“Regulation by Enforcement” in the Digital Asset Industry: A Lagging Response to Stale Facts

The Securities and Exchange Commission (SEC) has used and continues to use enforcement actions as the principal tool in its tool kit in asserting regulatory jurisdiction and oversight over the blockchain and digital asset industry. In its 2022 fiscal year, the SEC filed 760 total enforcement actions, including a number of significant enforcement actions involving a digital asset component, and significantly expanded the (newly renamed) Crypto Assets and Cyber Unit within the SEC’s Division of Enforcement. This enforcement activity continued in the first half of 2023 in the wake of the widely publicized FTX collapse, with the SEC announcing settlements with multiple well-known digital asset industry participants, including a settlement agreement shutting down Kraken’s staking-as-a-service product offering in the United States, and claiming victory in various enforcement matters such as the LBRY litigation.¹

Like other regulatory agencies, the SEC has two principal tools through which to implement its statutory mandates and regulate markets within its jurisdiction. First, whether by formal notice and comment rulemaking or by other informal means such as interpretive guidance released through agency channels (No-Action Letters, Staff Legal Bulletins, Compliance and Disclosure Interpretations, etc.), the SEC can establish guidelines and/or set expectations of general application on a prospective, forward-looking basis. Indeed, under prior administrations, there were some limited efforts and steps by the SEC toward providing interpretive guidance to the industry.²  More recently, however, these have come to an abrupt halt, with the last No-Action Letter to address digital asset issuance released in November 2020. 

Second, through enforcement actions, the SEC can enforce existing rules by way of ex post sanctions with respect to conduct it deems in violation of existing regulations.³  The SEC has chosen to rely primarily on this second tool, resulting in what has been dubbed “regulation by enforcement,” which many, including SEC Commissioner Hester M. Peirce,⁴ members of Congress such as House Financial Services Committee Chair Patrick McHenry,⁵  and digital asset industry leaders and participants, have lamented and strongly criticized due to its inherent limitations. 

Reliance on enforcement as the principal tool for regulation is beset by fundamental limitations as a means of policymaking and setting regulatory expectations for a nascent and rapidly evolving technology and industry. In particular, by reference to the example of the well-known and ongoing saga of the SEC’s litigation with Ripple concerning XRP, we set forth below how the ex post nature of enforcement actions as a response to factual scenarios and market trends that are now many years stale render it a lagging indicator and a deficient regulatory tool that provides relatively little by way of prospective, useful guidance to current market participants.

Sanctioning bad actors

Setting aside the baseline issue of whether the SEC has any jurisdiction over digital asset transactions as securities transactions, there are certain instances, typically in connection with capital raising transactions, in which fraudulent actors promised efforts and corresponding returns, thus satisfying the Howey test factors, or other examples of bad-faith actors such as those involved in Ponzi schemes and other fraudulent activities. The SEC has a statutory investor protection mandate, and enforcement actions represent an important tool in the furtherance of this mandate as a means to hold wrongdoers accountable, secure disgorgement of ill-gotten gain, and deter future misconduct. In that regard, this kind of use of enforcement is not seriously subject to criticism as regulation by enforcement. That is because these sorts of cases reflect the policing of established and uncontroversial norms and prohibitions — e.g., prohibitions against fraud and misappropriation — rather than true exercises in novel policymaking or the extension of existing regimes to good-faith actors in nascent industries.⁶ 

The limited predictive value of settlements

As is well known, the vast majority of enforcement actions pursued by the SEC are not ultimately resolved by contested litigation before the courts. Rather, most enforcement actions are concluded and made known to the public following settlement between the SEC and the relevant party, generally on a no-admit, no-deny basis. There are a range of factors that may go into a party’s decision to settle an enforcement action, from the party’s own perception of their culpability (or lack thereof) to more practical concerns such as the costs of litigating a matter (specifically, available financial resources relative to the high costs of protracted discovery and litigation and material legal expenses) in comparison to potentially more favorable settlement terms and the perceived beneficial certainty and time savings of an early settlement.

