Applying Old Laws To New Ideas: How The SEC Began Regulating Cryptocurrency

By: Taher Kameli & Steven Burke 

Without a clear need to protect any specific group of investors, this post will explore an alternative theory for why the SEC’s decision to bring an enforcement action against Ripple Labs and two of its executives. Namely, in this post, we will explore the SEC’s controversial practice of using litigation in lieu of formal rulemaking to police the crypto industry.

Keeping Pace in an Ever-Changing World

Congress enacted the core federal securities laws during the Great Depression, nearly 50 years before the invention of the internet, and certainly did not consider how the laws would apply to cryptocurrency. Accordingly, although Congress has amended and supplemented portions of the Securities Laws over the years, the SEC has been charged with keeping the regulations relevant to modern markets. Chiefly, the SEC has continued to modernize the securities laws through rulemaking and enforcement actions[1]. Although the Supreme Court has permitted Administrative Agencies to engage in what effectively constitutes rulemaking through enforcement actions, the primary method for advancing new rules is intended to be through the formal rulemaking process.

Traditional Method of Rulemaking

As Congress has delegated rulemaking authority to the SEC, the SEC may stand in its place to adopt rules equivalent to law. However, Congress recognized the significant power afforded by the ability to write and enforce regulations with the force and effect of law and placed certain procedural limits on the rulemaking abilities. Among other constraints, the Administrative Procedure Act provides that agencies may only create rules within their statutory directives, after giving notice of its intent to promulgate a rule, and after obtaining public participation through a public comment process. Through this rulemaking process, Congress can focus on the “Big-Picture” and allow agencies like the SEC to provide significantly more expertise in filling out the technical details. Through the formal rulemaking process, the SEC may adapt and create rules in a conscientious and controlled manner. Among other benefits, the formal rulemaking process allows the SEC to leverage its expertise to create an efficient and effective rule; moreover, the formal process provides meaningful notice to the public of how the rule will be applied and enforced, thus providing clarity on the manner in which the rule will control the[1] The distinction between the SEC’s use of Administrative Proceedings and Civil Litigation surpasses the scope of this article, and all enforcement actions shall be treated as one action towards which it was directed. While some new rules have been proposed, no federal agency appears to be currently considering any significant overhaul of their regulations.

Making Rules Outside of the Rulemaking Process

Absent a clearly developed set of rules addressing the peculiar issues, the SEC has relied heavily on its enforcement authority to regulate in the cryptocurrency space. Although many of its enforcement actions have focused on clearly fraudulent ventures, such as selling coins based on a non-existent blockchain or operating a Ponzi scheme, the SEC has also challenged a number of companies that engaged in what it determined to be unregistered securities offerings. Although regulations, and indeed our laws, constantly evolve through litigation, it is rare to see an agency rely as heavily on the courts to develop policy as the SEC has done with cryptocurrency. However, the SEC has not been entirely silent on the treatment of cryptocurrency under the federal securities laws and has provided the public with two key resources to navigate the regulatory netherworld of cryptocurrency.

The DAO Report

The first resource came in 2017 when the SEC published what has come to be known as the DAO report. Serving as its cornerstone, the SEC seems to at least reference the report in nearly every statement it makes about cryptocurrency. Summarily, the DAO report established that the SEC would apply the Howie Test on a case-by-case basis to determine if the Federal Securities Laws should apply to a particular cryptocurrency. Presumably, the SEC considered the DAO report to provide sufficient notice “that the U.S. federal securities laws may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.” Essentially, the DAO report provided the grounds for the SEC to take action against anyone selling cryptocurrency in the U.S., pursuant to the Howey Test. Limited to promulgating and enforcing rules within its statutory purview, the SEC wields the Howey Test to regulate transactions that involve instruments other than those traditionally understood to be securities. Namely, the Howey Test provides allows the SEC to classify novel instruments, such as cryptocurrency, as investment contracts, which are included in the legal definition of a security and thus subject to the federal securities laws.

