After a few years of relative dormancy, the SEC is once again targeting the flourishing cryptocurrency market. On August 3, 2021, SEC Chair Gary Gensler gave a speech to the Aspen Security Forum in which he referred to the cryptocurrency marketplace as the Wild West. Days later, the SEC filed its first case involving securities using DeFi technology and then a few days after that, reached a $10 million settlement with Poloniex for operating an unregistered digital asset exchange. Shortly after that, the SEC took aim at Coinbase’s planned crypto lending program causing the crypto giant to shelf the business model for the time being. SEC Commissioners are joining in, giving speeches in various forums focused on crypto and the regulatory environment.
In July 2017, the world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector, when the SEC issued its Section 21(a) Report on the DAO investigation finding that a cryptocurrency is, in most cases, a security (see HERE). Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape. Although I wasn’t focused on digital assets before that, upon reading the DAO report, I wasn’t surprised. It seemed clear to me that the capital raising efforts through cryptocurrencies were investment contracts within the meaning of SEC v. W. J. Howey Co.
The SEC’s Section 21(a) Report relied on the analysis in SEC v. W.J. Howey Co. to determine when a crypto is a security, building the guardrails to conclude that all, or almost all, cryptocurrencies at that time were/are indeed a security. For more on the Howey analysis, see HERE. Later in June 2018, the SEC gave some relief to the crypto world by announcing that Bitcoin and Ether were likely decentralized enough as to no longer be considered a security, hedging on the conclusion as to whether they were once considered such.
Using the same analysis as a backdrop, in March 2018, the SEC issued a public statement directed specifically to online platforms for the trading of digital assets/cryptocurrencies. The statement served as a dual caution to investors and warning to platforms. In essence, if a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration (see HERE).
In April 2019, the SEC’s Division of Corporation Finance published a “Framework for Investment Contract Analysis of Digital Assets,” issued a no-action letter to Turnkey Jet, Inc. and made a statement on both. Although the guidance was appreciated, it really offered nothing new or different about the analysis, which was firmly based on SEC v. W.J. Howey Co. (the “Howey Test”) (see HERE). Other than the Section 21(a) Report and this guidance, the world of crypto regulation has been enforcement-driven.
Even accepting that a cryptocurrency is a security and trying to comply with the federal securities laws has been a difficult task. Since the issuance of cryptocurrencies, by nature and function, would involve general information and gun-jumping, a traditional IPO with S-1 would not work, not to mention the plethora of custody issues for any broker-dealer willing to act as an underwriter. See here for more information on broker-dealer custody issues related to digital assets – HERE. Traditional exempt offerings would also not work – a distribution of cryptocurrencies is never limited to accredited investors.
That leaves Regulation A; however, the process of completing the offering circular with the SEC is a monumental task. Blockstack was the first back in 2019 to qualify an offering circular for the issuance of a full token with properties of what could be a utility token. Others have not followed. A few companies have tokenized their equity and several have completed offerings that operate in the cryptocurrency space, but the world has not seen the U.S. registration or qualification of an offering issuing a cryptocurrency.
Fast-forward to today and a new SEC Chair and administration. At the same time as decrying the world of cryptocurrency as out of control, the SEC is doing what we all want – asking Congress to enact legislation that provides legal boundaries and technologically appropriate guidelines – and what we don’t necessarily want – asking that the SEC be formally put in charge of regulating the marketplace.
Gary Gensler’s Speech to the Aspen Security Forum
In early August, SEC Chair Gary Gensler gave a speech to the Aspen Security Forum on the topic of cryptocurrency regulation. Beginning with a little history, and in particular, the publication of a white paper by Satoshi Nakamoto (whose identity remains a mystery) on Halloween night in 2008, solving two riddles that cryptographers and other technology experts had worked on for years. That is, the white paper provided a working method to move something of value over the internet without an intermediary, and to prevent the double spending of that digital token. Today, the crypto asset class is worth approximately $1.6 trillion with 77 tokens worth over $1 billion and 1,600 others with a value of at least $1 million.
Gary Gensler understands the technology behind digital assets having taught classes at MIT and regulated, at least in part, digital currency while running the CFTC. While fiat money is simply a store of value, unit of account and medium of exchange, Gensler sees cryptocurrency as only a highly speculative store of value and investment source. He does not believe crypto fulfills the functions of a unit of account or medium of exchange, other than by those looking to avoid, or worse, break the law. At this time, Gensler sees the crypto world as the Wild West lacking tangible investor protections.
