In a webinar hosted by the Federalist Society’s Financial Services & E-Commerce Practice Group, a distinguished panel of experts in securities regulation delved into the contentious landscape of the SEC’s adventures with the cryptocurrency industry. The conversation touched on the SEC’s current “regulation by enforcement” policy agenda, the challenges and key points of defending an SEC enforcement investigation in the crypto industry, potential legal claims to bring against the SEC, and a private sector initiative to craft a disclosure regime tailored for the digital assets class. Patrick Daugherty, adjunct professor of digital assets at Cornell and Northwestern law schools and leader of Foley & Lardner’s digital assets practice, organized and moderated the program.
Chris Brummer, Georgetown law professor and member of the 2020 Biden-Harris transition team, kicked off the program by surveying the current SEC involvement in the crypto industry. Setting the stage for the discussion, Brummer framed the SEC’s regulatory approach within the broader context of how a regulatory agency pursues its policy agenda with the tools in its toolbox. By bringing lawsuits against token issuers, Brummer suggested, the SEC is strategically leveraging litigation and the U.S. court system as primary tools to establish the boundaries of U.S. securities law in relation to the crypto industry. The SEC’s approach aims to define crypto assets as securities under existing law and, more importantly, use enforcement actions and court rulings to establish legal precedents. Brummer pointed out that even unsuccessful litigation can serve as a powerful deterrent within the industry, shaping behavior and expectations.
Brummer expressed some sympathy for the SEC enforcement staff, who are made more vulnerable to claims of regulation-by-enforcement because the rule-writing lawyers in the agency (“the other part of the building”) have not been tasked to do that job. When asked by Daugherty how a new SEC chairman might change things after the November elections, Brummer opined that, if Trump is elected, he might take a more open view on crypto, given his attention to the issue in his campaign. He suggested that, even if Biden is re-elected, the next SEC chair is likely to adopt a more flexible approach to the crypto industry than Chair Gensler.
What are the key differences between defending an SEC enforcement investigation in the crypto industry and defending any other kind of case? William McLucas, head of WilmerHale’s securities practice group and former Director of the SEC Division of Enforcement, analyzed the unique challenges of defending crypto industry cases. He emphasized two main distinctives. First, crypto cases often revolve around whether a cryptocurrency should be registered under the Securities Act, creating high-stakes and zero-sum scenarios where acceptable settlements are harder to achieve. Second, being part of the crypto industry often subjects one to an unfair presumption of guilt within the agency.
McLucas expressed concern about the SEC’s involvement in the crypto industry. First, he questioned the suitability of the Howey test, established in a 1946 Supreme Court case that involved orange grove contracts, for digital assets. No one in the Howey era could have anticipated technologies as advanced as smartphones, let alone crypto assets, he said. Second, McLucas questioned whether the SEC’s “regulation by enforcement” strategy for regulating crypto—a multi-trillion dollar market—was as efficient and clear as it should be. He argued that the SEC’s failure to clearly define the criteria for determining whether a token offering is a securities transaction leaves crypto investors and company managers uncertain and unprotected from post-facto assessments of liability for innocent behavior.
In response to a question from Daugherty about the SEC chair’s control over the SEC’s enforcement program relative to the crypto industry, McLucas observed that the SEC’s enforcement agenda in that industry is more intensive and direct than for other industries. He explained that, while the chairman and commissioners typically do not get heavily involved in the enforcement and investigation process, the chairman has the final say on critical issues. Therefore, what the staff communicates can generally be assumed to reflect the chairman’s views.
McLucas confirmed that a well-functioning regulatory regime is essential to strengthening the resilience of the crypto market, preventing it from being destabilized by a single bad actor. Daugherty mentioned Sam Bankman-Fried and FTX, asking whether their misconduct had affected SEC behavior. McLucas observed that the SEC took a much harder stance on regulating the crypto market after that case arose. He also gave credit to federal judges for their efforts and diligence in understanding the nuances of crypto cases, which is challenging for them because the technology and the assets are novel.
Next, Brian Richman, a senior associate at Gibson, Dunn & Crutcher LLP and a member of Eugene Scalia’s team, shared insights on preempting the SEC’s legal actions instead of waiting to be sued. One way to do this is to challenge the SEC based on the “rulemaking” context discussed by Brummer. The SEC is bound not only by the Administrative Procedure Act, which applies to all governmental agencies, but also by its organic statutes, such as the Securities Act of 1933 and the Securities Exchange Act of 1934. These and other securities laws require the SEC to conduct a rigorous economic analysis for any rule it creates to ensure that it promotes efficiency, competition and capital formation.
Richman noted that the SEC often fails to fulfill this obligation. To expound on that, he provided a current example where the SEC is attempting to expand the definition of what it means to be a securities “dealer” without even considering which crypto assets are “securities”—a defect that makes it impossible to conduct a proper economic analysis. This type of failure opens the SEC to suits challenging its rules.
Richman highlighted another claim that can be brought against the SEC under the APA. The APA requires an agency to provide notice and accept comments before it adopts rules. Also, the agency is required to address the facts and arguments presented in those comments. This process allows putatively regulated persons, such as token issuers, to challenge the SEC’s proposed rules by presenting relevant evidence and arguments. If the SEC does not address these arguments, that failure provides grounds for a challenge under the APA.
In the final segment of the program, Rachel Barnett, Chief Legal Officer of the IEX Exchange, discussed a work stream led by a Steering Committee (including herself, Daugherty and Brummer) appointed by the Global Digital Asset & Cryptocurrency Association and other trade groups to craft tailored disclosure guidelines for digital assets. She began by acknowledging the value of disclosure for investor protection purposes. She then pointed out that the existing disclosure system is designed for traditional equity securities, and she argued that it is unworkable and can lead to investor confusion when applied to digital assets that are non-equity securities. She provided two examples of this. First, the current disclosure system requires the company to describe the background of the board members. This is generally inapplicable in the crypto industry because a decentralized software protocol does not have a board of directors. Second, the existing disclosure regime mandates three years of past financial statements related to the company’s operations. This, too, is inapposite for the crypto industry because the token’s value is tied to the network economics, not necessarily a company’s operating results. Barnett explained that overemphasizing the company’s financials can be every bit as misleading as valuing a third-party iPhone application based on Apple’s financials.
What information is material and valuable for the crypto industry? Barnett advocated that the crypto industry needs a disclosure system tailored to digital assets. She outlined the committee’s vision for a more appropriate framework that would include information on the underlying networks, incentive and reward mechanisms, token economics, and associated risks. Finally, Barnett noted that the SEC and the private bar have in the past dealt successfully with the entree of other non-equity securities, such as asset-backed securities. She encouraged learning from the experience of establishing standardized disclosure regimes for asset-backed securities using no-action letters followed by rulemaking.
The webinar concluded with a forward-looking discussion of the global nature of crypto regulation. Brummer noted the unusual position of the United States in this regard, as Europe leads and the U.S. lags behind. But he noted that major market venues have identified the need for a tailored disclosure regime for digital assets and expressed optimism that there will be progress in this direction.
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