U.S. Crypto Law and Regulation Update: Checks, Balances, and Some Major Questions
|By Daniel Bulaevsky, GC at Hack VC, and previously partner and GC at Klaros Group, attorney at Wachtell, Lipton, Rosen & Katz, consultant at Promontory Financial Group, and investment banker at J.P. Morgan.|
If you’re the founder of a crypto company with some nexus to the U.S. in 2023, what do you do? Do you put your head down, build, and hope the regulatory environment in the U.S. improves? Do you go out and advocate for your company and the crypto industry? Do you follow SEC Chair Gary Gensler’s advice and “[go] in [and] register” with the SEC?
“I don’t know how to answer that question” SEC Commissioner Hester Peirce, one of Chairman Gensler’s four colleagues on the Commission, told me when I asked the same question at our firm’s hack.summit() conference earlier this year. “And that’s unfortunate,” she concluded. It is indeed.
As this article explains in more detail below, 2023 began with an onslaught of SEC activity across the crypto industry, as the SEC filed complaint after complaint after complaint against major crypto companies. But the tide began to turn, to some extent, midway through the year, as (on balance) positive legal and political developments materialized, with crypto defendants mounting strong defenses (and even scoring an early win!) in court and lawmakers pushing crypto bills to new heights in Congress. While these are still early developments, and much more progress is needed, they suggest that the U.S can still turn things around to provide crypto founders and other market participants with workable rules and certainty and reclaim its position as a leader in the crypto industry—and that would be a fortunate thing.
SEC Onslaught in H1 2023
The SEC turned up the heat in the first half of 2023. In that time, the SEC charged, among others:
Genesis and Gemini for the unregistered offer and sale of crypto asset securities.
Nexo with failing to register the offer and sale of its retail crypto asset lending product (and Nexo agreed to discontinue the product in the U.S. and pay $45 million in penalties).
Kraken with failing to register the offer and sale of its crypto asset staking-as-a-service program (and Kraken agreed to discontinue the program in the U.S. and pay $30 million in penalties).
Several Binance entities and founder Changpeng Zhao for operating unregistered exchanges, broker-dealers, and clearing agencies, for misrepresenting trading controls and oversight, and for the unregistered offer and sale of securities.
Coinbase for operating an unregistered securities exchange, broker, and clearing agency and for the unregistered offer and sale of securities in connection with its staking program.
In this flurry of H1 activity, the SEC made clear that it is committed to regulating the crypto industry by enforcement. That commitment is founded in Gensler’s (apparently evolved) view that the existing U.S. securities laws “cover most of the activity that’s happening in the crypto market.” The Commission has thus eschewed the standard rulemaking process, which could be used to work with relevant parties to create workable rules for consumers, the industry, and the SEC, in favor of the strict application of existing rules and, in turn, enforcement where those laws and the industry invariably diverge.
Existing Rules Don’t Work for Crypto
The SEC’s hardline approach would be a sensible one if existing U.S. securities laws worked for digital assets (and supported the important policy objectives of those laws with respect to them). But they don’t. That is:
A decentralized protocol cannot simply “[go] in [and] register” with the SEC. The nature of such protocols, including that tokens must necessarily exist at the earliest stages of development, makes it virtually impossible to provide all required disclosures (such as historical financials) and to comply with other ongoing regulatory obligations.
The existing required disclosures are also largely inapt; that is, the disclosures that matter most to purchasers of digital assets are quite different from those the SEC asks of traditional registrants (think tokenomics, technology controls and vulnerabilities instead of nonexistent financials), which further supports new rules in the name of investor protection.
The time and cost of registration and compliance is not economically viable for most protocols (unlike traditional registrants, which take upwards of ten years to reach sufficient maturity for an IPO, protocols would be required to register not long after raising their earliest rounds!).
The lack of support for digital assets among registered securities exchanges, registered broker-dealers, or alternatives, which would be the required trading forums under the SEC’s approach, along with other related intermediaries, raises questions about how registered tokens could even be traded in the U.S. (and, even if they could, disintermediated trading would be impossible).
A handful of protocols have made it through the SEC registration process, but all have either shut down or face significant headwinds. None have succeeded.
Put simply, applying existing rules, which do not contemplate decentralized technology, forces centralization in an absurd manner (e.g., registration at inception (if even possible; more likely, attempts at registration would result in effective rejection for failure to satisfy the SEC’s ill-fitting disclosure requirements), no trading venues, etc.) and works only to kill the core features of the technology.
