What You Need to Know about the SEC and its Attack on Crypto

While the rest of the “Regulatory World” is finding its feet to provide clear guidelines and safety rails for the emerging Crypto Industry, we find the U.S. Securities and Exchange Commission (SEC) in a power grab, trying to crowbar the proverbial square peg into a round hole… Let’s discuss what it means for crypto projects and the tokens you may hold.

Firstly, it's important to understand what powers and significant Case Law, the SEC uses to bring litigation proceedings. Following the impact of the 1929 stock market crash and subsequent Great Depression, the U.S. Congress passed the Securities Act of 1933 as well as the Securities Exchange Act of 1934. The reason for the passing of these Acts was to mitigate fraudulent activities, loose credit standards and risky investments that destroyed lives post-1929 and led to years of economic downturn.

• Industrial Production fell 47%
• Gross Domestic Product (GDP) fell 30%
• Unemployment reached 20%

As such, in 1934 the SEC was created. Its first Chair was Joseph P. Kennedy and together with four (4) other Commissioners, they were tasked with making sure nothing like the 1929 stock market crash and Great Depression EVER happened again.

Fast forward to 1946, and the US Supreme Court found in favour of the SEC after it successfully litigated a breach of securities law by the W. J. Howey Company and Howey-in-the-Hills Service, to be known as the “Howey Test”. (https://caselaw.findlaw.com/court/us-supreme-court/328/293.html)

The basic premise of the litigation surrounded an orange grove, where investment opportunities were offered to the public, with the efforts of the company to maintain and sell the oranges creating returns which were to be distributed to the investors.

• Money is invested: There must be monetary investment involved in the transaction, or at least some consideration passes from one party to another.
• There is an expectation of profits: The investor anticipates financial gains from the investment, typically through the enterprise’s success.
• There is a common enterprise: The investors and the enterprise behind the transaction, asset, or product are bound by a financial relationship, and the fortunes of the investors are tied to the enterprise’s success.
• Success relies on the efforts of others: The success of the investment depends predominantly on the efforts of individuals other than the investor. (https://www.investopedia.com/does-crypto-pass-the-howey-test-8385183#)

The U.S. Supreme Court articulated the Howey Test for determining whether U.S. securities laws govern a transaction, or whether it falls under some other Regulatory Agency, such as the Commodities Futures Trading Commission (CFTC). Also, of vital importance, is an understanding that the oranges themselves, were not deemed securities by the U.S. Supreme Court. The manner in which the investment in oranges was packaged and structured WAS the Securities Law breach. Heck, even beaver skins are a commodity but could be packaged up in a scheme representing a security offering.

The SEC presently uses this nearly 80-year-old legislation to frame the crypto industry; its raising of capital, development of projects, DeFi (Decentralised Finance) and the tokens themselves.

But why has the SEC been so aggressive towards the crypto industry of late? One would like to think that it’s because of risks to the public, the economy and the stability of the financial system. That’s why the SEC was created in the first place back in 1934 wasn’t it, “so nothing like the crash and subsequent Great Depression would EVER happen again”? Sadly, on the whole, it doesn’t appear to be from such a noble intent.

The current Chair of the SEC Garry Gensler, has gone on record of late claiming the industry is rife with "hucksters, fraudsters and scam artists", echoing the rallying cry of Democratic Senator Elizabeth Warren who sits on the Senate Banking Committee and has based her upcoming 2024 election strategy on being the leader of her so-called "anti-crypto army”.

It was discovered recently, through Freedom of Information Act (FOIA) requests, that Senator Warren was contacting Chair Gensler before an upcoming Senate Banking Committee enquiry on crypto. She was caught giving him the intended questions and suggested answers prior to the enquiry; an enquiry that is supposed to be used as part of holding public officials accountable for their actions (or inactions). Chair Gensler is a Democrat-appointed SEC Chairman. It's not inconceivable to draw the conclusion that the SEC's aggressive stance on the crypto industry, as well as its lack of formal rulemaking and guidance, is based upon political pressure and alliances.

(https://news.bitcoin.com/lawyer-says-senator-elizabeth-warren-conspires-with-sec-chair-gary-gensler-violating-her-oath/#google_vignette)

As we go further down the rabbit hole, let’s focus on the recent court proceedings involving the crypto industry and the SEC.

