Securities and Exchange Commission
The purpose of this blog post is to outline the guidance, rulemaking and enforcement actions undertaken by the Securities and Exchange Commission (SEC) related to cryptocurrencies and digital assets.
NOTE: Regulatory guidance in this area is rapidly evolving. As such, this blog post may not be entirely up to date. Please DYOR.
INTRODUCTION
The SEC was founded in 1934 under the Securities Exchange Act (15 U.S.C § 78d) as a result of the 1929 Wall Street Crash and Great Depression. The SEC’s stated goal is to protect investors and maintain “fair, orderly, and efficient markets, and facilitat[e] capital formation.”
The SEC has five divisions: Corporation Finance, Trading and Markets, Investment Management, Enforcement, and Economic and Risk Analysis. There are 11 regional SEC offices throughout the U.S.
The SEC is perhaps the most familiar government agency in the public eye as it relates to cryptocurrencies and digital assets. This is due in part to certain high-profile SEC enforcement actions against cryptocurrency companies (such as Ripple Labs) and the ongoing battle as to whether cryptocurrencies and non-fungible tokens (NFTs) should be considered as securities, regulated by the SEC, or as commodities, regulated by the Commodity Futures Trading Commission (CFTC).
The SEC’s approach to cryptocurrencies and digital assets thus far has been regulation through enforcement. Namely, the SEC has provided limited formal guidance (i.e, formal regulations that have undergone a public notice and comment period before publication in the Code of Federal Regulations) and has instead applied existing regulations while issuing public statements and enforcement actions.
To understand the SEC’s view towards cryptocurrencies and digital assets, one must first understand the Howey test that courts employ to determine whether a cryptocurrency/digital asset is an “investment contract,” and thus a security falling under SEC regulations.
HOWEY TEST
The Howey test is the outgrowth of a 1946 Supreme Court case titled SEC v. Howey Co., 328 U.S. 293 (1946). The case involved a dispute between the SEC and two Florida corporations that owned/cultivated large tracts of citrus acreage. The companies offered half of their citrus groves to the investing public through service contracts whereby company staff would tend to the groves and sell the fruit on behalf of the investors, who shared in the revenue. The company did not register the contracts with the SEC. The SEC sued and argued that these arrangements constituted unregistered “investment contracts” under § 2(1) of the Securities Act of 1933.
The Supreme Court held that such contracts were indeed investment contracts (i.e, securities) and in so ruling, developed a four element test to determine whether a business arrangement constitutes an investment contract. As stated by the Supreme Court, an investment contract for purposes of the Securities Act means:
“a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.”
Howey, 328 U.S. at 298-99.
Simply stated, an investment contract exists when there is:
(1) the investment of money;
(2) in a common enterprise;
(3) with a reasonable expectation of profits;
(4) derived from the efforts of others.
The Supreme Court further explained that the test is flexible, meaning “one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Howey, 328 U.S. at 299. The Supreme Court also explained that it is “immaterial whether the enterprise is speculative or non-speculative or whether there is a sale of property with or without intrinsic value.” Id.
Thus, the citrus grove service contracts were “investment contracts” precisely because the investors saw the arrangement as valuable given that the labor and expertise were provided by others and the investors only needed to invest capital to access the income stream from the citrus grove.
The SEC employs this test in arguing that cryptocurrencies and digital assets are “investment contracts” subject to the Securities Act and is central to understanding the SEC’s guidance, rulemaking and enforcement actions.
WRITTEN GUIDANCE
As noted above, the SEC has provided limited formal guidance in this area, but certain divisions within the SEC have issued several informal statements.
Strategic Hub for Innovation and Financial Technology
First, the SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) released a report outlining its approach in defining an “investment contract” under Howey for digital assets. Framework for “Investment Contract” Analysis of Digital Assets. Notably, FinHub disclaimed that its views represent those of the entire SEC and that the document is not a rule, regulation or official statement of the SEC.
With that said, FinHub concluded that the first two elements of the Howey test, the investment of money and a common enterprise, are usually met because (1) digital assets are purchased or otherwise acquired in exchange for value (such as fiat, cryptocurrency or other consideration) and (2) “the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter's efforts.”
As such, according to FinHub, the focus is on whether there is a reasonable expectation of profits (element 3) derived from the efforts of others (element 4). FinHub lists a number of factors relevant to each prong, which are largely based on the activities of “active participants” (AP), which are defined as promoters, sponsors or other third parties of the digital asset. FinHub explained that overall, “the more each factor is present,” the more likely it is that these elements of the Howey test are satisfied. For instance, if an AP retains a stake or interest in the digital asset, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset.
Simply put, the more active the involvement of an AP after the digital asset’s sale and the more transferable and appreciable the asset is, the more likely it is that the digital asset will be considered an investment contract.
