What’s Past is Prologue: Enforcing the Federal Securities Laws in the Age of Crypto

Prologue*

What follows is a speech I delivered at the William & Mary Business Law Review’s Third Annual Symposium entitled “Regulating Finance in a Changing Administrative State” on April 1, 2023. Since then, there have been many developments in the world of crypto asset securities, some of which I address in an epilogue to the speech, below.

Table of Contents

Introduction

I. Everything “New” is Old—Really Old—and Well-Established

II. Investors in Crypto Asset Securities Are Being Harmed as We Speak

III. Innovation and Compliance Are Not Incompatible. 

IV. Public Trust Requires Robust Enforcement of the Securities Laws.

Conclusion

Epilogue

Introduction

Thank you to the William & Mary Business Law Review for hosting this symposium and for inviting me to participate.

I’m thrilled to be back at my law school alma mater. This is a special place – one that not only helped me hone my legal skills, but also one that helped mold me into a “citizen lawyer.”

For me, it was my experience with the late Professor John Levy and participating in the legal aid clinic that he ran that first showed me how we can use our law degrees to not only protect, but also to uplift others. It’s an experience that has helped shape my entire public service journey.

I’m grateful that the law school continues to train excellent citizen lawyers—a number of whom I’ve had the privilege of working with during my time as New Jersey Attorney General and now at the U.S. Securities and Exchange Commission (“SEC”).

I am equally grateful that in developing the next generation of citizen lawyers the law school is emphasizing inclusion – a core value that has guided much of my work.

* * *

Today’s topic – “Regulating Finance in a Changing Administrative State” – is no doubt a timely one, but also one that could easily serve as my job description. And the panels you’ve organized touch on nearly every aspect of our work in the Enforcement Division.

So naturally, I have many thoughts I would like to share with you, but before I do, I must make clear that my remarks today are in my official capacity as the Director of the Division of Enforcement, but do not necessarily reflect the views of the Commission, the Commissioners, or other members of the staff.

Perhaps I should also add to that disclaimer that the views I plan to share this morning may not be the most popular you will hear today. I think that is because the theme underlying this symposium is a concept that I not only disagree with, but is also one that is frequently advanced in some corners—that technological innovations have so dramatically transformed the financial markets since the 1930s, when Congress first passed the federal securities laws and created the SEC to enforce them,[1] that those laws are now somehow ill-suited to regulate our financial markets, especially when it comes to crypto assets.

Some of our critics—perhaps a number of you—argue, instead, that new, bespoke rules and regulations are needed for this particular industry. They believe that this is best achieved either through notice and comment agency rulemaking or by Congress developing an entirely new regulatory framework for crypto assets.

At the same time, a number of defendants are using newly crafted legal concepts like the “major questions doctrine,” to challenge certain SEC enforcement actions as being beyond the authorities Congress delegated to the SEC.[2]

You will no doubt discuss all of these issues and more throughout the day, but in many cases you will do so in the abstract. What I would like to do this morning is provide you with some context because the securities laws are anything but abstract to the millions of investors that are harmed when promoters of securities, including crypto asset securities, and others engage in fraudulent activity or otherwise violate our rules and regulations.

I. Everything “New” is Old—Really Old—and Well-Established

The history of our securities laws makes clear that Congress always intended the definition of what is a security to be principles-based and flexible to cover the many kinds of schemes where promoters seek others’ money and promise profits in return. [3]

Following the stock market crash of 1929, in the midst of the Great Depression and during a period of grave economic crisis, there was a general loss of trust in our financial markets. In response, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the SEC, to protect investors and the markets.[4]

A key feature of the Securities Act was to require companies offering “securities” and raising money from the public to register their offerings with the SEC and to provide investors full, fair, and truthful disclosures of material information about their offerings, their financial health, and their executives.[5] The Act defined “securities” broadly to include various kinds of investments, including what it called an “investment contract.”[6]

No sooner was the Act passed than companies began arguing that whatever they were doing did not constitute the offer and sale of securities and, therefore, they did not need to comply with the law’s registration requirements. To support their positions, the companies often focused on the name or form of the product or transaction, not its substance. They argued that because their form of offering was not specifically enumerated by statute, it did not need to be registered.[7]

Sound familiar?

