The SEC's Looming DeFi Crackdown

[Shorter/Updated Version Also Published in Law360]

Without firing a single prosecutorial shot or even uttering a single discouraging public word, the U.S. Securities and Exchange Commission?(SEC) just completely defeated Coinbase, who, despite a tirade of online bluster from its CEO and bravado from its General Counsel, quietly posted that they have shut down their crypto-lending program of interest earning cryptocurrency products.

Will the same fate befall BlockFi and Celsius and other similar DeFi platforms who offer similarly designed crypto-lending programs? My opinion: Yes.?

A few states have already begun their regulatory onslaught into crypto-lending programs and there exists an obvious need for SEC federal enforcement action and intervention.?For instance, Texas, New Jersey and Alabama have each alleged that the DeFi cryptocurrency lending programs peddled by Celsius Lending, LLC and BlockFi Lending, LLC are unregistered securities in violation of state securities registration laws.

Below are links to all of the state orders, which make many of the same arguments that the SEC likely used to stop Coinbase. My guess is that the SEC enforcement staff has likely read all of these state actions carefully, reached out to the respective state investigators in each case and opened up formal investigations concerning them all.?

• Find the Texas Order concerning Celsius here.?
• Find the New Jersey Order concerning Celsius here.?
• Find the Alabama Order concerning Celsius here.?
• Find the Texas Order against BlockFi here.?
• Find the New Jersey Order against BlockFi here.
• Find the Alabama Order concerning BlockFi here.

SEC Chair Gary Gensler’s Concerns

The SEC enforcement staff are already investigating possible fraud and chicanery at DeFi platforms in particular, especially given SEC Chair Gary Gensler's oft repeated concerns that unregistered cryptocurrency trading and lending platforms pose a threat to investors and could be unlawfully selling unregistered securities.?

Indeed, Chair Gensler noted in a September 21, 2021, live-streamed interview with the Washington Post, that many of "hundreds or thousands" of tokens that trade on cryptocurrency trading and lending platforms are likely securities, which would require any platform on which they trade to register as an exchange or apply for an exemption.

Chair Gensler has remained remarkably consistent in his view of the risks to investors posed especially by unregulated crypto-platforms. In an August 5, 2021, response letter to a letter from Senator Elizabeth Warren, he stated:

"To the extent that there are securities on these trading platforms, under our laws they have to register with the Commission unless they meet an exemption. If a lending platform is offering securities, it also falls into SEC jurisdiction. Moreover, there are initiatives by a number of platforms to offer crypto tokens or other products that are priced off of the value of securities and operate like derivatives. It doesn’t matter whether it’s a stock token, a stable value token backed by securities, or any other virtual product that provides synthetic exposure to underlying securities. These products are subject to the securities laws and must work within our securities regime."

Chair Gensler is justifiably concerned about the lack of critical and sacrosanct investor protections at cryptocurrency trading and lending platforms, i.e. the lack of a regulatory framework: to safeguard investors and consumers; to patrol for illicit activity; and to ensure financial stability

For instance, with respect to U.S. federal regulation of crypto-platforms, there exists:

• No team of SEC, Federal Reserve, OCC, FINRA or other federal auditors and compliance experts not only inspecting and scrutinizing the fairness, execution and transparency of transactions and but also policing for fraud, manipulation and chicanery;?
• No liquidity, net capital or other depository or financial federal requirements;?
• No record-keeping and archiving requirements with respect to operations, communications, trading or any other aspect of business;?
• No requirements regarding the pricing or order flow of crypto transactions or the use internal platforms and payment systems by employees;?
• No adherence to federal statutes and rules prohibiting manipulation, insider trading, and other fraudulent behavior by customers or employees;?
• No mandated cybersecurity requirements or standards to combat hackers and protect customer privacy;?
• No mandated training or code of conduct requirements;?
• No mandated internal compliance, customer service or whistleblower teams to address and archive customer complaints;?
• No anti-fraud guarantee from a U.S. registered financial institution and, if any dispute or problem arises, no reversing of charges (typical cryptocurrency transactions are by definition irreversible);?
• No mandated process for customer complaint handling (and even if there was a formal complaint filing structure, the pseudo-anonymous nature of virtual currencies, ease of cross-border and interstate transport, and the lack of a formal banking edifice creates enormous challenges for law enforcement to investigate and apprehend any individuals who use cryptocurrencies for illegal activities); and
• None of the vigorous U.S. federal safeguards historically rooted in the DNA of U.S. financial institution registration and regulation. These sacrosanct standards and practices are not only the hallmark of U.S. financial institutions such as banks, investment companies, brokerages and other financial firms but have also rendered U.S. capital markets the most transparent, efficient, reliable, safe, trustworthy -- and most sought after in the world.

Why Cryptocurrency Lending Programs Will Lose Any Battle with the SEC

For a 5,000+ word treatise on why these De-Fi cryptocurrency lending programs are peddling securities that require SEC registration, please refer to my article entitled “Why Coinbase Will lose its Battle with the SEC.”??

In short, typical cryptocurrency lending programs easily meet the tests established by the 1946 Supreme Court decision?SEC v. Howey?and the1990 decision of?Reves v. Ernst & Young, the seminal cases applied when determining whether an investment product is a security.?

Moreover, the usual humdrum of antiquated and failing defenses -- the vagueness of SEC regulation, the lack of clarity about what is a security; the decades old go-to defense??decrying “legislation via enforcement,” etc. -- all fail miserably.??

The definition of security?is historically flexible?so as to be “capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Indeed, by emphasizing elasticity in the regulation of securities, Congress and the Supreme Court intentionally anticipated/contemplated that issuers would devise new investment vehicles to raise funds from the public.

