A Securities and Exchange Commission enforcement action brought last week held that a cryptoasset trading platform’s staking-as-a-service program was alleged to involve the offer and sale of an unregistered security.
In a complaint filed in a federal court in San Francisco, the SEC charged Payward Ventures, Inc., and Payward Trading, Ltd.— known as “Kraken”—with violating federal securities laws for offering and selling its staking program without SEC registration.
According to the SEC, Kraken agreed to settle the complaint by ceasing its staking program and paying a $30 million fine. Kraken clarified this cessation would apply solely to US persons.
In its complaint, the SEC did not claim that staking and receiving rewards in connection with proof-of-stake protocols implicated federal securities laws.
Instead, certain additional actions by Kraken—including pooling of customer tokens under its control, provision of certain services to help make the client experience with staking easier and more efficient, and the lack of certain disclosures—led the SEC to characterize Kraken’s staking service as a so-called “investment contract” and thus a security.
But operational services provided by a crypto broker should not transform a proof-of-stake consensus mechanism of a blockchain, or protocol that a client expressly requests its broker to participate in on its behalf into a security.
A contrary view is inconsistent with US Supreme Court precedent.
SEC Chairman Gary Gensler likened staking-as-a service offerings to lending and similar programs the SEC also has recently charged were unregistered securities offerings—e.g., against BlockFi, Gemini/Genesis, and Nexo.
However, each of those programs typically entailed customers transferring their crytpoassets to their intermediaries as a matter of contract, then intermediaries transferred the relevant cryptoassets in their total discretion to third parties to generate investment profits.
But Kraken’s staking program appears to have material differences from lending programs the SEC previously found objectionable.
The SEC emphasized that, under Kraken’s general terms of service relevant to all firm services—not exclusive to its staking program—crypto assets may be encumbered by Kraken’s creditors.”
But the SEC did not acknowledge that in the same terms (Section 6.7.1), Kraken expressly agreed that “all interests in Digital Assets we hold for Kraken Accounts are held for customers and are not property of [Kraken].” This is a very different situation than typically existed with crypto lenders.
Moreover, the SEC did not claim that Kraken chose in its own discretion what customers’ cryptoassets to stake to third parties to maximize investment returns.
Instead, as the agency acknowledged, customers expressly chose which crypto assets to stake, and Kraken either effectuated bonding of such cryptoassets to the relevant networks, or retained a portion of such cryptoassets to ensure it had sufficient relevant cryptoassets to meet client redemption requests.
Customer and Industry Impact
In its lawsuit against Kraken, the SEC relied on a 1946 Supreme Court decision—SEC v. W.J. Howey Co.—that established a four-part test to determine when a public offering constituted an investment contract: do persons invest money, in a common enterprise, and expect profits, “solely from the efforts of the promoter or a third party.”
Although Kraken’s customers’ may have elected certain cryptoassets to be committed to staking, the assets appear to have been always contractually owned by customers, the same way Kraken apparently held them for customers who did not elect to stake.
Even when customers’ cryptoassets were bonded for staking, customers apparently still owned them. There was no investment.
As a crypto trading platform, Kraken likely pooled customer cryptoassets operationally in the ordinary course in relevant wallets.
Although Kraken may have moved assets to dedicated wallets to be bonded, the wallets’ likelihood of being selected as the validator node was a function of a random decentralized network decisions, not that of any one person, let alone Kraken.
There was no common enterprise. If anything, by posting more cryptoassets in a single wallet, Kraken increased the probability the node would be selected to validate transactions and generate rewards, as acknowledged by the SEC—thus benefitting customers.
Kraken customers could not reasonably expect profits—rather, they could expect rewards in return for staking. This was not a return on an investment, but remuneration for placing tokens at risk on a network to help ensure the validity of proposed transactions. It was a service for earnings, not profits.
Moreover, the remuneration customers could expect could not reasonably be anticipated principally, let alone solely, through Kraken’s efforts.
Instead, customers could only reasonably expect that staking rewards—which in the first instance would be generated by a blockchain— could potentially be enhanced through Kraken’s operational acumen.
Although Kraken’s complaint and settlement are based on specific purported facts alleged by the SEC that Kraken neither admitted nor denied, the SEC has suggested that all unregistered staking-as-a-service programs offered by crypto trading platforms potentially violate federal securities laws.
However, the SEC bullies the crypto industry by threatening further enforcement actions where staking-as-a-service does not require customers to interact with their crypto intermediaries any differently than they ordinarily do. And the service solely enables customers to stake easier and more efficiently than if they staked directly.
At a minimum, the SEC should alternatively and productively engage with the industry to develop rules or at least guidance related to staking.
As SEC Commissioner Hester Pierce emphasized regarding the matter, “[u]sing enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating.”
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
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Daniel J. Davis, former CFTC general counsel, is a partner at Katten Muchin Rosenman.
Gary DeWaal is senior counsel to Katten Muchin Rosenman.