A Maze With No Exits

Mike Wawszczak
·Jun 28, 2023

Understanding the SEC’s Position on Crypto
(Disclaimer: the following is personal opinion only and is not intended as legal or financial advice.)
As Miller Whitehouse-Levine succinctly put it, after the past two weeks, “the SEC’s position [is] clear: centralize, shut down, or get out of the United States.”
It’s become increasingly stressful to explain the SEC’s position to founders. With every new lawsuit, founders call their lawyers, who have to recalibrate their advice to account for the SEC’s latest claims. The lawyers parse comments in speeches and TV appearances by Chair Gensler, but then the SEC argues in court that “those comments did not — and could not — constitute agency action.”
In 2021, Gensler said that we “do not have a regulatory framework at the SEC or at our sister agency, the Commodity Futures Trading Commission,” but now — despite, again, no change in law — he says that “the law is clear.”
In 2021, lawyers advised their clients that they may comply with SEC regulations in a number of ways, perhaps through “sufficient decentralization” or through a Reg A+ offering, but now most are advising them that compliance may be impossible unless you “centralize, shut down, or get out.”
Reasonable founders may ask, how does any of this make sense? If no new rules, no new laws, no new guidance has been promulgated— why should legal compliance advice change?
Even after a flurry of litigation over the past two weeks, it is nevertheless difficult to answer that question directly. Perhaps because the SEC’s logic is not legal or economic: it is nakedly political. Lawyers simply aren’t trained to give political advice in response to client legal questions.
But politics is exactly what the SEC is playing here. The SEC transparently wants to ban crypto, but they do not have explicit legal authority to do so. Their Congressional allies cannot get the votes, their Staff cannot craft rules that are legally or technologically coherent. Their only remaining option is to persuade the courts, but a blanket ban isn’t possible by judicial decree.
They’re not banning crypto, because they can’t. So instead, the SEC hopes to persuade a court to grant them total jurisdiction over all token transactions as “investment contracts”, and then make it impossible to register those investment contracts, and therefore impossible to trade them in the public markets. A de facto ban.
They’re building a bureaucratic maze, politely inviting us to “come in and register”, and then sealing the exits.
In their legal and regulatory filings over the past few weeks, the SEC finally revealed the full plan in detail:
Step 1: All transactions in tokens are securities transactions.
Everyone in crypto is familiar with the Howey test: the SEC considers a token to be an investment contract, and therefore a security, where a token transaction involves (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits or returns derived from the entrepreneurial or managerial efforts of others.
If a token is a security, then it falls under the SEC’s jurisdiction and must comply with American securities laws before it can be offered or sold to the public.
Unlike the other 30+ categories of securities, “investment contracts” are better understood as a catch-all category for things that function like securities but don’t neatly fit classic categories like stocks or swaps. For projects hoping to design tokens that don’t implicate securities laws, they can theoretically escape the maze of the Howey test by designing around one or more of the factors.
For example, you could try to avoid the “investment of money” factor, as Bitcoin arguably did with protocol rewards and no ICO.
Or, you could try to avoid the “common enterprise” factor by removing a token’s governance rights over a protocol.
Or, you could try to avoid the “efforts of others” factor through “sufficient decentralization” as outlined in the now-infamous When Howey Met Gary (Plastic) speech by Director Bill Hinman.
Unfortunately, those exits are now blocked. By the logic of its Howey analysis of DASH in the Coinbase case, and of BUSD in the Binance case, the SEC is now arguing that both the “investment of money” and “common enterprise” factors are virtually always met with respect to tokens.
In Coinbase, as they did in Bittrex, the SEC claims that DASH is a security. DASH began as a Bitcoin clone with additional privacy features enabled by specialized Masternodes. Anyone could lock up 1000 DASH to spin up a Masternode, which serves as mixer-type privacy mechanism native to the protocol.
