WSGR | Reading the Not-So-Subtle Tea Leaves: What the SEC Is Likely to Do Next in Crypto, and How Crypto Participants Should Prepare

It is highly likely, and hardly a surprise, that in the near future the U.S. Securities and Exchange Commission (“SEC“) will increase the number of enforcement actions it brings against crypto industry participants. It is widely known in the crypto industry that the SEC’s Division of Enforcement has been investigating a number of high-profile crypto industry participants for some time,² and at least some of those investigations likely will lead to enforcement actions relatively soon. The recent insider-trading case³ involving trading in digital assets by a former employee of Coinbase and others is perhaps a harbinger of crypto enforcement actions to come. The SEC’s recent hiring of 20 new enforcement attorneys focused on the crypto markets⁴ is a fairly straightforward signal of the SEC’s intent to bring additional crypto enforcement cases, as are specific statements about anticipated future crypto enforcement actions by SEC Enforcement Director Gurbir Grewal in his recent testimony to Congress seeking additional funding for the SEC’s enforcement program.⁵

Reading a number of just slightly-less-obvious tea leaves, it also is reasonable to expect the SEC, perhaps as early as this fall, to issue some type of interpretive statement (the “Statement“) that will purport to clarify how the SEC believes that crypto market participants can or should comply with the federal securities laws. One possible path the SEC may take is to offer crypto participants “safe harbors”—that is, assurances that the SEC won’t sue if the crypto market participants meet the requirements set out by the SEC—while at the same time bringing a significant number of enforcement actions against crypto participants who do not comply with the safe harbors.

A number of “tea leaves” suggest that the SEC may be working on a Statement of this type. Among them are that Chair Gensler has expressly and publicly said that he has directed the SEC Staff to develop plans to regulate crypto exchanges and crypto staking and lending platforms, and Chair Gensler has been clear that he views most tokens as securities that should be offered and sold to the public in registered offerings or through offerings that are exempt from registration, and that the issuers of publicly-sold tokens should be subject to periodic disclosure requirements.⁶ In addition, the recent significant downturn in the crypto markets seemingly calls out for some sort of regulatory response.⁷

Perhaps critically from a timing perspective, the SEC presumably is concerned about losing its jurisdiction over the crypto industry. For example, the Biden Administration issued a report that seemed to assign principal regulatory authority over the crypto markets to the Treasury and Fed;⁸ the Fed appears poised to become the central regulatory authority for stablecoins;⁹ and a recent bill in Congress would transfer a significant part of the regulatory responsibility for crypto from the SEC to the Commodity Futures Trading Commission (“CFTC“).¹⁰ If nothing else, the SEC presumably wants to “defend its turf.” It likely would be highly embarrassing to the SEC if Congress were to assign principal or significant regulatory authority over crypto to a regulatory agency other than the SEC. A likely basis for Congress to do so would be the unfortunate fact that, many years into the development of the crypto markets, and about 4 years after the SEC issued its DAO Report in which it first told the industry that it viewed many tokens as securities,¹¹ the SEC has yet to propose, much less adopt, a single rule or regulation governing the crypto markets.¹² The anticipated Statement would give the SEC the ability to argue to Congress that it has, in fact, finally taken steps to substantively regulate the crypto industry (albeit in a manner that did not include constructive consultation and collaboration with that industry).¹³

It is unlikely that the SEC will adopt crypto focused rules and regulations, at least in advance of the Statement. The SEC’s most recent semi-annual agenda of rulemaking activities¹⁴ does not list any crypto-related rule proposals in the works, and such a rulemaking initiative would likely take a long time to develop and pass (including required economic and other studies, the need to publish and seek comment on a rule proposal, and the preparation and adoption of the final rules and associated studies and response to comments). The SEC may well believe it must move quickly, and more quickly than the rulemaking process allows.