In December 2020, the then Chair of the SEC Jay Clayton, (on his last day in office) launched a devastating lawsuit against Ripple the company and its use of the digital asset XRP. The majority of that lawsuit has since been ruled upon as a summary judgment by District Judge Hon. Analisa Torres of The United States District Court for the Southern District of New York with assistance from Magistrate Judge Hon. Sarah Netburn during the discovery of evidence phase of the lawsuit.

During discovery, information was obtained from SEC Governor William (Bill) Hinman. When pressed about this information, the SEC changed its stance at least three (3) times in order to dodge being locked into a story. In a scathing response, Magistrate Judge Hon. Sarah Netburn accused the SEC of:

“The hypocrisy in arguing to the Court, on the one hand, that the

Speech is not relevant to the market’s understanding of how or whether the SEC will regulate cryptocurrency, and on the other hand, that Hinman sought and obtained legal advice from SEC counsel in drafting his Speech, suggests that the SEC is adopting its litigation positions to further its desired goal, and not out of a faithful allegiance to the law.”

During March - August 2023, Grayscale Investments LLC successfully appealed the SEC’s denial of their application to establish a Bitcoin Exchange Traded Fund (ETF). The United States Court of Appeals for The District of Columbia Circuit found in favour of Grayscale’s argument, agreeing that the SEC's decision-making process could be seen as arbitrary and capricious:

“To avoid arbitrariness and caprice, administrative adjudication must be consistent…”

(https://www.bloomberglaw.com/public/desktop/document/GrayscaleInvsLLCvSECNo2211422023BL301541DCCirAug292023CourtOpinio?doc_id=XS4O9PO0000N)

In August 2023, Hon. Judge Shelby of the United States District Court for the District of Utah issued asset freezes and restraining orders against a company called Debt Box. This was requested by the SEC for allegedly orchestrating a cryptocurrency investment scheme that defrauded investors out of $50 million. In December 2023, after determining that the SEC made “materially false and misleading representations” in bringing the case against Debt Box Hon. Judge Shelby reversed the asset freeze and sanctioned the SEC, ruling that it had:

 “undermined the integrity of proceedings” and caused "irreparable harm” to Debt Box. Shelby also ordered the SEC to cover Debt Box’s legal costs. Two (2) SEC lawyers resigned after this finding.

Presently, what important crypto industry-related cases are the SEC involved in? The first would be SEC -v- Coinbase with the SEC accusing Coinbase of selling multiple "Digital Asset Securities" a term that doesn't exist in law and that the SEC has made up as part of its attempt to "square peg round hole" the crypto industry and the digital assets that power various blockchains. Coinbase has vowed to fight the SEC all the way to the Supreme Court if necessary.

Secondly, we have learned that a “pre-lawsuit” notice called a “Wells Notice” has been issued to Consensys, an Ethereum development company. Consensys has since pre-empted a formal lawsuit by the SEC, and instead launched their own lawsuit against Garry Gensler.

 “The U.S. Securities and Exchange Commission seeks to regulate ETH as a security, even though ETH bears none of the attributes of a security – and even though the SEC has previously told the world that ETH is not a security, and not within the SEC’s statutory jurisdiction,” according to the lawsuit filed in The U.S. District Court for the Northern District of Texas.

Let’s summarise these recent cases for a moment, in the words of the Judges.

• hypocrisy
• not out of a faithful allegiance to the law
• arbitrariness and (capricious)
• materially false and misleading representations
• sanctioned by a Court
• undermined the integrity of proceedings
• (causing) irreparable harm

Also, a very important piece of information came out of the SEC -v- Ripple case, which could have wide-ranging positive implications for other crypto tokens and digital assets. The Summary Judgement ruling by the Hon. Judge Analisa Torres, ruled that "XRP in of itself is not an investment that embodies the Howey requirements of an investment contract."

The manner and method in which the Hon. Judge Analisa Torres delivered this information within the judgement itself meant that this decision could not be appealed. XRP the token or digital asset was safe as a non-security. This ruling is also important for the fact that other tokens or digital assets brought into question with litigation from the SEC have a basis from which to argue their tokens are “of themselves, just code on a blockchain” that allows someone to do something without the control of a central entity.

