As cryptocurrencies declined in value during 2022, state and federal regulators stepped up their enforcement efforts to regulate these evolving currencies. This article summarizes actions taken by the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), the Commodities Futures Trading Commission (CTFC), and the implications of certain private litigations.
SEC Enforcement Actions
In addition to the market capitalization decline, Crypto companies also dealt with a record number of crypto-related enforcement actions. The SEC issued 30 crypto-related enforcement actions, 24 litigations in U.S. federal court, and six administrative proceedings in 2022. This was a 50% increase from 2021.
The 2022 SEC Cryptocurrency Enforcement Update report indicated that of the 30 crypto-related enforcement actions in 2022, 14 were related to initial coin offerings (ICOs) and 57% of those ICO-related actions included fraud allegations. Further, 73% of the actions alleged unregistered securities offerings in violation of Sections 5(a) and 5(c) of the Securities Act; and 70% alleged fraud under Section 17(a) of the Securities Act and/or Section 10(b) and Rule 10b-5 of the Exchange Act; and 50% alleged both violations. FTX’s collapse caused the SEC and CFTC to file civil actions in the U.S. District Court for the Southern District of New York against the former CEO and CTO, both cofounders, of FTX and the former CEO of Alameda Research. The authorities have alleged that FTX’s CEO, Sam Bankman-Fried committed years-long fraud, provided misleading statements, and concealed information from its investors including the undisclosed diversion of FTX’s funds to Alameda Research, Bankman-Fried’s privately-held crypto hedge fund; the undisclosed special treatment afforded to Alameda on the FTX platform, including the near-unlimited “line of credit” funded by FTX platform’s customers to Alameda and exemption from certain key risk-mitigation measures; and the undisclosed risk stemming from FTX’s exposure to Alameda’s significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens. The complaint filed by the SEC charged FTX’s CEO with violating the anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. Bankman-Fried was also criminally indicted and charged with eight counts: conspiracy to commit wire fraud, wire fraud, conspiracy to commit commodities fraud, conspiracy to commit securities fraud, conspiracy to commit money laundering, and conspiracy to defraud the Federal Election Commission and commit campaign finance violations. After being released on bail, on Jan. 3, Bankman-Fried pleaded not guilty to the criminal charges. The trial is set to begin Oct. 2, 2023.
In four actions against crypto companies, the SEC alleged the companies failed to register as broker-dealers under Section 15 of the Exchange Act. The SEC also initiated proceedings against individuals for failing to disclose compensation for promoting crypto investments. Specifically, the SEC charged both billionaire Kim Kardashian for her promotion of Ethereum Max, and charged Ian Balina for promotion of Sparkster’s SPRK tokens for failure to disclose they were receiving compensation for their promotion of the projects under Section 17(b) of the Securities Act. The SEC also alleged market manipulation under Section 9(a)(2) of the Exchange Act against The Hydrogen Technology Corp., its former CEO, and its “market maker” in connection with the offer and sale of crypto-asset securities. Specifically, the SEC alleged that the defendants manipulated the price and volume of tokens traded on crypto-asset trading platforms so that their company could sell its own tokens for a greater profit. In other words, the company was accused of engaging in the classic “pump and dump.”
As of Dec. 31, 2022, the total monetary penalties the SEC charged in crypto-related actions since 2013 totaled $2.61billion, $242 million in 2022 alone.
The SEC has been successful in the courthouse. It prevailed in its motion for summary judgment against LBRY, Inc., a blockchain-based streaming and publishing firm. On Nov. 7, 2022, the U.S. District Court for the District of New Hampshire held that LRBY’s token, (while not distributed through an initial coin offering) constituted a “security” under the law. The court found that LBRY was in violation of Section 5 of the Securities Act. The effect of this ruling demonstrates at least one court’s willingness to find that digital assets fall under the definition of an investment contract under the U.S. Supreme Court’s Howey test, (the standard to determine what is considered an investment contract).
This decision may set precedent for the ongoing SEC v. Ripple matter, currently pending in before the federal court in the Southern District of New York. Such a ruling would further strengthen the finding that crypto offerings should be treated as securities and subject to security regulations.