And as happens today, back then the SEC sued to stop ongoing unregistered securities offerings. Time and again, federal courts focused on the economic reality of the transactions at issue and the broad investor protections Congress intended to advance in enacting the federal securities laws.

And time and again, those courts determined that the transactions at issue—ranging from investment opportunities in oil barrels to fishing boats to silver foxes—did in fact constitute the offer or sale of securities.[8]

And then in 1946, the Supreme Court issued its seminal opinion in SEC v. Howey, setting forth the test for what constitutes an “investment contract,” and therefore a security, for purposes of the federal securities laws.[9] The Court explained that Congress intended “investment contract” to apply broadly to a variety of situations in which individuals invested money in a common enterprise with the expectation that they would earn a profit through the efforts of others.[10] This approach “embodie[d] a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”[11]

And Howey has proven to be a remarkably flexible and resilient test that courts have since applied to find a wide variety of offerings to be investment contracts and, thus, securities. The list includes offerings related to whiskey, cosmetics, self-improvement courses, and pay phones,[12] as well as a surprising number of creatures: earthworms, beavers, chinchillas, and even cattle embryos.[13]

Notably, none of these offerings involved stocks or bonds or the kinds of investments you or I might have in our portfolios. And that’s really the point of Howey: whether something is a security depends on the substance of the transaction – not its name, not its form, and not its underlying technology.

As Justice Thurgood Marshall put it decades later, “Congress painted with a broad brush,”[14] and its “purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.”[15]

Critics who now dismiss Howey as outdated because it involved orange groves nearly 80 years ago and demand a new regulatory regime overlook this history and, I think, completely miss the point: the definition of a security is, and has always been, principles-based to allow for the flexibility that comes with innovative investment products, technology-driven or otherwise.

II. Investors in Crypto Asset Securities Are Being Harmed as We Speak

Against this backdrop, the “major question” for us is: are investors being hurt within our remit? If the answer is yes, then we must act, and we must do so with a sense of urgency. And increasingly, the answer to that question has been yes.

The current turmoil in the crypto markets is taking a real toll on everyday Americans. According to one survey, approximately 16% of U.S. adults have invested, traded, or used crypto, and among that group approximately 46% report their investments have done worse than they expected.[16] While some of this may be the result of natural market forces, some of it is certainly due to fraud and other unlawful activity.

Let me give you an overview of the type of activity we are encountering because it’s quite often left out of conversations like the ones you will have at this conference. To date, the SEC has charged many issuers with failing to register initial coin offerings, as well as their offerings of so-called lend, earn, and staking products, meaning that the offerings lacked required disclosures – disclosures that ensure that investors can make informed investment decisions.[17]

The SEC has also alleged in a number of our actions that certain unregistered crypto offerings are nothing but straight rips, Ponzi schemes, affinity frauds, or other types of scams.[18]

In the actions the SEC has recently brought in this space, our allegations have described, among other things:

• Products labeled as “defi” offerings that are neither decentralized, nor finance, but rather frauds;[19]
• Stablecoins that are neither stable, nor coins, but rather fraudulent;[20]
• So-called “trusted” protocols and “smart contracts” that, despite representations to the contrary, can be, and are, used to manipulate the market for crypto asset securities;[21]
• Platforms, protocols, and exchanges that fail to provide any details about their cybersecurity risks subjected to malicious attacks that result in investor harm;[22] and
• In the end, investors, large and small, defrauded, and billions in customer assets misused or stolen.[23]

Some of these alleged schemes have resulted in lines of investor victims at the doors of bankruptcy courts hoping to recover a fraction of their hard-earned money.[24]

And just this week, the SEC alleged that a noncompliant crypto intermediary simultaneously acted as exchange, broker, and clearing agency without registering with the SEC—thereby putting investors at risk from conflicts of interest and inadequate oversight.[25]

So, while we can appreciate the innovation around, and the technological advancements of, blockchain and distributed ledger technology, we must also be cognizant of the risks and harms to investors associated with the related products and offerings. As in any other space, we have a duty to analyze whether the activity is subject to the federal securities laws and, if so, whether those laws have been violated.