The same outcomes have generally followed on the centralized side of the crypto world. Coinbase, like other crypto exchanges operating in the U.S., has taken great efforts to attempt to register with the SEC but has found that “there is no existing way for a crypto exchange to register” with the Commission. Coinbase also filed a petition for rulemaking and asked the SEC for guidance on several occasions with respect to registration and other securities laws matters, including its token listing process. Rather than work constructively with Coinbase, the SEC responded with a Wells notice (i.e., a formal notice notifying a recipient of the substantive charges the SEC intends to bring against them) and, soon after, it filed the complaint noted above.
A Better Solution
There’s a better solution here. Commissioner Peirce summarized it perfectly in response to the SEC’s reopening of the comment period and provision of supplemental information on proposed amendments under Exchange Act Rule 3b-16:
A Commission serious about regulating—and not destroying—this market would reflect on [a] near unblemished record of regulatory failure and do something about it. We would consider the possibility that our rules, which in the past have evolved to address the needs of, and the risks presented by, investors and firms in the traditional securities markets, might require some tweaking to permit firms to offer innovative ways of doing finance using novel technologies.
The SEC need only look abroad, in almost any direction, for examples of regulators and lawmakers doing just that. The EU, UK, Hong Kong, Dubai, among other jurisdictions, are quickly filling the void by proposing and in some cases implementing major crypto laws and regulatory frameworks that promote innovation in the digital assets space (and, with it, capital formation and healthy markets) while protecting consumers. The developments in Hong Kong, one of the largest financial centers in the world, are particularly exciting, as regulators have stated a commitment to growing crypto in Hong Kong and have shown it by implementing a new licensing regime for crypto trading companies, inviting crypto companies to register (in this case, sincerely), and signaling that other regulatory initiatives will follow.
The SEC could do the same. It could work with the industry to create a path to compliance in the U.S., including disclosures that protocols can actually provide and that matter to crypto users, ongoing compliance obligations that consider the decentralized nature of these registrants, and rules that allow exchanges to safely offer digital asset trading, and at the same time satisfy its own mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. There are myriad examples of the SEC working with other market participants to create rules that work where a regulatory gap or other inefficiencies exist. But the SEC has so far chosen not to do so.
Checks and Balances
This is a tough situation, but there are reasons to be hopeful. Underlying such hope is a core tenet of the U.S. government: our system of checks and balances, or the division of our government into three branches—Executive, Legislative, and Judicial—to ensure that no person obtains too much power. It’s a cornerstone of the U.S. Constitution and a fundamental protection against government/administrative overreach. In recent weeks, we have seen crypto push back on the SEC, an independent federal agency, through the judiciary (arguing and, in the case of Ripple, winning a court decision agreeing in part, that the SEC does not have unilateral jurisdiction over the entire crypto industry) and Congress (working across the aisle to attempt to create new laws for the industry).
Positive Developments in Crypto Cases
Several pivotal court battles are ongoing that could in time materially restrict the SEC’s authority in the crypto space (i.e., clarify that not all crypto tokens or crypto token transactions are securities and that crypto exchanges are not operating as unregistered exchanges, among other things), including the SEC’s lawsuits against Ripple, Terra, and Coinbase, cases that are distinct on the facts, but which have important commonalities across them. It’s still early in each case, but developments are on balance positive.
In the Ripple case, the SEC suffered a rebuke to its current approach when Obama-appointed U.S. District Judge Analisa Torres ruled on cross motions for summary judgment, among other things, that XRP (the native Ripple token) “as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract” and that Ripple did not violate federal securities laws by selling XRP in blind bid/ask transactions on public exchanges or by compensating employees and service providers with XRP (but that it did by selling XRP to institutional investors). Put simply, the ruling found that XRP tokens, like the orange groves in the famous Howey case, are extricable from any investment contracts as part of which they might be sold (such as primary sales to institutional investors) and are not themselves securities. Context matters. This is a big deal, because, as is obvious, assets and transactions that are not securities or securities transactions (as well as relevant market participants) are not subject to securities laws or SEC oversight.
It should be noted that this decision is convoluted and results in a perverse outcome in terms of consumer protection (or, really, a lack thereof). That is, the decision, which follows existing law, gives institutional investors the protections of the U.S. securities laws but leaves retail investors without such protections. That is not to say that the court got it wrong; rather, the court (with some difficulty) reasonably applied existing law, and that application gives an answer that is inadequate from a public policy perspective. That suggests the laws need to change to ensure consumers of digital assets receive adequate protections without quashing the benefits of the new technology. Such protections are critical for further adoption.
