Gary Gensler comments on the SEC’s role in FinTech

Samuel L. Jackson’s character Jules Winnfield in the Quentin Tarantino classic, Pulp Fictionfamously described himself as the “righteous man.”¹ SEC Chairman Gensler is seen by some as the FinTech version of the righteous man. In a recent speech,² Gensler quoted the first chairman of the SEC, Joseph Kennedy³ who noted: “No honest business need fear the SEC.”⁴ Unfortunately, Gensler failed to note that, as the SEC often explains, whether a party has violated securities laws depends on a fact and circumstances analysis. Accordingly, whether a party must fear the SEC will also depend on the facts and circumstances. Chairman Gensler also failed to mention the other missions of the SEC and to acknowledge the important role of self-regulation.

Self-regulation

In his speech, Gensler discussed some of the laudable goals of the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act, and the Investment Advisers Act of 1940. He noted that the laws focused on providing public disclosure and protection. not only when a security is first issued, but also continuously when the security is traded in the secondary markets. Chairman Gensler failed to mention the SEC’s other responsibilities – to promote fair, orderly and efficient markets, and to facilitate capital formation. He also failed to mention that when Congress passed the securities laws, it gave certain entities self-regulatory power (self-regulatory organizations, or SROs) and left oversight responsibility for them to the SEC.

Under this system, broker-dealers, exchange members and listed firms and others are supervised or regulated, to some extent, by a number of SROs. Self-regulation is one of the hallmarks of securities regulation in the United States. Self-regulation has been an important part of the securities markets for over 200 years. Self-regulation was incorporated into the securities laws in the 1930s. These laws rely on self-regulation through exchanges and regulation of broker-dealers. The system of self-regulation in the US securities markets has remained strong and is based on legal acceptance and respect for the system of free enterprise.

Proponents of self-regulation note the benefits of a system that places responsibility for designing and enforcing regulations in the hands of the regulated. The system is in accordance with the principles of free market enterprise. This approach relies on the effectiveness of allowing the participants, who are industry experts, to create rules that reflect the industry’s issues, reducing the regulatory burden on market participants. Self-regulation promotes flexibility and allows the industry to respond to market developments and promote innovation. As Adam Smith noted, the self-interest of participants in a capitalist system allows the invisible hand to operate.⁵ Unfortunately, Chairman Gensler seems less committed to the invisible hand than Adam Smith and more committed to the righteous man’s way.

Digital assets⁶

Like Jules in Pulp Fiction, Chairman Gensler is without a doubt in the right in his chosen path. Gensler noted:

Of the nearly 10,000 tokens in the crypto market… the vast majority are securities. The offering and sale of these thousands of crypto security tokens is covered by the securities laws. Some tokens may not meet the definition of a security – what I will call crypto-non-security tokens. These probably represent only a small number of tokensalthough they may represent a significant portion of the crypto market’s overall value.⁷

Gensler confirmed his commitment to an expansive reading of what constitutes a security. Quoting Supreme Court Justice Thurgood Marshall, Gensler noted, “Congress painted the definition of a security ‘with a broad brush’.”⁸ The chairman stated, “the investment public buys or sells crypto-security tokens because they expect profits from the efforts of others in a common enterprise.”⁹ Gensler reminded the audience that his predecessor Jay Clayton had also recognized “most crypto tokens are investment contracts under the Howey test.” ¹⁰

Guidance? We do not need any additional guidance

Gensler dismissed calls for additional guidance from the FinTech community, noting that over the past five years the SEC has “spoken with a pretty clear voice” about whether digital assets are securities “through the DAO report, the Munchee order and dozens of enforcement actions.”¹¹ As Gensler put it, “[n]Liking the message is not the same as not receiving it.”¹² Gensler noted that:

It’s not about whether you created a legal entity like a nonprofit and funded it with tokens. It’s not whether you depend on open source software or can use a token in a smart contract… [I]Investors deserve disclosure to help them sort between the investments they think will prosper and those they think will flounder. Investors deserve to be protected from fraud and manipulation. The law requires these protections.^{1. 3}

Gensler informed the public that he has asked SEC staff to work directly with entrepreneurs to register digital assets as securities subject to regulation.

The righteous man has no respect for wicked lawyers

Like the righteous man, Chairman Gensler has no respect for lawyers who guide their clients down the path of evil. Gensler once again cautioned lawyers advising the FinTech community on token projects. He noted that if they advise clients who operate as “dispersed, unidentified group of individuals in an ‘ecosystem’ … The public deserves the same protection from your clients as they do with other issuers of securities. Other issuers in our capital markets also deserve to compete on fair terms.”¹⁴

Stable coins

Chairman Gensler believes that no digital assets are potentially outside the scope of the SEC’s jurisdiction. He noted that “so-called stablecoins …have features similar to and potentially competitive with money market funds, other securitiesand bank deposits, and raises important policy questions.”¹⁵ Referring to the work of the President’s Task Force on Stablecoins,¹⁶ Gensler reiterated his focus on appropriate “security and soundness protections, investor protections and protections against illegal activity.” Gensler noted:

depending on the design of the stablecoin, “such as if[] instruments pay interest, directly or indirectly, through affiliates or otherwise; what mechanisms are used to maintain value; or how tokens are offered, sold and used within the crypto ecosystem, they may be shares of a money market fund or another type of security.¹⁷

He warned that if stablecoins are securities, they must be registered and provide important investor protection.