Largely based on Chair Gensler’s public statements, likely elements of such a Statement could include:

• A reiteration of the SEC’s position that virtually all tokens are securities (with the exception of perhaps Bitcoin, Ether, and maybe a few others);¹⁵
• A requirement that the sponsors of many tokens, and perhaps especially tokens trading on significant crypto exchanges, register those tokens under the Securities Exchange Act of 1934 (the “1934 Act“), which would result in the sponsors becoming public reporting companies that must file annual and quarterly reports, and become subject to the proxy, tender offer, Sarbanes-Oxley, and other rules. The SEC may also, as part of the Statement or in a subsequent rulemaking, develop new disclosure requirements specifically tailored for digital assets;
• A requirement that the sponsors of most tokens must register or qualify tokens sold to the public in the United States, either through a Regulation A offering or a public offering on Form S-1 or Form F-1 (for foreign sponsors); and
• A requirement that crypto exchanges and perhaps other trading platforms that permit U.S. persons to participate must register as a broker-dealer and/or as some form of alternative trading system (“ATS“), perhaps subject to new and enhanced requirements tailored to retail participation in the crypto markets.¹⁶

All of these requirements are consistent with recent public statements of Chair Gensler. Each of these requirements, except the 1934 Act registration requirement, flows from the SEC’s often-stated view that most tokens are securities. The 1934 Act registration requirement is an outlier, however. Under Section 12(g) of the 1934 Act, an issuer of a class of equity securities is required to register the security under the 1934 Act (if the issuer has at least $10 million of assets and has at least 500 non-accredited or 2,000 total holders of record of those equity securities). It is possible that the SEC will suggest in its Statement that at least some tokens that are securities under the Howey test are equity securities issued by the sponsor of those tokens, perhaps because the value of those tokens depends to a significant extent on the efforts of that sponsor, and that the tokens therefore represent an interest in the sponsor and its business prospects and acumen. Chair Gensler’s public statements appear to suggest that the anticipated Statement will require at least some token issuers to register the tokens under Section 12(g). Also, the SEC has included precisely this type of Section 12(g) registration requirement in a number of its settlements with token issuers that the SEC alleged made illegal public offerings of the tokens.¹⁷ For a host of reasons, the SEC is probably wrong in its view that many tokens that are investment contracts are equity securities for purposes of Section 12(g), but it nonetheless is reasonable to expect the SEC to take this or a similar position in the anticipated Statement.¹⁸

Assuming the SEC will issue a Statement along the lines outlined above, how should crypto companies think about responding to this Statement? This Article offers some thoughts about this below, and crypto companies may want to begin thinking about how they would respond to such a Statement. In fact, crypto companies probably should be thinking about the types of options discussed below even if the SEC does not imminently issue a Statement. It is likely that the SEC will use the enforcement process, whether or not the SEC issues the anticipated Statement, to seek to achieve many of the regulatory objectives Chair Gensler has publicly laid out.

1. Approaching the SEC for Substantive Relief Is Unlikely to Be Helpful, at Least in the Near Term

Traditionally, securities lawyers would advise meeting with the SEC Staff, and perhaps some of the SEC Commissioners, to discuss concerns with the SEC’s pronouncements and suggest different approaches that would be better for the industry while still protecting investors. That option, unfortunately, has proven to be largely unhelpful in the crypto space. Crypto companies that have engaged meaningfully and in good faith with the SEC Staff over the last few years have generally been frustrated because it has been so difficult to navigate a successful outcome with the Staff. The Staff will meet; they may be sympathetic; they may engage collaboratively and in good faith; but the Staff by all appearances currently lacks the authority to move forward on substantive crypto initiatives without the Chair’s approval.

The same appears to be true with the non-Chair Commissioners. The Commissioners and their staff, much like the SEC Staff, are often quite gracious with their time, and seemingly genuinely interested in proposals and concerns of crypto companies. But time and again, meetings and discussions with the Commissioners have yielded few, and generally no, positive results for the crypto industry.

The sole remaining course of action within the confines of the SEC is to attempt to persuade the Chairman. Unfortunately, getting on the Chair’s calendar is often quite difficult, and based on his significant number of speeches on the subject of digital assets, the Chair already seems to have largely determined the course of action he would like the SEC to take. We are not aware of instances of industry meetings meaningfully swaying the Chair on crypto-related issues, and we are not aware of efforts by the Chair to meaningfully seek out industry suggestions and comments on the SEC’s approach to crypto regulatory matters that significantly differ from the course of action he already has laid out. (This lack of interest in public comment may not be limited to the crypto industry, given the large number of recent rule proposals in which the public has been given only 30 days to comment, despite repeated requested for longer comment periods.)

