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Long-Arm Lawsky, Part II: Interstate Commerce

Published on September 7th, 2014 by wildjo

The BitLicense is getting a lot of attention these days because it is the first significant regulatory attempt by a US authority to proscribe activity in the Bitcoin space. Not surprisingly, this first attempt is fundamentally flawed.

Last week, I demonstrated that the regulations proposed by the New York Department of Financial Services (DFS) were unlawful because the DFS lacked the statutory authority to regulate Bitcoin. This week we tackle the constitutionality of the regulations and come to a similar conclusion: the BitLicense violates the Commerce Clause of the US Constitution and is, therefore, unlawful.

The Commerce Clause is one of the most powerful parts of the United States Constitution, yet it is also one of the least well known. This obscurity is partly due to the fact that the term "commerce clause" is found nowhere in the document. Instead, the clause is mined out of Article 1, Section 8, Clause 3 of the Constitution, which states that the US Congress shall have the power to "regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes."

Over the years, the Supreme Court has interpreted the Commerce Clause as having two important functions: 1) granting Congress the power to act to regulate interstate commerce, and 2) prohibiting states from taking certain actions that have extraterritorial effect. The latter function is referred to as the Dormant Commerce Clause, and it has two important functions of its own. The first is to prevent state regulation in those areas where federal rather than state legislation is more appropriate. The second is to promote a national economy unobstructed by local protectionism.

Interestingly, it seems as if New York runs afoul of the Dormant Commerce Clause more often than any other state. Four of the seminal Supreme Court cases interpreting and developing the Dormant Commerce Clause involved the striking down of New York statutes as burdens on interstate commerce. With New York's BitLicense scheme, we may have found the fifth such case.

Under the Dormant Commerce Clause doctrine, state law or regulation must do all the following in order to pass Constitutional muster:

  1. pursue a legitimate state interest
  2. be rationally related to that interest
  3. include an interest that outweighs any burden on interstate commerce

Applying these three hurdles to New York's BitLicense proposal demonstrates that New York has, once again, gone too far (or not jumped high enough).

Hurdle #1: New York does not articulate any state interest being pursued by the proposed regulations, let alone a legitimate interest. The regulations contain neither a purpose statement, nor a finding of fact, two elements that regulatory bodies typically rely on to justify their actions. There are references to the Department of Financial Services' (DFS) statutory authority, but, as discussed in Part I, those statutes specifically involve the banking and insurance industries. The "virtual currency business activity" regulated through the BitLicense falls under neither banking services, nor insurance services laws. Moreover, the purpose clauses in those statutes take the tone of promoting their respective in-state industries to ensure that they are nationally competitive. The BitLicense does the opposite.

Hurdle #2: Having tripped over the first, it is hard to see how the DFS makes it to the second hurdle. But, for the sake of argument, let's give them a mulligan and assume that a legitimate interest had been articulated. We will pick a standard one and say the interest at stake is the catch-all of "consumer protection." The inquiry then becomes whether the regulations and restrictions proposed rationally assist the DFS in protecting New York consumers. As currently written, the answer would have to be "no."

For example, it is hard to see how anti-money laundering provisions directly protect New York consumers. They may assist state interests in fighting crime, but that is not consumer protection.

Instead, in order to be rational, the regulations would have to directly regulate the most common interactions between New York consumers and Bitcoin businesses. In fact, the opposite is true. Most of the day-to-day consumer activity - purchase or sale of goods or services - is specifically excluded from the regulations (see 200.3(c)(2)).

In fact, it can be argued that regulating and impinging on the Bitcoin space actually hurts consumers. Bitcoin brings a robust and decentralized ledger, removes gatekeepers and "trusted" third-paries that slow commerce and raise costs, and otherwise reduces the friction of consumer activity. All of these are positive changes that should be embraced, not unfairly regulated.

Perhaps the DFS will enlighten us in the future with revised regulations that articulate their true underlying purpose (e.g., protecting the big banks, being the first to the "market" of virtual currency regulation, etc.), against which we can gauge "rationality." Until then, the BitLicense scheme fails to clear hurdle #2, even when we assume a beneficent foundation.

Hurdle #3: The third hurdle is even higher than the first two. Even where a strong state interest is articulated, such as the protection of minors from pornography, courts have struck down state statutes where there is even a theoretical potential to negatively impact interstate commerce. (See American Library Assoc. v. Pataki, 969 F. Supp. 160.) Under the BitLicense regulations, impact on interstate commerce is not just theoretical, but will be very real and very immediate.

For example, the regulations prohibit the administering of a "virtual currency" without a license. Applying this prohibition as written would require every one of the hundreds of thousands of people around the world to obtain a license when they download the blockchain as part of their wallet use.

Or, consider the situation where a New York resident travels to Lukla, Nepal to climb Mount Everest. If they need to cash in some bitcoin for the local currency, they would fall under the BitLicense regulations. This is true even if the party accepting the bitcoin does not deal in US dollars and does not have any reason to know that the tourist is a New Yorker. Clearly, this would be an untenable extraterritorial extension of DFS authority.

I can come up with several more examples, but you get the picture. The BitLicense, as proposed, would not just have theoretical impacts on interstate commerce; the impact would be real and immediate. Companies are already making plans to try to block New Yorkers from their services, if the proposal is adopted. Yet, they remain fearful because there is really no way to be sure that such imperfect exclusion techniques will keep them out of the DFS crosshairs. This chilling effect on national commerce by local interests is precisely the kind of impact the commerce clause was meant to prevent.

Whether intentional or not, a precedent is being set by New York and its BitLicense scheme. That precedent can be positive, though, if the crypto community effectively articulates and communicates all the reasons why the proposed regulations are flawed and impractical, and the DFS actually listens.

The issues discussed in Part I (lack of statutory authority) and Part II (unconstitutional interference with interstate commerce) are two critical flaws of the proposed regulations, which we need to digest and further develop them - as they have the potential to stop state regulators, in New York and elsewhere, in their tracts.

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