/>iThe last two weeks have seen a flurry of Congressional hearings addressing key digital asset issues, alongside several noteworthy consent judgments against industry participants from the SEC. These fast-paced developments are expected to continue through the end of September, when both the CFTC and SEC conclude their fiscal years, as they strive to optimize their results for 2024. While there almost certainly won’t be crypto legislation passed this year, Congress looks to set the stage for potential digital asset legislation in the upcoming lame duck session after the November elections and beyond.
These developments and a few other brief notes are discussed below.
Congress Holds Hearing on Decentralized Finance (“DeFi”): September 10, 2024
Background: The House Financial Services Subcommittee on Digital Assets, Financial Technology and Inclusion held a hearing entitled Decoding DeFi: Breaking Down the Future of Decentralized Finance. It featured testimony from Rebecca Rettig (Chief Legal and Policy Officer at Polygon Labs), Peter Van Valkenburgh (Coin Center’s Director of Research), and others. The Committee Memorandum is available here. The Digital Chamber provided a nice summary of the hearing, available here.
Analysis: The fact that DeFi has even reached the level of importance to warrant a Congressional hearing is a big step for this burgeoning subset of the digital asset industry. This does not mean that the hearing was totally supportive of DeFi, with Representative Sherman and others using the hearing as a platform to make unsubstantiated claims that DeFi’s primary use is for tax evasion. These assertions were effectively countered by Van Valkenburgh stating that “Tax evasion is a crime. It should be aggressively policed…I do not, however, think that tax evasion and its existence warrant a 100% surveilled and controlled financial system.” The fact that subsets of digital assets remain a partisan issue is somewhat disheartening, but not entirely unexpected.
eToro Settles with SEC and Delists Virtually All Crypto Assets: September 12, 2024
Background: Trading platform eToro USA LLC has agreed to pay $1.5 million to settle charges that it operated an unregistered broker and unregistered clearing agency in connection with its trading platform that facilitated buying and selling certain crypto assets as “securities.” While the platform will continue to permit trading of BTC, ETH, and BCH (Bitcoin Cash), all other digital assets such as LTC (Litecoin), DOGE, and others will be removed. The Order curiously mandates that eToro immediately stop selling those assets while simultaneously requiring the company to sell those assets or otherwise refund customers within 180 days.
Analysis: It is unclear why BCH will be permitted to continue being traded on the platform despite not being meaningfully different from Litecoin. Could it have something to do with BCH having “Bitcoin” in its name? The requirements of the settlement do not appear to give eToro a feasible path forward to operate its U.S. business. This is disappointing considering that prior to the settlement, eToro seemingly tried to follow SEC guidance in that it de-listed assets that the SEC named in other lawsuits as securities, obtained a BitLicense and other state regulatory licenses, and otherwise acted cautiously in an attempt to remain in compliance. It looks like the only way for eToro to comply with the forced sell aspect of Order will be to sell overseas (likely at deep discounts), which will then be passed on to customers. As mentioned above, we expect more of these settlements/actions to flow in leading up to SEC’s September 30 fiscal year end.
Flyfish Club Settles with SEC over NFT Restaurant Membership Sales: September 16, 2024
Background: The SEC issued an Order against Flyfish Club, the creators of restaurant club passes in the form of NFTs. Flyfish Club NFTs represented membership in the private dining club, for which holders of the NFT could digitally verify such membership and make reservations at the restaurant, but the Staff took the position that the NFTs were marketed as securities because they could be resold for a profit. As usual, Commissioners Peirce and Uyeda dissented. As a part of the agreement, Flyfish Club agreed to destroy any NFTs in the company’s possession that it hasn’t sold, not take royalties on any ongoing secondary sales, and pay a $750,000 fine, among other things. This order was issued only a few days before the opening of the restaurant and did not prevent its opening or help the token holders obtain their membership benefits.
Analysis: The fact pattern in FlyClub closely resembles that of Silver Hills Country Club v. Sobieski, a California state court case from 1960. That court found that the country club memberships at issue were being sold as securities and did so through the creation of the “risk capital” test. That test almost exclusively looks at whether a seller is seeking risk capital to develop a business venture. The fact that the memberships were transferable led that court to determine that they represented “risk capital.” In the FlyClub order, while the SEC tries to connect the violations to the Howey test, this could be seen as a move towards the SEC adopting the risk capital test. It’s important to note that the risk capital test has never been recognized by any federal court in the United States. It is also interesting that the SEC has now entered two settlements with two consumptive NFTs and did not require the project to cease and desist, nor did it require a repurchase offer. This contrasts with most SEC settlements with and lawsuits against issuers of utility tokens, in which the SEC demanded that the project shut down. At least the people who want to eat can be fed.
