Failure to Register: SEC Shows No Signs of Letting Up on Crypto

The first half of 2023 has proven kinder to the fledgling industry. Bitcoin⁵ and Ethereum⁶ are both up more than 50 percent year-to-date. The engineers who pioneered the cryptocurrency Solana released Saga, a flagship smartphone tailor-made for web3.⁷ And after a seemingly swift and dramatic withdrawal from crypto in 2022, venture capital appears to once again be warming to DeFi.⁸

Cryptocurrency skepticism may well be receding amongst industry participants, but government enforcers and regulators seem far less optimistic. In fact, if the Securities Enforcement Forum West conference in San Francisco last month was any indication, the Securities and Exchange Commission (“SEC” or “Commission”) may just be getting started on its regulation of the industry.

On a panel titled Digital Assets and Cryptocurrency: Regulation and Enforcement of Exchanges, Crypto Lending, DeFi, NFTs and Stablecoins, SEC Assistant Regional Director for Enforcement Steven Buchholz described the sizeable growth the Commission’s Crypto Assets and Cyber Unit (“CACU”) has experienced since its 2017 impetus. The once-modest unit has doubled in size and now boasts roughly 50 dedicated professionals.⁹ CACU brings enforcement actions charging not only violations of the anti-fraud provisions of the federal securities laws, but also violations of the rules requiring the registration of securities — a topic which consumed the most of the panel’s attention.

Registration Requirements.

The emphasis on registration has been particularly troubling for crypto firms because, while they often serve as multiple traditionally regulated roles in one firm, most have not registered as securities exchanges, broker-dealers, or clearing agencies with the SEC. Opinions differ on who is at fault for this rift. SEC Chair Gary Gensler has placed blame squarely on the industry, remarking earlier this year that crypto institutions “know how to register — it’s just a form on our website.”¹⁰ But industry participants counter that this is a gross oversimplification. Firms that deal in decentralized digital assets do not fit neatly into the SEC’s registration process, which was designed for more traditional financial institutions.¹¹ And some argue that this square-peg-round-hole mismatch renders it “basically impossible” for crypto firms to register as national securities exchanges, brokers, or clearing agency.¹²

The bulk of the confusion stems from uncertainty as to when a digital asset — like a token — becomes a security. Under the landmark Supreme Court case SEC v. W.J. Howey Co.,¹³ a business operation becomes an “investment contract” when participants invest their money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. A token, by itself, may not rise to this standard, but what about tokens issued to fund the development of a crypto exchange? What if the token’s value is expected to respond to the value of the affiliated exchange? It is difficult to draw lines because the SEC has yet to promulgate rules concerning when digital assets become securities, much less when crypto firms should register as securities exchanges, brokers, or clearing agencies.

Firms that try nonetheless to register under one of these categories are typically rejected for being insufficiently forthcoming.¹⁴ Trickier still, when the SEC rejects a registration attempt, it often issues a Wells Notice to the applicant, a harbinger of an enforcement action. Some have argued that this creates a perverse incentive for crypto firms not to work with the SEC, further muddying the waters for investors and enforcers alike.¹⁵

Catch-22 or not, the SEC has not hesitated to initiate enforcement actions against crypto companies that have failed to register. Mr. Buchholz began his summary of the Commission’s registration enforcement actions by referencing two high-profile cases from the past year against the trading platforms Bittrex¹⁶ and Beaxy.¹⁷ He touted both actions as significant because they both involved failure to register under three different sets of requirements. In each case, the SEC charged the platform with failing to register as a national securities exchange,¹⁸ broker,¹⁹ and clearing agency.²⁰ The Commission’s willingness to invoke all three sets of registration requirements in enforcement actions against the two exchanges bodes ominously for other crypto exchanges operating in the United States.

Staking.