As every good securities lawyer knows all too well, the stark reality is that litigation is how most securities regulation becomes law. Indeed, securities laws are often intentionally vague and require adjudication to clarify. Along these lines, Howey and its progeny provide clear, explicit standards that courts have applied to SEC enforcement actions for decades, from investments in?eel farms?and?ostrich breeding?to?wholly bogus prime bank securities?and?digital coin offerings.?

The flexibility of the SEC’s statutory weaponry has always been its hallmark.??As renowned SEC scholar and Georgetown Law School professor(and former SEC staffer) Donald Langevoort wrote way back in 1993, Rule 10b-5?is an adaptive organism?– and it works.?Along those same lines, in 1996, William McLucas, the SEC enforcement director at the time, co-authored an article entitled, “Common Sense Flexibility and Enforcement of the Federal Securities Laws,” explaining how enforcement programs such as insider trading; foreign payments; municipal bond fraud and so many others grew out of the?intentionally?flexible SEC anti-fraud provisions.

Later, in 1998, when?I was named Chief?of the?SEC’s Office of Internet Enforcement, I co-authored an article entitled,?“The SEC’s Statutory Weaponry to Combat Internet Fraud,”?reiterating McLucas’s thesis in the context of the SEC’s Internet program.?In our article, we cited the same adaptive capacity extolled by Langevoort and championed by McLucas (and the?legendary?Stanley Sporkin?before him).

Who Does SEC Registration Benefit?

The resistance of cryptocurrency companies to register their investment products is not at all in the best interest of their customers. SEC registration of cryptocurrency lending programs would mean that the SEC, an independent and impartial 3rd?party, with only investor protection in mind, would ensure the fair, transparent and accurate depiction of all relevant information.?

The SEC would not render judgment as to the merits of the programs, but rather the SEC would police the candor, fulsomeness and clarity of its representations, to ensure that potential purchasers can make informed investment decisions.?While DeFi platforms might want to avoid the costly, exhausting and cumbersome regulatory burdens of registration, it is hard to imagine any investor objecting. SEC registration would clearly render these DeFi platforms more transparent, candid and trustworthy; keep their sales and marketing forces honest; and enforce a compliance regime designed to prevent fraud, chicanery and carelessness relating to investor funds.

Consider the legion of Celsius investors in its cryptocurrency lending program. According to the Texas filing related to Celsius:

• As of September 3, 2021, the Celsius Network claims it has more than $24,000,000,000 in assets under management, more than 1,000,000 community members, and more than $8,200,000,000 in loans processed;
• As of August 18, 2021, the Celsius Network had 348,158 active users worldwide invested in Celsius Earn Interest-Bearing Accounts with global assets under management exceeding $12,500,000,000. As of the same date, the Celsius Network had 139,054 active users in the United States invested in Celsius Earn Interest-Bearing Accounts with United States-based assets under management exceeding $7,000,000,000; and
• As of June 9, 2021, the Celsius Network has more than $344,000,000 in assets under management from more than 9,000 Texas residents and businesses.

How on Earth is giving these Celsius investors the added protection of SEC registration a terrible thing?

Looking Ahead

Advocating for SEC registration of crypto-related investment products does not mean being anti-blockchain. The two philosophies are too often mistakenly (and sometimes even maliciously) conflated.?

The growing and fanatical legion of cryptocurrency promoters will undoubtedly argue that those who seek to register investments involving cryptocurrencies in the U.S. need to “get educated” and “do the research” to understand cryptocurrencies.

Crypto-promoters in particular can spend hours pontificating about how cryptocurrencies will benefit U.S. citizens, such as: transforming the way U.S. businesses conduct financial transactions; rendering U.S. use of energy, water and any other raw material more efficient, more transparent, more reliable and less costly; instantaneously verifying transactions, eliminating significant costs, uncertainty and fraud; and will in general, dramatically improve the way we all carry out our daily lives.?

But these promoters have got it all wrong. Yes, the blockchain technology on which cryptocurrencies are based may turn out to be the most exciting, disruptive, transformative and efficiency enhancing breakthrough since sliced bread.?

But just because some mythical engineer has discovered a potentially revolutionary manner to engage in and verify commercial transactions (e.g. replacing a traditional corporate entry recorded in an intermediary institution’s centralized ledger with a virtual entry recorded on a blockchain’s decentralized distributed ledger), it does not mean that crypto-related investment products are somehow exempt from regulatory oversight.?

In the end, no matter how innovative, exciting, and technologically advanced, the mere fact that an investment is tied to a digital asset, replete with the usual blockchain technobabble, does not somehow exempt that investment product from SEC registration.?

Indeed, for any a crypto-related investment that meets the definition of an investment contract, note, or other type of security, there are only three SEC-related possibilities: That product is either SEC registered; SEC statutorily exempt; or 100% unlawful.?Period. End of story.

Along these lines, my message to DeFi or other digital trading platforms hawking unregistered cryptocurrency investment programs is clear and concise:?Stop marketing and selling unregistered securities; lawyer-up; and brace for an SEC enforcement onslaught.?Otherwise, fail not at your peril.?

*John Reed Stark?is president of?John?Reed Stark Consulting LLC, a data breach response and digital compliance firm. Formerly, Mr. Stark served for almost 20 years in the Enforcement Division of the U.S. Securities and Exchange Commission, the last?11 of which?as Chief of its Office of Internet Enforcement. He currently teaches a?cyber-law course?as a Senior Lecturing Fellow at Duke Law School.?Mr. Stark also worked?for 15 years as an Adjunct Professor of Law at the Georgetown University Law Center, where he taught several courses on the juxtaposition of law, technology and crime, and for five years as managing director of global data breach response firm, Stroz Friedberg, including three years heading its Washington, D.C. office. Mr. Stark is the author of "The Cybersecurity Due Diligence Handbook."