On the other hand, FinHub also outlines some countervailing factors that would weigh in favor of the digital asset not being an investment contract. These factors include, among others, whether the distributed ledger network and digital asset are fully developed and operational, whether holders of the digital asset are immediately able to use it for its intended functionality on the network, whether the digital asset can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for fiat currency and whether prospects for appreciation in the value of the digital asset are limited (such as when the design of the digital asset provides that its value will remain constant or even degrade over time).
Division of Trading and Markets
The SEC’s Division of Trading and Markets, alongside the Financial Industry Regulatory Authority (“FINRA”) issued a joint statement on key issues regarding intermediation and custody of digital assets, especially as they relate to the Customer Protection Rule (Rule 15c3-3 under the Securities Exchange Act of 1934) to digital assets. Joint Staff Statement on Broker-Dealer Custody of Digital Asset Securities. Again, the Division of Trading and Markets disclaimed that its views represent those of the entire SEC and that the document is not a rule, regulation or official statement of the SEC.
The joint statement addressed entities that engage in providing access to digital assets by serving as a broker-dealer and divides these dealers into two groups: custodial and non-custodial.
As it relates to non-custodial broker-dealers of digital assets, the statement notes that generally speaking, “noncustodial activities involving digital asset securities do not raise the same level of concern among the Staffs, provided that the relevant securities laws, SRO rules, and other legal and regulatory requirements are followed.” The statement justified this position by stating that in this scenario, the broker-dealer merely connects the buyer and seller and the buyer and seller settle the transaction directly.
As it relates to custodial broker-dealers, the statement notes that the broker-dealer must comply with the Customer Protection Rule. The statement acknowledges that this proves difficult because “custody” on the blockchain is fundamentally different than custody of traditional securities. For instance, having private keys tied to a digital asset wallet does not necessarily ensure that the broker-dealer alone can transact from the wallet. The statement raises other questions these brokers should consider related to auditing, control locations and book-keeping. The statement does not provide answers to these questions.
Division of Examinations
In February 2021, the SEC’s Division of Examinations issued a “Risk Alert” regarding digital asset securities and various considerations that firms involved in the space should keep in mind in advance of a specific regulatory examination. Risk Alert: The Division of Examinations’ Continued Focus on Digital Asset Securities. Again, the Division of Examinations disclaimed that its views represent those of the entire SEC and that the document is not a rule, regulation or official statement of the SEC.
The alert focuses on the compliance obligations of investment advisers, broker-dealers, national exchanges and transfer agents and the specific areas of division examinations.
For investment advisers, the alert states that the focus will be on: portfolio management; books and records; custody (including access to private keys and unauthorized transactions); disclosures; pricing client portfolios; and registration issues.
For broker-dealers, the alert states that the focus will be on: safekeeping of funds and operations; registration requirements; anti-money laundering; offerings; conflicts of interest; and outside business activities.
For national exchanges, the alert states that the focus will be on whether the exchange is required to, and actually has, registered as an exchange pursuant to the Exchange Act.
For transfer agents, the alert states that the focus will be on whether the agent is following SEC rules and whether the agent has registered with the SEC.
Slock.it DAO Report
By way of background, in 2015, an Ethereum based project called Slock.it developed one of the earliest decentralized autonomous organizations (“DAOs”) called “The DAO.” Individuals were able to exchange ETH (the currency that powers the Ethereum blockchain) for The DAO tokens, which granted them voting rights and other perks in The DAO.
The public sale of the tokens raised the equivalent of $150 million USD in ETH in one month. Shortly thereafter, a hacker exploited The DAO’s code to steal one third of the ETH raised. To restore the lost ETH to investors, Slock.it and Vitalik Buterin proposed a “hard fork” of the Ethereum blockchain, which was approved by the users of the blockchain.
In 2017, the SEC issued a report on The DAO (but declined to initiate an enforcement action) which stated that The DAO tokens were issued as unregistered securities, particularly in relation to the “reliance on the efforts of others” Howey prong. Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO.
The SEC concluded this, in part, because Slock.it and its “curators” exercised “significant managerial control” over The DAO that essentially overshadowed the “limited” utility of the voting rights of token holders. The SEC concluded that voting rights in this instance were akin to those of corporate shareholders. The report concluded by urging entities and individuals to register such securities or face the consequences. The report did not explain why the SEC declined to initiate an enforcement action.
ENFORCEMENT ACTIONS AND INVESTIGATIONS
The SEC’s cyber division has engaged in at least 90 Crypto Assets and Cyber Enforcement Actions since 2013. An up-to-date list on the SEC’s website is located here.
