The U.S. Securities Exchange Commission (the “SEC”) seems to have come out of the gate storming in the first quarter of 2023 with its enforcement actions and proposed rules that have changed (or will change) the crypto world fundamentally. Below we take a quick look at SEC’s active regulatory approach and briefly summarize the takeaways from those events.
On April 14, 2023, the SEC reopened the comment period for the amendments to the Securities Exchange Act of 1934 Rule 3b-16 (i.e., Title 17 section 240.3b-16), which were originally proposed in 2022 and resulted in abundant comments from the crypto industry on the contemplated scope expansion for the definition of “exchange”. These proposed amendments are closely watched because the expanded definition would render decentralized finance platforms/protocols (“DeFi”) a securities exchange that are subject to relevant securities laws without even including the term “DeFi” in the proposed amendments. Some of the SEC’s significant amendments include: (i) adding in “communication protocol” as “an example of an established, non-discretionary method that an organization, association, or group of persons can provide to bring together buyers and sellers of securities” and (ii) replacing “orders” with “trading interest”. The SEC expressly indicated in its written summary that if a trading system (e.g., a DeFi platform) meets the criteria of a securities exchange (as defined under the amended Rule 3b-16(a)) and is not subject to an exception under Rule 3b-16(b), such trading system shall then register as a regulated securities exchange and comply with applicable requirements or qualify it is as an exempted trading system.
The SEC also listed new questions to invite additional comments in this reopened comment period while clarifying certain questions raised in the previous comment period (e.g., (i) the custodial service is generally not relevant to the SEC’s exchange analysis and (ii) the trading system deemed as a securities exchange under the amended rule and seeking to operate as an ATS could register as a broker-dealer). What is worth watching at this stage, among other significant issues, is whether and how the SEC would enforce the amended Exchange Act Rule 3b-16 if the amendment does get adopted and be applied to DeFi and the crypto industry. In general, DeFi’s operation would involve various parties that include code developers, DAO(s), smart contract(s), protocol validators and issuers and/or holders of governance tokens. Although regulators can certainly rely on existing legal theories to bring an enforcement action against the developers or members of a DAO (as shown in the CFTC v. Ooki DAO), it remains a very fact specific determination as to the establishment that the involved parties are “acting in concert” in “establishing, maintaining, or providing a market place or facilities for bringing together buyers and sellers of securities” (which are one of the elements for a communication protocol’s securities-exchange classification). The SEC has given out some examples to the above question, suggesting:
(i) If there is a formal or informal agreement among the parties, then the parties are acting in concert (for instance, “if one entity agrees with another entity to combine aspects of each other’s market places or facilities (e.g., order books, display functionalities, or matching engines) to bring together buyers and sellers of securities, both entities could be considered part of the group and thus an exchange ”);
(ii) The ability to provide or maintain a smart contract that bring together buyers and sellers of securities, and the fact that such smart contract is later used for such purpose, could render relevant parties a part of an exchange (for example, “an organization deploys a smart contract that the organization cannot significantly alter or control but constitutes a market place for securities… that organization would be an exchange and would be responsible for compliance with federal securities laws for that market place”); and
(iii) In general, a service provider/vendor offering services to a securities exchange (as deemed under the proposed amendment) is not considered a party responsible for the compliance with relevant securities laws. In this regard, the deployer of an independent oracle that allows a DeFi platform (deemed as a securities exchange) to retrieve securities pricing information would not be deemed as a party collectively managing the platform. (However, the SEC also indicated that the foregoing determination will change if the service provider/vendor COULD exercise control or share control of the concerned platform.)
With all that being said, the determination of those issues may not be an easy one to make in real cases given the nature of DeFi, DAO and parties involved in the operation. If the proposed amendment is codified into law, how the SEC would draw the line and how such line would be tested in court will alter the DeFi landscape significantly.
In addition to the SEC’s regulation by enforcement as previously identified in the discussion concerning the regulator’s action against Ishan Wahi, Nikhil Wahi and Sameer Ramani, another development worth monitoring is the status of the staking-as-a-service program deemed by the SEC as an investment contract (and thus constitutes a security under securities laws). As chairman Gensler puts it, staking-as-a-service means investors lock up their tokens in the escrow of a service provider (e.g., an exchange) and help validate nodes/transactions in exchange for (financial) rewards. The first such determination was made in February 2023 in the SEC’s $30 million settlement with Kraken, in which the regulator indicated in its complaint that Kraken’s pooling of investors’ tokens, the discretionary returns determined by Kraken (but not by the underlying protocol generating/determining the actual returns) and other platform-specific arrangements constitute an offering and sale of investment contract that is subject to registration requirements under securities laws. Shortly following the settlement, it is reported that the SEC is going after Coinbase for its staking products that could constitute an unregistered security.
While the SEC’s settlement with Kraken and potential action against Coinbase do not mean a storm broadly sweeping all types of staking models that yield return to the investors staking their tokens, it surely signals how the SEC views staking-as-a-service, and such view, in the context of staking, leads to various questions:
(i) One key fact cited by the SEC with respect to Kraken’s staking program is that the investors participating in staking would lose possession and control over their crypto assets by transferring the assets to Kraken and thus assume the risks associated with the platform. However, will the SEC reach a different conclusion (i.e., a staking program is not an offer of investment contract) if such underlying fact is different? Also, in the context where the returns to the staking investors are solely determined by the underlying protocols rather than the discretion of the platform administrating the program, would such “return” still be regarded as an “expectation of profits” (which is a necessary element for an investment contract) or it would be deemed as an algorithm-determined consideration paid to the staking investors for putting in efforts of validating data?
(ii) As to the required “reliance on the efforts of others” for constituting an investment contract, in the event the platform making a staking program available only provides administrative, “purely ministerial” support, would such arrangement still be deemed as meeting the criteria of “efforts of other”? (The SEC has previously indicated in its Framework for “Investment Contract” Analysis of Digital Assets that the ministerial support could weaken the finding of the reliance on the efforts of others.) Additionally, how would the SEC draw the line for “ministerial support”?
All those questions and uncertainties have not yet been answered by the SEC (either by written statements or enforcement actions) and may be further tested in court. Regardless of how the SEC’s approach develops, it is without doubt that the path forward for the crypto industry might just become murkier than before.
Stay tuned to Ingram’s NFT Newsroom to learn more about the latest developments.
By: Chih-Hsun (Tim) Lin
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