In part 2 of or Digital Assets mini-series, Steve Gannon and Ed Wegener continue their discussion of the Regulatory actions that are occurring around digital assets, including cases that the SEC is bringing, and where they see these cases going.
Oyster Consulting has the expertise, experience and licensed professionals you need, all under one roof. Follow us on LinkedIn to take advantage of our industry insights or subscribe to our monthly newsletter.
Does your firm need help now? Contact us today!
In part 2 of or Digital Assets mini-series, Steve Gannon and Ed Wegener continue their discussion of the Regulatory actions that are occurring around digital assets, including cases that the SEC is bringing, and where they see these cases going.
Oyster Consulting has the expertise, experience and licensed professionals you need, all under one roof. Follow us on LinkedIn to take advantage of our industry insights or subscribe to our monthly newsletter.
Does your firm need help now? Contact us today!
Libby Hall: Thank you for joining us for the second podcast in our latest series talking about cryptocurrencies and digital assets. I'm Libby Hall, Director of Communications for Oyster Consulting. In our previous podcast, Oyster’s Ed Wegner and Steve Gannon, a partner at the law firm of Davis Wright Tremaine, walked through the evolution of the crypto asset class. Today, Steve and Ed discuss the regulatory actions that are occurring around digital assets, including cases that the SEC is bringing and where they see these cases going. You can learn more about Ed and Steve by visiting our website@oysterllc.com. Let's pick up where we left off.
Ed Wegener: The SEC has been extremely aggressive in asserting their jurisdiction, as of late. So I wonder if you can talk about the evolution that has happened in terms of the regulation of these and the cases that the SEC are bringing and where you see these cases going.
Steve Gannon: Sure. Well, I'm not going to go too far in predicting what results are going to be. I have got to leave that to the courts. But I will say this, let's start from the beginning with two propositions. One is the standard SEC definition of a security as developed in the famous Howey case - the sale of portions of orange groves that were going to be managed by the company, the promoter that was selling those particular lots. So the classic is, it has to be an investment of money, number one. Second prong is in a common enterprise, and then third is with profits to be made. Primarily, the word actually is solely, but the courts have softened it primarily from the efforts of others. So that definition has been durable throughout the years.
The court has said, not only about the securities laws in general, but about the Howey test in particular, it should be read broadly to encompass all the different kind of schemes and creative ideas that individuals and promoters can come up with in order, quite frankly, to avoid the regulation or the application of the securities laws to their particular investment scheme. So, it is read broadly. However, then you get into the specific use cases. And now we're very close to the nub of what the real difficult issue can be around what's called regulation by enforcement. A phrase that I'm guessing that many of your listeners, if not all of you, have heard before. When you are not regulating by rules, which apply in the same way across the board to everybody, and you're regulating by enforcement, what you're trying to do is do things on a case by case basis.
And that can be in some instances okay, or successful. There were some recent, a few years back, commission sweeps done in connection with 12b1 fees. The commission had tried for a long, long time to pass rules that satisfied everybody in connection with 12b1 fees, and they couldn't quite get there. And so in essence, they changed the law by brute force and awkwardness and practicality. They didn't actually amend the rule, but they did bring a whole lot of enforcement actions, all of which were settled in connection with additional disclosures around the payment of those kinds of fees to advisors. So that, as a practical matter, was a successful use of regulation by enforcement from the commission's perspective. But it also was talking about basically the same thing. It was the same fee with very similar disclosures from each and every advisor here.
The nature and quality of the asset differs from promoter to promoter or sponsor to sponsor. And so that makes it harder. So what exactly is an investment of money? If I buy a product that is going to help me generate some sort of digital asset reward is my purchase of that product an investment of money? Or have I just bought a product? I mean I can buy an iPhone with the belief and the hope that I'm going to be able to use that iPhone in a way that I'm going to generate some games or something else, or I'm going to make a lot of money. Is the sale of the iPhone to me a security? Okay, well, I'm not sure that's a bit of a head scratcher, probably not. Now, the SEC would say, well, that's not what we're talking about in this instance.