Nevertheless, this ruling could have several positive effects, including strengthening the defense postures of other industry players (e.g., Coinbase), incentivizing members of Congress to pass new laws (as this ruling makes clear the existence of the real, wide regulatory gap noted above; it’s a great opportunity for Democrats in Congress who generally love the idea of more financial regulation) and, with some luck, changing some hearts at the Commission, though I’m not holding my breath for that. It is important to note that this decision is specific to the facts of the case and is that of a sole district judge and thus not binding on other judges, meaning that much can still change (including an SEC interlocutory appeal or a future appeal after a final judgment on the balance of the case, adverse opinions in other districts or from other judges in the same district, which we have already seen in part in the recent Terra decision, etc.). But this opinion is undoubtedly an important win for the crypto industry in the U.S. for now.
In the Terra case, though headlines surrounding the recent motion to dismiss decision are certainly gloomy (most read as some version of “Terra Court Rejects Ripple Decision”), the opinion, though definitely a mixed bag, must be understood within the context of that case and the motion itself:
The court opined on a motion to dismiss filed by Terra, whereas the motions before the Ripple court were cross motions for summary judgment. These are very different motions. A complaint will generally survive a motion to dismiss, which typically occurs before discovery, if it contains enough allegations (which the court must take as true directly from the complaint) to state plausible claims. That’s a low bar! A court may grant a motion for summary judgment, which typically occurs after discovery, only if a movant shows that there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law. In short, the Ripple court sided with Ripple as a matter of law; the Terra court simply found that the SEC’s uncontested allegations were sufficient to state plausible claims. Those differences matter.
The allegations in Terra are also very different and in many ways worse than the facts in Ripple, in particular the various connections between the different digital assets within the Terra ecosystem and statements made by Terra and its executives that evince promises of profits based on their efforts. Of course, since discovery has not yet occurred in the Terra case, the record is subject to change, but Terra likely faces a steeper battle than did Ripple. Facts also matter!
The Terra court suggested that it largely agrees with the Ripple court that tokens “if taken by themselves, might not qualify as investment contracts.” This finding adds some support for the separation of tokens from investment contracts, of which they may or may not be a part (though, as noted, it’s not binding on any other judges). Again, this is a critical finding for the industry.
The Terra court did reject parts of the Ripple court’s decision, but its explanation for that rejection is not exactly a model of clarity. The Terra court stated that Howey makes no distinction between manners of sale or types of purchasers, and that any such distinction would have no impact on whether a “reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.” The court went on to explain that Terra and its executives marketed the profitability of the various tokens to both institutional and retail investors, including that all Terra token sales “would be fed back into the Terraform blockchain and would generate additional profits for all . . . holders.” If it’s unclear to you how to square this argument with the Ripple decision, you’re not alone. The Terra court is right that Howey makes no such distinction, but I’m not sure the Ripple court made it either; rather, the Ripple court, having determined that the tokens in question are not by themselves investment contracts, as did the Terra court, applied the Howey test to different contracts, transactions, or schemes, each with different facts, and reached different results. In other words, such distinctions played no part in the court’s analysis, they were merely the result of applying the law to the facts.1
The Terra court also firmly rejected Terra’s “major questions doctrine” argument. The doctrine provides that an extraordinary grant of regulatory authority requires clear congressional authorization, and that courts “presume that Congress intends to make major policy decisions itself, not leave those decisions to agencies.” The Terra court found that the SEC’s claims of authority were insufficiently “extraordinary” and that the crypto industry, though important, was insufficiently significant to warrant application of the doctrine. This finding is clearly unhelpful for Coinbase, but, as discussed below, Coinbase has presented a stronger argument for the application of the doctrine in its own case against the SEC (moreover, other courts, namely the Supreme Court, with its conservative majority, may be more ready to apply the doctrine).
It is important to note that this outcome is not unexpected (though it did arrive a bit quicker than most probably expected). Courts are sure to disagree on the application of Howey to digital assets and related transactions, just as the industry, regulators (see the CFTC’s disagreements with the SEC), and politicians have disagreed on the same for years. It serves as another clear sign to Congress that a regulatory gap indeed exists and that it needs to be filled with workable rules so that the digital asset industry can prosper in the U.S.
The Coinbase case is in the earliest stage of the three cases. Last week, Coinbase filed a motion for judgment on the pleadings asking the court to dismiss the SEC’s complaint against the U.S.-based exchange in its entirety. A motion for judgment on the pleadings, which typically occurs before discovery, is similar to a motion to dismiss challenging the legal sufficiency of the pleadings and carries the same legal standards on review. The key difference between the motions is that, if a court grants a motion to dismiss, a plaintiff can amend a complaint, but if a court grants a motion for judgment on the pleadings, the relevant claims are dismissed. Coinbase’s legal strategy, in filing a comprehensive answer followed by this less-used and possibly dispositive motion, which can cite its own answer, is brilliant (necessary disclaimer: I was previously an attorney at the firm leading Coinbase’s defense, Wachtell, Lipton, Rosen & Katz).