Many crypto companies nonetheless should speak with the Staff and Commissioners, or continue speaking with the Staff and Commissioners, to maintain a constructive dialogue that might bear fruit in a future SEC administration, or perhaps even later in this administration. It also often is helpful to maintain an open dialogue with the Staff, who genuinely will try to guide crypto companies and their counsel by discussing when the Staff may agree with, and when the Staff may have concerns with, particular business approaches and legal analyses. In the short-term, however, crypto companies should not expect the Staff to take any substantive actions relating to crypto projects, and especially novel crypto projects, without the Chair’s approval.

2. Can You Live with the SEC Statements?

Depending on the substance of the SEC’s anticipated Statement, some crypto companies may decide they can comply with the requirements set forth in that Statement, or that they may be able to modestly alter their business so that they can comply. Other crypto companies may decide that the time has come to move their operations and business offshore, including by geo-fencing U.S. participants, and avoiding the U.S. until the U.S. develops a more hospitable and collaborative regulatory regime.

Unfortunately, it is likely that many crypto companies will find complying with the anticipated SEC statements to be too burdensome. For example, assuming the SEC requires sponsors of digital assets to register under the 1934 Act (by filing a form 10), that sponsor will become a public reporting company that is required to, among other things, file annual and quarterly reports, and become subject to the proxy, tender offer, Sarbanes-Oxley, and other rules. A large number of sponsors of digital assets are not ready to, and lack the infrastructure to, successfully comply with those requirements. And, since none of the SEC’s disclosure and substantive rules have as-of-yet been tailored to crypto companies, it is unclear that compliance with these rules and requirements has a meaningful beneficial impact on the digital asset markets.

A sponsor that seeks to publicly offer its tokens and that needs to register or qualify those tokens under the 1933 Act will face a daunting process that only a few companies have successfully navigated; those that have successfully navigated the process took nine or more months to do so, and faced extraordinary costs in achieving that success (costs measured in the millions of dollars). Sponsors of digital assets that are located outside of the United States, or that for some other reason cannot use Regulation A and must instead register the digital assets on Form S-1 or Form F-1, will likely find the SEC costs to be even higher, and potentially will have to separately seek approval of the offering from each of 50 state securities administrators, and the securities administrators of Washington D.C. and U.S. territories (“Tier 2” Regulation A offerings, unlike crypto offerings on Form S-1 and Form F-1, are pre-empted from state registration and qualification requirements).

While it is hard to predict exactly what types of requirements a crypto exchange might be subject to under the anticipated SEC Statement, it likely will face significant concerns over the types of assets it can and cannot trade, the range of information available on such assets, the amount of diligence that brokers will need to conduct on each digital asset their clients trade, the suitability of such assets for investors, the method of custody of the digital assets, restrictions on the activities of liquidity providers associated with the crypto exchange (including, potentially, dealer registration), the method of publishing quotes and the manner of trading on the exchange, and other considerations that might have significant adverse effects on the current operations of crypto exchanges.

It bears repeating that many of these types of issues could have been addressed over the past few years had the SEC sought to work collaboratively and constructively with the crypto industry and engaged in a traditional rulemaking process that legitimately sought public input and comment. Alas, that is not the approach the SEC has taken, and it does not appear to be the approach the SEC will take (at least in the near term).

3. Disagree with the SEC

The SEC cannot unilaterally re-write the federal securities laws, or overrule the courts. If a token is not a security under the federal securities laws, the SEC lacks authority over that token, the sponsor of that token, and the exchanges and intermediaries that trade that token. It is likely that the anticipated Statement from the SEC will assert that all or most tokens are securities; with all due respect to the SEC, that does not make it so.