So let's go to commonality. What actually is commonality? Are all of the people who are purchasers of these digital assets treated in the same way, are all of the digital assets? And this is the case, for example, in the ripple matter, which we've alluded to briefly. Ripple, very well known, provider of digital asset services and tokens. They have a token called XRP that's used globally in order to facilitate payments, mostly institutional payments, that has a heck of a lot of utility. The SEC would say, XRP is a security, and it's a common interest because the actions of Ripple have to do with the value of XRP, that is, the sponsor itself is helping drive the value of the coin. So there's commonality there, and that everybody who owns XRP is treated essentially in the same way.
What if you have a situation where there's no connection between the sponsor and what happens to the value of the reward itself? So, for example, in a typical manner the 10th circuit, for example, has a test that says that securities are supposed to have the characteristics of a stock. So think about that for a moment. I buy a share of stock in the Ed Wegner company, and our friend, Bob, buys another share of stock in the Ed Wagner company. He and I are going to be treated exactly the same. We're going to get the same dividends. The value is going to go up or down depending on the success of the Ed Wagner enterprise. That's not necessarily the case with Ripple and the value of XRP.
They might be connected, they might not be connected if there's no connection at all. And if there's no connection between how different purchasers of XRP might benefit because there may be certain actions that are required of different XRP holders, then it's a little bit difficult to say that there's commonality there. Now, the SEC have been hanging tough on this. They'll say that there's commonality as long as there's a connection. And then from the efforts of others, a lot of digital assets, you purchase them, and the market is going to do what the market's going to do, and you're going to benefit without any action that you need to take at all. But in some cases, the actual tokens have utility based on what you as the token owner do with that token. And you might do something that is the same or different than your neighbor.
So is it really, if you have an expectation of profit, how much does it relate to the efforts of others? The efforts of others certainly went into generating the token, but do they have anything to do with actually driving value for that token? So, it becomes very, very complex. And as you can see, the results may differ depending on what actually the token is and what it does, which gets us to Wahi, which is the case that, and folks may remember this, the Wahi brothers, along with a couple of friends, worked at Coinbase and they wound up trading ahead of Coinbase and trading ahead of the listing, or not listing of different tokens or coins on the Coinbase exchange. And there happened to be historically a relationship between the value of what happened to the tokens once they either got listed or didn't get listed on Coinbase.
So if they got listed, typically, almost always, they went up in value. If they didn't get listed, they were going to go down in value. These folks worked at Coinbase, they knew what coins were going to be listed or weren't going to be listed, and they would go out and buy them. All of that sounds pretty not right and kind of fraudulent. And in fact, a couple of the guys fled to India, but a couple of them are in the US and they, in fact, pled guilty to wire fraud. However, whether or not what it is they were actually buying and selling were securities is pretty important because if they're not securities, the SEC doesn't have any jurisdiction. So the Wahi’s have pled guilty to the crime of wire fraud. But what they haven't done is settle with the SEC.
The SEC came in and sued them and said, well, you pled guilty. And so these are securities, and I think they believe the Wahi brothers are going to settle. Turns out the Wahi brothers haven't settled. The Wahi brothers are saying There were nine tokens that you guys charged us with. Those nine tokens are not securities. And Coinbase takes the view that no tokens, zero, that are ever listed on their exchange are securities. And they're digging in fairly hard on that. So that's going to be an incredibly interesting matter that when you think about it, is going to have to be litigated, coin by coin, by coin, because they're all going to have different characteristics, and those characteristics are going to drive whether or not they were securities. Just like, for example, the sale of the contract for the management of the orange groves and the payment of the same share of profits to everybody. Supreme Court said that was a contract, but the oranges weren't securities. It was a combination of things.
Ed Wegener: Yes. You know. One question I have just in thinking about what everyone has said, all the regulators have said that Bitcoin is a commodity, and then there's this issue with the Ripple case. Where's the primary difference there? Is it the efforts of others issue? In terms of what the SEC is looking at, where do you see the differences?