And that’s precisely what we have done. Over the last decade, based on Enforcement Division investigations and recommendations, the SEC has brought well over 100 crypto-related actions involving unlawful activity across the crypto markets as I have just outlined.

And in every case, where federal courts have had to determine whether there were “securities” at issue, the courts have applied the Howey test—looked at the economic realities of the offerings, and, even though the offerings at issue involved supposedly novel technologies, rejected defense arguments that they were not securities.[26]

During this same period, the SEC has spoken clearly and consistently about the applicability of the securities laws in the crypto space, citing decades of Supreme Court precedent explaining the test for determining whether something is an “investment contract,” and thus a security.[27]

To put it bluntly, there is not a lawyer or market participant in this area that does not know the applicable regulatory framework and tests. As Chair Gensler has stated, “Not liking the message isn’t the same thing as not receiving it.” [28] That is also likely why courts have rejected “fair notice” and due process arguments in a number of these actions.[29]

III. Innovation and Compliance Are Not Incompatible

I would like to turn now to another topic that also sometimes gets lost in the headlines, and that is the importance of compliance in the crypto markets.

First, when issuers of crypto asset securities do not comply with registration requirements, investors and analysts do not get mandatory disclosures about the issuer, their offerings, and their financial condition. Investors cannot make informed investment decisions without that information. Disclosures that are especially important in a market of thousands of different offerings involving technology that most laypeople do not understand.[30]

Second, in a compliant securities market, separate functions generally are performed by different legal entities, each of which are subject to separate regulations that protect investors. This creates separation and even a healthy degree of antagonism between the functions: brokers do not want to execute their clients’ trades on questionable exchanges, and exchanges do not want to work with unreliable clearing agencies. Importantly, national securities exchanges do not take custody of assets that trade on the exchange and thus do not have the ability to lend them out or use them to make risky bets.

In contrast, in the crypto world sometimes these functions collapse under one roof, as we alleged just this week with respect to the Beaxy exchange.[31] This aggregation of functions creates significant conflicts of interest and exponentially increases risk of investor harm as we saw with the collapse of FTX, where we allege that Sam Bankman-Fried and others not only fraudulently raised billions of dollars from investors in FTX, but also misused billions in funds belonging to FTX’s trading customers.[32]

Finally, in a compliant securities market, the firms fulfilling these various functions, such as exchanges, broker-dealers, and clearinghouses, are subject to supervision, oversight, and examination by the SEC.[33] Among other things, they are required to maintain books and records and make them available to the SEC, and they are required to have internal controls.[34] This all provides additional, essential layers of protection for investors.

The quarrel, therefore, is with noncompliant actors, not the technology or its promises. The technology is actually beside the point. We have to regulate markets and protect investors based on current realities and existing risks. There are no exceptions to the application of the federal securities laws based on the future potential or benefits that an offering may provide.

Moreover, innovation and compliance with the securities laws are not mutually exclusive. As Chair Gensler has repeatedly stated, the SEC staff stand ready to work with crypto entrepreneurs and understand the need to be flexible in applying our disclosure requirements.[35]

IV. Public Trust Requires Robust Enforcement of the Securities Laws

I would like to finish by touching on a topic that’s important to this conversation and a bit personal for me: public trust.

In my early speeches as Enforcement Director, I spoke about the declining trust in our financial institutions and markets.[36] While there is no single cause for this decline, it is in part due to the perception that we—the regulators—are failing to hold bad actors accountable, coupled with the belief that there are two sets of rules: one for the big and powerful and another for everyone else.

None of this is abstract either. I’ve seen it firsthand as a federal, county, and state prosecutor. I saw it firsthand speaking to victims as my state’s attorney general, and I see it now in this role. And the effects of this diminished trust can be especially pronounced among minority and marginalized communities.

