SEC Crypto Woes: Judicial Rebuke and a Critical Commissioner

The Securities and Exchange Commission has lost its fight to keep Ripple Labs LLC from discovering internal agency communications related to a 2018 speech by then-Director of the Division of Corporation Finance William Hinman.

It lost some face, too, after the judge overseeing the case scolded the agency for litigation tactics she said unnecessarily complicated the attorney-client privilege question at the heart of the dispute.

Judge Sarah Netburn, for the US District Court for the Southern District of New York, called the agency out for argumentative “hypocrisy,” writing that its vacillating arguments suggested the SEC was “adopting its litigation positions to further 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, its CEO Brad Garlinghouse, and its co-founder Chris Larsen recklessly participated in a scheme to distribute XRP without filing a registration statement.

In its earlier efforts to resist discovery challenges, the agency argued that Hinman’s speech wasn’t “relevant to the market’s understanding of how or whether the SEC will regulate cryptocurrency,” but then claimed that Hinman “sought and obtained legal advice from SEC counsel in drafting his speech.”

In the speech, Hinman explained his view that Ether—a cryptocurrency that Ripple argues “shared characteristics mirroring” the labs’ competitor, XRP—wasn’t a security, at least as it was then.

Setting aside whether Ether may have qualified as a security during its earlier fundraising efforts, Hinman said that in his view the Ethereum network was, at least as of 2018, sufficiently decentralized that its “current offers and sales of Ether are not securities transactions.”

Garlinghouse and Larsen also said the communications could show that they weren’t 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 around when digital tokens will be regulated as securities, and the “regulation-by-enforcement” approach it has relied upon instead has received pointed criticism, including from its own commissioner, Hester Peirce.

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 marketplace, she said it would be “better off constructing a regulatory framework, and then going after people who don’t abide by” it.

Peirce also said the regulation-by-enforcement approach was inefficient, insofar as the industry has to rely on fact-specific settlements to assess regulatory risks of contemplated arrangements.

The agency and the defendant organization are “going to resolve it in a way that’s best for themselves,” and their “model might not be the best model for everyone to follow,” she said.

Legislative Efforts

Some people in the industry are “celebrating” a bipartisan US Senate proposal—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 in 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 prompted feelings of disbelief at the SEC’s puzzling, out-of-character approach to regulation,” she said in remarks on June 14.

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 doesn’t want to see the agency rush its rulemaking process.

“When the Commission attempts rapidly to write and implement myriad rules, many of which are outside our longstanding mandate, it sets up conditions that could roil the markets,” she said later, in a June 22 statement.

Information Asymmetry

Peirce, who has proposed two iterations of a time-limited safe harbor for network developers. The most recent was updated in April 2021, after she solicited industry input on the idea.

To qualify for the safe harbor, which would be available for three years, developers would need to comply with certain notice and disclosure requirements designed to reduce buyer-seller information asymmetry.

Under the Token Safe Harbor Proposal 2.0, network developers would be required to file 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 notice that the 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 (R-N.C.) last fall as the Clarity for Digital Tokens Act of 2021, H.R. 5496, the idea of an exemptive approach has been slow to gain traction—that is until recently.

SEC Chair Gary Gensler signaled in July that the agency might be amenable to exempting the crypto industry from some securities laws in order to help bring them into compliance.

Read more: SEC Weighs Waiving Some Rules to Regulate Crypto, Gensler Says

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 with Bloomberg Law, she said.

This feature was adapted from this week’s Bloomberg Law—Litigation newsletter. Bloomberg Law subscribers may sign up here.