California law for crypto and VDAs takes a leaf out of India’s licence Raj?
The American state of California is on the verge of introducing a law that would make it mandatory for any entity to obtain a licence from the state government to operate a digital asset business in the state. The bill— Digital Financial Assets Law—will become a law only if it is signed by California Governor Gavin Newsom before September 30, 2022.
The law will come into effect on January 1, 2025, if and when it is signed by Newsom. He also has the option to veto the bill which was passed by California’s assembly on August 30, 2022 with 71 yes votes and zero no votes, Coindesk reported.
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The bill prescribes that an entity will have to apply for a licence with the California’s Department of Financial Protection and Innovation. The legislation was introduced by Timothy Grayson and sponsored by the Consumer Federation of California.
“…makes it riskier for consumers because cryptocurrency businesses are not adequately regulated and do not have to follow many of the same rules that apply to everyone else,” Grayson had said in a statement in June.
The bill has come under fire from various stakeholders who argue that the bill creates “shortsighted and unhelpful restrictions” that would impede crypto innovators’ ability to operate in California and push many out of the state.
6/ We urge all Assembly Members to reject this bill & engage with the Executive Order process as laid out by Governor Newsom. https://t.co/UWuITsKEra
— Blockchain Association (@BlockchainAssn) August 29, 2022
Why it matters: California is an important American state which offers a legislative reference point to many other American states and countries around the world. The new bill offers a glimpse into how California intends to regulate the crypto sector within its borders.
- Moreover, it is also important given that every country in the world is looking to introduce laws to regulate crypto assets. The bill offers a regulatory blueprint to jurisdictions, including India, which are working on a crypto law of their own.
Provisions of the bill
The bill, which seeks to cover digital financial assets, defines them as a “digital representation of value that is used as a medium of exchange, unit of account, or store of value, and that is not legal tender, whether or not denominated in legal tender”.
Licencing regime
The bill stipulates that “a person shall not engage in digital financial asset business activity, or hold itself out as being able to engage in digital financial asset business activity, with or on behalf of a resident” on or after January 1, 2025.
A licence application will have to keep in mind the following requirements:
- The application will have to be in a form and medium prescribed by the department. It will have to contain information relevant to the applicant’s proposed digital financial asset business activity.
- The application will have to contain a “description of the current and former business of the applicant for the five years before the application is submitted. It will also cover the entity’s products and services, website addresses and social media pages, principal place of business, projected user base, and specific marketing targets.
- The application will also have to include criminal conviction, litigation, bankruptcy, and pending criminal proceedings against its executives.
- The bill also requires a set of fingerprints for each executive officer and responsible individual of the applicant.
- The application will carry a “nonrefundable fee” which will be determined by the department to cover costs of regulation.
What will the department investigate?
- Financial condition and responsibility of the applicant;
- Relevant financial and business experience, character, and general fitness of the applicant;
- Competence, experience, character, and general fitness of each responsible individual;
- Business premises of an applicant.
The department will have to inform the applicant of its decision to approve or deny the application once it concludes its investigation. An applicant can appeal a denial of its application within 30 days of receiving a notice from the department.
The application will be considered void if the applicant does not comply with conditions specified by the department within 31 days of the notice of the conditions.
Maintaining a surety bond
The bill also mandates that a licensee will have to maintain a “surety bond or trust account in US dollars which will be determined by the department for the protection of users that engage with the platform.
The state can use the security to pay claims made against the licensee’s digital financial asset business activity by a resident. “A claimant does not have a direct right to recover against security deposited…,” read the bill.
The licensee has also been directed to maintain a certain amount of capital to ensure its financial integrity. The capital can be in the form of cash, digital financial assets, or high-quality, highly liquid, investment grade assets.
Licence’s renewal
An entity will have to renew its licence every year on or before September 15 by paying a renewal fee which will cover reasonable costs of regulation.
The report will have to include information on material change in the financial condition of the licensee, material litigation related to the licensee’s business, any federal or state investigation involving the licensee, or a data security breach.
Disclosures for consumer protection
A licensee will have to make certain disclosures as decided by the department which are necessary for the protection of users.
A licensee has to make the following disclosures:
- Fees and charges: The licensee will have to disclose the manner by which fees and charges will be calculated, and their timing besides how they are assessed.
- Insurance: The disclosure will have to bear information whether the service is covered by insurance or other guarantee against loss by a US agency. It will also have to inform users if they have private insurance against theft or loss, including cybertheft or theft by other means.
- Liabilities and responsibilities: The disclosures will have to cover licensee’s liability for an unauthorised, mistaken, or accidental transfer or exchange.