Furthermore, by the very nature of an SEC settlement, especially an SEC settlement on a no-admit, no-deny basis, the encapsulation of the underlying facts and conduct conveyed to the market is likely to be imperfect and one-sided. The facts recited in SEC settlements are the facts as the SEC asserts them, and thus rarely reflect anything remotely like a balancing of arguments or mitigating facts of the settling party, and have not been established by way of contested litigation. Additionally, settlements do not require fulsome legal analysis and are often conclusory on important points that, if more fully explained or argued before and ruled upon by a court, would actually provide valuable guidance to industry participants.

The point is that while settlements (and even contested litigation) may allow agency staff to broadly signal a general directional view or policy position (that the SEC does not like crypto is quite clear, for example), they serve as a highly imperfect predictive tool in terms of conveying precise regulatory expectations to other market participants. For example, what were the most relevant facts in motivating the enforcement? Were there potential mitigants that were available but not taken? Were such mitigants taken but not sufficient? Was the enforcement case truly a slam dunk, or was settlement just expeditious or prudent risk management?

Enforcement as a lagging response to stale facts

Perhaps the primary and most fundamental limitation of enforcement actions and litigation as a means of conveying regulatory expectations is their inherently backward-looking nature. Especially in the case of protracted litigation before the courts, the relevant underlying facts will have taken place many years prior and may represent market trends or practices that are stale and no longer extant in the industry. In these sorts of circumstances, the use of enforcement to convey regulatory expectations to other market participants based on stale facts that were never the subject of prospective rulemaking is legitimately subject to criticism as regulation by enforcement. As Commissioner Peirce has remarked, “[t]he regulation-by-arbitrary-and-tardy-enforcement-actions approach . . . is the opposite of a rational regulatory framework.”⁷ 

These limitations on the use of enforcement actions as a means of conveying prospective regulatory expectations are well illustrated by comparison of the initial coin offering (ICO) boom and the material evolution in the way in which protocols and digital assets are now launched. The evolution of the industry, in part in response to the early SEC actions through which the SEC firmly staked its claim of jurisdiction over the industry, but more heavily attributable to improved technological means of achieving fair distributions to seed more mature decentralized networks, has resulted in the industry moving away from certain offering models and features of early ICOs that are now viewed as indicative of an unregistered securities offering. For example:

• Many early ICOs were expressly intended as capital raising exercises.
• Many early ICOs marketed themselves as investment or profit-making opportunities.
• Digital assets were sold prior to the relevant network or protocol launching or being operational.
• Many projects touted their own efforts to increase the value of the relevant digital asset, develop an ecosystem of use cases around the relevant digital asset, or pursue listing on exchanges to promote secondary market trading.

In stark contrast, in our experience, more recent protocol and digital asset launches reflect materially different factual circumstances to those of the early ICO boom. For example, in typical, current market practice:

• Equity capital from sophisticated institutional investors is the primary financing tool for development.
• Digital asset sales, especially to retail individuals, are not utilized to raise capital.
• Digital assets are launched after the relevant network or protocol is operational and in use, and they serve a useful function within such network or protocol.
• Good-faith market participants are launching the respective protocol’s native tokens with real utility within the relevant network or protocol, often well after the launch of the underlying project, application or protocol.
• Many digital assets are launched in connection with an application, network, or protocol that is decentralized, serving as the tool powering overall governance or facilitating transactions among globally decentralized counterparties.

In this regard, the SEC’s ongoing litigation with Ripple Labs concerning the security status of XRP is illustrative of the limited utility of enforcement as a means of prospective regulation for other market participants. Quite simply, the facts are stale and market practice has evolved. Many of the facts alleged by the SEC align with common characteristics exhibited in the early ICO boom identified above. For example, the SEC alleges that XRP was sold prior to any actual use case or functionality. The SEC’s allegations also emphasize touting of XRP’s profit potential, managerial efforts to create an “ecosystem” around XRP, and the supply of XRP retained by Ripple and its founders so as to align incentives.

