitcoin network is not capable of substantial transactions with minimal delay and low transaction costs. For example, a recent Bitcoin transfer of $850,000,000 took place with a few keyboard clicks and a transaction cost of 93 cents. The funds were immediately available to the recipient. Planning to receive cryptocurrency in substantial transactions will require preparation for receiving the proceeds and making necessary disbursements after closing. It might not make sense to convert 100% of the proceeds into a fiat currency. Depending on the stakeholders' interests, funds can be retained in the original transmitted form or quickly converted to other cryptocurrencies or into USD or EUR. As a result, major banking entities are introducing cryptocurrency custodial services in partnership with Web 3.0 technology companies.[iv] We expect these services to begin to be important in M&A transactions. Documenting cryptocurrency as the transaction consideration will require additional language in the documents. Generally, parties are free to specify any form of consideration. However, if price volatility concerns either the buyer or seller, the agreement may require Exchange Rate or Dollar/ Currency Equivalent provisions. The language of existing provisions of this type can be repurposed to accommodate a cryptocurrency marketplace that trades 24/7. The parties may also agree to include a predefined trading range or period to allow for a volatility buffer and post-closing adjustments price adjustments. Another disruptive change to transaction documentation will be substituting a cryptocurrency wallet address in the place of a bank account and wiring instructions. A wallet address will be required as the destination for the transfer of consideration at closing. The highest degree of care will be necessary to assure that the wallet address is accurately stated, most likely through an officer’s certificate. The certificate will be highly confidential and redacted from any disclosures of the Stock Purchase Agreement or Agreement of Merger for security reasons. It will be incumbent on the lawyers and authorized corporate representatives to verify that the wallet address is accessible only by the appropriate parties. These will be multi-signature wallets, requiring at least two authorized parties to access. Proof that the wallet address and private keys are linked to the parties to the transaction is possible via several alternatives now. We anticipate that certificates of verification of the wallet address will become as routine as the issuance of an incumbency certificate is today. Decentralized acquisition financing Decentralized finance ("Defi") currently generates great excitement in the cryptocurrency trading and speculation markets. Automating algorithmic transactions through smart contracts and near-instantaneous settlements are feeding an explosion of innovation. Most Defi lending protocols today are used to facilitate cryptocurrency trading. However, the bridge between financing real-world assets (“RWA”) with decentralized finance protocols is taking shape. Recently a bitcoin mining operation raised $60 million to finance their operations. A German company, Centrifuge GmbH, has teamed up with the AAVE protocol to provide pools of RWA that can be funded through staking AAVE tokens for yield. Some of the current pools include trade finance instruments and revenue share agreements.[v] The amount involved, about $1,000,000 as of December 29, 2021, is relatively modest, but they have only just launched.[vi] The critical takeaway is that the connections between RWA and Defi have been made and will only grow from here. As with every financial innovation, once the larger financial institutions get comfortable with the technology and the regulatory framework, it may be only a short time before M&A buyers and sellers begin to accept Defi-based financing in the ordinary course of business. Blockchain-enabled entity formation Sometimes in a transaction, an entity needs to be formed to hold assets or facilitate the acquirer's liability containment strategy. The entity may have a limited existence, as in an assignment for the benefit of creditors, or a perpetual one. Where the entity is unlikely to have any changes in ownership, simple LLCs formed on blockchain applications may be used. The ability to quickly create a legal entity, and prove existence with nearly instantaneous effect, can be a handy tool in a closing. Beginning in 2017, Wyoming began adopting pro-cryptocurrency and blockchain legislation. [vii]They have amended their LLC statute to allow crypto wallet addresses to serve in place of a named person as a member. Using crypto wallet addresses will simplify Web 3.0 companies' formation because companies and their lawyers can use smart contracts to create entities customized to facilitate transactions. For example, at least one company has worked with the State of Wyoming to promote the formation of limited liability companies on the blockchain with a decentralized application. The company claims that a legally formed LLC can be created for less than $40 and in only six seconds. [viii] How many creative ways these new entity formation options can be used remains to be seen. But, for lawyers advising clients, these new entities would create new challenges if the entities involved must be the subject of "status, power, and action" opinions, including whether traditional approaches for validating the status, power, and authority for actions for blockchain-based entities are suitable for the task. What’s next? These are just the beginning of the developments that we predict will transform the M&A process. Significant sports stars, city mayors, and movie theater chains are announcing their acceptance of cryptocurrency compensation. With institutional capabilities increasing daily, our professions will undoubtedly be seeing announcements from early adopters willing to apply newly developed techniques for transaction management. The developments described here are just the beginning of changes we will see as M&A dealmakers adopt Web 3.0 technology. With the greater acceptance by corporate finance professionals and corporate transaction use cases, powerful transformations of business processes are possible. In a follow-on post on this topic, I will discuss other disruptive Web 3.0 developments that are likely to begin making appearances in M&A transactions as the technology gains acceptance. The views expressed herein are solely those of the author. They should not be construed as legal advice, and the suitability of any such matters discussed for a particular transaction should not be assumed without the advice of legal counsel. Any reference to a company or product is solely for illustrative and informational purposes and is not an endorsement or recommendation of such a company or product. None of the opinions expressed herein should be construed as investment advice. As is regularly stated in writings that are crypto-related, DYOR (Do Your Own Research)! Russell Murphy is a founder of lex[array]'s Emerging Companies and Venture Capital practice based in Silicon Valley. Russell brings over thirty years of experience working in private practice and as outside general counsel, advising innovative companies in the software and hardware, wireless/ IoT, and eCommerce spaces through their lifecycle—from formation and launch through critical milestones to exit. Russell supports clients across a broad range of transactions, and he has a focus on the intersection of law, business technology, and data, providing transaction counseling and strategic advice to multidisciplinary founder teams. [i] Top 10 Cryptocurrencies In December 2021 – Forbes Advisor [ii] Eye-Popping Projection for $3T Crypto Market Underpins Bakkt Deal - CoinDesk [iii] An Introduction to Smart Contracts and Their Potential and Inherent Limitations (harvard.edu) [iv] U.S. Bank announces new cryptocurrency custody services for institutional investment managers | Company blog | U.S. Bank (usbank.com) [v] Tinlake | Centrifuge | Decentralized Asset Financing [vi] How to onboard on to the RWA Market — a step-by-step guide | by Anna | Centrifuge | Dec, 2021 | Medium [vii] Wyoming Blockchain Bills, Laws, and Regulations | Gemini [viii] Otoco - Automated Company Assembly on Blockchain |
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