Steve Gannon: Focusing on both, I'd say it's both commonality and efforts of others. And if you look at how the SEC has dealt with it, their theories have been reasonably flexible and they've had some success with this, because what they're saying is yes, this is indeed a new type of thing, but the same principles broadly apply. So, for example, what they would say, and you've seen this in both the KIK case, and also in the library case, library being LBRY, which were two digital asset projects where the court held, yes, these are securities. And what the SEC argued is, you can't look at any individual characteristic by itself and say, okay, it has this characteristic, it has utility and therefore it's not a security.
What the SEC would say is, you have got to look at the whole ecosystem because these things were not planned, like people planned to if they issue shares of stock. But nonetheless, they are investments which would have no value unless there were some sort of commonality. You need a market to develop in some way for these things to have value. So there's your common enterprise, and then the developers, if they're developing this to have utility, the token itself is going to increase in value the more utility it has. So what they say is, pull the camera back, don't be too narrowly focused on one or two characteristics. Pull the camera back, look at the whole thing. And if the ecosystem as a whole looks like one, it's a contract, a contract for the purchaser sale of a particular token or a coin. Two, there are a lot of people getting together to pool their funds to help fund and raise money so that the promoters can develop this system. And then three, as they develop more utility, the value of the coin tends to go up. What the SEC would say is, that's it. I've got my three elements, I'm good to go. By the way, read the cases for yourselves. I haven't tried to state the holdings or even the facts precisely, but roughly that's where the SEC is headed. There are bones you can pick with each one of those arguments, and people are going to pick bones going forward on each and every case
Ed Wegener: In thinking about pulling that camera back and taking the wider lens, the nature of these assets can change over time too. So, when you talk about something starting out early on where the sponsors are very involved in the development of the tokens and capitals being raised, that can change over time. And is there an appetite for eventually saying, well, something that started out as a security all of a sudden becomes something other than a security,
Steve Gannon: What you say is true. When you start out, if you are a security, you need to be registered. But once you get to this point, when the project becomes sufficiently decentralized, it no longer has the characteristics of a security anymore. And therefore you can essentially end your registration and you will go forward as essentially an unregistered entity. I think that that would be essentially the creation of a regulatory sandbox. And we don't have one of those, unfortunately. We should, I think if there was one and there was a period of time where the SEC could sort of observe and test and figure out what the point was where they could finally say, okay, now we can cut the cord, and you can go forward without registration and without the oversight that the registration implies, that would be fine.
The fear that the industry has is once they get in, it'll be like Hotel California. You can check out any time you want. You can just never leave the SEC once you're in there. We should have regulatory cooperation with clear lines of when you can leave the regulatory world, because there are certain projects that are so decentralized that nobody could reasonably say Bitcoin, for example, is a security. Where would you go? Let's, you and I, Ed, get in a car and go to Bitcoin headquarters. We'd be driving around for a long time. That's a crying need, but it doesn't exist unfortunately.
Ed Wegener: So are there other significant cases that are out there, that you think will be impactful to the direction of how this regulatory landscape is going to develop?
Steve Gannon: Oh, sure. There's already been impactful cases like the Kraken staking suit has everybody that engages in staking looking at their products, and do they have the same characteristics that Kraken did? Now, Kraken’s staking was different from some of these other products, and they have a global staking program. And so frankly, closing it down in the United States was not that big a deal for them. This was more of an event than an SEC action, but the Terena failure of risk controls was a total absence of risk controls. And that really put the industry on its back foot. There may be some algorithmic stable coins that are traded on decentralized exchanges, but not many unfortunately. UST, which was the quote unquote stable coin, from the Terra Luna project, wasn't actually a stablecoin.
It was an algorithmic stablecoin. And once the algorithm failed, it was curtains and by the way, you would think that they would've stress tested all an algorithm is as a model. You can trust test models. You'd think that they would've done that. So far, there's been no evidence that they ever did which is an abject failure of risk controls and risk frameworks and risk appetites. Block five was another one where, and there are others. Genesis and Gemini, the same thing, where lending programs were put in place that while they worked actually were generating very attractive returns. They were essentially, I don't want to say it, shut down. Their product was changed, and they had to register and then unfortunately they had exposure to FTX. And so that took them down.
