This article is co-authored by Luo Xuhong and Prathit Maran.
Goodbye Gary Gensler. The 33rd chair of the Securities and Exchange Commission certainly will not be missed by the crypto industry as he steps down today. Known for his radical approach to regulating the nascent sector, Gensler has overseen one of the most tumultuous periods in the history of crypto during his 4 years. Read on as we examine why many are glad to bid good riddance and how Trump’s hand picked successor can usher in a new era of prosperity for crypto.
Much to the dismay of the crypto industry, outgoing SEC chair Gary Gensler has made tough crypto regulation a defining feature of his tenure.
The law is clear... of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities. ~ Gensler at the Practicing Law Institute, Sep 2022
Known for insisting that almost all crypto tokens can be classified as securities and therefore must abide by existing securities laws, Gensler has defined his approach by applying established securities regulations (namely the Securities Act of 1933 and Securities Exchange Act of 1934) to the crypto sector. Gensler has also side-stepped industry demands for new guidelines that would improve regulatory clarity on crypto - a move that has drawn sharp criticism over concerns that such heavy-handed moves would drive talent out of the US to more crypto-friendly jurisdictions. Over the past 3 years, the SEC under Gensler has pursued a controversial “regulation by enforcement" strategy. In the aftermath of the crypto winter of 2022, Gensler has expanded the SEC’s Division of Enforcement to target some of the biggest names in crypto in a series of civil lawsuits alleging various violations of securities laws such as engaging in an unregistered securities offering and the failure to register as a broker-dealer and clearing agency. However, these lawsuits have revealed that the SEC’s own stance is often riddled with inconsistencies even when enforcing securities laws. Unsurprisingly, Gensler’s agenda has garnered bipartisan criticism from representatives who believe that his efforts should be redirected towards producing formal rules for crypto assets instead of playing an unproductive game of whack-a-mole.
The Howey Test
At the core of the Securities Act and Exchange Act, the financial instrument in question must first be deemed a “security” before familiar investor protections kick in. Apart from common financial instruments such as stocks, bonds and derivatives, the term “security” itself is vaguely defined. In the absence of a statutory definition, federal courts are tasked with determining the meaning of an “investment contract” through case law - any financial instrument that is found to satisfy the Howey test is deemed a “security” and must comply with disclosure requirements as per the above mentioned securities laws. Named after a 1946 Supreme Court case (SEC v. W. J. Howey Co.) that involved an investment scheme in a Florida orange grove, the Howey test spells out the 4 elements that must be fulfilled for the term “investment contract” to be satisfied (a) an investment of money (b) in a common enterprise (c) with the expectation of profit (d) to be derived from the efforts of others. The Howey test has since served as the primary tool that the SEC uses in its numerous civil litigation suits. Let’s examine some of the notable cases below.
The curious cases of Ripple and Terraform
In June 2015, Ripple Labs Inc (issuer of the token XRP) was fined $700,000 by the Financial Crimes Enforcement Network (FinCEN) for violations of the Bank Secrecy Act. Ripple was accused of acting as a money services business without FinCEN registration and failing to implement an anti-money laundering programme. For the purposes of the FinCEN complaint, XRP was deemed as a virtual currency. Strangely, the SEC filed its own suit nearly 5 years later in 2020 alleging that Ripple Labs raised more than US$1.3bn through its unregistered offering of digital asset securities (XRP), despite at least 3 other jurisdictions (Japan, Singapore, United Arab Emirates) previously finding that XRP is a currency and not a security.
Judge Analisa Torres eventually held that while XRP sales to institutional investors did constitute securities transactions, programmatic sales of XRP to individual retail investors on public exchanges did not constitute securities transactions. Crucially, the court held that institutional investors who entered into written sales contracts would have had reasonable expectations that their capital would be used to generate profits by Ripple and thus satisfied the Howey test. In contrast, programmatic sales (automated, anonymous transactions in which the seller is unknown to the buyer) were not deemed as securities transactions as buyers could not have reasonably expected Ripple to specifically use their capital to generate profits and create investment returns. This split judgement handed a public relations victory to the crypto industry as it ended Gensler’s previous winning streak of successful enforcement actions against all who marketed crypto tokens as investments.
However, the crypto industry’s joy was short lived as another judge (also of the same jurisdiction, Southern District of New York) rejected Judge Torres’ reasoning. The facts in SEC v Terraform Labs are largely similar - Terraform Labs was accused of selling crypto tokens to both institutional and retail investors through 2 separate channels. Judge Rakoff found that “Howey makes no distinction between purchasers” and justified that there was no need to distinguish between the 2 categories of investors given that all proceeds would be used to support the firm’s efforts and “would generate additional profits for all crypto-asset holders”.
Judge Torres’ ruling that implied unsophisticated retail investors deserved less protection under securities laws than institutional investors shocked many industry observers as it went against the very spirit of the law. In contrast, Rakoff’s ruling in Terraform Labs is seen as more aligned with the conventional approach to applying the Howey test. The Ripple-Terraform split reveals the pitfall of Gensler’s approach as courts can no longer reliably hand victory after victory to the SEC. Worse still, the atmosphere of legal uncertainty has only thickened as a result of Gensler choosing to litigate rather than proposing rules for the crypto industry.
A Study in Irony
Next, a brief analysis of cases the SEC has brought against 3 major crypto exchanges also reveals that the murky nature of the process through which the "investment contract" test is applied to specific crypto assets. SEC v Bittrex saw the identification of 6 specific crypto assets available for trading on the Bittrex platform as securities while other crypto assets that had higher market capitalisations and greater trading volumes (e.g Ether, Cardano, Dogecoin and Litecoin) were excluded. No explanation was offered as to why multiple other more visible and popular crypto assets were not part of the SEC's analysis.