As alleged by the SEC, “[t]he initial distribution of DASH was as rewards to miners that provided value to the Dash network by mining blocks for the blockchain, with miners receiving rewards directly from the protocol.” DASH had no pre-mine, no VC allocation, no ICO. Protocol rewards are now split between miners, Masternodes, and the Dash Treasury, with the Dash Treasury’s allocation distributable through DAO-like votes of the Masternodes.
But because there is a secondary market for DASH, the SEC presumes that the “investment of money” prong is met. Because Masternodes “indirectly” control the Dash Core Group through allocations from the Dash Treasury, the SEC claims that the Masternodes and DCG are a “common enterprise.” And finally, because DCG “promotes” Dash on social media, and because DCG proposes the majority (though not all) of accepted protocol improvements, the SEC claims that investors rely on the “managerial efforts” of DCG. These arguments are broad enough to effectively cover the entire possible design space for token launches, no matter how decentralized.
In SEC v. Binance, the SEC further alleges that even stablecoins like BUSD were offered and sold as securities. They claim claim that tokenholders are in a common enterprise with each other and a company where “proceeds from investor purchases” of a token are “pooled in reserves” and then the company uses “at least a portion of those returns to enable and promote the ecosystem that gave [the token] its profit potential.” Between DASH and BUSD, the SEC seems to claim that all tokenholders are in “common enterprise” with each other simply by virtue of holding a token with some secondary market value, however indirect.
Note that stablecoins inherently have no expectation of profit, but the SEC points to profit potential as sufficient to satisfy the third Howey factor. It’s apparently sufficient, in the SEC’s view, that users could choose (or not) to earn yield through Binance Earn.
To put it bluntly: if DASH and BUSD are securities, then every token — even Bitcoin — could be a security under similarly broad logic, if the SEC chose to make the argument.
Many projects attempting to comply in good faith with SEC guidance have relied on the “sufficient decentralization” analysis. However, as revealed in the Hinman emails back then and in the SEC’s arguments today, the SEC affords no legal weight to decentralization. So long as some “associated third person[]” provides any “statements … to the investing public” while a project is publicly available for trading, the SEC is willing to argue that a project is centralized and therefore the Howey test is satisfied.
The SEC also directly alleges that many major tokens — including BNB, SOL, ADA, MATIC, FIL, SAND, AXS, CHZ, FLOW, ICP, NEAR, VGX, DASH, and NEXO — are securities. The few that haven’t yet been named (most notably BTC and ETH) would almost certainly satisfy their Howey analyses in Coinbase and Binance if those tokens were introduced today.
There is no other reasonable conclusion one can draw from these two complaints other than this: the SEC will bend legal logic past its breaking point to claim any token is a security. No project active in the United States market can be confident that it won’t be subject to the unacceptable business risk of an expensive SEC enforcement action.
Step 2: No securities exchange is allowed to trade tokens.
If a token is a security, then to be publicly tradable it must either be registered with the SEC or qualify for an exemption. As thoroughly explained here (hats off to Rodrigo Seira, Justin Slaughter, Katie Biber, and the policy team at Paradigm), registration of tokens is effectively impossible under current rules without eliminating the entire value proposition of using decentralized blockchains — and as argued by the SEC last week in the Coinbase v. SEC mandamus action, they have no intention of telling anyone (not even the court) if or when they plan on changing the rules.
If a token qualifies for an exemption, it faces two new problems. First, if you purchase a token pursuant to an exemption, the token is considered to be a restricted security. This means that it cannot be resold without another applicable exemption. Restricted securities, in other words, cannot be publicly traded.
Second, even if somehow a token became unrestricted, because it is a security, it can only be publicly traded on a registered securities exchange — either a national securities exchange or alternative trading system, or through a broker-dealer. No crypto exchange in the world is registered with the SEC as a securities exchange, and no registered securities exchange has SEC approval to trade crypto. On the day the SEC sued Coinbase for operating an unregistered securities exchange, Robinhood (who is registered with the SEC as a securities trading platform) testified that it tried to register as a crypto securities exchange and was rebuffed without explanation by Gensler:
“When Chair Gensler at the SEC in 2021 said, ‘come in and register,’ we did. … We went through a sixteen-month process with the SEC Staff trying to register a special purpose broker-dealer. We were pretty summarily told in March that that process was over and we would not see any fruits of that effort.”