Mr. Buchholz’s initial remarks did not address the kraken in the room, but other panelists wasted no time bringing up the Commission’s action against Payward Ventures, Inc., Payward Trading, Ltd., and Payward, Inc. (together, “Kraken”) for their failure to register the offer and sale of their crypto staking service as a security.²¹ Staking is a relatively low-risk activity that lets holders of cryptocurrency pool their digital assets, which are then used to help validate transactions on the blockchain. The blockchain protocol rewards the pool with additional crypto for this service. The reward then gets distributed amongst the stakers — typically in proportion to how much crypto each contributed to the pool. Kraken offered a staking service to its users, which the SEC determined to be a security. Kraken never registered its staking service as such, and the Commission filed an enforcement action in February of this year.²²

This got the industry’s attention. If the SEC considers Kraken’s staking service to be a security, does that mean all staking operations are securities? Mr. Buchholz declined to draw explicit lines concerning when staking becomes a security, but he suggested that the idiosyncrasies of the Kraken service were significant enough to bring it within the purview of Howey.²³

“From the efforts of others” appears to be the part of the Howey test that may distinguish Kraken from other staking operations. Crypto holders could, for example, pool their tokens and rely on the blockchain’s underlying protocol to sort out the other details. In such a case, the protocol — as opposed to a service provider — might determine the minimum amount that has to be staked, the reward, and any rules concerning when stakers can take their tokens out of the pool. There, it is less obvious that the stakers would be reliant on the efforts of others to generate a return.

Not so for Kraken. Here, crypto holders turned their assets over to Kraken, which set the rules of the scheme. Kraken advertised that its users could enjoy the passive income associated with staking while getting greater liquidity than they otherwise might (which is to say, they could get their money out faster than the blockchain protocol might allow). Moreover, Kraken had discretion over users’ returns, whereas the blockchain protocol might predetermine returns absent Kraken’s involvement. These factors were material in the SEC’s charging decision and may provide information as to which staking schemes fall within the Howey parameters and which do not.

Conclusion.

Regardless of how broadly one reads Beaxy, Bittrex, or the Kraken enforcement decision, this much should be clear: the SEC remains hawkish on crypto, especially in the registration context. Mr. Buchholz stressed that the SEC’s registration requirements serve important functions to protect individual investors and the market broadly. The past year’s wave of crypto bankruptcies and enforcement actions, he would continue, make this point painfully apparent. Practitioners should be cognizant of this attitude and make their clients aware that the crypto space remains a hotbed for enforcement.

