Over the last two Administrations, successive chairmen of the Securities and Exchange Commission (SEC), from both political parties, have led the agency through an erratic and confusing approach to regulating cryptocurrencies. What both chairmen had in common was a decision to not use rulemaking and public engagement to write a clear playbook for market participants, but to aim discretionary lawsuits at specific crypto companies and crypto trading exchanges to regulate the market instead.
Unfortunately, one of the SEC’s highest profile crypto lawsuits has backfired by pulling back the curtain to show several officials ignoring the law and apparent conflicts of interest as they picked winners and losers in the nascent industry.
Last month, Ripple Labs notched a landmark legal victory against a December 2020 SEC enforcement action where the agency alleged the cryptocurrency XRP qualifies as an investment contract in Ripple and that all sales, including on the secondary markets, are unregistered securities. Judge Analisa Torres ruled that only early institutional sales of the XRP token that were specifically packaged as investment contracts fall under the SEC’s jurisdiction.
The legal significance of this distinction is potentially enormous for the $1 trillion crypto industry, as SEC Chairman Gary Gensler has made the agency’s fight against XRP a linchpin of its regulatory efforts against cryptocurrencies. The SEC is appealing the ruling but, according to some legal scholars, faces tough odds in a new context of appellate courts pushing back on federal agencies that go outside the authority that Congress has explicitly given them as the demise of the Chevron Doctrine may be at hand. Torres’ strict reading of securities law will make the SEC’s litigation efforts of crypto more difficult to execute.
The SEC’s overreach with its crypto litigation did not begin with Gensler: The Ripple case was filed by his predecessor, Republican Jay Clayton, on his last day in office, voting with the Commission’s two Democrats to file it before leaving the building for good.
The discovery process in the Ripple lawsuit revealed chaotic and confused internal discussions in the agency concerning crypto. Internal SEC emails and documents shed light on the backstory leading up to then-Director of Corporation Finance William Hinman’s [read my previous article on him here] speech on crypto at the 2018 Yahoo Finance conference in which he seemed to be picking a winner in the crypto market when he said “we believe that offers and sales” of “sufficiently decentralized” tokens like Ethereum’s native cryptocurrency, ether, “are not securities transactions.”
The SEC did not want those emails made public, and fought to keep Mr. Hinman’s emails secret, going so far that Magistrate Judge Sarah Netburn slammed the agency for “adopting its litigation positions ….. not out of a faithful allegiance to the law.”
Those emails, along with troves of others obtained separately by the good governance organization Empower Oversight, revealed that Mr. Hinman went ahead with his 2018 speech about Ethereum despite warnings from the SEC’s Office of General Counsel.
The emails also suggest that Joseph Lubin, the billionaire co-founder of Ethereum, influenced “the ether speech:” Lubin reached out to Hinman months before the speech, met several times with him and SEC staff, and made a presentation that jibes with much of Hinman’s rationale about the “decentralization” of networks articulated in his speech.
After extensive consultations with Lubin and ConsenSys, Hinman drafted “the ether speech” and insisted it should reach the conclusion that “we shouldn’t be regulating ether.” But the SEC Office of General Counsel warned Hinman that the arguments Luban made were not aligned with securities law, creating a “regulatory gap” that would confuse the markets. He was urged to drop the reference to Ethereum and speak in greater generalities. Hinman ignored this advice.
After Hinman gave the speech, the conference posted ether’s surging real time price on crypto exchanges across a large display screen for the audience. “Whoa!”, exclaimed Yahoo Finance host Andy Serwar, jokingly adding: “This is why insider trading is against the law, people!”
The SEC emails also show that the agency frequently reminded Hinman of his potential conflicts because of the millions of dollars in payments he was still receiving as a retired profit-sharing partner at the Wall Street law firm Simpson, Thacher and Bartlett (STB). (Hinman “unretired” immediately after leaving his position at the SEC and returned to STB.) Just like he ignored the SEC general counsel about giving “the ether speech,” Hinman appeared to have ignored the ethics counsel about avoiding these conflicts of interest.
Taken together, the emails suggest a pattern of flouting the law regarding conflicts of interest.The question remains as to why Clayton put such a consequential lawsuit on the final meeting agenda of his chairmanship for a vote, and why did the Republican chair vote with the two Democratic commissioners to approve it?
The choice to regulate cryptocurrencies via lawsuits has been extremely problematic for most of the players in the industry, although this may be the intent of doing it this way, as Gensler appears to not be a fan of the industry. The fact that this process has not only hindered the industry but appears to have been influenced by conflicts of interest is a good reason for the SEC to reconsider its strategy.
