Blockchain+ Bi-Weekly - October 19, 2023

Thursday, October 19, 2023

The Blockchain Bi-Weekly presented by the Polsinelli Blockchain+ team is a rundown of some of the key stories in the Web3, blockchain and crypto ecosystems curated by our attorneys navigating the intersections of code, smart contracts, and US law.

For the past two weeks, all eyes have been on the trial of Sam Bankman-Fried, the disgraced founder of the defunct digital asset exchange FTX. Of course, it’s only natural for peoples’ attention to be drawn to the biggest alleged financial fraud trial since Bernie Madoff; but the SBF story is more of a story of unchecked power than anything specific to digital assets.

While many were focused on that front-page criminal trial, the SEC has been busy the past two weeks as well—to far less media fanfare.  The agency’s request for an interlocutory appeal in Ripple was denied, and it also did not file an appeal in the Grayscale matter signaling potential digital asset financial product approvals in the future. The agency also filed its response to Coinbase’s motion for judgement on the pleadings and had a range of amicus come out in support of its motion.

These developments and a few other brief notes are discussed below.

Criminal Trial of FTX Founder Sam Bankman-Fried Begins: October 3, 2023

Background: The Sam Bankman-Fried (“SBF”) trial started on October 3, 2023, and is the biggest financial fraud trial since Bernie Madoff. SBF was the founder of the now-defunct digital asset exchange FTX. He is accused of seven counts of fraud, conspiracy and money laundering centering on his alleged use of customer deposits on the crypto trading platform FTX to cover losses at his hedge fund, Alameda Research, and on personal expenses. The trial is expected to last six weeks.

Summary: The first two weeks of trial resulted in some headline-grabbing moments, as did the Michael Lewis book “Going Infinite” which follows SBF and was published the weekend before SBF’s trial began. It will be impossible to tell the story of Web3 law in 2023 without mentioning the SBF trial, but this is less a story about cryptocurrency and more a story about standard financial fraud, albeit on a larger scale than most. While we will continue to cover the trial in these updates, we will likely keep the ongoing updates in the Briefly Noted section to not distract from the real developments in blockchain law.

SEC’s Request for Interlocutory Appeal in Ripple Denied: October 3, 2023

Background: The SEC was denied its request for an interlocutory appeal at the trial court level, meaning the agency will need to take up its arguments on appeal after the trial on remaining merits issues scheduled for April 23, 2024. This means there is no chance of appellate review prior to 2024 as the SEC hoped for, and there is virtually no chance any decision could reach the Supreme Court before 2026

Summary: The judge in Ripple clarified her Order that a Howey analysis is a facts and circumstances analysis, and her ruling was based on the facts and circumstances specific to this case and not the laws of digital assets generally. Any loss for the SEC is good for the industry at this point. However, there is no way to know if the 2026 or beyond SCOTUS will be made up of justices who are as hostile to agency overreaches as the current SCOTUS is. This leaves lower courts to continue to decide one-off issues until there is Congressional movement, the SEC changes its enforcement strategies or SCOTUS decides the issue in 2026 or beyond.

SEC’s Files Response in Opposition to Coinbase Motion for Judgment: October 3, 2023

Background: The SEC has filed their opposition to the Coinbase Motion for Judgment under Rule 12(c). The agency came out swinging, calling the Coinbase argument flawed and attempting to distance itself from prior statements by the agency which seem to contradict its current litigation posture. There were also three amicus filed in support of the SEC—the first from a group of administrative law scholars; the second from the New Finance Institute (which appears to be a blog); and the third from the North American Securities Administrators Association.

Summary: The SEC claims in their briefing that both (1) the rights conferred by digital assets are inherent in the code itself (fn. 5); and (2) the SEC is merely there to assure investors receive adequate disclosures (pg. 23). Which is contradictory on its face but does not take digital assets necessarily outside the jurisdiction of the SEC. The agency also claims its briefing in Edward where it said: “‘investment contract’ makes clear that instruments of that name include those in which a return—whether labeled income or profit—is promised in a contract” (emphasis in their briefing) does not mean they were stating a contractual promise is required (fn. 7). That said, despite logical inconsistencies, the briefing is overall strong as could be expected from the top litigators in the agency, so it remains an uphill battle for Coinbase to get a dismissal this early in the case.