U.S. Department of Treasury
During the first half of 2022, the Treasury sanctioned the decentralized privacy protocol used by Tornado Cash for its failure to impose effective controls to prevent cybercrime related to money laundering. This was the first time that a government agency sanctioned a smart contract, or an immutable code living on the blockchain. The U.S. Department of Treasury’s Office of Foreign Assets Control (OFAC) and Financial Crimes Enforcement Network (FinCEN) also partook in its largest virtual currency enforcement actions in 2022 against Bittrex, Inc. OFAC and FinCEN discovered apparent violations of multiple sanctions programs and willful violations of the Bank Secrecy Act’s (BSA) anti-money laundering (AML) and suspicious activity report (SAR) reporting requirements. On Oct. 11, 2022, the Treasury announced two enforcement actions for $24 million and $29 million against Bittrex, Inc. These enforcement actions signal that going forward, violations of OFAC and FinCEN regulations will be subject to appropriate risk-based sanctions compliance controls and meeting obligations under the BSA.
FINRA
FINRA also began to exercise its regulation prerogative by announcing that it would conduct a new examination of “crypto asset communications” by broker-dealers with retail investors regarding “crypto assets.” Crypto assets are defined as assets that are issued or transferred using distributed ledger or blockchain technology and include virtual currencies, coins, and tokens. The exam letter requests, among other information, that all recipient firms conduct an assessment of retail communications concerning crypto asset products and services to ensure compliance with FINRA Rule 2210. FINRA Rule 2210 governs broker-dealers’ communication with the public and intends to ensure that communications include “material facts or qualifications necessary to ensure such communications are not misleading.” This new exam letter regarding crypto-market communications will push broker-dealers to review their communications in relation to crypto assets to assess whether the communications reflect material risks investing in crypto assets.
The Commodity Futures Trading Commission
The CFTC continued to focus on cryptocurrency companies during 2022, with 18 of the 82 enforcement actions it filed involving digital assets. In addition, the CFTC filed its first action against a decentralized autonomous organization. In the CTFC’s enforcement results for the Fiscal Year 2022, the commission highlighted its penalty against bZeroX, for offering illegal, off-exchange digital asset trading, failing to comply with the Bank Secrecy Act, and numerous registration violations. The CTFC also charged a major U.S. cryptocurrency spot exchange for making materially false and misleading statements and omissions to the CTFC in connection with a designated contract market’s self-certification of a bitcoin futures product. The CTFC also charged Digitex, a digital asset derivatives platform, and a Florida resident for facilitating unlawful futures transactions, failing to register, and the attempted manipulation of a native token. Cryptocurrency trading platform Bitfinex was found to be engaged in illegal, off-exchange retail commodity transactions in digital assets without registering as required. In addition, Tether Holdings Limited was found to have made misleading statements and omissions of material fact in connection with its U.S. dollar-tied stable coin and was fined a civil monetary penalty of $41 million.
The CFTC also charged a South African pool operator, Mirror Trading International Proprietary Limited, with commodity pool fraud, a $1.7 billion fraud action, marking its biggest action involving cryptocurrencies to date.
U.S. Private Litigations
Private litigation relating to crypto companies and offerings exploded last year. Approximately 44% of the suits filed against crypto companies were class actions. Of these, there were 25 crypto-related class actions filed in federal courts. Celebrities were accused of pump-and-dump schemes, for either the promotion of cryptocurrency or the promotion of cryptocurrency with misleading information. Class action lawsuits were filed against major cryptocurrency companies including Coinbase, Binance, TerraForm Labs, Celsius Network, and FTX, alleging securities fraud, false and misleading statements, false advertising, inadequate risk management, and running Ponzi schemes. Most recently, FTX customers filed a class action lawsuit at the end of December against FTX and its former top executives, seeking a declaration that the company’s holdings of digital assets belong to the customers.
Conclusion
Enforcement actions by the SEC, CFTC and Treasury will continue as regulators determine whether to treat these assets as securities, commodities or a hybrid of both. The regulators are all trying to determine their roles in these evolving currencies and are awaiting legislative action. Until such direction is provided, the story will likely evolve in our court system.
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Reprinted with permission from the March 1, 2023 edition of the The Legal Intelligencer © 2023 ALM Global Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-256-2472 or reprints@alm.com.