On April 14, 2021, the Senate confirmed Gary Gensler to be the next Chairman of the Securities and Exchange Commission. Chairman Gensler assumes leadership of an agency that is facing a number of politically charged issues, such as “meme trading”; payment for order flow; and climate change and environmental, social, and governance matters.
Under Chairman Gensler, the SEC also has the opportunity to provide much-needed clarity concerning the applicability of the federal securities laws to digital assets, FinTech, and blockchain companies. Chairman Gensler, who is well versed in blockchain technology, has praised its innovative potential, while expressing concerns about the risk for fraud and abuse.
Chairman Gensler has an established record of favoring increased regulation. For example, he advised in the drafting of the Sarbanes-Oxley Act of 2002 and, as Chairman of the Commodity Futures Trading Commission (May 2009 – January 2014), he led its adoption of sweeping rules governing the swaps markets.
Chairman Gensler may explore (i) adding SEC rules and regulations tailored to digital assets, and (ii) asking Congress to pass legislation to that specifically gives the SEC jurisdiction over cryptocurrencies. Any such efforts may encounter opposition from other federal and state agencies that have asserted jurisdiction over digital assets. He also may face internal resistance from Commissioner Hester Peirce, who advocates a more free-market approach.1
Some market participants may view any attempted regulation over digital assets as antithetical, while others may welcome greater regulatory certainty.
SEC’s Approach to Digital Assets under Chairman Clayton
Under former SEC Chairman Jay Clayton, the SEC tried to regulate digital assets through speeches, written guidance, and enforcement actions. In July 2017, the Commission published a Report concluding that the particular digital assets offered and sold in a 2016 token sale by “the DAO” were securities (the “DAO Report”).2 In December 2017, the Commission issued a settled cease-and-desist order against Munchee, Inc. (the “Munchee Order”) for conducting unregistered offers and sales of securities,3 which was followed by a number of other enforcement actions. In October 2018, the SEC launched its Strategic Hub for Innovation and Financial Technology (“FinHub”) within the Division of Corporation Finance.4 In April 2019, Commission Staff published a framework explaining how it will analyze whether a digital asset is a security under SEC v. W. J. Howey Co.5 and its progeny.6
Under Chairman Clayton, the SEC did not propose or adopt any rules that would help clarify what constitutes lawful conduct in this fast-growing industry. Nor has the SEC adopted any regulatory “safe harbors,” as Commissioner Hester Peirce has suggested.7
At the end of Chairman Clayton’s tenure, the SEC filed a civil enforcement action alleging that XRP was offered and sold in violation of the registration provisions of the Securities Act of 1933.8 That case is being litigated, and the defendants have asserted an affirmative defense that the SEC’s approach to digital assets did not provide fair notice that XRP was a security.
Chairman Gensler’s Views on Digital Assets
Chairman Gensler has recognized the virtues and risks of cryptocurrencies and blockchain. In a December 2019 opinion article, he wrote: “The potential [of] this technology to be a catalyst for change is real…. This new form of private money and its underlying shared ledger technology already have been catalysts for central banks, big finance and big tech.”9 Chairman Gensler also praised blockchain’s potential to lower verification and networking costs, economic rents, and data privacy costs, as well as to “jumpstart multiparty network solutions in fields that historically have been fragmented or resilient to change.”10 But he also observed that “Crypto markets have been rife with scams, fraud, hacks and manipulation.11
Chairman Gensler’s testimony before Congress in 2019 provides some insights into the principles that might animate his approach to digital assets at the SEC. Specifically, Chairman Gensler identified three broad public policy goals for the financial regulatory agencies with respect to digital assets: guarding against illicit activity, ensuring for financial stability, and protecting the investing public.12 He also suggested that the SEC should consider whether to propose regulations specific to digital assets.13 Chairman Gensler has also identified “no action” letters as an effective tool that he used at the CFTC to provide some, albeit narrow, guidance to the industry.
Here are some specific areas where the SEC may provide greater clarity to market participants.
Definition of When Digital Assets are Securities
Some jurisdictions have passed laws that define and specifically govern digital assets. The SEC could explore rulemaking or requesting legislation that addresses when a digital asset is (and is not) a security. The classification of a digital asset is relevant not only to whether a particular offer or sale must be registered, but also to the potential registration and other obligations of a wide range of crypto ecosystem participants.
Under current SEC guidance, some digital assets may be securities while others may not be. Determining whether a particular digital asset is a security involves a detailed facts-and-circumstances analysis, and even leading legal and technical experts may reach different conclusions about the same digital asset. And SEC officials have said that a digital asset may transition between being a security and a non-security.14
Under Chairman Clayton, the SEC brought enforcement actions alleging that an initial coin offering (“ICO”) constituted a violative securities offering. Whether the SEC’s approach provides fair notice to market participants is being litigated.15
Chairman Gensler’s earlier statements suggest that he, too, views most ICOs as securities offerings: “Nearly every ICO token’s economic realities — its risks, expectation of profits, monetary policies, manner of marketing, and capital formation — are attributes of investment schemes.”16 He said that, if an ICO occurs when the token is not yet functional, it is a security, and if the token later becomes functional, it may or may not be a security.17
Regulatory Safe Harbors
In February 2020, Commissioner Peirce proposed a three-year regulatory safe harbor that would allow digital asset issuers to work on developing a functional or decentralized network for digital assets without registering with the SEC.18 After expressing some initial skepticism,19 Chairman Gensler suggested that small financial tech startups should be placed in a “regulatory sandbox” to foster innovation.20
On April 13, 2021, Commissioner Peirce released an updated version of her proposed safe harbor.21 The update has three significant additions:
- Requiring semi-annual updates to the plan of development disclosure and a block explorer;
- Adding a requirement to provide, at the end of the three-year grace period, an exit report that includes either an analysis by outside counsel explaining why the network is decentralized or functional, or an announcement that the tokens will be registered under the Securities Exchange Act of 1934; and
- Providing guidance (but not a bright-line test) on what outside counsel’s analysis should address when explaining why the network is decentralized.
Registering Digital Assets and Digital Assets Custodians
Chairman Gensler has recognized that requiring registration of digital assets raises additional practical challenges. For example, he asked, if the SEC were to require retroactive registration of digital assets sold in ICOs, how could companies track beneficial ownership?22
A similar issue applies with digital assets custodians that wish to register as broker-dealers, thus allowing them to offer trading in security tokens, among other securities. After longstanding industry requests for regulatory clarity,23 the SEC announced a five-year “safe harbor” for those custodians meeting certain criteria.24
Potential for a Bitcoin-Based Exchange Traded Fund
The SEC under Chairman Gensler may approve an exchange-traded fund (“ETF”) based on Bitcoin and/or other digital assets. Under Chairman Clayton, the SEC twice rejected Gemini’s application to offer such an ETF. In March 2019, Chairman Gensler observed that it was “inconsistent” that Bitcoin and Ether futures contracts would be traded on certain markets, but that a Bitcoin-based ETF would not.25
Chairman Gensler may pursue new SEC rules and regulations, as well as federal legislation, concerning digital assets. Although government involvement in any still-evolving technology may present certain challenges, some market participants may welcome greater regulatory certainty.