House Financial Services Committee Holds Hearing on SEC Approach to Digital Assets: September 18, 2024
Background: Following up on the DeFi hearing the week before, the House Financial Services Subcommittee on Digital Assets, Financial Technology and Inclusion held a hearing entitled Dazed and Confused: Breaking Down the SEC’s Politicized Approach to Digital Assets. It featured testimony from Dan Gallagher (former SEC Commissioner), Michael Liftik (former Deputy Chief of Staff to SEC Chair White), and others. The Committee Memorandum started with the following Introduction: “The Securities and Exchange Commission (SEC) has long struggled with the application of the United States’ securities laws to the digital asset ecosystem. Under Chair Gensler, the SEC has prioritized and pursued an enforcement and regulatory agenda to the detriment of the digital asset ecosystem.”
Analysis: The battle lines of crypto supporters (led by Ritchie Torres (D-NY) and French Hill (R-AR)) vs. detractors (led by Stephen Lynch (D-MA) and Brad Sherman (D-CA)) stayed consistent in this hearing. The detractors echoed SEC Chair Gensler’s position that 1940's-era court cases on securities laws are fit for purpose in regulating the digital asset industry. On the other side, industry participants and Congressional supporters argued that updated rules would ultimately better protect consumers while keeping innovation in America. Even Maxine Waters (D-CA) responded, “That’s odd,” when learning established FinTech Robinhood attempted to follow SEC registration procedures but was denied registration without further explanation.
SEC Charges DeFi Platform with Securities Law Violations: September 18, 2024
Background: The SEC has charged the creators of the Rari DeFi platform with acting as unregistered brokers. MATIC, LINK, FTM, UST, and RGT were listed as “crypto assets offered and sold as securities” in the Complaint. The Complaint and Order are vague as to whether the Agency is alleging that only the Rari-operated liquidity pools (which the Rari team would algorithmically rebalance) are what caused the violations, or if any pool (including user-created pools that Rari had no contact with other than providing a front end to access those pools) were also violations of securities laws.
Analysis: Rari was literally created by high schoolers. So it shouldn’t be shocking that it suffered a protocol hack and lost $80 million. This also very likely led to upset individuals reporting them to the SEC, which started the investigation leading to these charges. The hack exposed that the protocol was DeFi in name only, as it exhibited significant centralized control beyond just the interface. DAO votes were either ignored or delayed, along with other questionable practices. Interestingly, unlike nearly all previous settlements, this one went to great lengths to avoid labeling the tokens as “digital asset securities.” This is significant, as the SEC has consistently struggled to win this argument in courts across the country. That said, this isn’t great precedent, particularly with the looming Uniswap Wells notice still outstanding.
Briefly Noted:
Members of Congress Ask for SEC Stance on Airdrops: Representatives Emmer and McHenry have sent a letter to SEC Chair Gensler regarding the agency’s official stance on airdropped tokens. The letter stated, “The ethos of crypto and blockchain technology is premised on decentralization. The SEC’s regulatory approach seems to make the goal of decentralization impossible to obtain.
Details Emerge Regarding Collapse of Silvergate Bank: The recently filed Declaration of the then Chief Administrative Officer of Silvergate Bank (Elaine Hetric) reveals that the bank was solvent at the time of its closure, and it was only closed due to actions from financial regulators (the Federal Reserve, FDIC, and OCC), which hampered its ability to be an ongoing business. This raises troubling questions about due process and other related issues.
Details Emerge Regarding Former President Trump’s Proposed DeFi Platform: It appears the proposed DeFi platform backed by former President Trump will include a Reg D/S token sale with locked tokens and no venture or presale allotment. The platform appears to primarily just be providing an attractive interface on top of existing technology with an intention to provide easy access to DeFi. The platform may find it challenging to comply with the transfer restrictions imposed under the securities law exemptions from registration that they are relying on.
NFT Bill Gets Attention in House: In light of the Flyfish settlement, the Digital Chamber-backed NFT bill becomes even more critical. The bill seeks to provide clarity that digital versions of real-world assets that are not typically deemed securities do not become securities merely through tokenization.
SEC Files Proposed Amended Complaint in Binance: The SEC v. Binance Amended Complaint dropped, and looking at the redline, it appears that the SEC is prepared to go forward with claims against many tokens despite early statements that its proposed amended compliant would alleviate the Court’s need to reach a determination on those issues. Also of note, the SEC complaint included a footnote about how the SEC didn’t mean that a crypto asset is necessarily a security when they previously used the phrase “crypto asset security.”
Kraken Files Answer in SEC Lawsuit: The Kraken Answer in SEC v. Kraken also dropped, in which Kraken denies everything, like most answers do. The affirmative defenses are worth a close reading, especially the free speech affirmative defense claiming that the SEC is retaliating against Kraken for being critical of the SEC in certain Congressional testimony.
Conclusion:
As the flurry of regulatory and legislative activity surrounding digital assets continues, the upcoming weeks could be critical in shaping the future of the industry. The Congressional hearings and SEC actions discussed here illustrate the growing importance of decentralized finance, the increasing scrutiny on platforms dealing with digital assets, and the persistent friction between regulators and industry participants.
With the CFTC and SEC looking to finalize their fiscal year and Congress preparing for potential action in the lame duck session, the digital asset space is poised for further developments. As always, the industry remains in a state of flux, with major legal, regulatory, and technological shifts on the horizon.
