An appeals court panel rules that the SEC rejection of a proposed spot bitcoin ETP was arbitrary and capricious, opening the door for the potential launch of numerous ETPs in the near future.

On August 29, 2023, a three-judge panel on the District of Columbia Circuit Court of Appeals ruled in favor of Grayscale Investments, LLC On Petition for Review of an Order of the Securities and Exchange Commission (SEC).

Grayscale proposed to the SEC in October 2021 that Grayscale would convert its Bitcoin Trust into an exchange traded product (ETP) based on the spot bitcoin market (rather than bitcoin futures). As ETPs are traded on stock exchanges, and investors in the ETP would not need to buy the digital asset directly, an ETP could potentially accelerate retail and institutional adoption.

The SEC rejected Grayscale’s proposal in June 2022 because it asserted that the ETP failed to meet consumer protection requirements, including measures “designed to prevent fraudulent and manipulative acts and practices.” Grayscale subsequently sued the SEC under the Securities and Exchange Act of 1934, petitioning the Court of Appeals to review the SEC’s denial. In its decision, the Court of Appeals panel vacated the SEC’s denial.

The Court’s Reasoning

At the outset, the Court stated that the Administrative Procedure Act requires the Court to rescind agency action that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” The Court reviews the agency’s decision to determine whether it is “reasonable and reasonably explained.”

Grayscale maintained that the approved bitcoin futures ETPs and its proposed bitcoin spot ETP are “materially similar” and therefore deserve similar treatment.

The Court agreed with Grayscale that the SEC failed to adequately explain why it disagreed that the bitcoin futures and spot markets are highly correlated or why it ultimately approved the listing of two bitcoin futures ETPs but not Grayscale’s proposed spot bitcoin ETP. According to the decision, “Grayscale presented uncontested evidence that there is a 99.9 percent correlation between bitcoin’s spot market and CME futures contract prices.” Grayscale also demonstrated identical surveillance sharing agreements to detect fraud or manipulation in the market, and material similarity “across relevant regulatory factors.”

The Court held that the approval of one and the denial of the other was arbitrary and capricious because “[i]n the absence of a coherent explanation [from the SEC], this unlike regulatory treatment of like products is unlawful.”

Procedural Next Steps

The SEC has indicated that it was reviewing the Court’s decision. It has 45 days after entry of the judgment to request a rehearing by the panel or an en banc session in the same court (i.e., a rehearing with all Circuit Court of Appeals judges participating rather than the three-judge panel). According to the Court’s Rules and Handbook of Practice And Internal Procedures, a petition for rehearing en banc must set forth why the case is of exceptional importance or cite precedent that is purported to be contrary to the panel judgment.

The SEC may also petition for a writ of certiorari for review by Supreme Court of the United States (within 90 days from the entry of judgment or the denial of a timely petition for rehearing, whichever is later).

If the SEC chooses not to petition for a rehearing or appeal, the Court will issue a formal mandate seven days after the period for seeking rehearing has expired. The mandate would specify what actions the SEC should take due to the decision, such as instructing the SEC to approve Grayscale’s proposed bitcoin ETP, or to review the proposal anew.

The SEC could file a motion for stay of the mandate, but must show that the petition would present a substantial question and that there is good cause for a stay. The Court may grant unopposed motions for stays for up to 90 days.

If the SEC is ordered to review the proposal anew, it could still reject the proposal with a better justification of its original grounds for denial, or on other grounds. For example, the SEC could provide clearer evidence to support its contention that the bitcoin futures and spot markets are uncorrelated, or that the underlying spot market is demonstrably subject to manipulation due to its lack of regulatory oversight.

Conclusion

Despite the fact that the decision is a straightforward determination of reasonableness and fairness under the Administrative Procedure Act (rather than any commentary on the company or underlying asset class), it has encouraged the digital asset industry, coming on the heels of a perceived win in the SEC v. Ripple case (for more information, see this Latham blog post). Multiple spot bitcoin ETP proposals remain open with the SEC. The Court’s ruling is therefore a positive development for all market participants advocating for a spot bitcoin ETP.