Amicus Come Out in Support of SEC: October 10, 2023

There were three amicus filed in support of the SEC this week —the  first from a group of administrative law scholars; the second from the New Finance Institute (which appears to be a blog); and the third from the North American Securities Administrators Association. The securities administrators focused on the regulation of digital assets at large, the administrative law scholars focused on major question doctrine issues and the bloggers focused on seemingly just disliking cryptocurrencies generally.

Tl;dr: The blogger’s brief is…interesting. It claims that viewing gold as an investment vehicle is incorrect and that the reason there are no cases of an “investment contract” without some contractual arrangement for future work or profits is due to the “base rate fallacy” and not because the SEC is moving the goalpost. It also cites the academic literature of “Wikipedia” and a total of five cases in the briefing.  The administrative law scholars focus on the major question doctrine claiming the doctrine does not apply to agency enforcement actions, even though the Administrative Procedures Act does apply to such situations. The securities regulators of course argue that securities regulations are clear and the SEC’s enforcements have been consistent. In sum, it appears that (as could be expected) the Coinbase amicus with interested industry filers were seemingly stronger than the SEC amicus, as it is rare to see administrate agencies gain support at the trial level for enforcement actions over any industry actors.

SEC Lets Appeal Deadline Pass in Grayscale Matter: October 13, 2023

Background: We previously covered the D.C. Circuit’s decision in Grayscale, which found the agency acted arbitrarily and capriciously in denying the Grayscale spot Bitcoin ETF. The Court ruled that there was no basis for the SEC to claim that a Bitcoin Spot ETF would be any more subject to potential manipulation than the Bitcoin futures ETF which had already been granted by the agency. The SEC’s deadline to appeal that decision was October 13, 2023, and the agency apparently decided against filing an appeal in the Grayscale matter, which signals a likely approval for one of the various spot Bitcoin ETFs in the near future.

Summary: While the SEC’s failure to appeal the Grayscale matter is an important indicator of the likelihood of future approvals, it does not mean approvals are imminent. It certainly does not help that a recent and since retracted leak of an early approval caused Bitcoin price to quickly rise, only to fall when it was revealed to be false reporting. It is possible the SEC will point to that as evidence of spot market manipulation ability. It is important to note that, at minimum, any decision for approvals or denials on products like a spot Bitcoin ETF would come from a closed meeting of the Commission and is not something that the SEC would delegate this for random approval.

Briefly Noted:

U.S. Registered ETH Futures Trading Begins: The ETH futures ETF has started trading in the U.S., making it clear that even the SEC does not consider ETH a security, otherwise it would never be allowed to trade in securities markets. The playbook for a spot ETF is clear, with Grayscale again leading the way.

SEC Updated Third Circuit on Rulemaking: The SEC sent their Court-mandated update on the status of digital asset rulemaking, and it technically meets the Court’s order but just barely. I can’t imagine this is the expected level of transparency the Third Circuit was expecting when they kept this case on their docket to babysit the agency. Coinbase filed their own reply in response, accusing the SEC of more delays and gamesmanship.

California Passes Comprehensive Digital Asset Registration Law: California Governor Newsom has signed the state’s “Bitlicense” bill into law which will go into effect on July 1, 2025. California joins New York as a state with fairly comprehensive regulatory regimes for digital assets. Any companies in the space operating in California should begin working towards compliance now.

SEC Includes Crypto Assets on Examination Priorities Report: The SEC released its Division of Examinations Priorities Report outlining the Division's examination priorities for the coming year. Crypto is once again an exam priority for registered investment advisers and broker-dealers. The Division said it will keep monitoring firms and conduct exams "when appropriate," in light of "the continued volatility of, and activity around, the crypto asset markets."

Conclusion:

In the midst of the high-profile trial of Sam Bankman-Fried and the buzz surrounding the cryptocurrency world, it becomes evident that this legal landscape is evolving rapidly. The SBF trial serves as a stark reminder of the perils of unchecked power, transcending the digital asset realm to illuminate broader issues of financial fraud. Meanwhile, the SEC's recent developments, from the denial of its interlocutory appeal in Ripple to its response in the Coinbase case, hint at the complex and ever-changing regulatory environment for cryptocurrencies. As the legal saga continues to unfold, it is clear that the future of blockchain law will be shaped by these pivotal moments, and we'll be here to keep you updated on these critical developments.