On October 8, 2024, Crypto.com filed a civil complaint against the Securities and Exchange Commission (“SEC”) and each of its Commissioners in the Eastern District of Texas seeking declaratory and injunctive relief. Crypto.com sued the SEC after the regulator sent it a Wells notice, indicating the Division of Enforcement intended to recommend an enforcement action against the Company for operating as an unregistered securities broker-dealer and an unregistered clearing agency in connection with secondary-market sales of certain Targeted Network Tokens.[1]
In its lawsuit, Crypto.com alleges that the SEC exceeded its legal authority in asserting jurisdiction over nearly all crypto assets. The Complaint further alleges that the SEC improperly created a financial instrument known as the “Crypto Asset Security,” which is subject to regulation under the Securities Act and the Exchange Act. Crypto.com claims that the SEC did so without statutory authority or formal rulemaking in an impermissible attempt to extend the SEC’s regulatory reach over the digital asset industry.
What Makes a Digital Asset a Security
The SEC has brought a large number and variety of enforcement actions against crypto asset market participants, arguing that existing securities laws conferred jurisdiction over transactions involving those assets to the SEC. Many leading crypto market participants and executives, along with academics, policy leaders, and members of Congress, have criticized the SEC’s approach and questioned its authority to regulate crypto assets under existing law. Crypto.com’s suit against the SEC raises some of those same criticisms and arguments, setting up the possibility that the foundational issue of who regulates crypto asset transactions could be resolved in an affirmative case filed against the SEC, rather than one brought by the regulator at the time and place of its choosing.
In previous crypto cases brought by the SEC, the agency has applied the Supreme Court’s investment contract formulation from SEC v. Howey and its progeny, to support claims that the crypto assets at issue were offered and sold as securities. Under the Howey test, an investment contract is formed when there is an investment of money in a common enterprise with an expectation of profits derived from the efforts of others.[2]
The SEC has taken the position in a variety of enforcement actions that crypto assets offered and sold in the secondary market were investment contract transactions and therefore securities. According to the SEC, in those transactions passive investors made investments of money in a common enterprise in reliance on the efforts of promoters to generate investor profits. In light of the SEC’s litigation history, Crypto.com took the initiative and filed suit against the SEC, rather than wait to see if the SEC was going to proceed with its indicated intent to pursue an enforcement action against it.
Crypto.com’s Theory of the Case
In its Complaint, Crypto.com asks the court to declare that the SEC lacks authority over it, providing several arguments why. First, Crypto.com argues that the SEC has effectively expanded the definition of security to include a new instrument, Crypto Asset Securities, but the SEC lacked the legal authority to expand the definition in this way. Crypto.com next directs the Court’s attention to a recent acknowledgement by the SEC that tokens, on their own, do not constitute investment contracts and therefore securities.[3] According to Crypto.com, the SEC’s jurisdiction hinges on whether Crypto.com engages in transactions of investment contracts, which require enforceable commitments to undertake profit generating efforts.[4] Crypto.com asserts that it only buys and sells tokens without making any additional promises or representations. There are therefore no investment contracts formed. Instead, they only transact in tokens, which are not securities. Crypto.com further argues that even if promoters made encouraging statements about their intent to work to support a network, that is not an enforceable obligation, which must be present to form an investment contract. Crypto.com also questions whether the common enterprise requirement is satisfied and that token purchasers do not invest in a common enterprise because the payment for the tokens they buy goes only to another secondary market participant and is never received by the promoter or issuer or used by them to further the interests of investors.
Crypto.com’s Complaint also asserts that the SEC’s enforcement approach is impermissibly arbitrary and capricious because it treats similar network tokens differently without explanation or good basis. Earlier in 2024, the SEC approved the listing and trading of spot bitcoin and spot ether exchange traded products (“ETPs”) under the rules applicable for non-securities commodity-based trust shares.[5] That would not be the correct structure if the SEC considered either bitcoin or ether to be offered and sold as securities. Crypto.com argues the SEC lacks a reasonable basis to treat bitcoin and ether as being outside SEC jurisdiction while claiming other Targeted Network Tokens with similar characteristics are within it.