¹See Rashi Maheshwari, Bitcoin Price Prediction: Can Bitcoin Reach $1,000,000 by 2025?, Forbes (May 26, 2023), https://www.forbes.com/advisor/in/investing/cryptocurrency/bitcoin-prediction/.
²See David Yaffe-Bellany, Embattled Crypto Exchange FTX Files for Bankruptcy, N.Y. Times (Nov. 11, 2022), https://www.nytimes.com/2022/11/11/business/ftx-bankruptcy.html.
³Jeff John Roberts, Exclusive: 30-year-old billionaire Sam Bankman-Fried has been called the next Warren Buffett. His counterintuitive investment strategy will either build him an empire—or end in disaster, Fortune (Aug. 1, 2022) https://fortune.com/2022/08/01/ftx-crypto-sam-bankman-fried-interview/.
⁴Jason Nelson, SBF Charged With Conspiracy, Wire Fraud, Money Laundering by Justice Department, Securities Violations by SEC, Decrypt (Dec. 12, 2022), https://decrypt.co/117060/sam-bankman-fried-criminal-charges-justice-department-sec-conspiracy-wire-fraud.
⁵See Bitcoin, Coindesk, https://www.coindesk.com/embedded-chart/jMmtjdMzK6Bcw/ (last visited May 24, 2023).
⁶See Ethereum, Coindesk, https://www.coindesk.com/embedded-chart/r7mmKnbMLBktb/ (last visited May 24, 2023).
⁷See Jacquelyn Melinek, Ring Ring, Solana’s web3-focused Saga Phone is Calling, TechCrunch (Apr. 13, 2023), https://techcrunch.com/2023/04/13/ring-ring-solanas-web3-focused-saga-phone-is-calling/.
⁸See Jacquelyn Melinek, Dispersion Capital Launches $40M Fund Focused on Decentralized Infrastructure, TechCrunch (May 23, 2023), https://techcrunch.com/2023/05/23/dispersion-capital-launches-40m-fund-focused-on-decentralized-infrastructure/.
⁹See Press Release, Sec. & Exch. Comm’n, SEC Nearly Doubles Size of Enforcement’s Crypto Assets and Cyber Unit (May 3, 2023), https://www.sec.gov/news/press-release/2022-78.
¹⁰SEC’s Gary Gensler on Kraken staking settlement: Other crypto platforms should take note of this, YouTube (Feb. 10, 2023) https://www.youtube.com/watch?v=dlzX2UDTtUI.
¹¹See, e.g., Paul Grewal, We Asked The SEC for Reasonable Crypto Rules for Americans. We Got Legal Threats Instead, Coinbase (Mar. 22, 2023), https://www.coinbase.com/blog/we-asked-the-sec-for-reasonable-crypto-rules-for-americans-we-got-legal.
¹²Matt Levine, The SEC Cracks Down on Crypto, Bloomberg (Feb. 13, 2023), https://www.bloomberg.com/opinion/articles/2023-02-13/the-sec-cracks-down-on-crypto.
¹³See 328 U.S. 293 (1946).
¹⁴See Jason Gottlieb (@ohaiom), Twitter (Feb. 11, 2023, 10:25 PM), https://twitter.com/ohaiom/status/1624534998069006337.
¹⁵See Matt Levine, Gary Gensler Wants to Regulate Crypto, Bloomberg (Sept. 8, 2022), https://www.bloomberg.com/opinion/articles/2022-09-08/gary-gensler-wants-to-regulate-crypto.
¹⁶See Press Release, Sec. & Exch. Comm’n, SEC Charges Crypto Asset Trading Platform Bittrex and its Former CEO for Operating an Unregistered Exchange, Broker, and Clearing Agency (Apr. 17, 2023), https://www.sec.gov/news/press-release/2023-78.
¹⁷See Press Release, Sec. & Exch. Comm’n, SEC Charges Crypto Trading Platform Beaxy and its Executives for Operating an Unregistered Exchange, Broker, and Clearing Agency (Mar. 29, 2023), https://www.sec.gov/news/press-release/2023-64.
¹⁸According to the SEC, a firm must register as an exchange when it facilitates the trading of digital assets that qualify as securities and meets the definition of “exchange” as defined under the federal securities laws.  See Sec. & Exch. Comm’n, Cryptocurrency/ICOs (May 18, 2023), https://www.sec.gov/securities-topics/ICO.
¹⁹The U.S. Securities Exchange Act of 1934 defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.”  15 U.S.C. § 78c(a)(4).
²⁰The U.S. Securities Exchange Act of 1934 defines a “clearing agency” as “any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for comparison of data respecting the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities.”  15 U.S.C. § 78c(a)(23).
²¹See Press Release, Sec. & Exch. Comm’n, Kraken to Discontinue Unregistered Offer and Sale of Crypto Asset Staking-As-A-Service Program and Pay $30 Million to Settle SEC Charges (Feb. 9, 2023), https://www.sec.gov/news/press-release/2023-25.
²²See Rebecca Fike & Eli Sterbcow, A Stake in the Ground? — What the SEC’s Settlement With Kraken Tells Us About the Future of Crypto Regulation and Enforcement, Vinson & Elkins LLP (Feb. 27, 2023), https://www.velaw.com/insights/a-stake-in-the-ground-what-the-secs-settlement-with-kraken-tells-us-about-the-future-of-crypto-regulation-and-enforcement/.
²³See 328 U.S. 293.