So many of the very big projects, in terms of how regulation by enforcement is going to go forward. There's also going to be regulation by bankruptcy. Because what's going to be happening in the Gemini case, in the Genesis case, in FTX, in block file, which is still in bankruptcy, and Voyager and Celsius, I don't think, I think 3 hours was Singapore. I'm not even sure they're in any kind of bankruptcy. But all of those have different bankruptcy judges that are going to have to think about what a bankruptcy judge is supposed to do, gather the assets, value the assets, and distribute the assets to whoever the legitimate creditors are. In doing that, you've got to make some judgements about are they securities. Are they something else? Whose claim is superior to what other person's claim might be. And that's going to have a lot to do with the characteristics of the asset itself. So there's going to be a secondary market, if you will, of law coming out of these bankruptcy courts. That's going to impact, how these assets are dealt with going forward. The SEC is being very aggressive in filing lawsuits and sending notices out. There's literally activity all over the country, some of which is getting attention, some of which is not. But one of the things that I would note, is a brand new yesterday, I believe, and we're having this discussion on March 10th, the New York Attorney General filed litigation against an exchange called Coco. Ku coin is a Dutch digital asset exchange that among other things, allowed its customers to trade ether. And this memorandum of law and support of the petition that the New York Attorney General filed states that Ether is a security, and Ether has never been, no regulator has ever claimed, that ether's a security. So that's something that is new, and the new developments keep coming. And of course, FTX is the granddaddy of them all. There is a lot of litigation about that. What exactly happened how did the fraud happen? Who did know about the fraud, should have known about the fraud, et cetera. And you can see again, I think it was the 8th of March, could have been the 7th, when Silver Gate Bank, which had customers that did a lot of business with FTX and FTX was a customer of theirs as well.
Silver Gate Bank agreed to an orderly wind down of itself as a bank. It's going to sell its remaining deposits and loan portfolio, and it has a certain amount of cash that it can dividend up to its holding company. But that is yet another casualty of the FTX fiasco. And it is going to be a big piece of what's going forward with the digital asset community, because it's going to be very difficult for projects to exist if they can't get access to banking services, because they need to send wires, they need to have secure places to hold their cash deposits. It's that kind of a weird step backward as if we're dealing with cannabis banking again. So it's going to be a while before we work our way out of the regulatory woods.
Ed Wegener:
Well, and I think that's what makes it so challenging for the industry is that as opposed to looking to see what the regulations say and the guidance coming out from the regulators, it's really waiting to see how these court cases resolve. And these cases, like you had mentioned, are with the SEC or with the bankruptcy courts and things, and it's really kind of shaping up in a very fragmented manner.
Steve Gannon: Right. Well, I do want to emphasize this though, that entities that have size and that have capacity to build compliant risk systems are continuing to double down into this space. And they'll be thriving. So, you know, you can take a trading venue like Stonex, that would be one, Fidelity is another. They're continuing to invest in this space. Bank of America has projects, Morgan has projects, Citi has projects. Bank of New York Mellon is using blockchain and digital assets quite a bit. And this was a headline a couple of years ago that JP Morgan had developed its own internal digital asset called a JPM coin that would simply help them transfer funds over a blockchain instead of having to use wires, which for a global bank like that makes all the sense in the world.
So I would say that there still is going to be an appetite for this among those entities that can build compliant systems around it. For those that can't, it's going to be a little bit tough. Iif you are a project sponsor and your project is off the ground and it's running and you still haven't really spent a lot of time and attention on what you're going to do about monitoring KYC and a ML, then you better get busy like real soon.
Ed Wegener: We're going to be continuing this discussion and future podcasts as these issues develop. Really appreciate you joining us and hope you can join us again. Thanks, Steve.
Libby Hall: Thanks everyone for listening. If you'd like to learn more about our experts and how Oyster can help your firm, visit our website @oysterllc.com. And if you like what you heard today, follow us on whatever platform you listen to and give us a review. Reviews make it easier for people to find us. Have a great day.