This article originally appeared in Law360 on May 25, 2022. It is republished here with permission.
The U.S. Securities and Exchange Commission 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 proposed two new regulations recently, each of which would augment its powers while potentially stifling the burgeoning digital asset industry. While the SEC is pumping the brakes on growth and development of that industry, other government actors, including the Biden administration, Congress and the Newsom administration in California are taking a more balanced approach.
The cities of Miami, New York and now Dallas and Fort Worth, Texas, are aggressively recruiting digital asset businesses, vying to add them to their local economies. The differences in philosophical outlook inherent in these divergent treatments of the very same businesses can be explained.
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 100 crypto asset offerings and platforms, obtaining more than $2 billion in settlements. The SEC trumpets this record as a success, and without question some of its cases served the public interest by shutting down frauds and scofflaws.
Aggressive SEC action was warranted during the 2017 initial coin offering craze, when token teams that had no business at all, nary a business plan in some cases, sought to raise quick bucks from an unsuspecting public. Fraud should always be prosecuted by some government agency and the SEC acted properly by moving quickly to shut down fraudulent offerings.
But bad facts create bad law, as subtleties that matter in harder cases are swept away or ignored. Fraud is relatively easy to spot and is rarely controversial. Registration violations, in contrast, require detailed analysis and are often controverted.
While the SEC has addressed registration as well as fraud in its enforcement actions, 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.
The result has been a lack of clear guidance about how digital tokens can be sold lawfully. We can spot the plainly unlawful offerings easily enough. It's much harder to navigate through the thicket toward a lawful result without nuanced SEC guidance pointing the way. We fear that adding enforcement lawyers to the SEC staff while understaffing the SEC's advisory and interpretive function will only make things worse.
Most recently, on May 6, the SEC issued an order in connection with settlement of charges it brought against Nvidia Corp., one of the world's largest producers of graphics processing units, or GPUs, 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 Inc. agreed to pay $50 million to settle with the SEC and $50 million more to settle state law charges. In the BlockFi matter, the SEC asserted that BlockFi was selling notes to the public without registration.
This claim did not surprise us, but it was notable because the SEC has previously relied almost exclusively upon investment contract analysis as its basis for jurisdiction. BlockFi shows that the SEC is prepared to assert that particular crypto assets might be securities even if they are not investment contracts.
Meanwhile, SEC v. Ripple Labs Inc. is expected to go to trial in November of this year. Ripple 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. The outcome of Ripple is certain to affect advice given to core development teams, traders, platforms and investors in this industry.
The SEC's move to beef up enforcement comes on the heels of President Joe 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.
Prominent skeptics like Ray Dalio of Bridgewater Associates LP and Ken Griffin of Citadel Securities LLC have publicly announced that they were wrong to doubt the bona fides of this new asset class. Fidelity Investments Inc., the largest retirement plan provider in the U.S., announced recently that later this year it will allow employers to offer 401(k) retirement funds allocated to bitcoin.
The federal executive order directed the Biden 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 Financial Stability Oversight Council is given a central role in that process, as is the U.S. Department of Commerce, emphasizing a desire to help rather than hinder this new technology-driven industry. The SEC is mentioned of course, but is not directed to lead the federal initiative.
One might wonder, therefore, why the SEC is continuing along the same course as in the past. 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 Assets 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, or DeFi, platforms;
- Nonfungible tokens, or NFTs;
The first four categories are well-known targets of SEC enforcement action. The SEC's jurisdiction over NFTs 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. An NFT that represents ownership of a Babe Ruth baseball card is a hard asset, not an investment contract.
Stablecoins that offer no profit opportunity 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. Watch for the SEC's creativity to be put on display as the recent selloff
and subsequent crash of Terra and Luna are explored.
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 the SEC's U.S. enforcement actions enforcement. Dubai is a third and increasingly prominent choice for digital asset development and experimentation.
Many crypto businesses founded in the U.S. have moved offshore because of the SEC's 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 company 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 tweeted: "The SEC is a regulatory agency with an enforcement division, not an enforcement agency. Why are we leading with enforcement in crypto?"
Peirce will soon be joined by two new commissioners, one of whom had been seconded to Sen. Pat Toomey's, R-Pa., staff. Toomey, who is retiring at the end of this term, was a thoughtful moderate on digital asset regulation. So Peirce may soon have an ally at the SEC.
Potential responses from Congress include new legislation. On April 28, a bipartisan group of U.S. House of Representatives
members introduced the Digital Commodity Exchange Act of 2022, which would extend the Commodity Futures Trading Commission
oversight powers to cryptocurrency activities via digital commodity exchanges. The bill encourages digital asset platforms to register as exchanges that would be regulated by the CFTC.
Sen. Cynthia Lummis, R-Wyo., 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, Lummis' 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, as noted at the outset, it also has proposed two new 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.
Many 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
- The 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 Gov. Gavin 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, 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, 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. We believe this is a wholesome approach.
At the local level, the competition to attract and retain digital asset teams is hot. Miami Mayor Francis Suarez has attracted more than a trillion dollars of assets under management to his city by enticing financiers and technology mavens to relocate from metro New York and California.
Vowing to take his pay in crypto assets, newly elected New York City Mayor Eric Adams is waging his own campaign to retain and attract business to the Big Apple. In doing so, he needs to contend with a state legislature that is inclined to shut down bitcoin mining in the Empire State and a Department of Financial Services that has been slow to license digital asset businesses in New York.
Texas, too, is getting into the act. Austin and lately Dallas have attracted crypto talent and built profitable digital asset businesses. Most recently, Fort Worth became the first city in the nation to mine Bitcoin for its own account.
We view the varied initiatives of state and local governments as salutary experiments in economic development. The laboratory of the states is a feature, not a bug, of our federalism, from which optimal policy can emerge over time.
The federal government speaks best in one voice, not several. The president's executive order calls for a coordinated all federal government response, not just heightened enforcement action.
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.
As we look forward, the digital asset industry could thrive from the Digital Commodity Exchange Act being enacted by Congress, the FSOC and the Department of Commerce driving the federal regulatory response after taking input from all their constituents including the industry and the public, the digital asset industry growing from hospitable American cities — rather than offshore — and the SEC regulating first, and enforcing second.