SEC "Reverse-Sweep" Spotlight: Kraken (And How the SEC Has Ironically Become Perhaps the Most Culpable Grifter In History)

SEC “Reverse-Sweep” Spotlight: Kraken, Another One Bites the Dust

Yesterday, the SEC reportedly dismissed its enforcement action involving Kraken, continuing its unabashed quest to gleefully usher in the greatest era of fraud and chicanery in the history of the world.?

?Some Background

Trading platforms like Kraken allow their customers to deposit fiat (legal tender issued and approved by a country) into bank accounts and crypto assets into wallets controlled by the platform, and then to purchase and sell those assets for fiat or other crypto assets. These exchanges may be conducted on- or off-chain. The crypto assets offered on the Kraken Trading Platform are available for sale to an individual or institution who creates an account with Kraken.

The SEC's suit against Kraken parents Payward Inc. and Payward Ventures alleged that the platform failed to register as a broker, dealer and exchange for "crypto asset securities.” In its motion to dismiss the case, Kraken argued the transactions it enables on its platform were not securities.

The SEC alleged that Kraken, through the Kraken Trading Platform and Kraken Services, made available for trading crypto assets that are offered and sold as investment contracts, and thus as securities. Judge William H. Orrick focused on the SEC’s factual allegations regarding two crypto assets: ALGO and SOL – and held that both could be securities.

The SEC’s allegations against Kraken concern crypto assets that were originally issued by third-party cryptocurrency networks. Although Kraken agrees that the initial offering of the digital assets involved an investment of money, Kraken argued that when the asset hits the resale market on its platform, the investment contract doesn't follow, failing the so-called Howey Test, which is a test the U.S. Supreme Court created for lower courts to use when determining if an investment product is a security. ?Kraken went so far as to label the SEC’s argument as a "perversion" of the Howey test.

In one of the more blistering and resolute opinions asserting that digital assets are securities, Judge Orrick stated:

?"The court in Howey said nothing about an investment of money requiring privity between the issuer and the investor, nor has Congress ever drawn such boundaries around what constitutes an investment contract . . . It defies common sense to suggest that when someone purchases crypto assets from a reseller or another investor, that person or entity does not understand themselves to be investing money in the asset."?

Why This Decision Was Yet Another Home Run for the SEC’s Crypto-Enforcement Efforts

Like so many of the crypto-enforcement action “motions to dismiss” and “motions for summary judgment” decisions, the defense spent tens of millions in legal fees to litigate their failed position and the end result has been pretty much the same: SEC victory every single time.

However, what has always intrigued me most are not the outcomes of the decisions, but rather the intensive time and effort judges routinely take in drafting their decisions on these exhaustive dispositive crypto-related motions.?

Thanks to all of these hard-working and thoughtful judges, anyone who can read now has a robust, extensive, ubiquitous and extraordinary library of judicial crypto-decisions -- all glaringly presented in plain view, for all securities lawyers to incorporate into their corporate legal counseling practices.

Along these lines, below are five especially compelling excerpts of Judge Orrick’s compelling Kraken Order:

Excerpt #1: Judges must look at the totality of the circumstances when applying the Howey Test to crypto-products:

?“Howey and its progeny require any court considering whether a secondary market transaction constitutes an offer or sale of an investment contract to apply the same analysis that it would if that transaction were to occur on a primary market. The determinative factor does not involve the nature of the platform upon which the asset is transacted, but rather the reasonable expectations of the individual initiating the transaction. That analysis considers the totality of the circumstances and the economic reality of transaction.” (Emphasis Added)

?Excerpt #2: There is no need for post-sale obligations to trigger the Howey Test:

“Kraken argues that an investment contract requires “post-sale obligations” from the issuer to the receiver; the SEC insists that it does not. The weight of authority, both recent and well-established, favors the SEC . . . In short, the blue-sky laws from which Howey drew inspiration may have involved more formal contracts, but the Court in Howey, the Ninth Circuit in Hocking, and numerous courts since have made clear that contractual formalities are not required for something to qualify as an investment contract, and therefore a security. What counts is the totality of the circumstances surrounding a sale, trade, or exchange, and the expectations of the investor. Kraken’s argument would improperly constrain Howey.” (Emphasis Added)

?Excerpt #3: Whether a crypto asset is offered in the primary market or the secondary market, the analysis is the same:

?“The parties disagree about the degree to which Kraken’s nature as a secondary market for cryptocurrency transactions changes the way the transactions are considered when determining whether the SEC has plausibly alleged that they constitute investment contracts. Ultimately, the resolution is simple: The Howey test applies wherever a court seeks to determine whether a transaction involves an investment contract, regardless of whether that transaction is on a primary or secondary market . . . In short, binding authority requires the court to evaluate whether an investment contract is formed in a secondary market to consider the features of that secondary market transaction. It does not require that the court ignore anything that happened in a primary market transaction; if a reasonable investor would understand representations made during the primary market transactions to carry forward into the secondary market, then those representations may be considered. What matters are the reasonable expectations of the investor. That a transaction does not involve the asset’s primary issuer does not foreclose the possibility that the primary issuer’s representations follow the asset through to the secondary market . . . Kraken agrees that the initial offering of the Kraken-Traded digital assets involve an investment of money. But it argues that once the asset hits the resale market on Kraken’s platform, that investment does not follow the asset, meaning that an asset that may have originally met the first Howey prong no longer does upon resale. Kraken’s perspective is too narrow.” (Emphasis Added)

Excerpt #4: Why the Ripple Decision (as precisely proclaimed by the deciding Judge herself in the Ripple decision) has little, if any, value as legal precedent for any U.S. Court:

“Kraken compares this case to Ripple Labs I, where the court held on summary judgment that purchasers on digital asset trading platforms (including Kraken) had no reasonable expectation of profits. It determined that the “economic reality” showed that the third Howey prong was unsatisfied where there was no relationship between the alleged issuer and the purchasers on digital asset platforms. ?. . . It explicitly declined to address whether secondary market sales of the crypto asset in question constituted offers and sales of investment contracts because the question was not before her. The court’s opinion is carefully constrained to the facts of the case and predicated on findings from a fully developed record.Again, “[w]hether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme.” As discussed, the way the court foreshadowed how a court would have to consider secondary market sales of crypto assets is consistent with the Ninth Circuit’s holding in Hocking. See Hocking, 885 F.2d at 1462 (declining to recognize an absolute rule about when secondary market transactions involve a security and noting that Howey requires the examination of the “economic reality” of each secondary market transaction, including analysis of how assets are promoted to investors, and what the investor’s intentions and expectations were when they invested).The SEC has plausibly alleged that investors in crypto assets offered on Kraken possessed an expectation of profits from the efforts of others that they derived from the promoters’ representations that Kraken republished and reasserted on its platform. Whether or not the record ultimately supports that allegation will be revealed through discovery.” (Emphasis Added)

Excerpt #5: Why the major questions doctrine argument is a losing one (and why I have stopped counting the times that judges have said so):

“Kraken, and its numerous amici, insist that the question posed in this case is the kind reserved for Congress, because resolution of the dispute in the SEC’s favor would expand its regulatory power. Other courts have already considered whether similar claims brought by the SEC violate the major questions doctrine and found that they do not. The same is true here. The major questions doctrine originates from the idea that Congress does not delegate extraordinary powers that transform an agency’s authority without making its intent clear. . . This is not such a case. The cryptocurrency industry “falls far short of being a ‘portion of the American economy’ bearing ‘vast economic and political significance . . . Moreover, the SEC is not asserting a “transformative expansion in its regulatory authority” or a “highly consequential power beyond what Congress could reasonably be understood to have granted it.” ?. . . ?While cryptocurrency itself is a relatively novel financial instrument, the principles driving the SEC’s attempt to assert regulatory authority over it are not new.” (Emphasis Added)

Why The SEC Case Against Kraken Protected Investors

The SEC charged that Kraken turned a blind eye to its legal responsibilities and engaged in its securities intermediary conduct without registering with the SEC, depriving investors of the disclosures and protections that registration entails.

The SEC argued that by failing to prevent known conflicts of interest and commingling its investors’ assets with its own, Kraken demonstrates why registration and the investor protections that come with regulatory oversight are critical to the soundness of U.S. capital markets.

U.S. SEC registration of financial intermediaries: (1) mandates that investor funds and securities be handled appropriately without conflicts of interest; (2) ensures that investors understand the risks involved in purchasing the often illiquid and speculative securities that are traded on a cryptocurrency platform; (3) makes buyers aware of the last prices on securities traded over a cryptocurrency platform; and (4) provides adequate disclosures regarding their trading policies, practices and procedures.

Overall, entities providing financial services must carefully handle access to, and control of, investor funds, and provide all users with adequate protection and fortification.