Gensler continues that the digital asset class is rife with fraud, scams, and abuse. Moreover, he believes that many (MANY) cryptocurrencies that currently trade in the marketplace are securities firmly fitting within the Howey definition of an investment contract. As such, the purchase and sale of these digital assets must comply with the federal securities laws and the SEC has jurisdiction to enforce such compliance. Gensler is clear, stating, “[I]t doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime.”
It isn’t just digital assets and cryptocurrencies that Gensler believes are out of control, but also crypto trading platforms, lending platforms, and other “decentralized finance” (DeFi) platforms. DeFi software applications generally allow users to borrow, lend, earn interest and trade assets and derivatives. Some DeFi developers say the technology shouldn’t face federal oversight because the automated programs aren’t controlled by people or companies and don’t hold traders’ assets. The services are often used by people seeking to borrow against their cryptocurrency holdings to place larger bets.
Gensler believes that platforms where people can trade tokens and venues where people can lend tokens both implicate the securities laws as well as the commodities and banking laws. Giving a heads-up to enforcement proceedings to come, he believes that even some platforms that purport to operate outside of the United States and prohibit investment or trading by U.S. investors, are facilitating U.S. investors through private networks.
Turning to stablecoins (cryptocurrencies pegged or linked to the value of fiat currencies), Gensler is concerned that these stablecoins are circumventing traditional banking regulations and in some cases securities regulations, such as the Investment Company Act of 1940. I’ll talk more about stablecoins in a future blog.
Gensler rounds out his speech by suggesting that crypto ETF’s may see approval from the SEC after years of trying (he likes the idea that they will be regulated) and touches on the SEC’s recent request for comment on crypto custody arrangements by broker-dealers. Confirming that the SEC will continue to regulate cryptocurrency markets to the greatest extent of its ability, Gensler calls upon Congress to fill regulatory gaps, provide increased budgetary resources to regulation the marketplace and, of course, empower the SEC to oversee this trillion-dollar marketplace.
Recent Enforcement Proceedings
In the weeks following Chair Gensler’s speech in Aspen, there were a slew of enforcement-related proceedings targeting the cryptocurrency/digital asset space. On August 6, 2021, the SEC filed its first ever case involving securities using DeFi technology. The SEC charged a Cayman Island company for the unregistered sale of more than $30 million of securities using smart contracts and DeFi technology. The SEC claims that the company used smart contracts to sell mTokens and DMG governance tokens. The mTokens claimed to pay 6.25% interest and the DMG tokens gave voting rights, profit participation and an anticipated secondary trading market. Both could be purchased with digital assets.
Although the headlines caught the attention of anyone operating in the DeFi space, in reality the case involved standard fraud claims. The company ran into roadblocks in their planned business model and then lied to investors to cover up the shortcomings. Also, the fact that the SEC found both the mTokens and DMG tokens to be securities was not surprising. The token offerings were intended to raise capital for business operations and hit squarely on the well-published SEC Howey analysis related to digital assets.
Even though the SEC action was a standard unregistered sale of securities and fraud claim, the DeFi industry is clearly in the crosshairs of world regulators. Generally, DeFi businesses (think payment processing like Zelle or Venmo over the blockchain and peer-to-peer lending) are currently unregulated in the U.S., it isn’t likely to stay that way. In an August interview, Chair Gensler stated that where DeFi platforms reward participants with valuable digital tokens or similar incentives their activities should be regulated, even if the management claims to be decentralized.
On October 28, 2021, the Financial Action Task Force (FATF) published guidance stating that DeFi apps and services supporting peer-to-peer transactions over the blockchain should keep tabs on their users’ identities and funds as a way of preventing money laundering and terrorism financing. The Task Force generally publishes anti-money laundering (AML) rules that governments follow worldwide, including the U.S. Treasury, which is expected to issue its own guidance in the short term. I will go over the FATF guidance in an upcoming blog.
On August 9, the SEC reached a $10 million+ settlement with Poloniex for operating an unregistered online digital asset exchange in connection with its trading platform. Poloniex operated a web-based trading platform that facilitated buying and selling digital assets, some of which the SEC determined were investment contracts and therefore securities. Unlike many exchanges today, Poloniex was open to U.S. investors. The theme is that that the SEC intends to investigate trading platforms that purport to only host non-security digital assets to ensure that is the case. In Gensler’s speech he indicated that if a trading platform offered 50 or more cryptocurrencies, he is certain there are securities in the bunch. For perspective, crypto giant Binance offers more than 500 different cryptocurrencies.