For example, studies show that a majority of Black Americans, Hispanic Americans, and LGBTQ Americans feel that traditional financial institutions “are not meant for people like me.”[37] Due to historical injustices and negative experiences, many members of these communities may also have skepticism, or outright hostility, towards the government.

This lack of trust can lead to further victimization. I’ve seen this with certain types of affinity frauds, especially among immigrant communities, where the perpetrator may appeal to the victims’ closeness to their own community and potentially their suspicion of outsiders.[38]

Not infrequently, we encounter suspicion so strong that the victims are reluctant to cooperate with us or believe our allegations even in the face of overwhelming evidence of the fraud.

And through these experiences, I have developed a playbook, one that we are employing at the Enforcement Division, to protect investors and reclaim and enhance public trust. It’s built on three principles: robust enforcement – moving our investigations with a sense of urgency and addressing emerging risks; robust remedies – seeking penalties and remedies at levels adequate to both hold bad actors accountable and deter misconduct; and robust compliance ­­­­– working with market participants and gatekeepers to create a culture of compliance and cooperation to prevent misconduct.[39]

Another response to this decline in trust has been the “predatory inclusion” tactics of crypto entities directed at Black, brown, and other marginalized communities.[40] Here, I’m talking about the familiar (but so far unsupported) narratives that crypto will be predicated on a permissionless and trustless environment; that it will increase financial inclusion;[41] that it will uplift the unbanked or underbanked; that it will help them build wealth and increase upward mobility; and that if you “step right up, everyone’s a winner.”[42]

We’ve also seen predatory tactics on full display in case after case, where the SEC has alleged that “influencers” are touting unregistered offerings to investors without disclosing that they are being compensated to do so.[43] We allege they do so by lying about their returns from their own, in some cases fictional, crypto investments, and without disclosing they are being paid tens of thousands of dollars for their tweets.[44]

Whether it’s the direct result of these efforts or for other reasons beyond the scope of this presentation, crypto assets are the only major financial products that Black Americans are more likely to own than white Americans.[45] And there is some evidence that Black and brown investors have now been disproportionately harmed during the downturn of crypto markets over the last two years.[46]

But despite such losses in the crypto industry, distrust in the traditional financial system is still driving investors towards crypto. We saw that just a few weeks ago when the collapse of Silicon Valley Bank and questions about the stability of the wider banking system pushed increased interest in crypto assets.[47]

In some ways, we are now at the intersection of the two responses to addressing diminished public trust I just outlined. People who looked to crypto as a refuge from the ills of traditional finance are now experiencing those same ills in the crypto markets. They are being harmed by the very types of behavior that led Congress to create the securities laws in the first place—the same behaviors that have led to reduced trust in the markets: misstatements or misleading disclosures, conflicts of interest, and insiders abusing their positions for personal advantages at the expense of ordinary investors.[48]

I believe that in this moment, we have to leverage the playbook I described. We must act with all the tools at our disposal to protect investors and enhance public trust and confidence in our markets.

This means continuing to get behind the labels, focusing on substance over form, ensuring that actors comply with the securities laws, and holding those that do not accountable, without fear or favor.

Conclusion

In the end, I believe that it should be against this backdrop of real investor harm, precedent, and the need to enhance public trust and confidence in our markets, that you consider the familiar industry talking points (or tweets in this day and age), that I’m certain you’ll hear (or reference) throughout the day—that according to some we are exceeding our authority, regulating by enforcement, stifling innovation, and driving it overseas.

As long as investors in securities are being harmed now, we must act now.

Thank you again to the William & Mary Business Law Review for inviting me to speak to you today. I am privileged to have had this opportunity and I hope that you have a great, contextualized discussion today.

Thank you so much.

