The pace of the SEC’s crypto crackdown ramped up last week with its highest profile actions against crypto trading platforms since the crypto market turmoil at the end of 2022. The SEC’s actions place crypto trading platforms and the market as a whole on extremely uncertain regulatory footing in the US, and the frustration from the industry is palpable.
The SEC’s enforcement activity comes immediately on the heels of promising legislative efforts from Congress, giving rise to conflict and uncertainty on the applicability of existing regulations to the crypto industry from different branches of the US government. Unfortunately, we are unlikely to have much clarity on these legislative efforts or from on-going litigated matters for some time. Thus, the question for crypto trading platforms operating or seeking to operate in the US market is: what to do we do now?
The threat of SEC enforcement is very real, and crypto trading platforms must seriously consider potential costs associated with defending a regulatory enforcement action. In this client alert, we discuss some of the major questions our clients are thinking about due to the recent events.
Is staking-as-a-service a dead end in the US?
Staking-as-a-service programs (“Staking Programs”) continue to be a focus of the SEC enforcement actions. As we noted after the settled order released in February 2023, the SEC appeared especially concerned with staking programs that pooled multiple customers’ assets and commingled those customer assets with those of the staking program provider. In a speech following the filing of the recent complaints, SEC Chair Gensler reiterated his view on Staking Programs, describing them as “classic securities” where “[c]ustomers invest their assets with the platform, which then . . . pools and stakes them, in each case promising a return.” Gensler noted that it doesn’t matter what kind of assets the investor places with the platform, and that the analysis is the same regardless of whether crypto is involved.
Gensler’s summary is a simplified application of the Howey test, which requires finding a contract, scheme or transaction whereby a person who (1) invests money; (2) in a common enterprise; (3) is led to expect profits; (4) from the essential managerial efforts of others which affect the success or failure of the enterprise. Of course, the complaints lay out a more detailed analysis than Gensler’s shorthand, but there are arguments to be resolved with application of each of the elements to the Staking Programs at issue. There are clear differences between a service provider passing through staking rewards that are determined by the blockchain protocol (less a service fee), and a service provider promising returns that, while influenced by the protocol’s staking rewards, are ultimately set by the provider. Notwithstanding these and other significant differences between the Staking Programs concerning which the SEC has brought enforcement actions, much of the SEC’s argument cites elements of Staking Programs that are set by the relevant blockchain protocol and the Staking Programs have zero influence over, such as the amount and timing of staking rewards distributed, the staking lockup periods and liquidity risks.
Thus, if the SEC wins on its broad application of Howey to the Staking Programs at issue in the recent complaints, it is unclear how a Staking Program could operate in the US without registering as a securities offering or seeking reliance on a registration exemption. As a result, for the time being, offering any kind of Staking Program in the US carries significant regulatory risk. Further, it is important to note that shortly after the SEC filed its second complaint on June 6, the Alabama Securities Commission announced the issuance of a Show Cause Order to the same crypto trading platform alleging that their Staking Program constituted an unregistered securities offering and giving the platform 28 days to show cause why they should not be directed to cease and desist offering the Staking Program. The order is the result of a multi-state task force of 10 state securities regulators, including Alabama, California, Illinois, Kentucky, Maryland, New Jersey, South Carolina, Vermont, Washington, and Wisconsin. State securities regulators followed a similar approach when the SEC cracked down on crypto lending programs in 2022, a similarity that Gensler also noted in his June 8th speech. Thus, it is not only the SEC that is willing to act in relation to these programs.
To delist or not to delist?
An important question facing crypto trading platforms right now is whether they should delist any of the crypto assets identified as securities in the complaints and other SEC regulatory actions. As we discuss below, there is no clear answer, and crypto trading platforms must consider all factors and risks as they move forward.
The SEC has now brought four enforcement actions since March 2023 alleging that a crypto trading platform has engaged in unregistered broker-dealer, exchange, and clearing agency activities. Prior to the recent enforcement trend, the SEC had only brought two enforcement actions (all settlements) against crypto intermediaries for unregistered exchange activity (one in 2018 and the other in 2021), and only one enforcement action in 2018 alleging unregistered broker-dealer activity. Notably, none of the prior enforcement actions alleged unregistered clearing agency activity.