As an interesting example of this, in the recent insider trading case the SEC brought against a former Coinbase employee and others, the SEC specifically identified as securities 9 out of 25 tokens traded by those employees.¹⁹ Regardless of whether the SEC was correct in asserting that those 9 tokens were or are securities, it appears that even the SEC may have concluded that 16 of those tokens either were not or might not be securities. Notably, in the parallel criminal action involving wire fraud allegations,²⁰ the U.S. Department of Justice (“DOJ“) did not allege that any of the tokens were securities.²¹ In addition, following the announcement of the SEC’s action, Coinbase posted on its blog post that “Coinbase does not list securities on its platform. Period.” And “[s]even of the nine assets included in the SEC’s charges are listed on Coinbase’s platform. None of these assets are securities.”²²

Because the SEC has in the crypto space relied almost exclusively on enforcement actions, and has declined to adopt (or even propose) any crypto-specific rules or regulations—including rules and regulations that might define when a digital asset is or is not a security—the crypto industry is fully justified in reading the definition of a security under the federal securities laws, reviewing the relevant court cases determining when an instrument is and is not a security, and reaching their own conclusions. Courts may (or may not) grant a degree of deference to the SEC’s determination of whether and when tokens are securities under the federal securities laws,²³ but even if a court does grant the SEC’s views deference, the SEC can still be wrong, and a court can still hold that the SEC is wrong.

4. Litigation

A litigation strategy might present itself and play out in several different ways. Most obviously, one or more crypto participants, or crypto trade groups or the like, may sue the SEC over its anticipated Statement. Any such causes of action will depend on exactly what the SEC’s Statement says, but causes of action could include that the SEC has violated the Administrative Procedure Act (“APA“) by engaging in de facto rulemaking without following the requirements of the APA; that the SEC’s definition of security is too broad and at odds with the statute and relevant court decisions; that the SEC’s regulation of assets that are not clearly securities exceeds the SEC’s jurisdiction; and that the SEC’s de facto regulation of crypto exchanges and intermediaries is inconsistent with the requirements of the federal securities laws and inconsistent with the SEC’s obligations to act in the public interest, to enhance capital formation, and to foster fair trading markets.

A second way a litigation strategy could play out is if the SEC, as is perhaps likely, couples its anticipated Statement with contemporaneous or near contemporaneous enforcement actions against a variety of crypto participants. It is not hard to conceive of the SEC attempting a “carrot and stick” approach, in which it sues (or threatens to sue) crypto issuers, exchanges, and intermediaries (the stick), and says in effect that it will not sue if the platform agrees to comply with the requirements of the Statement (the carrot). The SEC’s recent announcement that it increased by 20 the number of enforcement lawyers focused on the crypto industry suggests that the SEC may be assembling the appropriate personnel in place to attempt to execute such a strategy.

Crypto market participants should be thinking about and be prepared for both litigation eventualities. One note here: it is almost certainly wrong to think the SEC will bring enforcement actions only against the largest and most prominent players. The SEC may seek to do so, but the largest and most prominent crypto industry participants often have the resources to fight back. So, it would not be surprising to see the SEC bring and perhaps settle a number of these carrot-and-stick enforcement actions against mid-size or smaller crypto participants, which may simply not have the resources to face a protracted litigation battle with the SEC.

5. Lobbying

In the medium- to long-term, both the SEC and the crypto industry may ask Congress to resolve a number of their issues. In fact, one school of thought is that the SEC might take a number of aggressive positions in its anticipated Statement, fully aware that those positions might eventually be successfully challenged in court. If that happens, the thinking goes, the SEC might be in a relatively strong position to go to Congress to ask for much of the authority that the court struck down.

Crypto participants who are interested in lobbying Congress (and perhaps the Administration) on crypto legislation might be well-served to seek a broad industry consensus on some key issues, such as who the principal crypto regulator should be (the SEC, CFTC, Fed, etc.); whether and when the securities laws should apply to crypto, and importantly, when those laws should stop applying to crypto; how the securities laws or another statutory scheme should be tailored to apply to crypto; and how the proposed consensus approach would serve key regulatory purposes such as investor protection, capital market formation, and fair and liquid trading markets.

Author:

• Please contact Rob Rosenblum (rrosenblum@wsgr.com), Wilson Sonsini partner, with any questions about this Article.

The opinions expressed are those of the authors and do not necessarily reflect the view of the firm or its clients.

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