One final loophole remains: decentralized exchanges are not “exchanges” as understood under the Securities Exchange Act of 1934. They are simply protocols that people can use to exchange tokens peer-to-peer.
At least in theory, you can buy and sell restricted securities peer-to-peer under private placement exemptions. However, as argued by many major industry participants last week in comment letters to the SEC’s proposal to amend the definition of “exchange”, the SEC is seeking to change the rules to force providers of decentralized exchange software to register under the Exchange Act, closing this loophole (to the extent it even qualifies as a “loophole”).
So, what’s next?
There is some hope for optimism. First, Congress is aware of the problem, with both powerful Republicans like Patrick McHenry and influential Democrats like Ritchie Torres publicly calling out Gensler’s overreach. McHenry introduced a new market structure draft bill shortly before the SEC filed its lawsuits, and that bill is receiving bipartisan attention despite Gensler’s public opposition. It may even receive a House vote in the next month.
Second, judges in both the Coinbase v. SEC mandamus action and SEC v. Binance have expressed skepticism of the SEC’s litigation strategy, echoing earlier judicial skepticism that we heard in Voyager’s bankruptcy case. Remember: it is the courts, not the SEC, that ultimately interpret the law.
And third, large players outside of our industry are beginning to take notice. The U.S. Chamber of Commerce, one of the most powerful lobbying organizations in America, filed a brief supporting Coinbase in its mandamus action, and the Securities Industry and Financial Markets Association, a powerful banking trade group, wrote a scathing comment letter against the SEC’s proposed exchange rule change. Public sentiment may be starting to shift.
(A potential fourth point, that the SEC has finally granted special purpose licenses to organizations like Prometheum, is beyond the scope of this article, but it is worth noting that Prometheum is considered by many to be a red herring. As one attorney noted, “if, indeed, Prometheum represents the only “compliant” path for crypto trading platforms, then … the SEC’s failure to provide new rules for crypto amounts to a de facto ban on the industry in the United States.”)
Nevertheless, I believe any regulatory clarity in America remains on the other side of the horizon. The SEC asserts all tokens are securities, the CFTC asserts that many are commodities, and in two seemingly conflicting rulings involving the bZx protocol and Ooki DAO, federal judges found that the same DAO’s governance tokens can be a general partnership interest and an interest in an unincorporated association. Securities, commodities, and partnership interests are generally considered to be mutually exclusive categories under American law.
Though Congress is increasingly supportive of a legislative solution to this regulatory attack, powerful voices in the Senate and White House remain staunchly opposed to anything short of an outright ban. Despite increasing industry optimism, I do not see any reason for President Biden to entertain the House GOP-led bills.
So, what can a business do in such an environment, if they wish to comply with the law in good faith?
Lawyers across the industry are now reluctantly telling their clients that it’s time to leave the U.S. market behind. In practice, this means geoblocking all U.S.-based IP addresses, at a minimum. If your project involves any activities that the SEC or CFTC has alleged directly implicate their laws, consider blocking all VPNs as well. If you want to be maximally protective against American regulatory aggression, consider KYC’ing your users and blanket banning all Americans.
Businesses need to be able to plan for the future. Even if the law is ultimately on crypto’s side, even if Congress finally debates the substance of crypto bills, it will take years for anything to meaningfully change. In the meantime, American regulators have made clear that they will be as hostile as possible to crypto businesses serving U.S.-based users. This is simply not an environment where good faith business owners can operate.
It is terribly unfortunate that it has come to this, but we can no longer assume good faith on the part of American regulators. They are openly hostile to our industry. They are more interested in political power plays than faithful application of the law.
By weaponizing regulatory ambiguity, they have made themselves perfectly clear.
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