SEC Crypto Woes: Judicial Criticism and a Critical Commissioner
The Securities and Exchange Commission has lost its battle to prevent Ripple Labs LLC from discovering internal agency communications related to a 2018 speech by then-Treasury Department Director William Hinman.
It lost some face, too, after the judge overseeing the case scolded the agency for litigation tactics she said unnecessarily complicated the issue of attorney-client privilege at the heart of the dispute.
Judge Sarah Netburn, of the US District Court for the Southern District of New York, called out the agency for argumentative “hypocrisy,” writing that its faltering arguments suggested that the SEC “adopted its litigation in furtherance of its desired goal, and not out” of a faithful allegiance to the law.”
Read more: Ripple Labs Wins Access to SEC Documents in XRP Crypto Fight
The SEC’s lawsuit alleges that Ripple, CEO Brad Garlinghouse and co-founder Chris Larsen recklessly participated in a scheme to distribute XRP without filing a registration statement.
In its previous attempts to resist discovery challenges, the agency argued that Hinman’s speech was not “relevant to the market’s understanding of how or whether the SEC will regulate cryptocurrency,” but then argued that Hinman “sought and obtained legal advice from SEC counsel in preparing his speech .”
In the speech, Hinman explained his view that Ether — a cryptocurrency that Ripple claims “shares characteristics that mirror” the labs’ competitor, XRP — was not a security, at least as it was.
Putting aside whether Ether may have qualified as a security during its previous fundraising effort, Hinman said that in his view, at least as of 2018, the Ethereum network was sufficiently decentralized that its “current offerings and sales of Ether are not securities transactions. “
Garlinghouse and Larsen also said the communications could show they were not reckless in failing to recognize sales of XRP as transactions for unregistered securities if agency officials reached the same conclusion.
Regulation by enforcement
The SEC has offered limited guidance on when digital tokens will be regulated as securities, and the “regulation-by-enforcement” approach it has opted for instead has drawn sharp criticism, including from its own commissioner,
The approach is “problematic,” Peirce told Bloomberg Law.
“There are a lot of projects out there and the agency has limited resources, so figuring out which ones to go after is kind of an arbitrary exercise,” she said.
If the agency really wants to improve things for the market, she said it would be “better to construct a set of rules, and then go after people who don’t follow it”.
Peirce also said that the regulation-by-enforcement approach was ineffective, to the extent that the industry must rely on fact-specific settlements to assess the regulatory risks of planned schemes.
The agency and the defendant organization “are going to solve it in a way that’s best for themselves,” and their “model may not be the best model for everyone to follow,” she said.
Legislative effort
Some people in the industry are “celebrating” a bipartisan proposal from the US Senate — the Responsible Financial Innovation Act, S. 4356, which would give more regulatory authority over crypto markets to the Commodity Futures Trading Commission — Peirce said.
Peirce attributed the enthusiasm for the proposal in part to disappointment with how the SEC has so far handled its oversight of the emerging market.
“Watching the SEC refuse over the past four years to engage productively with crypto users and developers has created feelings of disbelief at the SEC’s confusing, out-of-character approach to regulation,” she said in June 14 comments.
Peirce prepared the remarks for an event titled “Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?”
Despite Peirce’s frustration with a lack of clarity around the agency’s regulation of digital tokens as securities, she does not want the agency to rush the rulemaking process.
“As the commission rushes to write and implement myriad rules, many of which are outside our longstanding mandate, it sets up conditions that could disrupt markets,” she later said in a June 22 statement.
Information asymmetry
Peirce, who have proposed two iterations of a time-limited safe harbor for network developers. The last one was updated in April 2021, after she asked for industry input on the idea.
To qualify for the safe harbor, which will be available for three years, developers must comply with certain notice and disclosure requirements designed to reduce information asymmetry between buyers and sellers.
Under the Token Safe Harbor proposal 2.0, network developers will be required to submit an “exit report” at the end of the exemption period, providing either an analysis by outside counsel explaining that the network is decentralized and operational, or noting that tokens will be registered under the Securities Exchange Act of 1934.
Although Peirce’s proposal found its way into legislation proposed by Congressman Patrick McHenry (RN.C.) last fall as the Clarity for Digital Tokens Act of 2021, HR 5496, the idea of an exception approach has been slow to gain traction—that is until recently.
SEC Chairman Gary Gensler signaled in July that the agency may be able to exempt the crypto industry from some securities laws to help bring them into compliance.
Read more: The SEC is considering waiving some rules to regulate crypto, says Gensler
Peirce is a Trump appointee who has served as one of the agency’s five commissioners since 2018.
She was expressing her own views, and not necessarily those of the SEC or her fellow commissioners, when she spoke to Bloomberg Law, she said.
This feature was adapted from this week’s Bloomberg Law—Litigation newsletter. Bloomberg Law subscribers can register here.
