Among many other national and international challenges, the Biden administration will be faced with handling two last-ditch efforts by the Trump administration to curb perceived abuses in the virtual currency markets. On December 22, 2020, a day before the departure of former Securities and Exchange Commission (SEC) Chairman Jay Clayton, the SEC filed a complaint against Ripple Labs, Inc. (Ripple) alleging that the company and two of its executives raised over $1.3 billion through an unregistered, ongoing digital asset securities. The enforcement action could potentially lead to stricter regulation of cryptocurrency transactions on certain exchange platforms. Separately, on December 18, 2020, the Financial Crimes Enforcement Network (FinCEN) rushed a proposed rule that would impose additional reporting, verification and recordkeeping requirements on banks and money service businesses (MSBs) for certain transactions involving convertible virtual currency (CVC) or digital assets with legal tender status (LTDA).
Securities and Exchange Commission v. Ripple Labs, Inc.
On December 22, 2020, the SEC filed a complaint in the U.S. District Court of the Southern District of New York (SDNY) against Ripple, its executive chairman, Christian Larsen, and its chief executive officer, Bradley Garlinghouse, alleging that the defendants raised over $1.3 billion through an unregistered, ongoing digital asset securities offering over a seven-year period. Ripple is a U.S.-based technology platform, which functions as both a currency exchange and remittance network. The platform has its own currency, known as XRP.
The SEC alleged that since 2013, the defendants improperly sold over 14.6 billion units of XRP, an independent digital asset traded on Ripple’s platform, in return for cash or other consideration worth over $1.38 billion to fund Ripple’s operations, develop its business, and profit Larsen and Garlinghouse. The SEC argues that XRP met the test for an “investment contract” and as such, was a “security,” the offer and sale of which, had to be registered under the Securities Act of 1933. In addition, the agency charged the executives with aiding and abetting the company’s alleged violations. According to the complaint, Larsen and Garlinghouse structured and promoted XRP sales to finance the company’s business and effected personal unregistered sales of XRP totaling approximately $600 million. Notably, the complaint does not make any allegations of fraud.
This enforcement action has had an immediate impact on the value and trading activity of XRP. Within days of the filing of the SEC’s complaint, large and small digital assets platforms including Coinbase, Binance and OSL (among others) had suspended trading of XRP, and its value had dropped by more than 60 percent.
This was a significant enforcement action commenced in the waning days of the Trump administration. The SEC and its staff have been consistent in their view that digital asset offerings must be evaluated under the five-part Howey test for investment contracts and have brought numerous enforcement actions on the basis that digital asset offerings were illegal unregistered securities offerings. The SEC has stated that certain fully decentralized digital assets (e.g., Bitcoin and Ether) are not securities under the Howey test. However, significant questions remain with respect to the treatment of many types of digital assets. The outcome of the Ripple litigation may be particularly significant in shaping the legal analysis regarding digital assets and in particular the notion of decentralization and what efforts to increase or support the price or volume are sufficient to cause an asset to be treated as a security under the federal securities laws.
Proposed Requirements for Certain Transactions Involving Digital Assets
On December 18, 2020, the Financial Crimes Enforcement Network (FinCEN), a bureau within the U.S. Treasury Department, issued a Notice of Proposed Rulemaking (NPRM) requesting comments on a proposed rule under the Bank Secrecy Act (BSA) for recordkeeping, verification and reporting requirements for certain convertible virtual currency (CVC) or legal tender digital assets (LTDA) transactions.
Per the proposed rule, banks and money services businesses (MSBs) would be required to submit reports, keep records and verify the identity of customers engaged in transactions involving CVC or LTDA held in “unhosted wallets—i.e., wallets not hosted by a financial institution, or in “otherwise covered wallets”—i.e., wallets held at a financial institution located in a foreign jurisdiction identified by FinCEN that is not subject to the BSA. Such jurisdictions would be identified on a list that initially would include jurisdictions of primary money laundering concern (e.g., Burma, Iran, and North Korea).
To effectuate certain requirements, the rule proposes expanding the definition of “monetary instruments” to include CVC and LTDA thereby extending certain BSA requirements for wire transfers and currency transactions to relevant CVC or LTDA transactions. Applicable transactions above $10,000 in value in the aggregate over a 24-hour period between a bank’s or MSB’s hosted wallet customer and an unhosted or otherwise covered wallet would be subject to reporting and verification requirements. Banks and MSBs would be required to file a report with information related to their customer’s transaction and the counterparty within 15 days following the day on which a reportable transaction occurred. The rule proposes to exempt transactions between hosted wallets held at financial institutions subject to the BSA, including both domestic and foreign financial institutions.
Further, the proposed rule would create a recordkeeping requirement for relevant CVC or LTDA transactions with a value of more than $3,000. Banks and MSBs would be required to keep records and verify the identity of their customers where the counterparty uses an unhosted or otherwise covered wallet.
Per the proposed recordkeeping requirement, banks and MSBs would need to collect and retain an electronic record of the following information:
Citing “significant national security imperatives,” the then-outgoing Trump administration rushed the proposed rule through the notice-and-comment process providing interested parties an unusually short 15 days instead of the typical 60 days to submit comments. This short comment period was highly criticized, including on December 31, 2020, by nine members of Congress who sent a letter to FinCEN expressing concerns regarding the process to respond to the NPRM, stating “[i]t would be impossible for the public to give meaningful comment with so little time, and a rushed process threatens the legitimacy of this rule.” As a result of criticism, and the receipt of over 7,500 comments by the Jan. 4 deadline, on Jan. 14 FinCEN extended the comment period.
On Jan. 20, the White House issued guidance directing federal agencies to delay the rulemaking process generally to allow Biden appointees to weigh in on proposed rules. Accordingly, the FinCEN proposal is now under review by the new administration, and the timing of any final rulemaking is uncertain.
Biden’s Nomination of Gensler to Lead SEC: A Preview of Digital Assets Regulatory Policy
With the nomination of Gary Gensler to chair the SEC, President Biden has selected an aggressive regulator with a broad understanding of the financial markets generally and particularly deep expertise on digital asset matters. As CFTC chair, Gensler was widely regarded as a tough regulator and is credited with developing and implementing the agency’s framework for the regulation of derivatives under the mandate of the Dodd-Frank Act. That initiative—coupled with his decades of industry experience—puts Gensler in a strong position to lead the SEC’s efforts to refine the rules of the road for the digital asset markets.
Backed by Democratic Commissioners Crenshaw and Lee, we expect a Gensler-led Commission to continue the SEC’s aggressive enforcement approach to crypto-related misconduct. Unlike during the Clayton era, however, the Commission under Gensler might shift its enforcement focus to crypto matters that involve fraud and other serious charges (unlike, for example, in Ripple). While the SEC might continue to bring cases against digital asset issuers and platforms regarding failures to comply with the registration provisions of the securities laws, we anticipate Gensler will act to address the perceived uncertainty regarding the circumstances under which digital assets qualify as securities.
Mindful that Gensler is already on the record indicating that most digital assets are in fact securities, we do not believe that any regulations promulgated under his watch will exempt large categories of digital assets from the purview of the securities laws. However, we are hopeful that a Gensler-led SEC will provide more definitive guidance than some of the existing commentary and will act to modernize payments and securities technology in the U.S. markets.
Our team will continue to monitor the regulatory landscape impacting the digital asset industry as President Biden rounds out his financial services regulatory team.