The Supreme Court may have recently struck down overreach by the Environmental Protection Agency, but at the Securities and Exchange Commission, chairman Gary Gensler remains undeterred in expanding the agency’s power beyond its constitutional boundaries.
For proof, you need no better example than his all-out assault on the cryptocurrency space.
It doesn’t take a constitutional law expert to understand that the SEC has limited jurisdiction over the crypto industry; barring congressional action, front line regulation of digital assets belongs with the Commodity Futures Trading Commission – the main regulator of investments that are not deemed traditional securities.
Yet Gensler, President Biden’s pick to run an agency intended to focus on stock scammers ripping off the unsuspecting, has dived headfirst into crypto like Eliot Ness going after Al Capone. If successful, almost 80 years of U.S. securities laws will be upended within Gensler’s first two years as Chair.
The Securities Act of 1933 lists the types of securities regulated by the SEC, including investment contracts. In 1946, the Supreme Court decided the landmark Howey Test, providing a four-part test determining what constitutes an investment contract. Seventy-six years later, Gensler seeks to turn the test on its head with his promises to regulate digital assets in a more intrusive manner than even his trigger-happy predecessor Jay Clayton (more on that in a moment).
Howey involved the offer and sale of orange groves at a Florida resort owned and operated by the W.J. Howey Company where hotel guests invested in harvesting oranges. The company pitched to its guests that it would do all the necessary work involved in growing and selling oranges. Aside from signing the land purchase and service contracts, the investors did nothing – except collect money. The Supreme Court found this business scheme constituted an investment contract and set out the so-called "Howey Test" establishing a standard for decades.
According to the Howey Test, an investment contract occurs when a person; 1) invests money; 2) in a common enterprise; 3) and is led to expect profits; 4) solely from the efforts of the promoter or a third party. All four prongs must be met.
Since Howey, Congress has failed to pass any new legislation that would directly involve the regulation of crypto. This should mean that it’s Congress’s intent that crypto’s de facto regulator is the CFTC, which has chosen a lighter touch because it fears stifling an emerging technology that blockchain and their digital assets represent. Yet Gensler has used this perceived lack of clarity to unleash a campaign of regulation by enforcement – stretching Howey beyond recognition. When Gensler looks at crypto, he not only sees an opportunity to regulate how the land and service contracts were sold, but an opportunity to regulate the oranges. As a legal theory, it should frighten everyone well beyond the crypto space.
The SEC has two key pending cases. First, the Ripple case, launched by Jay Clayton on his last day as Chairman of the SEC, but being advanced by Gensler, it involves the digital asset XRP. Clayton, possibly fearing Gensler would take credit for what he viewed as an easy agency enforcement victory, brought charges against Ripple executives for selling XRP in a way that classified it as a security under Howey because the proceeds, the SEC alleged, were used in part to help expand Ripple’s business. Thus, they should have "disclosed" information to investors on those sales as if they were a public company.
The case is now being heard in Federal Court with Gensler’s lawyers arguing the merits before a skeptical judge that has made a series of rulings in Ripple’s favor (Full disclosure: I serve as amici curiae representing seventy-two thousand XRP holders – the majority of whom had never heard of the company Ripple when they acquired the tokens). Then there’s the LBRY case, which is also allegedly about a lack of disclosure. This one is Gensler's brainchild involving the digital token LBC and it further underscores Gensler’s intent to anoint the SEC as the primary regulator of crypto. Keep in mind, these are two vastly different cryptocurrencies operating on separate blockchain networks - yet testing the same dangerous theory.
For comparison, blockchains are the orange groves, but instead of producing oranges, each blockchain produces a native cryptocurrency. The Bitcoin Network produces Bitcoin; the Ethereum Network produces Ether; and the XRP Ledger produces XRP; and so on. From Bitcoin on down, every network’s token performs whatever function that blockchain was invented to serve. The XRP Ledger, on which Ripple and other unrelated companies operate their different businesses, uses XRP, the network’s native currency, to settle transactions in other currencies. LBC, meanwhile, operates on the LBRY blockchain like dollar bills left on a restaurant table for the server, tipping artists on a decentralized multimedia content platform.
The most important thing to realize is that the SEC’s allegations are not limited to when or how Ripple or LBRY sold tokens. The SEC is asserting that both of these unique tokens are securities per se, no matter who sells them or why. It makes no distinctions between the Ripple or LBRY executives selling their tokens and the people who merely traded the cryptos later. If true, the SEC could then regulate secondary market sales independent of these companies, including sales made by exchanges and retail holders. It’s like saying the Howey oranges eventually sold by a grocer are unregistered securities. Imagine the economic consequences for innocent consumers.
Although securities laws govern investments, like the one in Howey, the SEC now claims it is immaterial as to why anyone acquired these tokens - even if the purchaser intends to use the token to access the technology for non-investment reasons. A recent LBRY hearing revealed Gensler’s absurd theory in a nutshell – if one person bought a token on the secondary market to use it on a blockchain network, even without knowledge that some company might also be using it on that same network, then all the tokens are investment contracts with that company.
With meme stocks attracting leagues of first-time investors, and the crash in SPACs you would think Gensler has too much on his plate to be messing with cryptocurrencies that have traded for over a decade. Yet, he calls crypto the "Wild West" of investing because digital assets are known to finance illegal activity. But the vast majority of money laundering takes place using the greenback and there’s lots of bad stuff happening on an unregulated internet.
Moreover, power-grabs seem to be Gensler’s thing: He has limited public input on SEC rule making and expanded the broadest environmental (ESG) data disclosure requirements ever proposed in the United States. This may advance a progressive social agenda, and as Fox Business’s Eleanor Terrett and Charles Gasparino have reported, it might help him secure a bigger job in the Biden Administration, possibly as Treasury Secretary.
Either way, Gensler’s war against crypto might be his most ambitious and dangerous affront to constitutional norms. Every single case since Howey found that the security involved an actual contract or some level of privity between the buyer and seller. Absent congressional action, Gensler intends to turn nearly a century of legal precedent on its head with his enforcement bulldozer.
John Deaton is the Founder of the Deaton Law Firm and CryptoLaw. He currently serves as amici curiae representing over seventy thousand XRP investors in a class-action lawsuit against the Securities and Exchange Commission. A former marine, Deaton is a crypto investor and owns a farm in Rhode Island.