Earlier this year, on this blog and in a Federalist Society panel, I discussed the dangers of agencies “regulating” through enforcement actions in lieu of issuing clear rules. My post noted that, in addition to yielding inconsistent, arbitrary policies, regulation by enforcement threatens the rule of law, guarantees lack of transparency, and circumvents the notice and public participation that comes with agency rulemaking or enacting legislation

The post and panel focused on the digital currency industry, which has become central to the debate over regulation by enforcement generally and the handling of emergent technologies that do not fit neatly into existing legal statutes and taxonomies. As various federal agencies race to assert jurisdiction in this new industry, the Securities and Exchange Commission has tried to shoehorn cryptocurrency into the Securities Act of 1933 and its SEC-enforced requirements by asserting in various enforcement actions that some of these digital coins are securities—that is, a financial interest in a company, partnership, or fund. Yet at the same time, the SEC refuses to provide meaningful guidance on when cryptocurrency is a security.

The regulatory uncertainty engendered by the SEC’s approach is exemplified by its lawsuit against Ripple Labs, a company which offers cross-border payment services using a decentralized blockchain network and the popular XRP cryptocurrency. For years, Ripple and other XRP users asked the SEC in vain for usable guidance on when a crypto token is a security. Now the SEC claims XRP has always been a security and should have been registered with the agency back in 2013 when it was first distributed.

Since my earlier post, the need to fill the regulatory void in the crypto space has become even clearer. Nonetheless, the SEC has doubled down on its refusal to clarify the rules, spurring new attempts in Congress to provide the industry with more certainty.

It was hoped that Gary Gensler, the SEC’s new chairman under President Biden, would revamp the agency’s approach to cryptocurrency. After all, Gensler had served as a senior advisor to the Digital Currency Initiative at the Massachusetts Institute of Technology’s Media Lab. Instead, Gensler has dismissed the regulatory uncertainty surrounding crypto, claiming this summer that “we’ve been awfully clear on a bunch of this stuff.”

As if to emphasize that claim, the SEC ended its lawsuit against Coinschedule (now Blotics) this July with a strong-armed settlement that went out of its way to avoid giving any clues about when a crypto token is a security. The SEC’s order tells us only that some of the 2,500 cryptocurrencies profiled on the once-popular Coinschedule website were securities.

As SEC Commissioners Hester Peirce and Elad Roisman point out in a separate statement, the order “provides no useful information to market participants either about which or how many of the 2,500 listed token offerings the Commission has determined to be securities offerings or about the reasoning underlying those determinations.” This omission “is symptomatic of our reluctance to provide additional guidance about how to determine … which tokens are securities.” At best, “[p]eople can study the specifics of token offerings that become the subject of enforcement actions and take clues from particular cases.” But in the case of Coinschedule, the SEC denied market participants even the clues that would come with identifying which of the 2,500 tokens are securities.

The Commissioners emphasize that “providing clear regulatory guideposts … is a better approach than the clue-by-enforcement approach that we have embraced to date.” They suggest that “one of the ways to help work through the issue might be to develop a safe harbor along the lines of that which Commissioner Peirce has proposed, which would allow token offerings to occur subject to a set of tailored protections for token purchasers.”

Clear guideposts can come from agency rulemaking or legislation enacted by Congress. Legislation is preferable because the underlying problem, exemplified by the Securities Act of 1933, is that cryptocurrency is not contemplated by existing legislative frameworks. Moreover, legislation can provide greater certainty than agency rules, which can change from one Administration to the next.

Legislation that would go a long way to fix the regulatory void has been introduced in Congress, including the bipartisan Token Taxonomy Act, which among other things would specify that cryptocurrencies are not securities and, most recently, the Clarity for Digital Tokens Act. Rep. Patrick McHenry (R-NC), the ranking member of the House Financial Services Committee, introduced the latter bill this fall. He explains that it would provide “a ‘safe harbor’ for startup digital asset projects, while maintaining important investor protections [in order to] provide much-needed legal clarity.”

McHenry’s bill implements Commissioner Peirce’s proposal for a three-year safe harbor—that is, an exemption from federal securities laws. The three-year period would begin when the tokens of a new cryptocurrency are first sold or, for pre-existing digital currencies, when the Act becomes law.

Investors are protected by the bill’s requirement that developers of the currency make various disclosures up front, publish them on a public website, and provide updates every six months. At the end of the three-year period, the exemption from securities laws ends unless the coin’s development team provides an analysis by outside counsel explaining why the digital asset and its underlying blockchain network is a legitimate cryptocurrency.

Rep. McHenry points out that his legislation is necessary because “our current regulatory framework threatens to push [digital asset] technology—and the jobs created by this rapidly growing industry—overseas.” The Blockchain Association, in endorsing McHenry’s bill, expressed the same concern that “[t]his regulatory uncertainty has been stifling innovation for years and thereby resulting in an exodus of innovators from the U.S. to jurisdictions with a clear regulatory framework.”

None of this is an argument that this nation’s financial regulators shouldn’t be allowed to go after genuinely bad actors, fraudsters, and scam artists. Instead, the point is that it’s neither fair nor efficient to treat innovators bringing new technologies and healthy competition like criminals, when they have neither notice that their activity is considered unlawful nor guidance on how to be in compliance.


Note from the Editor: The Federalist Society takes no positions on particular legal and public policy matters. Any expressions of opinion are those of the author. We welcome responses to the views presented here. To join the debate, please email us at [email protected].