Crypto assets are causing “a lot of risk and harm to investors” and institutional investors should be careful about acting as statutory underwriters, said David Hirsch, chief of the SEC Crypto Assets and Cyber Unit, Division of Enforcement. Hirsch discussed SEC enforcement actions against crypto exchanges, celebrity touters, and NFT issuers, among other topics, in a Q&A session at the Securities Enforcement Forum Central 2023 conference on September 19.
The Q&A was conducted by A. Kristina Littman, partner at Willkie Farr & Gallagher. The conference was organized by Securities Docket.
Crypto crackdown. The SEC has been “very active” in the crypto space because it is seeing a lot of risk and harm to investors, said Hirsch.
“We are seeing huge amounts of money vaporize overnight, in ways that are surprising to investors and risk market contagion, at least within the crypto markets,” said Hirsch.
As a result, the SEC has continued to emphasize the need for registration, disclosure, and best practices, said Hirsch. The agency has also continued its anti-fraud mission.
On registration, the SEC has continued to look at issuers of tokens, NFTs, and anything else that can be classified as a security, said Hirsch. The SEC has also continued to be active as to intermediaries. This includes brokers, dealers, exchanges, clearing agencies, and any others that are active in the space and not meeting their obligations with respect to registration.
Warning for institutional investors. A lot of clients are asking about the statutory underwriter theory of liability, said Littman.
While the SEC has not gone after institutional investors under this theory so far, the Telegram and Sparkster cases raise concerns that distributing tokens could trigger liability for institutional investors as statutory underwriters.
- In Telegram, the court used “pretty specific statutory language” that the institutional investors could be deemed statutory underwriters, said Littman.
- In Sparkster, the SEC charged a promoter who bought a large number of tokens and created a pool, and sold opportunities to other investors to buy from that pool. The SEC alleged that the promoter bought the tokens with a view toward distribution and charged him with violating Section 5. While the SEC complaint did not explicitly articulate a statutory underwriter theory, it used similar language.
Littman asked if institutional investors who buy large quantities of tokens should be worried.
Yes, said Hirsch.
“To the extent that Section 2a(11) sets out the rules for statutory underwriters, if institutional investors and others are buying tokens with a view to distribute them, then they potentially fall within that definition,” said Hirsch. “They need to either satisfy an exemption or register as such.”
Hirsch pointed to guidance put out by the Division of Examinations in February 2021. The guidance mentioned the potential for statutory underwriter liability and indicated the Division would be looking at this.
Ripple impact. Turning to recent actions, the July decision in SEC v. Ripple caused a lot of excitement, said Littman. The decision ruled that the XRP token was not a security in some contexts. While Hirsch could not discuss the ongoing litigation, Littman gave observations.
“[Ripple] is up is down, black is white. It turns everything I think we all thought about how securities occupy the space on its head,” said Littman.
But while clients celebrated the ruling, Littman is urging caution.
“What I say to clients is, look, take a beat,” she said. “This is probably going to be appealed and there are some areas here that I think are vulnerable to appeal.”
Clients were excited because the “programmatic” purchases that were found not to be securities transactions were situated similarly to secondary market purchases, she said.
“What it said to people was, secondary market transactions are not securities transactions. So, Coinbase wins. Binance wins,” she said.
However, Littman explained, the ruling did not actually extend to secondary market transactions. That issue was not before the court, so that was dicta. Now, the SEC has filed for interlocutory appeal.
Littman further noted that just weeks after the July ruling, Judge Rakoff explicitly said he thought the Ripple judge got it wrong and he would not apply that ruling in SEC v. Terraform Labs . Rakoff’s ruling threw water on the idea that the Ripple ruling might survive appeal, she said.
Coinbase, Binance, and other exchanges. Littman asked why the SEC is going after Coinbase and Binance in particular, when many other exchanges have the exact same business model.
Generally, the SEC brings cases depending on when the investigation is ready, resources, and priority, said Hirsch.
The SEC’s concerns about crypto intermediaries extend beyond these specific exchanges, said Hirsch. There are over 20,000 tokens, more than the SEC or any agency has the resources to oversee directly. He added that some crypto trading platforms are operating in multiple unregistered capacities, including as brokers, clearing agencies, and dealers.
When those functions are separated out, it creates checks and balances, said Hirsch. A broker is unlikely to route traffic to an untrustworthy exchange, because it would be bad for the broker’s business if clients got bad execution or lost custody of their assets. Similarly, exchanges do not want to clear and settle through an untrustworthy clearing agency.
These levels of oversight are absent when all these functions are collapsed into one, said Hirsch.
“While I don’t think it’s impossible in traditional finance to put all those functions under one roof, it’s inadvisable and potentially illegal,” said Hirsch.
Consolidated functions also create challenges for surveillance. Large centralized crypto exchanges are internalizing trades and processing them in large blocks between exchanges, said Hirsch. This results in the blockchain not showing individual trades in the form of a visible, auditable trail. This reduces transparency.