We now cast our mind to the current state of play with the SEC -v- Coinbase and Consensys -v- Gensler, where, particularly in the Coinbase case, a bunch of randomly selected crypto tokens were attempted to be gaslit as “digital asset securities” by the SEC, in the hope that Coinbase would capitulate, pay a pre-trial settlement to the SEC. Again, the term digital asset securities, or any tweaked version of that doesn’t have any basis in established law… its a rouse. Perhaps, the SEC -v- Ripple case can help Coinbase in prevailing that the tokens listed by the SEC are similarly “in of themselves” not securities offerings. The same could be said of Consensys -v- Gensler with respect to ETH (Ethereum token). What remains to be seen is the manner in which the tokens or assets (oranges or beaver skins) were packaged.

How can a Federal Agency fall so far from the protective mandate under which it was originally created in 1934? It was created to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination ..., to remove impediments to ... a free and open market ..., and, in general, to protect investors and the public interest.

The answers may lie with the actions, rather the INACTIONS of the SEC to give clear guidance. You see, if the SEC keeps the rules of the road obscure, they create opportunities for “gotcha moments”, which can lead to litigation and early cash settlement by the projects who can’t afford potentially years of court and lawyer costs. It’s the stuff of Hollywood mafia movies! What an incredible funding model, considering, as a Government Agency, you have access to unlimited resources and capital.

In addition, would the SEC allow the CFTC to take control of their perceived “turf” when it’s been so lucrative in the majority of cases involving settlement from crypto companies wishing to avoid (if they can, some don't) bankruptcy? Why else would they invent words such as "digital asset securities" if not to attempt to gaslight citizens, and government officials and intimidate crypto companies? They want this turf to control because within it are ever-increasing flows of value and capital to milk.

Perhaps another reason for the SEC’s behaviour is that they have been given a political green light to stifle the crypto industry (commonly referred to as Chokepoint 2.0) so as to protect large incumbent banking participants. The last thing such banking elite want, are deposits leaving the banks and being exchanged for value outside their system. Remember, the banking system is a fractional reserve system. (In the U.S., since the pandemic, the reserve requirements are actually zero!) The last thing they want to do is sell the treasuries they bought with customer deposits, which due to the Federal Reserve’s recent interest rate hiking cycle, are now billions of dollars underwater. That would be locking in losses and something they don’t want to do.

Regardless of this perceived doom and gloom, hope springs eternal. The rest of the regulatory world is not playing these games and are in fact welcoming, if not targeting crypto projects to their shores. Economic hubs such as Dubai, Singapore, Japan, London, Brazil, Switzerland, and Germany (this list goes on) have, or are in the process of establishing clear “rules of the road” within which to do what the 1934 SEC was originally tasked to do. Hence, projects and potential economic windfalls are leaving the U.S. with their capital, and going to where the capital investments are best treated.

Paraphrasing Brad Garlinghouse CEO of Ripple, “Give us clarity. All we want to know is the rules. It’s like driving on a road with no speed signs and being pulled over by regulators for speeding. How are we to know?”

The other positive that seems apparent, is that the U.S. Court system is seeing through the SEC’s tactics, misleading practices and attempts to recreate law to their own benefit. The outcomes of recent cases have clearly shown the SEC as a “win at all costs” Agency that has clearly lost its way, especially under the Chairmanship of Garry Gensler.

As mentioned earlier, the SEC -v- Howey was an important milestone as case law for regulation and subsequent enforcement actions IF required. In 1946 it gave important and clearly defined pillars of interactions between promoter, developer and investor. However, technology has grown and evolved with the advent of blockchain technology, decentralisation of participants, transaction verification, and ecosystems that are maintained by not a single entity but by community. How does this 2009-2024 and beyond technology fit into nearly 80-year-old case law. Quite frankly, for the most part, it doesn’t, and in the case of the USA, Congress needs to stand up and create sensible laws; take the power to be “arbitrary and capricious” away from the SEC and its potentially politically motivated attacks on the crypto industry.

The technology is here to stay. The rest of the world is embracing the efficiencies of blockchain and the value prospects that growing networks represent. The digital assets or tokens themselves are representations of part ownership of that network effect and its continued growth.

Investopedia highlights this value proposition with what’s called Metcalfe’s Law.

“Metcalfe's law states that the financial value or influence of a (network) is (proportional to) the number of connected users of the system.” The bigger the “network” or “network of networks” the greater the potential value.

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