On January 10, 2022, tZERO’s ATS settled a matter with the SEC in which it agreed to an $800,000 fine. Given the size of the penalty and substantial attention on the SEC’s approach to regulating digital asset securities, readers may have thought that this would present a blockbuster set of facts. Unfortunately, the settlement shines little light on how the SEC seeks to regulate digital asset security trading platforms, other than to show that the SEC continues to apply existing rules and regs, even when there are novel facts and circumstances at play. In fairness to the SEC, they have literally and continually told the public that they are taking this approach. But saying something over and over again does not validate a particular course of action.
By way of background, tZERO operates an ATS that offers trading in both traditional securities (including “NMS securities”) and what tZERO refers to as “digitally enhanced securities”—a term we have only seen tZERO use until the SEC reiterated it in the settlement order—that sort of makes it a real thing now. tZERO considers digitally enhanced securities to be those that are “settled using software and a distributed ledger as the primary record of beneficial ownership” and others that are “traditional, uncertificated securities whose ownership is tracked by a transfer agent, with certain additional ‘technology elements’ such as a ‘digital courtesy carbon copy’ of the official stock register.” The two most notable digitally enhanced securities were issued by affiliates Overstock and tZERO Group, which mandated that those securities trade only on tZERO’s ATS.
The settlement focuses on three alleged violations:
- tZERO did not timely file a required amendment on Form ATS to reflect a material change to the operation of the platform. In particular, tZERO failed to disclose (for a period of nearly three years) that it was sharing order information from its NMS stock order book after hours with an unregistered entity based in Asia, the assets of which a tZERO affiliate eventually acquired. tZERO took even longer to file the required disclosure regarding the affiliated nature of the relationship. ATSs are required to file amendments to Form ATS at least 20 days before any material changes in operations.
- In a similar but separate violation, tZERO did not timely file a Form ATS amendment to disclose that customers of the ATS’ sole broker-dealer subscriber would be able to see the orders for digitally enhanced securities resting on tZERO’s ATS. In this case, tZERO seems to have made the required filing approximately three months after this activity began.
- tZERO violated the “fair access” rule of Regulation ATS, which requires an ATS with at least 5% of average daily volume for any equity security that is not an NMS stock and for which transactions are reported to an SRO to establish written standards for granting access to trading on its system, not unreasonably prohibit or limit any person from accessing the system, maintain certain records, and report certain information on Form ATS-R. tZERO’s ATS was the sole trading venue for certain digitally enhanced securities and the SEC seems to view this as a de facto crossing of the 5% threshold—no real surprise there. tZERO’s policies and procedures did not include standards for granting access as required by the rule—at one point in time they even mistakenly stated that the ATS was not subject to the requirement.
This settlement spawns several questions to which we will likely never have answers. Does the SEC consider tZERO’s sharing of information with the Asian entity (later an affiliate) to be problematic, or was it really just relevant because tZERO did not disclose it? Did tZERO fail to provide fair access, or did it simply not have polices covering that requirement? Did the SEC consider the “digitally enhanced” or blockchain nature of tZERO’s business in setting the fine amount? Or did the duration and number of the alleged violations contribute to the penalty amount? Anecdotally, $800,000 feels like an outsized penalty for tZERO’s alleged violations, but we’ll likely never know if there was more at play here.
What we do know is that the SEC is content to apply existing rules and frameworks to new technologies and processes. We have all heard rumblings of ideas for a new crypto regulator or new legislation from Capitol Hill. Neither of those are likely, at least not anytime soon. And so the crypto and blockchain community should take this settlement as yet another reminder that the SEC expects their business practices to comport with requirements under existing, traditional federal securities laws, even when the platform or protocol deploys novel processes and technologies.
This is difficult for industry participants in the case of simple “digitally enhanced securities” and extremely difficult with other digital assets, as we noted previously [link] where ownership, governance, participation, development and operations may be decentralized across the globe.
 An “NMS security” is any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.