The Securities and Exchange Commission intends to become “the primary cryptocurrency cop,” but SEC Chair Gary Gensler’s position that cryptocurrencies are regulated under securities law depends on the outcome of the SEC’s enforcement suit against Ripple Labs Inc.
State securities regulators, on the other hand, have already been active in policing cryptocurrency-related products without depending on tokens being securities. That’s because state enforcement treats cryptocurrency as an investment, or value given, for a financial product that can be categorized as a security. This increase in state activity will likely continue into 2023.
If the Southern District of New York finds that Ripple’s XRP token is not a security under the Supreme Court’s “Howey test"—which defines a “security” as an investment of money in a common enterprise with the expectation of profit solely from the efforts of others—the SEC’s regulatory agenda will be curtailed. For example, if XRP is not a security, Chairman Gensler’s contention that proof-of-stake cryptocurrencies are securities may also fall.
A Busy—and Productive—Year for State Regulators
Beyond the industry-shaking pronouncements of the SEC, 2022 has been a busy year for state securities enforcement against digital asset instruments. From Jan. 1 through Oct. 28, state regulators issued 109 securities enforcement orders related to cryptocurrency or digital assets (not including money transmission or consumer finance regulation without a securities law violation). That total more than doubles the number of state enforcement actions in all of 2021.
Of the statutory violations set out in the enforcement actions, illegal sale of unregistered securities was alleged in 103 orders; fraud, misstatement, or material omission in the sale of securities were cited in 89 orders; and the organizations selling the crypto assets were cited as unlicensed broker-dealers 54 times.
Of the actions above, relatively few claimed that the crypto asset itself was a security. The actions that do make the claim have been over non-fungible tokens (NFTs), not cryptocurrencies. Frequent targets are NFTs that purportedly finance the development of “metaverse casinos.” The sellers of these NFTs claim to provide purchasers with a share of the profits of the casinos. The payment of money for later profit in a venture is almost exactly the definition of a security under the Howey test.
The misleadingly named metaverse casino Sand Vegas Casino Club (in actuality a Cypriot entity, with no connection to Las Vegas Sands Corp.) received cease and desist orders from Alabama, Kentucky, and Texas; the Republic of Georgia-based Slotie NFT also received cease and desist orders from Alabama, Kentucky, and Texas. A separate metaverse casino, Flamingo Casino Club, received enforcement orders from Alabama, Kentucky, New Jersey, Texas, and Wisconsin for essentially the same NFT scheme.
States Ignore Tokens, Find Securities in DeFi Accounts
For fungible cryptocurrency, states pursue a different strategy that puts crypto as the “investment” in an “investment contract"; the token purchases the security instead of being the security itself.
For example, Idaho excludes virtual currency from the definition of “security.” Yet in 2022, Idaho has engaged in enforcement actions against digital currency businesses Celsius Network Inc. and BlockFi Lending LLC despite the explicit exemption. In both actions, the unlicensed security was not the investors’ digital assets but rather the companies’ interest-earning accounts, into which investors deposited the assets.
Alabama enforcement actions against a cryptocurrency mining pool and a cryptocurrency trading platform didn’t directly charge the sellers with sale of unregistered securities—but the packaging of the cryptocurrency for deposit into a financial product was deemed a security, the sellers were deemed unregistered brokers, and their statements as to the value of the product were categorized as securities fraud.
How the States Are Handling BlockFi, Other Lenders
The approach described above, with cryptocurrency as value given for a security instead of the security itself, is best demonstrated by three multistate actions that make up the majority of the year-over-year increase in state enforcement: 39 state and District of Columbia actions against BlockFi Lending LLC, 11 state and District of Columbia actions against Voyager Digital Ltd., and eight state actions against Nexo Inc., each over essentially the same “decentralized finance” product.
BlockFi Lending—which was also the subject of an SEC enforcement action—faced a coordinated action by the North American Securities Administrators Association over its offering of “BlockFi Interest Accounts,” deposits of cryptocurrency that generated “interest.” The SEC and the individual states all treated the bank-like description of the BlockFi Interest Accounts as “investments,” even when the states didn’t completely agree on related securities violations.
Voyager Digital had a similar cryptocurrency lending scheme, called the “Voyager Earn” program, that paid interest on investors’ accounts. Given the similarity in overall function – customer deposits value, then gets return for use of that value – it is unsurprising that state regulators have found the product to be a security. Similarly, Nexo ran afoul of state securities regulators for its “Nexo Earn Interest Product,” where “investors” passively loaned cryptocurrency to Nexo in return for regular interest payments.
Actions by state regulators show no signs of slowing down. On the day after the actions against Nexo were issued, California’s Department of Financial Protection and Innovation issued orders against 11 “high-yield investment programs,” schemes where an investment of money is promised a guaranteed return—all of which bear similarity to the BlockFi, Voyager Digital, and Nexo crypto lending programs.
And in a filing in Voyager Digital’s bankruptcy proceeding, Texas objected to crypto exchange FTX’s offer to purchase Voyager Digital’s assets, based on allegations that FTX was also offering an interest-bearing cryptocurrency investment that violated Texas law. Texas’s investigation may expand in light of FTX’s Nov. 11 filing for Chapter 11 bankruptcy.
SEC Focus on Tokens as Securities
At the federal level, the SEC has pressed the case that any cryptocurrency it is enforcing over is also a security. Besides the Ripple Labs case over the XRP token, a Nov. 7 decision by the US District Court for the District of New Hampshire, SEC v. LBRY Inc., agreed with the SEC that LBRY’s cryptocurrency, the LBC token, claimed by its sellers to be a cryptocurrency, was actually a security.
“LBRY made it obvious to its investors that it would work diligently to develop [LBRY’s blockchain efforts] so that LBC would increase in value,” the court said. In other words, buying LBRY’s token was buying value related to the business, once again qualifying as a security under Howey.
XRP is intended as a payments token, and the SEC’s claims against Ripple Labs that XRP is a security are distinguishable from the LBRY case. But since XRP is not paying interest or dividends to its purchasers, regardless of the outcome of the Ripple Labs case, states will be able to continue under the “cryptocurrency as value” theory unless Congress intervenes. The proposed Lummis-Gillibrand Responsible Financial Innovation Act and the Digital Commodities Consumer Protection Act would both pose federal preemption issues, although neither is likely to pass in the 117th Congress, leaving the way clear for state enforcement efforts.
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