Many of these actions result in fast settlements or collapse of the business, which makes the precedential nature of the action limited mostly to discernment of certain facts that may trigger an SEC enforcement action. However, there are a couple more “obvious” categories that may trigger an enforcement action: initial coin offerings (see, e.g, In re Loci, Inc. and John Wise; In re Blotics LTD. f/d/b/a Coinschedule LTD); and fraudulent offerings (see, e.g, SEC v. Uulala, Inc.).
SEC V. RIPPLE LABS
A more recent and impactful question revolves around establishment of new blockchain technologies and the tokens that exist/power them. The most well-known case in this regard is SEC v. Ripple Labs, Inc., No. 20-cv-10832 (S.D.N.Y. December 22, 2020).
By way of background, Ripple Labs was founded in San Francisco in 2012 and created RippleNet and the XRP payment protocol, which purportedly facilitates and improves cross-border payments and is an alternative to traditional international payment networks like SWIFT. The SEC claims that Ripple Labs and its founders created and allocated among themselves 100 billion units of their digital token, XRP, and then offered and sold over $2 billion worth of XRP to the public and then used those proceeds to fund Ripple’s business without registering XRP as a security.
The central question in the lawsuit is thus whether XRP is a currency or a security.
The SEC argues that XRP is a security because it meets the Howey test outlined above. Specifically, the SEC argues that XRP is an “investment in a common enterprise with other XRP holders and Ripple” because all units of XRP are fungible with each other, the price of all units of XRP rise or fall equally and XRP sales constituted 90% of Ripple’s funding source. In addition, the SEC argues that Ripple led investors to expect a profit from buying XRP given that Ripple allegedly directed “investment” inquiries to its “how to buy XRP” webpages, specifically targeted “speculators” when offering and selling XRP, and promoted XRP price “rallies” and investors’ ability to buy and sell XRP on online marketplaces.
Ripple argues that XRP is not a security, in part, because in many instances, the sale, donations, giveaways and purchases using XRP created no contractual relationship between Ripple and XRP recipients. Ripple also argues that where contracts did exist, the contracts did not define any investment related rights, imposed no post-transaction obligations on Ripple to take actions for XRP recipients’ benefit, and gave no rights to those XRP recipients to demand and receive any future profits from Ripple or anyone else. Ripple also argues that there is no “common enterprise” in which purchasers of XRP invest and that there is no evidence that purchasers of XRP reasonably expected profits from Ripple’s efforts, as opposed to resulting market forces affecting cryptocurrencies generally.
A full analysis and summary of each party’s arguments is beyond the scope of this blog post. The case is currently in the summary judgment stage. The SEC’s brief is here. Ripple Lab’s brief is here. A number of interested parties have filed amicus briefs in support of Ripple, including a group of 75,000 XRP holders and industry participants such as Coinbase.
The outcome of the case will have wide-spread impacts on cryptocurrencies and digital assets and the regulatory framework that will apply to them.
NFTs
More recently, the SEC has launched a probe into Yuga Labs, Inc. (the creators of the popular Bored Ape Yacht Club (BAYC) NFT collection). The stated purpose of the investigation is to determine whether Yuga Lab’s NFTs should be considered securities. SEC Probing Bored Ape Creator Yuga Labs Over Unregistered Offerings.
This is significant given that Yuga Labs is behind five of the most popular and lucrative NFT collections, including BAYC, CryptoPunks, Otherdeeds, Mutant Ape Yacht Club and Meebits. The company’s token, ApeCoin, is also under review.
The investigation comes on the heels of a report in March 2022 that the SEC would more heavily scrutinize NFT creators and the exchanges they trade on to determine if they operate as securities, similar to ICOs. SEC Scrutinizes NFT Market Over Illegal Crypto Token Offerings. Also under review are “fractional NFTs,” which involve breaking down digital assets into units that can be bought and sold among many different individuals.
It is important to note that Yuga Labs has not been accused of acting illegally and the investigation does not necessarily mean that the SEC will file a lawsuit against Yuga Labs.
ANTI-TOUTING
The SEC has issued statements telling celebrities (and individuals) that they must disclose any payments for their cryptocurrency endorsements and that failure to do so would be a violation of the anti-touting provisions of federal securities laws. Specifically, the SEC has stated “[a]ny celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.” This is because section 15(a)(1) of the Securities Exchange Act makes it unlawful for a person to “attempt to induce the purchase or sale of, any security” unless he or she is a broker or dealer under the rules and regulations of FINRA, which regulates certain aspects of the security industry.
For instance, the SEC fined Kim Kardashian $1.26 million for “touting” on social media a cryptocurrency asset sold by EthereumMax (“EMAX”). Specifically, the SEC alleged that Kardashian failed to disclose that she received $250,000 for publishing an Instagram post about the EMAX token. Kardashian agreed to pay the fine without admitting guilt. SEC Charges Kim Kardashian for Unlawfully Touting Crypto Security.