In its motion, Coinbase makes four primary claims: (1) the SEC’s complaint does not plead “securities” transactions (i.e., that transactions in digital assets through Coinbase and Coinbase Prime, as well as its staking services, are not investment contacts under Howey), (2) the regulation of secondary markets for digital assets “qualifies as extraordinary” and the digital assets industry is sufficiently significant to implicate the major questions doctrine, which would separately compel rejection of the SEC’s incorrect construction of an investment contract, (3) Coinbase did not act as an unregistered broker through Coinbase Wallet, and (4) Coinbase’s staking services do not constitute unregistered securities. As noted, if the court grants the motion, it would dismiss all or parts of the SEC’s complaint against Coinbase, and the surviving claims, if any, would continue to discovery.
A few interesting points to note from the motion:
As expected, Coinbase cited on several occasions the decisions of the Ripple court, to support its arguments, and the Terra court, both to support its arguments and to distinguish facts of each case.
Coinbase makes several strong arguments, aided by better facts due to it being a secondary exchange as opposed to primary issuer, with respect to the application of the Howey test:
Coinbase argues that digital asset transactions through Coinbase and Coinbase Prime lack any “contractual undertakings” beyond the point of sale (merely the spot purchase of an asset) to “deliver future value reflecting the income, profits, or assets of a business,” all necessary components of an investment contract. Coinbase focuses on the requirement that an instrument must at least appear to confer contractual rights to delivery of future value and supports this claim by citing a long list of cases involving such fun assets as rabbits and muskrats.
Coinbase argues that a “scheme” under Howey requires a contractual arrangement (usually involving a series of contracts) and that “no court had ever adopted the atextual position that a bare investment accompanied by a hope of value increase but no contractual undertaking could qualify as an investment contract.” Coinbase claims that the SEC does not allege any such contractual undertaking beyond the point of sale.
Coinbase cites Ripple (and several other cases) claiming that a digital asset is not itself a security and that it “can be a component of a security—an investment contract—only if accompanied by relevant contractual undertakings.” If Coinbase wins on this point, it could expand the Ripple court’s decision beyond the XRP to digital assets generally (except, of course, for tokens that otherwise implicate the definition of “securities,” like tokenized equity or bonds or tokens with similar features).
Coinbase argues that an investment contract requires an “expectation in the income, profits, or assets of a business” and that purchasers of digital assets on Coinbase and Coinbase Prime get no share in business income, profits, or assets, as digital assets are merely products of a business, such that any increase in the value of digital assets is separate from the “income or profit” of the business.
In a nice summation of what is one of its strongest arguments concerning Howey, Coinbase writes: “On Coinbase’s secondary-market exchange and through Prime, there is no investment of money coupled with a promise of future delivery of anything. There is an asset sale. That’s it. It is akin to the sale of a parcel of land, the value of which may fluctuate after the sale. Or a condo in a new development. Or an American Girl Doll, or a Beanie Baby, or a baseball card.” Or a muskrat!
Lastly, Coinbase presents a strong argument for why the “major questions doctrine” should apply to this case. Specifically, Coinbase writes that the regulation of secondary markets for trading digital assets is sufficiently extraordinary and that the digital assets industry is sufficiently significant, noting that its market capitalization is valued at approximately $1 trillion, that “[o]ne in five adults in the United States has owned a cryptocurrency,” and that “hundreds of millions of people globally use cryptocurrencies that are traded on platforms in the United States for myriad purposes.” Coinbase highlights the fact that Congress is actively considering new rules to show that the authority over crypto regulation is indeed a major question. Coinbase also touches on the Terra court’s arguments concerning the doctrine, arguing that the Terra court “overlooked entirely the Supreme Court’s recent clarifications and application of the doctrine” in two Supreme Court decisions, including the recently decided Biden v. Nebraska. Although the doctrine presents a high bar to clear, Coinbase’s facts are in many ways analogous to those in Biden v. Nebraska, and the doctrine feels ripe for further application. Should a court apply such doctrine, it would turn the major question over to Congress.
Coinbase’s arguments are persuasive, but this is a difficult motion to win, and it’s unlikely that a district judge will be keen to take too many risks in a decision here, so it won’t be a surprise if at least some part of the complaint survives (for now).