Epilogue

By the time I became Enforcement Director in July 2021, the SEC had already brought dozens of enforcement actions to address widespread noncompliance in the crypto markets. But, noncompliance, and the attendant investor risk, remained pervasive. Meanwhile, four months later, the combined market capitalization of crypto assets reached approximately $3 trillion. [49] This marked a 15-fold increase from just two years earlier.[50] Soon after, however, the crypto market cratered, abetted by a series of high-profile failures and bankruptcies of major firms that caused extensive investor losses.[51] It lost two-thirds of its market capitalization in just nine months, shedding value even quicker than it had gained it.[52]

In short, my tenure as Director has coincided with extreme volatility and investor risk in the crypto markets. This has been vividly demonstrated by the dramatic increase in the number of complaints about crypto that investors submitted to the SEC’s Office of Investor Education and Advocacy (“OIEA”), from 820 in fiscal year 2019,[53] the first year that OIEA’s annual list of Top Ten Categories of Complaints included crypto, to 5,357 in fiscal year 2023.[54]

In response to this upheaval and rampant noncompliance, we have redoubled our enforcement efforts, some of which I was privileged to highlight in my speech at William & Mary. Perhaps unsurprisingly, there have been even more developments in the crypto markets since those remarks. Just days later, the Pew Research Center released a survey finding that nearly a third of Americans who had ever invested in, traded, or used crypto, no longer held any. [55] The number of lower-income Americans who had gotten out of crypto was even higher, at 43%,[56] providing another vivid rejoinder to the narrative that crypto will uplift the unbanked, help them build wealth, and increase upward mobility.[57]

The same survey found that a whopping three-quarters of Americans who have heard about crypto do not believe that crypto is reliable and safe.[58] Given the continued noncompliance in this space, they have good reasons to be concerned. For example, in June 2023, the SEC charged the operators of the largest crypto asset trading platform in the world with allegedly combining the functions of an exchange, broker, dealer, and clearing agency without complying with the registration provisions of the federal securities laws applicable to any of those functions, depriving investors of crucial investor protections.[59] The SEC’s complaint also alleged that the operators commingled certain customer assets and attempted to evade U.S. securities laws by announcing sham controls that they disregarded so that they could keep high-value U.S. customers on their platforms.[60]

The next day, the SEC also charged the operator of the largest crypto asset trading platform in the United States with intertwining the traditional services of an exchange, broker, and clearing agency without complying with the registration provisions applicable to any of them.[61] Taken together, these matters, which were brought just about two months after my remarks, highlight what I believe to be the continued risk to investors in the crypto markets.[62]

As if that were not enough, the Enforcement Division continues to address fraud and noncompliance in new and old forms in the crypto space. Among others, the SEC filed its first actions charging the illegal unregistered offerings of crypto asset securities in the form of purported non-fungible tokens (NFTs), applying the same well-trod test discussed above to determine that the NFTs were offered and sold as “investment contracts,” and therefore were securities.[63] The SEC also brought its first case charging a purportedly decentralized autonomous organization with failing to register its pooled crypto asset vehicles as investment companies, as required under the federal securities laws.[64] And in another recent action, the SEC brought charges against individuals allegedly responsible for a $1.7 billion crypto asset-related pyramid scheme.[65]

Also notable, since my remarks, several courts have issued rulings in ongoing litigation expressly reaffirming Howey’s application to crypto assets and rejecting not only the defendants’ blanket arguments that the crypto assets at issue were not securities, but also, in the cases where the court addressed it, their attempt to invoke the “major questions doctrine.”[66]

In addition, in April 2024, the SEC completed its first trial involving crypto asset securities. After a nine-day trial, a jury in the United States District Court for the Southern District of New York found the defendants liable for orchestrating what the SEC alleged was a years-long fraud involving crypto asset securities that led to massive investor losses when the scheme unraveled.[67] Following the verdict, the defendants agreed to pay more than $4.5 billion in disgorgement, prejudgment interest, and civil penalties.[68]

In sum, the crypto markets remain fast-moving, volatile, and, I believe, rife with investor risk. But as the foregoing remarks and this epilogue make clear (and if the past and my remarks at William & Mary are prologue), the Division of Enforcement has moved with urgency, and will continue to do so, to fulfill our investor protection mandate in these markets.