Regulation By Enforcement

The SEC is well known for, and often criticized for, its practice of regulation by enforcement.  In recent years the SEC has been more willing to regulate by enforcement, propounding novel and new interpretations to longstanding rules and regulations.  Market participants have taken notice, and offense.  Advocacy groups have been very vocal against the practice including the Financial Services Institute and Small Public Company Coalition (SPCC).

Although not limited to matters involving cryptocurrencies, blockchain and all things Web3, is the area that garners the most attention for the SEC’s enforcement-based guidance, probably because it is undeniably the topic that is in the most need of actual rule-based regulation.  Starting with the SEC’s 2017 Section 21(a) Report stemming from the enforcement action against the DAO, (see HERE), almost all substantive regulatory prescription related to the world of crypto has come from enforcement actions.

Rather than heed the calls for rules and regulations over the years, the SEC has stepped up its enforcement proceedings such that industry participants have adapted in an interesting way.  First, there is the large scale “ignore it” mantra as the global crypto market has reached $3 trillion USD with every major financial player participating.  In February 2022 alone, over $1 billion in new crypto/Web3 funds were formed backed by heavyweights such as Fidelity, Hiro Capital, Sequoia Capital, Adreessen Horowitz and more.  All the major banks are participating, as well, including JPMorgan Chase, Wells Fargo and Goldman Sachs.

Famously, Facebook is all in, changing its name to Meta and already committing over $10 billion to the metaverse, which is all powered by tokens/cryptocurrencies.  There are hundreds if not thousands of crypto exchanges.  The relatively new NFT marketplace has already reached $35 billion (see here for more on NFTs – HERE).   Clearly, the industry is neither slowing down nor bowing to the looming regulatory presence of the SEC, CFTC, FinCen, Treasury Department, etc.

Second, there is the “fight it” mantra.  The SEC sued Ripple in late 2020, claiming that its issuance of 14.6 billion XRP tokens for $1.38 billion USD involved the unregistered sale of securities.  Ripple, in turn, is claiming that XRP is a currency and not a security subject to regulation by the SEC.  Importantly, Ripple is tackling the SEC’s lack of rules and regulations in the crypto space, basing its defense on a lack of fair notice that its conduct was in violation of the law.  That is, Ripple is claiming that the lack of regulatory clarity is so prominent that it had no way of knowing that its conduct could violate the federal securities laws.  The SEC moved to strike the defense and in a big win, in March 2022 the court denied the SEC’s motion stating that Ripple is entitled to a full opportunity to assert its fair notice defense and have it adjudicated before a plaintiff (here, the SEC) may impose liability.

In effect, Ripple has flipped the enforcement proceeding, putting the SEC on trial after years of conflicting and confusing guidance on the rules for cryptocurrencies.  The blowback on the SEC has extended throughout the industry with a huge wave of support for Ripple/XRP from cryptocurrency investors – the very investors the SEC is claiming to protect.  In its war chest, the crypto community has built a media ecosystem that connects millions of investors, consumers, developers, and entrepreneurs across the globe.   The SEC is facing backlash against regulation by enforcement and deliberate market confusion that has exasperated investors and driven developers overseas.  The crypto community, with its culture of decentralization, is not afraid to fight the regulators, both directly and indirectly, and has been doing so in earnest.

Fighting it has been working at times as well.  In November 2021, a defendant prevailed over the SEC, arguing that hashlets were not securities and thereby beating an unregistered sale of securities claim.  Hashlets are contracts that entitle purchasers to share in profits from hashing power in the cryptocurrency mining business.  The case went all the way through a jury trial. The case is significant as it is the first time that a case has gone the distance and resulted in a judgment that a digital asset was not a security.

Third, there is the “make it work for you” mantra.   In February 2022, BlockFi settled an SEC enforcement proceeding for $50 million plus an additional $50 million to 32 separate states.  The SEC lawsuit claimed that BlockFi engaged in the unregistered sale of securities of its lending product, BlockFi Interest Accounts (BIA), and that BlockFi violated provisions of the Investment Company Act of 1940.  In an interesting twist, BlockFi was able to negotiate a settlement that didn’t just include a monetary component but also set out a course of action that would allow BlockFi to proceed to register the BIA product under the Securities Act and to reorganize its business to comply with the Investment Company Act.

That is, the settlement provided BlockFi, and therefore the industry, with a clear path forward instead of just the usual, “You violated the law, and we won’t tell you how to fix it” issue with enforcement proceedings. In its settlement press release Gary Gensler, Chair of the SEC, stated the settlement “demonstrates the Commission’s willingness to work with crypto platforms to determine how they can come into compliance with those laws. I’d like to thank and commend our remarkable SEC staff and state regulators for their efforts and collaboration on this settlement.”

This was a huge win for BlockFi and the crypto industry as a whole and demonstrates a way to use regulation by enforcement to an advantage.  As one Bloomberg article pointed out, “[I]f a crypto startup went to the U.S. Securities and Exchange Commission and said ‘we want regulatory clarity about what we need to do to run crypto lending programs, so you should write some rules about it,’ the SEC would say ‘sure, we’ll give that some thought in like 2036.’ If it went to 50 different U.S. states and asked them for clarity it would get even more confused. If it went to the SEC and said ‘look, to speed this process along, why don’t we pay you $50 million to prioritize writing these rules,’ that would be a very bad crime and it would go to prison. But BlockFi will give the SEC $50 million, and it will give some states another $50 million, and now it has clarity about crypto lending programs.”

The order was most remarkable because the SEC generally does not provide a path forward in a settled enforcement proceeding; rather, it generally refuses to do so citing that the SEC does not give legal advice.  For example, since 2017 the SEC has launched an enforcement driven attack against small and micro-cap lenders claiming they are acting as unlicensed dealers.  Nothing in the prior SEC rule making, interpretive guidance, or enforcement actions foresaw the current dealer litigation issue.

The SEC litigation put a chill on convertible note investing and has left the entire world of hedge funds, family offices, day traders, and serial PIPE investors wondering if they can rely on previously issued SEC guidance and practice on the dealer question.  To add to the confusion, the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes in penny stock issuers.  There is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded or the size of the issuer.  The SEC has had a series of wins in the pending litigations, but at the end of the day, it only leaves market participants with the uncomfortable, purely enforcement-driven conclusion that it is within the legal boundaries to be a convertible debt lender without registering as a broker-dealer, if you limit that lending activity to exchange traded companies.

To make matters worse, there is no real methodology for a company to register as a dealer when it only engages in investment activities for its own account, is not a market maker, does not carry customer accounts, etc.  These targets are not being given the opportunity for a path forward that BlockFi has.  BlockFi is unique in that it has $100 million to invest in regulatory certainty.  More often that not, the targets of SEC regulation by enforcement lawsuits do not have the financial wherewithal to negotiate with the SEC so fruitfully.

It isn’t just crypto and unlicensed broker-dealer matters that are being regulated by enforcement.  For years the law surrounding insider trading has been a moving target, largely judicially based – i.e., enforcement based.  Recently short sellers have been under attack for the same practices they have been engaged in for decades.  Likewise, I expect enforcement to outpace regulations involving SPACs as subpoenas and investigations turn into proceedings.

As SEC officials and agendas change every four to eight years with whichever party is in control of the executive and legislative branches, and rules are passed, then undone and redone, it may be that the SEC is finding that the path of least resistance is via regulation by enforcement.  However, the constitutional rights to due process and fair notice are by far worth protecting.

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