DeFi. In January the SEC brought a case alleging a crypto Ponzi scheme, SEC v. Eisenberg. Although the SEC did not charge Mango Markets, the trading platform involved, it did discuss governance tokens, which grant rights to vote on things like changes to protocols. Littman asked about a section in the complaint called “The Illusory Rights of Governance Tokens” that implied the SEC did not think the exchange was truly decentralized. She observed that the SEC has not brought an action against a decentralized platform.
“That’s likely a matter of time,” said Hirsch. “With DeFi as with everything, what you call something does control the SEC’s interpretation. We look at function and substance. If the idea is that you’re assuming you’ll avoid liability or accountability by rescuing yourself with new technology, but the substance of what you’re doing is similar to activities that are already under our jurisdiction and securities laws, then we’re going to use those securities laws to bring enforcement actions.”
Littman asked if the recent CFTC settlements against DeFi platforms were an example of dividing labor between the CFTC and SEC.
“My view is that crypto enforcement is a team sport,” said Hirsch.” There is more activity out there than any one agency has the resources for. So by definition we have to work with our law enforcement partners, our civil partners like the CFTC, local law enforcements, as well as state regulators.”
Hirsch continued, “I expect there will continue to be cases where we and the CFTC are both on the scene, where we both have our own independent jurisdictional prerogatives that we have to advance. But there will also be matters where we say that ultimately the result we need—registration, notice to investors that a market’s got problems, enforcement and deterrence—can be accomplished by one agency, we won’t necessarily both be there.”
Celebrity touting. One thing that attracts attention is celebrities like Kim Kardashian, said Littman. But when the Kardashian touting case came out, a lot of people questioned why the SEC went after Kardashian, given all the important stuff happening in crypto. Why are celebrity touting cases important to the SEC’s larger mission?
Hirsch recommended reading Enforcement Director Grewal’s speeches on this topic. A lot of crypto has been marketed to investors who are less financially educated and less able to withstand losses. Touting cases often protect younger and less affluent investors in particular. There is a lot of hype and volatility in these markets, and anything that makes it seem like profits are easy, inevitable, and available is problematic for the SEC. It is extra important for people selling into those markets to be explicit about the compensation they are receiving, said Hirsch.
Littman pointed out that as the Kardashian case made clear, you can’t just slap an #ad hashtag on a post. Disclosure requires more.
NFTs. Littman asked if Hirsch agreed with market sentiment that although the SEC has brought enforcement actions against two non-fungible token (NFT) issuers (Impact Theory and Stoner Cats 2 ), a lot of NFTs are differently situated and many don’t meet the Howey test.
It comes down to expectation of profits, said Hirsch.
Some NFTs suggest they’re as much about personal signifiers as it is about generating profits, Hirsch noted. If the NFT issuers can demonstrate that the mechanism they’re employing is not intended to generate profits for anybody, then that likely would not meet the Howey test.
“So it’s really about whether or not there’s a profitability supporting the distribution. And that extends beyond NFTs to lots of other crypto generally,” said Hirsch. “But a lot of what is driving development in this industry as it exists now is trying to incentivize early adoption by getting in early and drifting off the efforts of others. The promoters make this thing capable of mass adoption and then scarcity will create possibilities for profit, and that would bring in Howey.”
“Nobody wants to miss out on the next Bitcoin,” said Littman.
Yes, said Hirsch.
“To the extent that Section 2a(11) sets out the rules for statutory underwriters, if institutional investors and others are buying tokens with a view to distribute them, then they potentially fall within that definition,” said Hirsch. “They need to either satisfy an exemption or register as such.”
Hirsch pointed to guidance put out by the Division of Examinations in February 2021. The guidance mentioned the potential for statutory underwriter liability and indicated the Division would be looking at this.
Ripple impact. Turning to recent actions, the July decision in SEC v. Ripple caused a lot of excitement, said Littman. The decision ruled that the XRP token was not a security in some contexts. While Hirsch could not discuss the ongoing litigation, Littman gave observations.
“[Ripple] is up is down, black is white. It turns everything I think we all thought about how securities occupy the space on its head,” said Littman.
But while clients celebrated the ruling, Littman is urging caution.
“What I say to clients is, look, take a beat,” she said. “This is probably going to be appealed and there are some areas here that I think are vulnerable to appeal.”
Clients were excited because the “programmatic” purchases that were found not to be securities transactions were situated similarly to secondary market purchases, she said.
“What it said to people was, secondary market transactions are not securities transactions. So, Coinbase wins. Binance wins,” she said.
However, Littman explained, the ruling did not actually extend to secondary market transactions. That issue was not before the court, so that was dicta. Now, the SEC has filed for interlocutory appeal.