- It will also have to feature a user’s responsibility to provide notice to the licensee of an unauthorised, mistaken, or accidental transfer or exchange.
- General error resolution rights applicable to fix an unauthorised, mistaken, or accidental transfer or exchange.
- Prior notice: The disclosure will have to include information about the user’s right to at least 14 days’ prior notice of a change in the licensee’s fee schedule, other terms and conditions that have a material impact on digital financial asset business activity.
Offering investment advice
The licensee has to act in the best interest of the user at the time of making a recommendation over an investment strategy without worrying about the financial or other interest of the licensee. They will have to reveal conflicts of interest associated with the recommendation.
- The licensee has to establish, maintain, and enforce written policies and procedures designed to do the following:
- Identify and disclose, or eliminate, all conflicts of interest associated with a recommendation.
- Identify and mitigate any conflicts of interest associated with recommendations that create an incentive for a licensee to place its interest ahead of the interest of users.
- Identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific digital financial assets or specific types of digital financial assets within a limited period of time.
- The licensee will have to exercise due diligence while listing a particular digital financial asset or types of digital financial assets. It has to keep the following in mind:
- What is the probability that a state or federal court or regulator will deem the digital financial asset a security?
- What is the utility or potential utility other than as a method for speculative investment?
- If technical design of the digital financial asset is vulnerable to hacks or exploits that would cause the digital financial asset to rapidly lose value?
- The licensee will have to use diligence to ascertain the best market for a digital financial asset and exchange it in that market so that the outcome to the user is as favourable as possible.
- Every business will have to display on its internet website a toll-free telephone number through which a resident can contact the licensee for customer service issues and receive live customer assistance.
“The telephone line shall be operative 24 hours per day, Monday through Sunday, excluding federal holidays,” read the bill.
Press Release: Consumer Federation of California Sponsored Digital Asset/Cryptocurrency Licensing Bill Sent to Governor with Strong Bipartisan Support@AsmGrayson #AB2269 #CALeg pic.twitter.com/1J0mWio8xE
— Consumer Federation of California (@consumercal) August 30, 2022
Oversight by regulators
The department has the power to examine the business and office of any licensee to ascertain whether the business is being conducted in a lawful manner and whether all digital financial asset business activity is properly accounted for under the bill.
The examination can be carried out without any prior notice. The company’s executives will have to furnish accounts, books, correspondence, memoranda, papers, and other records to facilitate the examination.
The entity has been asked to maintain a user’s data for five years. Furthermore, the department can share and jointly examine records and other information with other regulatory agencies including a regulator of a jurisdiction outside the US.
Enforcement measures in the bill
The bill enables the department’s powers to take action against a licensee or person that is not registered but continues to conduct business activity.
- The department can take action against a licensee if it violates provisions under this bill, or does not cooperate substantially with an examination or investigation by the department, fails to pay a fee, or fails to submit a report or documentation.
- The entity will be subject to action if it engages in any of the following:
- Unsafe or unsound act or practice,
- Unfair or deceptive act or practice,
- Fraud or intentional misrepresentation,
- Misappropriation of legal tender or a digital financial asset.
- The department may take action only after notice and opportunity for a hearing is provided to the licensee, especially if the department intends to impose a civil penalty. The department can impose a civil penalty which does not exceed $100,000 for each day of the violation.
“If a licensee materially violates a provision of this division, the department may assess a civil penalty in an amount not to exceed twenty thousand dollars ($20,000) for each day of violation or for each act or omission in violation,” read the bill.
Revoking licence: A licence can be revoked one day after the department has sent a notice to the licensee. The suspension is also effective within one day of the notice being sent to the licensee.
Maintaining policies
The bill directs an applicant to create and maintain policies and procedures for all of the following:
- Information security program and an operational security program,
- Business continuity program,
- Disaster recovery program,
- Anti-fraud program,
- Preventing money laundering and funding of terrorist activity.
Tackling fraud: The bill lays down the following measures which should be included in an entity’s policy—
- Identification and assessment of the material risks related to fraud including any form of market manipulation and insider trading by the licensee, its employees, or its customers.
- Protection against any material risk related to fraud identified by the department or the licensee.
- Periodic evaluation and revision of the antifraud procedure.
What about stablecoins?
The bill prevents a licensee from exchanging, transferring, or storing a stablecoin or engaging in its administration.
The bill makes an exception only if the stabelocin is issued by the department or a bank. Moreover, the bill states that the provision will become inoperative on January 1, 2028.
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