However, as described above, current market practices around protocol and digital asset launches are materially different. Furthermore, the application of the laws implicated by protocol and digital asset launches — including the Securities Act of 1933 and its interpretation in Howey and its progeny — is always highly dependent on the facts and circumstances surrounding the offer and sale of the alleged security. Thus, while the outcome of the XRP litigation will undoubtedly be of significance for Ripple and XRP holders, the implications for modern launch plans and digital asset distribution models with materially different facts are likely to be limited.

Ultimately, the inherently ex post nature of enforcement actions as a response to factual scenarios in the past fundamentally limits its utility as a means to convey regulatory expectations to current market participants. This is true notwithstanding the fact that the SEC’s enforcement approach with respect to the digital asset industry now resembles carpet-bombing efforts rather than strategic or targeted actions intended to signal principled policy positions, as was more typical of the SEC under its prior leadership. The messages conveyed to the market now resemble more of an attempt to sow chaos and confusion rather than trying to signal particular policy directions or regulatory expectations to the market. In a context where market practices evolve nearly as quickly as blockchain technology itself has evolved, the specific factual circumstances at issue in an enforcement action are typically stale and no longer prevalent in practice, thus rendering the guidance value of the enforcement action as a means of conveying regulatory expectations to others minimal or arguably even counterproductive where no reasonable strategy is discernible. Absent actual ex ante rulemaking, market participants are left in the same uncertain position they have been in for years — uncertainty as to the regulatory expectations with respect to current facts and market practices. 

^[1] SEC v. LBRY, Inc., No. 1:21-cv-00260-PB, 3 (D.C. N.H. Nov. 7, 2022)
^[2] See, e.g., Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Securities Act Release No. 81207 (2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf; SEC Strategic Hub for Innovation and Financial Technology, Framework for “Investment Contract” Analysis of Digital Assets (Apr. 3, 2019), available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets; SEC Division of Corporation Finance, No-Action Letter on TurnKey Jet, Inc. (Apr. 3, 2019), available at https://www.sec.gov/divisions/corpfin/cf-noaction/2019/turnkey-jet-040219-2a1.htm; SEC Division of Corporation Finance, No-Action Letter on Pocketful of Quarters, Inc. (July 25, 2019), available at https://www.sec.gov/corpfin/pocketful-quarters-inc-072519-2a1.
^[3] Notwithstanding the prolific use of speeches, tweets, and YouTube videos by the SEC chair, none of these are actions or words attributable to the SEC as an agency nor, despite apparently being deployed as a tool by the chair, do they serve as actionable policy or reliable interpretations of the agency or its staff.
^[4] See, e.g., Commissioner Hester M. Peirce, Outdated: Remarks before the Digital Assets at Duke Conference (Jan. 20, 2023), available at https://www.sec.gov/news/speech/peirce-remarks-duke-conference-012023.
^[5] See, e.g., Politico, McHenry clashes with SEC’s Gensler over crypto crackdown (Apr. 18, 2023), available at https://www.politico.com/news/2023/04/18/mchenry-gensler-crypto-hearing-00092531.
^[6] This has typically held true until recent actions by the SEC in cases of “insider trading” with respect to secondary trading markets for digital assets in which the Department of Justice was able to police bad actors but the SEC also filed a complaint on the basis that the trading activity related to trading in securities. See SEC v. Wahi, No. 2:22-cv-01009 (W.D.Wash. Jul. 21, 2022), available at https://www.sec.gov/litigation/complaints/2022/comp-pr2022-127.pdf; United States v. Wahi, No. 22-cr-392 (SDNY Jul. 21, 2022), available at https://www.justice.gov/usao-sdny/press-release/file/1521186/download.
^[7] Commissioner Hester M. Peirce, Outdated: Remarks before the Digital Assets at Duke Conference (Jan. 20, 2023), available at https://www.sec.gov/news/speech/peirce-remarks-duke-conference-012023.