Regulation for all

Chairman Gensler also addressed the regulation of intermediaries who facilitate transactions in digital assets that are securities.¹⁸ Gensler noted whether they “call themselves centralized or decentralized (e.g. DeFi)”, they are “often a mix of services that are typically separated from each other in the rest of the securities markets: exchange functions, broker-dealer functions, custody and clearing functions, and lending functions .”¹⁹ He warned the audience that “platforms [that] match orders i [digital assets] of multiple buyers and sellers using established non-discretionary methods…” is an exchange.²⁰

Gensler noted that if digital asset intermediaries engage in transactions in digital assets on behalf of others, they are brokers.²¹ If they are in the business of buying and selling digital assets on their own account, Gensler indicated they would be dealers.²² Finally, Chairman Gensler warned about digital asset intermediaries that provide lending functions for returns, offer and sell securities and are subject to the SEC’s jurisdiction.

Conclusion

Gensler concluded, “Investors, issuers and our overall economy have benefited from these securities laws and the SEC’s involvement for nearly 90 years.”²³ He recognized the public benefits investors receive from disclosures and related protections about a project’s prospects and operations. We urge the Chairman to focus on the important role of self-regulation embodied in the securities laws as he and the SEC staff consider how best to carry out the SEC’s threefold mission—to protect investors, promote fair, orderly efficient markets, and facilitate capital formation. We agree with the chairman that the public benefits from intermediaries being registered and supervised. However, self-regulatory organizations can and must play an important role in the regulation of digital assets.

^FOOTNOTES

¹ “The path of the righteous is marked on every side by the injustices of the tyranny of the selfish and wicked people. Blessed is he who, in the name of charity and good will, shepherds the weak through the valley of darkness, for he is truly his brother’s keeper and finder of lost children. And I will strike down upon you with great vengeance and furious wrath those who seek to poison and destroy my brethren. And you shall know that I am the Lord when I bring my vengeance upon you.” Pulp Fiction (1994).

² Gensler, G., Kennedy and Crypto (Sept. 8, 2022) (hereafter “Kennedy and Crypto”), available here.

³ Chairman Gensler failed to note in his speech that when President Franklin Delano Roosevelt was asked why he had chosen “such a scoundrel” as Joseph Kennedy to serve as one of the first SEC commissioners, the President replied “‘Takes one to capture one.’ “Rather, Dan and Isaacson, Walter, People of the century (1999), on page 133.

⁴ Kennedy and Crypto (quoting TIME Magazine“Reform & Realism” (22 July 1935)), available here.

⁵ Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations5th edition (1904).

⁶ For the purposes of this Client Alert, we use the terms “digital asset” in the same manner as the SEC to refer to “an asset that is issued and transferred using distributed ledger or blockchain technology.” Statement on the Issuance and Trading of Securities in Digital Assets, SEC Division of Corporate Finance, Division of Investment Management, and Division of Trading and Markets (Nov. 16, 2018), available here. As the SEC has noted, digital assets include, but are not limited to, virtual currencies, coins, and tokens. ID. A digital asset may, under certain circumstances, be considered a security under federal securities laws. Although not defined in the securities laws, the SEC often refers to digital assets that are securities as “digital assets”. ID.

⁷ Kennedy and Crypto. (Emphasis added.)

⁸ Kennedy and Crypto (quoting Reves v. Ernst & Young494 US 56, 60-61 (1990)).

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^{1. 3} ID.

¹⁴ ID. (Emphasis added.)

¹⁵ ID. (Emphasis added.)

¹⁶ (Emphasis added.) The President’s Task Force on Financial Markets, the Federal Depository Insurance Corporation and the Office of the Comptroller of the Currency, “Report on Stablecoins” (Nov. 2021), available here.

¹⁷ ID. (Emphasis added.)

¹⁸ ID. (citing Gensler, G., Prepared Remarks On Crypto Markets at Penn Law Capital Markets Association Annual Conference (April 4, 2022), available here.

¹⁹ ID. Authors of this alert warned readers in early 2018 that operators of digital asset trading platforms may meet the definition of an exchange or a broker-dealer and will be required to register with the SEC. Levin, et al. al., Betting Blockhain will change everything (2018) pages 187-212; available here.

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²³ ID.