2023 Q1 SEC and Crypto | Ingram Yuzek Gainen Carroll & Bertolotti, LLP

Reopened comment period for proposed change to Exchange Act rule

On April 14, 2023, the SEC reopened the comment period for the amendments to 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 ample comments from the crypto industry on the planned expansion of the scope of the definition of “exchange”. These proposed changes are being closely watched because the expanded definition would make decentralized finance platforms/protocols (“DeFi”) a securities exchange subject to relevant securities laws without even including the term “DeFi” in the proposed changes. Some of the SEC’s significant changes include: (i) adding “communication protocol” as “an example of an established, non-discretionary method that an organization, association or group of persons may offer to bring together buyers and sellers of securities” and (ii) replace “orders” with “trading interest”. The SEC expressly indicated in its written summary that if a trading system (eg, 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 exemption under Rule 3b-16(b), such trading system shall then register as a regulated securities exchange and comply with applicable requirements or qualify as an exempt trading system.

The SEC also listed new questions to invite additional comments in this reopened comment period, while clarifying certain issues raised in the previous comment period (e.g., (i) the custody service is generally not relevant to the SEC’s exchange analysis and (ii) the trading system considered a securities exchange under the amended rule and seeking to operate as an ATS may register as a broker-dealer). What is worth watching at this stage, among other important questions, is whether and how the SEC will enforce the amended Exchange Act Rule 3b-16 if the amendment is adopted and applied to DeFi and the crypto industry. In general, DeFi’s operation will involve various parties that include code developers, DAO(s), smart contract(s), protocol validators, and issuers and/or holders of governance tokens. While regulators can certainly rely on existing legal theories to bring an enforcement action against the developers or members of a DAO (as shown in CFTC v. Ooki DAO), establishing that they involved the parties are “performing in concert“in”establish, maintain or provide a marketplace or facilities for bringing together buyers and sellers of securities” (which is one of the elements of a communications protocol’s securities exchange classification). The SEC has released some examples of the question above, suggesting:

(i) If there is a formal or informal agreement between the parties, the parties act in concert (for example, “if an entity agrees with another entity to combine aspects of each other’s marketplaces or facilities (eg order books, screen functions or matching engines) to bring together buyers and sellers of securities, both entities may be considered part of the group and thus a Exchange “);

(ii) The ability to provide or maintain a smart contract that brings together buyers and sellers of securities, and the fact that such smart contract is subsequently used for such a purpose, may make relevant parties part of an exchange (for example, “an organization deploys a smart contract that the organization cannot substantially change or control, but constitutes a marketplace for securities… that organization will be an exchange and will be responsible for compliance with federal securities laws for that marketplace“); and

(iii) Generally speaking, a service provider/provider offering services to a securities exchange (as deemed under the proposed amendment) is not considered a party responsible for compliance with relevant securities laws. In this regard, the deployer of an independent oracle that allows a DeFi platform (considered a securities exchange) to retrieve information about securities prices will not be considered a party that collectively manages the platform. (However, the SEC also indicated that the preceding decision would change if the service provider/supplier COULD exercise control or share control over the relevant platform.)

Having said all that, these issues may not be easy to resolve in real cases given the nature of DeFi, DAO and the parties involved in the operation. If the proposed change is codified into law, how the SEC will draw the line and how such a line will be tested in court will significantly alter the DeFi landscape.

Contribution-as-a-service and investment contract

In addition to the SEC’s regulation by enforcement as previously identified in the discussion of 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 which is considered by the SEC to be an investment contract (and thus constitutes a security according to the securities legislation). As Chairman Gensler puts it, staking-as-a-service means that investors unlock their tokens in the escrow of a service provider (eg an exchange) and help validate nodes/transactions in exchange for (financial) rewards. The first such decision was made in February 2023 in the SEC’s $30 million settlement with Kraken, where the regulator indicated in its complaint that Kraken’s pooling of investors’ tokens, the discretionary return determined by Kraken (but not by the underlying protocol that generates/determines) . the actual return) and other platform-specific arrangements constitute an offer and sale of an investment contract that is subject to registration requirements under securities laws. Shortly after the settlement, it is reported that the SEC is going after Coinbase for its betting products that may constitute an unregistered security.

While the SEC’s settlement with Kraken and potential actions against Coinbase does not mean a storm that will largely sweep away all types of staking models that provide returns to investors staking their tokens, it certainly signals how the SEC views staking-as-a-service, and such . view, in the context of striking, leads to various questions:

(i) A key fact cited by the SEC with respect to Kraken’s staking program is that the investors participating in the staking will lose possession and control of their crypto assets by transferring their assets to Kraken and thereby assuming the risks associated with the platform. But will the SEC reach a different conclusion (ie, an incentive program is not an offer of an investment contract) if such underlying fact is different? Also, in the context where the return to the staking investors is solely determined by the underlying protocols rather than the discretion of the platform managing the program, such “return” will still be seen as an “expectation of profit” (which is a necessary element of an investment contract) or will it be considered an algorithmic remuneration paid to the investors who have invested effort to validate data?

(ii) Regarding the necessary “reliance on the efforts of others” to enter into an investment contract, in the event that the platform making available an investment program provides only administrative, “purely ministerial” support, such an arrangement will still be considered to meet criteria for “others’ effort”? (The SEC has previously indicated in its Framework for “Investment Contract” Analysis of Digital Assets that ministerial support may weaken the finding of reliance on the efforts of others.) Additionally, how will the SEC draw the line for “ministerial support” ?

All of these questions and uncertainties have yet to be answered by the SEC (either through written statements or enforcement actions) and may be tested further in court. Regardless of how the SEC’s approach develops, there is no doubt that the road ahead for the crypto industry could be scarier than before.