The SEC also took action against Floyd Mayweather and music producer DJ Khaled for promoting investment in Centra Tech Inc.’s initial coin offering through a series of tweets. The two called Centra Tech Inc. a “game changer” and Mayweather titled himself “Floyd Crypto Mayweather". Khaled and Mayweather earned $50,000 and $300,000 respectively for their endorsement. The SEC fined them a combined $767,500, which they agreed to pay, without admitting guilt. SEC Fines Floyd Mayweather and DJ Khaled.
INTEREST BEARING LENDING PRODUCTS
The SEC fined Blockfi $100 million (which Blockfi agreed to pay) for failing to register its lending product (an interest bearing account) as a security. BlockFi Agrees to Pay $100 Million in Penalties and Pursue Registration of its Crypto Lending Product.
PROPOSED RULES
The SEC has issued two proposed rules.
The first proposed rule purports to change the definition of an “exchange” under the Exchange Act. Amendments to Exchange Act Rule 3b-16 Regarding the Definition of “Exchange”; Regulation ATS for ATSs That Trade U.S. Government Securities, NMS Stocks, and Other Securities; Regulation SCI for ATSs That Trade U.S. Treasury Securities and Agency Securities.
The altered definition would expand “exchange” to include not just platforms that match buyers and sellers of securities based on certain orders, but would also “include systems that offer the use of non-firm trading interest and communication protocols to bring together buyers and sellers of securities.”
The broadening of the definition could encompass unrelated businesses that simply provide tools for individuals interested in discussing digital assets that result in securities trades (like Discord and Telegram).
The proposed rule has met significant opposition from the industry.
The second proposed rule purports to expand the definition of “dealer” under the Exchange Act. Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer.
The rule would require traders who provide “significant liquidity” to the market to register with the SEC (which they are not currently required to do). This means that the rule could encompass automated market makers so as to require them to register as securities.
STATEMENTS AND TESTIMONY
There were relatively few SEC remarks on cryptocurrencies and digital assets prior to 2021, but there were some notable exceptions.
In 2017, former SEC Chair, Jay Clayton, cautioned investors to be wary of initial coin offerings because they were not registered with the SEC and therefore did not have disclosure protections that accompany registered securities filings. He also noted that in his view, most ICOs were securities offerings. Statement on Cryptocurrencies and Initial Coin Offerings.
Shortly thereafter, William Hinman, former Director of the SEC’s Division of Corporate Finance, remarked that neither Bitcoin nor Ethereum were securities since they were “sufficiently decentralized.” He also stated that cryptocurrency and digital asset projects may start as securities and could later become non-securities depending on the level of decentralization. Digital Asset Transactions: When Howey Met Gary (Plastic). These comments have been front-and-center in the SEC’s Ripple lawsuit (discussed above), given Ripple’s alleged reliance on those statements in the absence of other guidance from the SEC at the time.
Shortly after Hinman’s remarks, Clayton issued a statement that “all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties." Statement Regarding SEC Staff Views.
In April 2021, Gary Gensler was appointed as Chair of the SEC. Since then, he has issued numerous statements regarding the SEC’s priorities with respect to enforcement of securities laws in the cryptocurrency and digital assets arena.
In September 2021, Gensler stated that the cryptocurrency/digital asset space was essentially “the Wild West or the old world of ‘buyer beware’ that existed before the securities laws were enacted.” Testimony Before the United States Senate Committee on Banking, Housing, and Urban Affairs.
In this same testimony, he outlined five areas where the SEC is looking to regulate: (1) crypto tokens, (2) crypto exchanges and lenders, (3) stablecoins, (4) investments offering exposure to crypto assets, and (5) custody of crypto assets. He also noted that the SEC would continue to work with the CFTC and other agencies given that the agencies have “overlapping jurisdiction” of certain crypto assets. Finally, he noted that “the probability is quite remote that, with 50, 100, or 1,000 tokens, any given platform has zero securities.”
In October 2021, Gensler gave remarks to industry leaders that as new technologies emerged, the SEC would “need to continue to work toward our public-policy goals” of protecting investors, maintaining efficient markets, facilitating capital formation, and policing illegal activity. Prepared Remarks At DC Fintech Week.
In November 2021, Gensler responded to the President’s Working Group Report on Stablecoins, stating that some stablecoins “may be securities, commodities, and/or derivatives” and that the SEC would work with the CFTC to “deploy the full protections of the federal securities laws and the Commodity Exchange Act to these products and arrangements, where applicable.” President’s Working Group Report on Stablecoins.
Notably, in September 2022, Gensler suggested (albeit informally) that following Ethereum’s move to a Proof-of-Stake consensus protocol, it may satisfy the Howey test noted above. Ether's New 'Staking' Model Could Draw SEC Attention.
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