The “catch-all” provision of SEC authority, the Howey Test intentionally offers a flexible and broad interpretation of what may qualify as an investment contract. In summary, the SEC has the power to take action when there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. See SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). Although worlds apart from the formal notice and comment process required for formal rulemaking, the DAO often serves as the SEC’s basis for why an individual or company knew that they needed to register the sale of cryptocurrency with the SEC. Notably, arising from a 1946 case involving the status of orange groves, the application of the Howey Test to digital assets proved to be more challenging and controversial than the SEC likely intended. Accordingly, with external pressure mounting, the SEC published its second key resource sought to provide additional clarification to the public.

Framework for “Investment Contract” Analysis of Digital Assets

In publishing the Framework for Investment Contract Analysis of Digital Assets, the SEC intended to provide guidance for analyzing whether a digital asset is an investment contract and whether offers and sales of a digital asset are securities pursuant to the Howey Test. The core of this guidance begins with the SEC summarily concluding that the first two prongs of the Howey test—the investment of money and a common enterprise—are “typically satisfied” and offering no further insight on these issues. Conversely, the SEC provided a laundry list of considerations for determining whether the third prong—reasonable expectation of profits derived from efforts of others—may be satisfied for a particular cryptocurrency. Specifically, in its guidance, the SEC extrapolated a single prong of the Howey Test into a set of 62 discrete characteristics and factors that may increase the likelihood that the prong has been satisfied. However, unlike the general applicability of formal rules, the SEC largely treated this guidance as a means to consolidate specific circumstances, largely from its previous enforcement actions, that tend to support an inference that the third prong of the Howey Test could be satisfied.

As mentioned above, the SEC could use the formal rulemaking process to leverage the knowledge and expertise possessed by both its own agents and, through the public comment process, the general public in order to provide the public with bright-line rules and determinative factors for when cryptocurrency may be subject to the federal securities laws. However, the SEC has thus far chosen to forgo this path; moreover, as its Spring 2021 Regulatory Agenda omitted any mention of rulemaking for digital assets, the SEC appears content to continue avoiding the official rulemaking process in relation to cryptocurrency. Conversely, we anticipate that the SEC will continue using enforcement actions to advance its rules and to police the crypto space, at least as long as it continues to be successful in its actions. Accordingly, the public will likely continue to bear the burden of interpreting a patch-work amalgamation of anecdotal situations and balance competing factors relative to a particular cryptocurrency.

Relating to Ripple

A significant portion of Ripple’s defense hinges on the SEC’s prior guidance related to Bitcoin and Ether. Namely, in answering the SEC complaint and seeking discovery, Ripple has indicated that it will seek to demonstrate that XRP would be more properly classified among the likes of ETH and BTC rather than the slew of security tokens that the SEC has previously challenged. Ordinarily, informal opinions of this nature would not provide significant support to litigants and would certainly not rise to the level of binding authority; however, we would not be surprised to see these considerations given greater weight under the circumstances. Particularly, by choosing to rely on enforcement actions to advance the federal securities law’s applicability to cryptocurrency rather than engaging in the formal rulemaking process, the SEC essentially permitted, if not required, Ripple to defend itself by taking such a position.

Additionally, Ripple will likely seek to strengthen its argument for XRP being treated like BTC and ETH through reference to the lack of concrete guidance regarding the particular situation involved. Namely, Ripple indicates that the SEC knew of the XRP sales for several years, and, despite having numerous opportunities to identify its position, the SEC made no attempts to discuss the matter with Ripple, clarify its classification of XRP, or halt further XRP sales. In such a light, it is understandable why Ripple and others have accused the SEC of “picking virtual currency winners and losers.” Although its validity remains to be seen,  Ripple’s unique position, if successful, would likely be a crippling blow to the SEC’s current approach to regulating the cryptocurrency space.


[1] The distinction between the SEC’s use of Administrative Proceedings and Civil Litigation surpasses the scope of this article, and all enforcement actions shall be treated as one.