Regulation
The cryptocurrency counteroffensive highlights the need for regulation
A potential new trend in litigation in the cryptocurrency industry has begun to emerge as private businesses and nonprofits related to the industry begin filing complaints against the Securities and Exchange Commission. The complaints seek to insulate the plaintiff companies from enforcement actions. Importantly, they also highlight the need for regulation.
Ultimately, the SEC and the Commodity Futures Trading Commission – and not the courts – are best positioned to provide clarity to companies in this complex and evolving space.
The plaintiffs seek declaratory and injunctive relief in complaints filed in Texas federal courts by Lejilex and Crypto Freedom Alliance of Texas and by Beba LLC and DeFi Education Fund. Lejilex describes It bills itself as “a non-custodial digital asset trading platform that allows users to trade digital assets through the use of underlying smart contracts” in “blind bid/ask transactions.”
Try to avoid being forced to register “as a stock exchange, broker, or clearing house.” And the grievance in Beba LLC describes the lead actor as a small online clothing company that has “embedded digital assets into its business” and distributed its BEBA token for free via an airdrop.
That complaint alleges that the SEC “will take the position that the BEBA tokens are investment contracts and that the airdrop is a securities transaction.” Both complaints allege that the SEC has no jurisdiction to take enforcement action against them.
The central claims in these two cases are similar to arguments made by defendants in recent cases in the U.S. District Court for the Southern District of New York, including SEC vs. Ripple Labs, SEC vs. Terraform LabsAND SEC vs. Coinbase. The plaintiffs’ choice of venue in the Texas federal courts means that the U.S. Court of Appeals for the Fifth Circuit will likely have the opportunity to decide those central issues, potentially creating a divide in the federal appellate courts and inviting review by the United States Supreme Court.
From a political perspective, the complaints demonstrate an unusual “offensive” against the SEC and put under scrutiny the SEC’s chosen regulatory approach, which has been criticized as “regulation through enforcement.” Anti-fraud enforcement is undoubtedly a key pillar of our securities and derivatives markets. Enforcement as policy, on the other hand, is not the most effective means of regulating these markets.
One of us has tracked how the SEC began with anti-fraud enforcement on cryptocurrencies, protecting investors in primary market transactions. His contributions in cases against fraudulent initial coin offerings, or ICOs, have undoubtedly been positive.
Yet the SEC has slowly moved toward enforcing the mandatory registration provisions of the securities laws, first against issuers and then against exchanges and brokerages. This progression has led to questionable results in terms of investor protection, particularly when projects are not fraudulent and businesses are profitable. This course of action also failed to ensure future regulatory clarity, which is an important element of sound regulation.
The recent complaints are a natural corollary to these enforcement trends and highlight a fundamental need for certainty in primary markets and secondary trading. At the heart are jurisdictional questions and a complicated doctrinal inquiry: Do cryptoassets and cryptoasset transactions fall under the jurisdiction of the SEC? Are they titles?
Lejilex and Beba’s complaints challenge as exaggerated and unconstrained the SEC’s likely assertion that the BEBA token and the tokens to be traded on the Lejilex exchange are “investment contracts” and therefore “securities” within the meaning of SEC v. Howey. Both complaints suggest that an underlying contractual relationship between asset creators and investors is central to Howey.
After a primary distribution of cryptoassets, secondary trading of the underlying assets follows. Secondary market traders I’m not anymore parties to the initial contractual agreement between the cryptoasset issuer and the original investors. So what is the nature of the assets they acquire? Are assets still investment contracts or simply unsecured assets in the form of lines of code?
In deciding the parties’ cross-motions for summary judgment in the Ripple Labs case, Judge Analisa Torres found that institutional sales of Ripple were investment contracts, but that programmatic sales of Ripple to public buyers on cryptocurrency exchanges were not . In the Terraform case, Judge Jed Rakoff “refused to draw a distinction” between Terraform cryptoassets sold “directly to institutional investors and those sold through secondary market transactions to retail investors.”
Similarly, in the Coinbase case, Judge Katherine Polk Failla found that the SEC had adequately held that some cryptoassets traded on Coinbase were investment contracts, even if the investors had not purchased those assets directly from the issuer.
If Texas courts decide that cryptoassets, particularly those traded on secondary markets, are not securities, the SEC will not be able to claim jurisdiction over the trading platforms where these assets are listed. This outcome could, in theory, conflict with a future decision by Coinbase, among others.
Congress or the SEC and the Commodity Futures Trading Commission (through joint rulemaking) could address these and related issues more effectively than the courts. The justice system is not a useful regulatory tool for modern markets, and research supports the need for reform.
One of us valued how investors perceive enforcement by the SEC and CFTC. SEC enforcement, particularly toward stock exchanges, generates a more negative investor reaction than CFTC enforcement, suggesting the need to modernize U.S. securities laws. The global cryptoasset market appears more receptive to anti-fraud law enforcement, indicating that investors appreciate commissions’ efforts to root out fraud, resulting in quality improvements that offset an overall negative reaction to regulation by the application.
Regulatory reforms are urgently needed. Litigation can take years, while the technology is developing rapidly. Furthermore, the EU, UK and other jurisdictions already have or are about to introduce concrete legal frameworks for both cryptoassets and the infrastructure for their issuance and trading. In doing so, they distinguish between securities and cryptoassets.
In the future, a cryptoasset authorized for trading in Europe as a non-financial instrument could be found to be in violation of US securities law. As a result, we may be heading not so much for a circuit split as for a jurisdictional clash between major markets on both sides of the Atlantic.
This article does not necessarily reflect the views of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
About the author
Douglas S. Eakeley is a professor and founder/co-director of the Center for Corporate Law and Governance at Rutgers Law School.
Yulia Guseva is a professor of law and director of the fintech and blockchain research program at Rutgers Law School.
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