This trend is repeated in SEC v Binance in which the SEC did not elaborate on why multiple new crypto assets (e.g SOL, ADA and MATIC) that were excluded from the Bittrex complaint were now included or why there was a significant time lapse involved. Finally, SEC v Coinbase saw the identification of more new crypto assets but other key assets such as LTC and DOT remain omitted from the list. The seemingly arbitrary nature of SEC enforcement clearly calls into question its chair's repeated claims that application of the Howey test is simple and obvious. Case in point: the Coinbase complaint took up some 47 pages and 191 paragraphs to explain how a mere 13 crypto assets were securities in the SEC's opinion.
Evidently, the present game of whack-a-mole is highly unsustainable as new token issuers only need to argue that the facts are materially different from that of a previous SEC victory, thereby bringing on another few months of tedious litigation. Rather than Gensler’s baffling selective enforcement approach, many have called for SEC staffing and resources to be redeployed to promote greater regulatory clarity instead - for instance, there is ongoing discourse over a potential cross-jurisdictional approach to regulating crypto assets in future that “cuts across the boundaries of SEC and CFTC” proposed by Timothy Massad, former CFTC chairman during the Obama administration.
Paul Atkins
Now that we have looked at the incoherence that has characterised Gensler’s SEC, we will next cover the outlook for crypto under incoming chair Paul Atkins.
Trump’s appointed SEC Chair, Paul Atkins is expected to heavily influence regulatory changes that may occur during his presidency. Known to be ‘crypto-friendly’, he has served as a co-chair of the Chamber of Digital Commerces’ Token Alliance, a crypto advocacy group, during which he emphasises the importance of regulatory clarity and smart policies in the space. Atkins believes that this is a means of increasing growth and adoption within the industry. These insights are consistent with his time as an SEC Commissioner (2002-2008) where his speeches also reinforced the same ideas, one particular example being his remarks to the SEC Speaks in 2008.
Seriously, there should not be anything mysterious about what happens at the SEC, but somehow we have allowed an Olympic-like cloud to shroud our workings. Investors, companies, brokers, advisors, attorneys, accountants, and others participating in our capital markets should be able to predict whether conduct is permissible or prohibited.
We expect Atkins to guide the SEC and push for legislation that improves clarity for the crypto industry. Bills such as the Financial Innovation and Technology for the 21st Century Act will help to define whether a cryptocurrency is considered a security or a commodity helping market participants make actions that align with the respective laws, while knowing which regulatory body is in charge. Such legislation reduces the need for unnecessary enforcement that potentially poses a threat to stifle innovation and growth inside the crypto sector. This poses a considerable contrast to Gensler’s SEC, who is currently playing ‘whack a mole’.
Another theme we expect to witness when Atkins becomes chair is a reduction of large-scale penalties dished out to firms, especially when the wrongdoing does not directly cause investor loss. We make this assumption as Atkins constantly pointed out the importance of understanding that large fines against corporations unfairly punish shareholders and this conflicts with the SEC's main goal “to protect investors”. Evidence to support this claim includes a speech he made at the Securities Regulation Institute.
If the victims are shareholders of the corporation being penalized, they will still bear the cost of issuer penalty payments (which is the case with any penalty against a corporate entity).
During his time as a commissioner he voted against levying monetary fines against companies. We believe that Atkins’ views against corporate punishment apply to cryptocurrencies as well, for example, token issuing companies may have to use funds allocated to token development to pay the fine that can otherwise potentially hinder long-term growth prospects. This harms the stakeholders in the coin who may have already suffered from a fall in the price of the cryptocurrency. In fact, the Bank of International Settlements concluded in 2018 that news events announcing impending SEC enforcement action are found to have the strongest adverse impacts on the prices of crypto assets. Even though we expect fewer and milder corporate punishments to be meted out during Atkins's term, we want to emphasise that we still expect to see enforcement actions taken however they will likely target the individual that committed the financial crime directly.
Finally, but equally importantly we anticipate a key focus on deregulation. This is predominantly driven by Trump and his advisors who wish to remove the encumbrance faced by cryptocurrency firms and implement more crypto-friendly policies. One of the regulations that Trump's upcoming government already plans to revoke is the Staff Accounting Bulletin (SAB 121). It requires companies that hold crypto assets on behalf of others to account for them as a safeguarding liability on their balance sheets. This increases the cost to hold crypto on behalf of third parties as it creates a different set of capital requirements. It also increases the costs for all financial institutions to hold crypto in custody. This can potentially cause the USA to lag behind other countries which do not have such restrictions on financial institutions. On the whole, we believe deregulation is a step in the right direction to increasing the adoption of cryptocurrencies in America. However a balance must also be struck to prevent what we learnt from cases such as FTX from recurring again. These events undo a great deal of progress in the sector and shine a negative light, undoing a lot of progressive steps.
Starting today we are moving on to a new phase for crypto, with the past year providing us events like the bitcoin halving and approval of the first spot etfs. We do not expect any less from the future especially with Atkins and Trump in the front seat undoing ‘Operation Choke Point 2.0’. Legal clarity, deregulation, reduction of corporate punishments, consistent enforcement coupled with a potential strategic bitcoin reserve will likely lead to an exponential increase in large-scale adoption of crypto by key players in capital markets. Our team at Discuss Diglett wishes all market participants the best of luck while we strap in for a ride through unchartered territory.
References
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