With traditional SEC-registered financial firms, the SEC has unlimited and instantaneous visibility into every aspect of operations. With crypto trading platforms, the SEC lacks any sort of oversight and access — and has scant ability to detect, investigate and deter fraudulent conduct. As a result, the crypto marketplace operates without much supervision, lacking:

?-- The hallmarks of the traditional transparent surveillance program of a financial firm like an SEC-registered broker-dealer or investment adviser, so the SEC cannot analyze or verify market trading and clearing activity, customer identities and other critical data for risk and fraud;

?-- SEC and/or Financial Industry Regulatory Authority licensure of individuals involved in crypto trading, operation, promotion, etc., so the SEC cannot detect individual misconduct and enforce violations;

?-- Traditional accountability structures and fiduciaries of financial firms, so the SEC cannot ensure that every customer's interest is protected and held sacrosanct;

?-- The compliance systems, personnel and infrastructure, so the SEC cannot know where crypto came from or who holds most of it; and

?-- The verification and investigatory routine and for cause SEC or FINRA examinations, inspections and audits, so the SEC and FINRA cannot patrol, supervise or verify critical customer protections and compliance mechanisms.

By failing to register with the SEC, the SEC charged that Kraken has placed their own financial interests ahead of the legal obligations they owe to customers as securities intermediaries, failing to register as an exchange, a broker, a dealer, and a clearing agency without registration in violation of Exchange Act Sections 5, 15(a), and 17A(b) [15 U.S.C. §§ 78e, 78o(a), and 78q-1(b)].

Along these lines, the SEC sought a final judgment: 1) Permanently enjoining Kraken from violating the federal securities laws; 2) Ordering Kraken to disgorge their ill-gotten gains, on a joint and several basis, and to pay prejudgment interest thereon; 3) Permanently enjoining Kraken from acting as an unregistered exchange, broker, dealer, or clearing agency; and 4) Imposing civil money penalties on Kraken.

?Looking Ahead

Alas, the Kraken case -- just like the Binance and Coinbase cases, where a federal judge handed the SEC huge, decisive victories -- is now no more and the fast and furious demolition of the SEC’s crypto-enforcement program continues without hesitation or qualification.

For instance, the SEC has now dismissed or “paused” crypto-related enforcement actions against Coinbase, Binance, Consensys,?and Tron — and other major SEC crypto-related cases against Ripple, Cumberland Pulsechain and Hex will soon likely follow. Along the same lines, the SEC has reportedly closed crypto-related investigations involving OpenSea, and Uniswap, — and other reported SEC crypto-related investigations Immutable?Crypto.com?and Unicoin will soon likely follow. ?

Bruce Carton of Securities Docket has labelled the SEC’s radical crypto-turnabout a “Reverse-Sweep” (antithetical to the SEC's enforcement sweeps of yesteryear) while lone Democratic SEC Commissioner Caroline Crenshaw has ridiculed the new SEC posture as “regulation by non-enforcement.” ?

Whatever the new catch-phrase or nomenclature, the SEC’s comprehensive and indiscriminate dismantling of its crypto-enforcement program is not just unprecedented and irresponsible -- its regulatory heresy.?

What so many crypto-commentators glaringly omit is the extraordinary success the SEC's crypto-enforcement efforts, becoming the most winning enforcement program in SEC history, prevailing in court in most (arguably all, including the Ripple case) of the 200+ crypto-related enforcement actions the SEC has ever filed.

The SEC's robust volume of crypto-related victories is not surprising. As securities compliance expert Matt Kelly commented recently:

“Every day in every way, crypto demonstrates that it has no useful purpose other than fraud, tax evasion, and corruption. Otherwise, it's just a speculation toy for billionaires and a sucker's bet for everyone else.”?

Moreover, despite the incessant carnival barking of crypto-promoters, the cryptoverse has failed to create any sort of newfangled utopian decentralized financial panacea. Instead, the cryptoverse is mostly a mammoth affinity fraud, where crypto-shills have turned victims into victimizers, first, by hijacking an earnest libertarian ethos and then by metastasizing that ethos into a cancerous morass of mathematical computational blather custom designed for speculation and manufactured exclusively for crime, terrorism and predatory inclusion. That’s the Big Crypto con.

Welcome to the golden age of fraud, where crypto-charlatons run-free, wreaking FOMO financial havoc upon innocent investors, while the once-storied SEC not only stands by and lets it all happen, but also gleefully celebrates the genesis of a phantasmagorical SEC/Big Crypto partnership.

So there you have it. Under the bogus auspices of innovation, clarity and capital formation, the SEC has renounced and abandoned its critical investor protection mandate -- ironically emerging as perhaps the worst and most culpable grifter of them all. This Stark reality is not just glaring -- it's all in plain view.