Friday, November 11, 2022

What will be the regulatory fallout of the busted Binance-FTX rescue?

By Mark S. Nelson, J.D.

In the hours after Binance decided to back out of a plan to rescue FTX, FTX’s CEO and founder, Sam Bankman-Fried, appeared to take much of the blame for FTX’s recent troubles, stating in a sometimes profanity-laden tweet that “I'm sorry. That's the biggest thing. I … up, and should have done better.” Bankman-Fried also said the financial woes at FTX concerned FTX International and partly blamed “poor internal labeling of bank-related accounts” for errors regarding user margin.

Wednesday, crypto markets were focused on whether Binance, the largest crypto platform by volume, would acquire competitor FTX. By afternoon, that deal had fallen through leaving confusion about whether FTX could be saved by another firm or might have to take other steps to avoid collapse. While no obvious solution has materialized, the regulatory response to FTX’s fall may be about to begin.

Already, multiple bills introduced in the 117th Congress would largely place authority to regulate crypto markets with the CFTC. The several bills vary in their details, but most would give the CFTC explicit authority over crypto spot markets. Critics of the bills, however, have raised concerns that some of the bills may not do enough to prevent the CFTC from using any new authorities to take a closer look at other non-crypto markets. The most prominent of these bills do not explicitly purport to alter SEC authorities, but there are equally strong calls to preserve SEC authority as there are to ease SEC rules regarding tokens. A legislative solution for crypto markets may have to await the next Congress.

In an appearance on today’s CNBC’s “Squawk Box” with Andrew Ross Sorkin and Becky Quick, SEC Chair Gary Gensler addressed issues surrounding tokens more generally and, while not directly speaking to any possible SEC action regarding FTX, he tangentially noted the requirements for disclosures concerning mergers.

With respect to tokens, Gensler said the key issue is the small number of lending platforms and exchanges that take customers’ money and then borrow and trade against customers. Gensler said it can take time to build enforcement cases against these entities, but he suggested that the SEC would continue to pursue a tripartite path of investor education, registration of intermediaries, and enforcement. Gensler also noted that crypto markets are highly interconnected.

With respect to Binance and FTX, and others who might seek to bail out FTX, Gensler declined to speak about any SEC action, although he observed that even in the case of a letter of intent regarding a merger, there must be full, fair, and truthful disclosure.

Representative Tom Emmer (R-Minn) added his voice to the confusion that surrounds the next steps for FTX. In a somewhat cryptic tweet, and without offering further evidence, Rep. Emmer stated: “Interesting. @GaryGensler runs to the media while reports to my office allege he was helping SBF and FTX work on legal loopholes to obtain a regulatory monopoly. We’re looking into this.”

During Gensler’s “Squawk Box” appearance, Sorkin had asked about a March 29, 2022 entry in Gensler's calendar indicating a meeting Gensler had with Bankman-Fried. Sorkin asked, “Do you feel like you were hoodwinked?” Gensler replied: “I think we’ve been clear in these meetings and you can look at my calendar’s public, many meetings with folks in this industry, it’s very clear in these meetings, same message to the public, same message to them that non-compliance is not going to work, the public is going to be hurt, but also we’re going to continue on these dual paths and if we need to going to be the cop on the beat, going into court, putting the facts and the law in front of judges.”

Although it is unclear if Rep. Emmer was referring to the meeting noted by Sorkin, the lawmaker has been an outspoken proponent of enacting legislation to clarify rules for blockchain ventures. Representative Emmer has, over several Congresses, authored at least three blockchain bills: (1) the Blockchain Regulatory Certainty Act (H.R. 5045) (safe harbor from licensing requirements for certain non-digital-currency-controlling blockchain developers and service providers); (2) the Safe Harbor for Taxpayers with Forked Assets Act (H.R. 3273) (excluding from gross income the receipt of any forked convertible virtual currency); and (3) the Securities Clarity Act (H.R. 4451) (purporting to distinguish an investment contract from an asset sold pursuant to an investment contract for purposes of Howey analysis).

With respect to the last bill, the Howey analysis referred to is that required under a Supreme Court precedent that provides that an investment contract is a security if it involves an investment of money, in a common enterprise, with a reasonable expectation that others will use their managerial skills to generate profits. Howey has been a workhorse of SEC enforcement in the blockchain space. Gensler and his predecessors have remained steadfast in telling the public that most blockchain tokens are securities under Howey.