Littman further noted that just weeks after the July ruling, Judge Rakoff explicitly said he thought the Ripple judge got it wrong and he would not apply that ruling in SEC v. Terraform Labs . Rakoff’s ruling threw water on the idea that the Ripple ruling might survive appeal, she said.
Coinbase, Binance, and other exchanges. Littman asked why the SEC is going after Coinbase and Binance in particular, when many other exchanges have the exact same business model.
Generally, the SEC brings cases depending on when the investigation is ready, resources, and priority, said Hirsch.
The SEC’s concerns about crypto intermediaries extend beyond these specific exchanges, said Hirsch. There are over 20,000 tokens, more than the SEC or any agency has the resources to oversee directly. He added that some crypto trading platforms are operating in multiple unregistered capacities, including as brokers, clearing agencies, and dealers.
When those functions are separated out, it creates checks and balances, said Hirsch. A broker is unlikely to route traffic to an untrustworthy exchange, because it would be bad for the broker’s business if clients got bad execution or lost custody of their assets. Similarly, exchanges do not want to clear and settle through an untrustworthy clearing agency.
These levels of oversight are absent when all these functions are collapsed into one, said Hirsch.
“While I don’t think it’s impossible in traditional finance to put all those functions under one roof, it’s inadvisable and potentially illegal,” said Hirsch.
Consolidated functions also create challenges for surveillance. Large centralized crypto exchanges are internalizing trades and processing them in large blocks between exchanges, said Hirsch. This results in the blockchain not showing individual trades in the form of a visible, auditable trail. This reduces transparency.
DeFi. In January the SEC brought a case alleging a crypto Ponzi scheme, SEC v. Eisenberg. Although the SEC did not charge Mango Markets, the trading platform involved, it did discuss governance tokens, which grant rights to vote on things like changes to protocols. Littman asked about a section in the complaint called “The Illusory Rights of Governance Tokens” that implied the SEC did not think the exchange was truly decentralized. She observed that the SEC has not brought an action against a decentralized platform.
“That’s likely a matter of time,” said Hirsch. “With DeFi as with everything, what you call something does control the SEC’s interpretation. We look at function and substance. If the idea is that you’re assuming you’ll avoid liability or accountability by rescuing yourself with new technology, but the substance of what you’re doing is similar to activities that are already under our jurisdiction and securities laws, then we’re going to use those securities laws to bring enforcement actions.”
Littman asked if the recent CFTC settlements against DeFi platforms were an example of dividing labor between the CFTC and SEC.
“My view is that crypto enforcement is a team sport,” said Hirsch.” There is more activity out there than any one agency has the resources for. So by definition we have to work with our law enforcement partners, our civil partners like the CFTC, local law enforcements, as well as state regulators.”
Hirsch continued, “I expect there will continue to be cases where we and the CFTC are both on the scene, where we both have our own independent jurisdictional prerogatives that we have to advance. But there will also be matters where we say that ultimately the result we need—registration, notice to investors that a market’s got problems, enforcement and deterrence—can be accomplished by one agency, we won’t necessarily both be there.”
Celebrity touting. One thing that attracts attention is celebrities like Kim Kardashian, said Littman. But when the Kardashian touting case came out, a lot of people questioned why the SEC went after Kardashian, given all the important stuff happening in crypto. Why are celebrity touting cases important to the SEC’s larger mission?
Hirsch recommended reading Enforcement Director Grewal’s speeches on this topic. A lot of crypto has been marketed to investors who are less financially educated and less able to withstand losses. Touting cases often protect younger and less affluent investors in particular. There is a lot of hype and volatility in these markets, and anything that makes it seem like profits are easy, inevitable, and available is problematic for the SEC. It is extra important for people selling into those markets to be explicit about the compensation they are receiving, said Hirsch.
Littman pointed out that as the Kardashian case made clear, you can’t just slap an #ad hashtag on a post. Disclosure requires more.
NFTs. Littman asked if Hirsch agreed with market sentiment that although the SEC has brought enforcement actions against two non-fungible token (NFT) issuers (Impact Theory and Stoner Cats 2 ), a lot of NFTs are differently situated and many don’t meet the Howey test.
It comes down to expectation of profits, said Hirsch.
Some NFTs suggest they’re as much about personal signifiers as it is about generating profits, Hirsch noted. If the NFT issuers can demonstrate that the mechanism they’re employing is not intended to generate profits for anybody, then that likely would not meet the Howey test.
“So it’s really about whether or not there’s a profitability supporting the distribution. And that extends beyond NFTs to lots of other crypto generally,” said Hirsch. “But a lot of what is driving development in this industry as it exists now is trying to incentivize early adoption by getting in early and drifting off the efforts of others. The promoters make this thing capable of mass adoption and then scarcity will create possibilities for profit, and that would bring in Howey.”
“Nobody wants to miss out on the next Bitcoin,” said Littman.