Stop Making Sense: What’s New in the Law of Digital Assets
Article originally published in Reuters Westlaw on 5/18. Reprinted with permission.
The Securities and Exchange Commission announced last week that it is adding 20 positions to its Crypto Assets and Cyber Unit. These positions are all enforcement-related. None of the new staff will be charged with carrying out the SEC’s statutory duties to propose rules and interpret the law for industry participants. The SEC has proposed several regulatory initiatives in recent months that would further augment its powers, while potentially stifling the burgeoning digital asset industry.
Meanwhile, we provide a brief update on the cacophony of potential responses from Congress, the Executive and private industry as we continue trying to make sense of the law of digital assets.
We begin with the SEC’s Crypto Assets and Cyber Unit, which has existed for five years, during which time it has initiated enforcement actions against more than 80 crypto asset offerings and platforms, obtaining more than $2 billion in settlements. Virtually all SEC enforcement actions are settled without admitting or denying the government’s allegations because of the cost and distraction of mounting a defense. SEC orders issued in connection with settlements are written by the SEC staff and do not have the same legal precedential value as court orders and opinions by federal judges.
Most recently, on May 6, 2022, the SEC issued an order in connection with settlement of charges it brought against Nvidia Corporation, one of the world’s largest producers of graphics processing units, from which the Unit extracted a $5.5 million fine over alleged inadequate disclosures about the impact of crypto-mining on its publicly filed financial results.
According to the order, during two consecutive quarters in 2018, the SEC alleged that the company failed to make clear that demand from crypto miners was responsible for a significant part of the increase in sales of its GPUs that were also used for gaming.
On the same day, the SEC announced fraud charges against MCC International Corp., which does business as Mining Capital Coin Corp., as well as its founders and related entities, in connection with allegedly unregistered offerings and fraudulent sales of investment plans called mining packages. This was also led by the Unit.
In February, lending protocol BlockFi agreed to pay $50 million to settle with the SEC and $50 million more to settle state law charges. A high-profile SEC lawsuit, SEC v. Ripple, is expected to go to trial in November 2022. That case is closely watched for clues about the SEC’s changing positions in the new Biden administration and judicial rulings which, unlike SEC orders resulting from enforcement proceedings, have deep precedential value.
This SEC move comes on the heels of President Biden’s Executive Order on Ensuring Responsible Development of Digital Assets, which noted that 40 million Americans now invest in crypto assets. Crypto assets have been the fastest-growing asset class since they were first invented in 2010.
Indeed, to demonstrate the point, virtually all major university endowments now own digital assets, as do most of the largest hedge funds. Fidelity, the largest retirement plan provider in the US, announced recently that by the end of summer 2022, it will allow employers to offer up to 20% of their investors’ 401(k) retirement funds in Bitcoin.
The federal executive order directed the President’s administration to study the industry carefully and to work with the industry in the course of developing a comprehensive federal approach to regulating crypto assets. The SEC is an independent agency that need not take orders from the White House.
Still, the growing emphasis on “regulation by enforcement” rather than “regulation by regulation” is noted by many observers as being inconsistent with the executive order, as well as the SEC’s own traditions of careful study and consultation with stakeholders in the course of adopting rules and regulations to govern financial markets.
Including the 20 new positions, the SEC’s Crypto and Cyber Unit will have a total of 50 staff employees and will seek to increase its focus on the growing crypto market, with particular focus on:
- Crypto asset offerings
- Crypto asset exchanges
- Crypto asset lending and staking products
- Decentralized finance (DeFi) platforms
- Non-fungible tokens (NFTs)
- Stablecoins
The first four categories are well-known targets of SEC enforcement action. NFTs and stablecoins also have generated some attention to date and will apparently receive more of the same. The enforcement action against Nvidia underlines the vast array of tools at the disposal of the SEC to flex its enforcement muscle, including against some of the largest companies in the world in hyper-competitive industries.