The SEC is not the only U.S. regulator targeting the cryptocurrency space. The CFTC settled two enforcement actions against cryptocurrency companies totaling $140 million. CFTC Chair Rostin Behnam, like Gary Gensler, calls the actions the tip of the iceberg and is also asking Congress to expand his agency’s scope of authority over the markets. Similar to swap markets, Gensler and Behnam envision joint authority and a division of responsibility overseeing the entire crypto market.
Other Commission Views
Cyrpto Mom/Hester M. Peirce
On October 8, 2021, Crypto Mom and SEC Commissioner Hester M. Peirce gave a speech at the Texas Blockchain Summit directly responding to Chair Gensler’s Wild West depiction of the cryptocurrency markets. Ms. Peirce has a different take on the Wild West – as opposed to a criminal playground, she sees the Wild West as a place where people go to build a new and better future. Sure, things are tough at first, but the spirit and energy form the basis for a thriving community. The West represents opportunity and the future.
Despite a lack of formal government regulation, the old West had a system of effective private regulation inspired by competition and societal needs. Once there was wealth in the West government regulation was inevitable. Ms. Peirce sees the analogy to the crypto frontier – “[T]he crypto frontier, like the Wild West, appears pretty wild at first glance: home to lots of codeslingers and speculators and some hucksters too, this new West also has its inter- and intra-protocol fights, friendships forged through shared difficulties and successes, colorful personalities, passions, dreams, hardships, spectacular failures, and remarkable victories.” Also, the crypto community itself has built a system of protocols and has consistently called on Congress for regulatory clarity illustrating that lawlessness is not the prevailing culture.
Ms. Peirce continued her speech with actual suggestions and comments surround digital asset regulation. The SEC Commissioner does not believe that the current regulatory framework offers clarity for the digital asset space. She continues to advocate for her safe harbor proposal (see HERE). Moreover, despite other members of the SEC asserting that Howey provides all that is needed to analyze whether a digital asset is a security or not, the best and brightest attorneys in the country continue to struggle with the real-world application.
Ms. Peirce points to the plethora of comments received by the SEC in response to its request for comments related to custody of digital assets by broker-dealers (HERE) mainly complaining that a broker-dealer will not be able to distinguish security vs. non-security digital assets without greater regulatory clarity. She also points out that the SEC has been relying on enforcement proceedings to provide regulatory guidance but settled enforcement proceedings do not provide a good basis for legal analysis.
Related to stablecoins, Commissioner Peirce feels the SEC is fighting for jurisdiction rather than protecting investors. Questions such as “Should stablecoin issuers be registered as banks? Should stablecoins be backed by deposit insurance? Should stablecoins be designated as systemically important by the Financial Stability Oversight Council? Are stablecoins money market funds? Should the Consumer Financial Protection Bureau step in to protect consumers?” all raise regulatory jurisdictional matters. Like cryptocurrencies in general, Ms. Peirce supports the use of stablecoins and calls for greater support and understanding of their role in the cryptocurrency marketplace.
Trading platforms are likewise in need of guidance. Deeming digital assets to be securities means that platforms that trade them and entities that intermediate them have to register with the SEC, but they cannot operate as a registered entity under the existing rules so they would not be able to register. It is the proverbial Catch-22.
The bottom line is that Hester Peirce’s views have been consistent for the four years she has sat on the SEC Commission. There is a complete lack of regulatory clarity over digital assets, including cryptocurrencies and DeFi businesses. Regulating through enforcement is not working. The SEC has not taken the time or effort to answer the hard questions and figure out a regulatory system that works.
Commissioner Caroline A. Crenshaw
On October 12, 2021, SEC Commissioner Caroline A. Crenshaw gave a speech at the SEC Speaks conference, focusing on digital assets. While maintaining that she supports the digital asset space, Commissioner Crenshaw also believes that the current regulatory framework, including Howey sufficiently provides enough guidance for those raising capital in the digital market space. However, Commissioner Crenshaw does admit that there has been a lack of clarity from the SEC and that it is difficult for developers to employ digital asset securities in new blockchain network applications in a compliant manner. Unfortunately, her answer to this problem is for businesses and entrepreneurs to engage in discussions with SEC staff. My experience is that the SEC is not willing to engage in meaningful conversations for fear of improperly giving legal advice.
Commissioner Crenshaw takes aim at Hester Peirce’s safe harbor proposal as not providing necessary investor protections. In particular, “granting a special exemption to these projects would provide unfair advantages to blockchain related businesses and disadvantage everyone else: participants who raise capital in compliant ways that support healthy markets and informed investors.”