A prerequisite to finding unregistered broker-dealer, exchange or clearing agency activity is that the crypto tokens involved must qualify as securities. Chair Gensler has repeatedly shared his view that the “vast majority” of crypto tokens available are securities. The SEC staff, through settled orders and complaints, have now expressly identified more than 50 crypto tokens as securities. For the SEC, this is viewed as sufficient precedent. However, no US court has yet found that any of the crypto tokens identified in the recent complaints are securities, and courts are not bound by the SEC staff’s views.
For crypto trading platforms in the US or with US customers, this unsettled legal status may provide some comfort but to bring an enforcement action, the SEC needs only to find that one crypto token listed by a platform is a security. If just one of those tokens is deemed to be a security, finding violations for unregistered broker-dealer, exchange, and/or clearing agency activity may be difficult to avoid.
The SEC’s current argument ties the initial offering of a token and continued participation of its founders and issuing organizations with the secondary trading of such tokens on crypto trading platforms as an ongoing investment scheme under Howey—effectively arguing that each customer of the platform is buying and selling investment contracts offered by the token issuers. A leading opposing argument is that the underlying asset (the crypto token) of an investment contract (the initial offering, distribution, pre-sale, etc.) does not become a security solely because it was obtained via an investment contract and, instead, that any secondary sale must be assessed separately as to its status as a security. The opposing argument also is the basis for the Securities Clarity Act, a bi-partisan bill reintroduced a few weeks ago in the US House of Representatives that would clarify that the underlying assets to an investment contract are not securities themselves, unless they also meet the definition of a security.
Without definitive US case law or legislation, deciding whether to list or delist any particular crypto token for trading in the US or for US persons will continue to be a risk decision. In this regard, crypto trading platforms should take immediate steps to review their listing standards (or establish them), taking into consideration the evolving views of the SEC, past enforcement actions and guidance, and continuously monitoring for changes in regulatory activity.
Delisting a crypto token identified by the SEC may provide temporary relief but, even then, only until the SEC identifies more crypto tokens as securities. A platform’s listing standards should be reasonable, applied consistently, and reviewed both periodically and in response to market events. If changes are made to the listing standards, previously listed tokens should be re-evaluated under the updated standards. While the SEC seemed to brush away the existence of one of the platform’s established listing standards in its complaint, a court may view a robust listing standard process differently. Unfortunately, despite the strength of any argument against classifying a token as a security and the prospects of winning that argument if litigated in court, platforms must consider the potential costs to defend and the reputational impacts of an SEC enforcement action.
Is there really a path to registration?
Chair Gensler has repeatedly claimed that crypto trading platforms need only “come in and register,” but several crypto trading platforms have claimed they did just that–only to ultimately be met with shut doors or, in the case of the recent events, an enforcement action. On the flip side, FINRA has approved a number of firms to engage in the digital asset securities business by operating as an alternative trading systems (ATS), and in May 2023, a crypto platform obtained the first special purpose broker-dealer registration from the SEC and membership with FINRA. The unique approval requires that the platform only deal in crypto assets that are securities and adhere to a number of conditions laid out in a time-limited relief issued by the SEC in December 2020.
The limitations for obtaining special purpose broker-dealer approval make it highly unlikely that most crypto trading platforms currently in operation could meet the required conditions without delisting at least some crypto tokens and creating separate business lines and/or entities. Further, seeking registration as a broker-dealer, a national securities exchange (or more likely an ATS) and/or a clearing agency have many complications that would need to be considered to unwind what are typically combined functions in the crypto market. If there is a path to registration, crypto trading platforms will need to consider the interplay between these various registration categories and how the platform may need to transform in order to comply.
Is Congress the only hope?
In the midst of the SEC’s crypto crackdown, there are glimmers of hope that Congress could be on the path to providing a clear and practical regulatory framework. As noted above, a bi-partisan bill was introduced a few weeks ago to clarify that the underlying asset of an investment contract is not a security unless it otherwise meets the definition. Barely a week ago, the Chairs of the House Financial Services Committee (overseeing the SEC) and the House Committee on Agriculture (overseeing the CFTC) released a discussion draft for a digital asset market structure proposal intended to provide a comprehensive statutory framework for digital asset regulation in the US. Without Congressional action, the SEC is expected to continue its aggressive crypto crackdown and regulation by enforcement approach. However, in a politically divided government, whether there is sufficient support for a legislative fix remains unclear.
We are continuing to monitor regulatory and legislative activity affecting our clients and the crypto industry as a whole. Please reach out if you are interested in discussing how the SEC’s recent activity may impact you.