The SEC’s jurisdiction over NFTs and stablecoins is debatable in light of the absence of legislation that governs these instruments, at least as interpreted by modern judicial precedent. The NFT industry sees itself as being engaged in the collectibles business, not the securities business. Stablecoins offer no profit opportunity, so they are not investment contract securities. Still, the SEC has been aggressive in positing novel theories of law to justify expanding its reach and enlarging its turf.
Other countries are taking a more deferential approach to crypto asset regulation. Switzerland and the Bahamas, for example, are frequently cited as places to domicile crypto industry business because the regulations adopted there are clearer and more accommodating than SEC enforcement actions brought in the United States.
Many crypto businesses founded in the U.S. have moved offshore because of SEC regulation by prosecution. It is possible that more will do so as the SEC ramps up with these new hires. Mike Fasanello of crypto trading LVL was quoted expressing concern that more enforcement by the SEC “will stifle innovation in an emerging market.”
Make no mistake, however, that when the SEC doubles the size of the Crypto Assets and Cyber Unit, more enforcement actions are on the way. At least one SEC Commissioner is not on the same page. On the heels of the SEC’s announcement that it was doubling the size of the Unit, SEC Commissioner Hester Peirce tweeted1: “The SEC is a regulatory agency with an enforcement division, not an enforcement agency. Why are we leading with enforcement in crypto?”
Commissioner Peirce will soon be joined by two new Commissioners, one of whom had been seconded to Senator Toomey’s staff. Toomey, who is retiring at the end of this term, has been perceived as a moderate on digital assets.
Potential responses from Congress include new legislation. On April 28, a bipartisan group of House members introduced the Digital Commodity Exchange Act of 2022, which would extend the CFTC oversight powers to cryptocurrency activities via digital commodity exchanges.
In the Senate, Cynthia Lummis, a Republican from Wyoming, has revealed plans to introduce the Responsible Financial Innovation Act, which would attempt to “fully integrate digital assets into our financial system,” detailing regulation on taxation and payments.
Perhaps most importantly, Senator Lummis’s bill would include a definition of “digital asset” that would help the industry design compliant instruments while clarifying which regulatory agencies have jurisdiction.
While the SEC has increased its enforcement staff, it also has proposed two amendments to existing regulations that would make it harder, if not impossible, to trade crypto assets that it deems to be securities. One proposal would redefine the word “exchange” to include “communication protocol systems” that “make available for trading” any type of security, including crypto assets that are correctly or mistakenly treated as investment contract securities. Commentators have objected on multiple grounds, including: the SEC’s failure to assess the impact on the crypto industry; the unworkability of the proposed redefinition for digital asset markets; and lack of authority to revise statutory terms such as “exchange” beyond their settled interpretations.
The other proposal would redefine the term “dealer” to include most proprietary trading firms and other day-traders on the theory that they are “dealer-like” and therefore should be regulated as if they were dealers. Critics have pointed out that Congress, not the SEC, properly determines what sort of entities should be regulated as dealers (and what sort should not be so regulated); and that day traders of digital assets cannot comply with the SEC’s proposed redefinition because of the SEC’s own interpretations regarding capital requirements, custody and quotations of market prices for digital assets.
While the SEC continues on its unique path of discouraging digital asset industry growth every chance that it gets, California Governor Newsom has chosen a different path. Noting that California has the fifth largest economy in the world and is home to the leading technology companies across the country and around the globe, Governor Newsom on May 4 signed an executive order to foster responsible innovation, bolster California’s innovation technology and protect consumers.
Referring to the President’s executive order, Governor Newsom inaugurated a regulatory approach in California that will “spur responsible innovation while protecting California consumers, assess how to deploy blockchain technology for state and public institutions, and build research and workforce development pathways to prepare Californians for success in this industry.” The California order signifies a desire to engage with stakeholders and “engage in and encourage regulatory clarity.”
Potential responses from the industry to escalating SEC intervention may be founded in legal limits on federal agency powers. In this chess game, each side has players to maneuver on the board. The SEC is using Congressional money grants to beef up its team, but the industry is not without resources and talent to deploy as well.
Meanwhile, we will keep trying to make sense of it all…
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