Congress In Action
Congress has been hard at work on new proposed crypto rules, which is positive for the industry both from a checks and balances perspective (as protection against overreach) and substantively (the draft bills are pretty good!). At the time of this article, two major crypto bills, among several more specific crypto bills, are in process in Congress:
In the House, the Financial Innovation and Technology for the 21st Century Act, sponsored by Congressmen Patrick McHenry, Glenn Thompson, French Hill, and Dusty Johnson, all Republicans, aims to provide regulatory clarity as to the framework applicable to digital assets in the U.S., including allocating oversight over the industry between the CFTC and the SEC. The bill recently passed both the U.S. House Financial Services Committee and the House Agriculture Committee and will move on to a vote on the House floor. Importantly, several House Democrats supported the bill’s passage.
In the Senate, the Lummis-Gillibrand Responsible Financial Innovation Act, sponsored by Senators Cynthia Lummis and Kirsten Gillibrand, a Republican and a Democrat, respectively, also aims to create a comprehensive regulatory framework for crypto assets. The bill has not passed the Senate committee with authority over the bill, and faces significant hurdles to do so, despite that the bill is bipartisan.
The bills are quite different, and each needs some fine-tuning, but both propose new rules for the crypto industry that would, as a general matter, reduce the role of the SEC and promote certainty and greater confidence for crypto market participants, reduce attendant risks, and protect consumers. The House bill is the more likely of the two to move to the other chamber, as it has already passed two House committees with bipartisan support. But both bills face long odds of turning into law in the short term given the sentiment in the Democrat-controlled Senate and across the Biden Administration.
Other, more specific proposed bills, including the Clarity for Payment Stablecoins Act of 2023, which aims to provide a clear regulatory framework for the issuance of payment stablecoin, are also making the rounds, and it’s quite possible that some of those bills receive greater support compared to their more comprehensive and thus harder-to-pass counterparts. The Clarity for Payment Stablecoins Act of 2023 bill, along with other smaller bills, is also headed to the House floor for a vote.
The checks have provided some balance in the courts and in Congress for the crypto industry. Both are key spaces to watch in H2 2023 and beyond, as real clarity must come from one or the other (and ideally the latter).
TradFi Making Crypto Moves
Lastly, in recent weeks, TradFi renewed its push into crypto, as several of the world’s largest asset managers filed applications for spot Bitcoin ETFs with the SEC, including BlackRock, Fidelity Investments, and other large asset managers, as well as for Ethereum Futures ETFs. Elsewhere, PayPal announced that it will launch a new dollar-backed stablecoin, PYUSD, in partnership with Paxos.
While a spot Bitcoin ETF approval by the SEC is anything but certain at this point, BlackRock has a pretty good track record on its ETF applications—of the 576 applications it has filed, the SEC has approved 575 of them. Shortly following its ETF filing, Blackrock CEO Larry Fink, a one-time crypto skeptic, stated in an interview on Fox Business that if we “can create more tokenization of assets and securities—that’s what bitcoin is—it could revolutionize finance.”
Where This Leaves Us
Despite all the regulatory developments, not much has changed on the ground level. None of the court cases have created binding precedent, though we did at least receive some support for the current approach to crypto company institutional financings (i.e., initial sales under Regulations D or S, etc.), and none of the proposed bills have become laws, and it’s unlikely that any of that will happen anytime soon, other than some of the more specific crypto bills. That means that uncertainty in the U.S. will persist for the time being. As always, crypto founders and other market participants are advised to work closely with their counsel to ensure their activities fall within applicable rules and regulations.
Ultimately, while the SEC’s current approach poses challenges for the crypto industry in the U.S., it is no death knell for crypto globally. Crypto is a global technology that does not depend on the SEC or the U.S. But all is not lost at home. These recent developments suggest that the U.S. can still turn things around to provide crypto founders and other market participants with workable rules and certainty and reclaim its position as a leader in the crypto industry—and that would be a fortunate thing.
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Lastly, almost everything in the world of crypto law and regulation remains in a state of constant flux, so matters covered in this article may well be stale by the time you read it.
Or did the Terra court mean that if one contract, transaction, or scheme involving a given asset is an investment contract, that all other contracts, transactions, or schemes concerning the same asset, even with different facts and different types of purchasers, are necessarily investment contracts? Or that a “reasonable individual” is a person that receives the same information and that has the same understandings and expectations as all other types of purchasers in all other contracts, transactions, or schemes concerning the same asset, even with different facts? Had the allegations in Terra provided that one type of purchaser did not see or receive any information from Terra or its executives whatsoever, would the Terra court have held differently? ↩