Finally, it is important to note that Crypto.com chose to file this Complaint in the Eastern District of Texas, Tyler Division. A casual observer might think Crypto.com is based in Los Angeles, where its name adorns the arena for the NBA Lakers, or in Miami, where it has had an influential presence in the city’s crypto scene and long had its U.S. headquarters. But in fact, Crypto.com moved its headquarters to Tyler, Texas—announcing the move on October 3, 2024—and within a week filed its Complaint there. It is not clear that the chance to establish favorable venue played into Crypto.com’s relocation plans, but it had the effect of shifting the litigation to the Fifth Circuit, which has taken a skeptical view of SEC authority in several other cases.[6] In contrast, although the Eleventh Circuit has not yet directly addressed the jurisdictional issues Crypto.com raised in its Complaint, a district court in Miami issued rulings indicating that whether a crypto asset was offered and sold as part of an investment contract always depends on facts and circumstances, and whether the asset transacted on a secondary market is not dispositive.[7]
Implications for the Cryptocurrency Industry
Historically, financial market participants rarely sued regulators to challenge their jurisdiction. However, crypto has changed this dynamic. In recent years, several crypto companies have gone to court to challenge the SEC’s jurisdiction and regulatory approach. This case by Crypto.com indicates that crypto companies remain willing to take on the expense and risk of litigation against what the crypto industry has argued constitutes regulatory overreach.
The outcome of this litigation has the potential to reshape the digital asset industry by either confirming or curtailing the SEC’s regulatory authority. A decision in favor of Crypto.com would signal that the SEC lacks jurisdiction over secondary-market sales of network tokens without new formal rulemaking or clear legislative authority. Conversely, if the SEC prevails, platforms like Crypto.com may be required to meet the same registration and compliance obligations as traditional securities platforms, which would impose significant costs and regulatory burdens on these companies. A variety of crypto market participants have argued that their crypto projects are not structured in such a way as to even be able to register with the SEC under current registration requirements, and that complying with SEC registration obligations would be so restrictive as to put them out of business.
Even if Crypto.com is successful in this case, there are a variety of cases pending in other courts and districts around the country that include many of the same arguments and issues. That makes it likely that SEC jurisdiction and the legitimacy of its enforcement approach may not be resolved with any uniformity for some time. Thus, crypto asset market participants operating in the U.S. should continue to think carefully about regulatory exposure and steps that can help reduce it. Some companies have established a separate off-shore presence through which to operate crypto asset ventures beyond the SEC’s jurisdiction. Others have identified exemptions that allow them to control for regulatory risks while still actively participating in crypto markets. And having a regulatory response strategy in place can be very helpful in order to respond most effectively if a regulator asks for information or begins an investigation. Working proactively with internal legal, governance, and compliance functions can help account and control for the challenges of operating a crypto business in the U.S.
Additional Considerations for Companies in the Crypto Industry
- Stay up to Date: Though difficult given the quickly evolving legal landscape, it is important that industry insiders keep informed of legal developments across jurisdictions.
- Be Proactive: Consider periodic legal and compliance reviews to ensure practices keep pace with operations and regulatory developments.
- Get Cyber Confident: The SEC to date has not generally focused on cyber issues in crypto enforcement matters, but cyber vulnerabilities remain a source of significant losses across crypto projects.
McGuireWoods is a national leader in securities enforcement defense. The team comprises former senior SEC and FINRA enforcement attorneys and litigators, as well as high-level federal prosecutors, and is experienced at managing every stage of complex regulatory investigations. Additionally, McGuireWoods attorneys have extensive experience helping clients navigate the intricacies of crypto-related securities laws. Please reach out to us if we can assist you in any manner.
[1] A “network token,” as defined in Crypto.com’s Complaint, is a digital asset used to access or interact with a public blockchain network. Network tokens are transferable digital units that can be bought and sold on secondary markets. The Targeted Network Tokens at issue are SOL, ADA, BNB, FIL, FLOW, ICP, ATOM, ALGO, NEAR, and DASH.
[2] William Hinman, Director, SEC Division of Corporation Finance, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at Yahoo Finance All Markets Summit: Crypto (June 14, 2018), https://www.sec.gov/newsroom/speeches-statements/speech-hinman-061418
[3] On September 12, 2024, the SEC filed a Motion for Leave to File an Amended Complaint in its action against Binance Holdings Ltd., which stated that “[w]ith its use of the term ‘crypto asset securities,’ the SEC is not referring to the crypto asset itself as the security [but as a] shorthand.” Plaintiff Securities and Exchange Commission’s Motion For Leave To Amend The Complaint, S.E.C. v. Binance Holdings Ltd., et al., 1:23-cv-01599-ABJ-ZMF (D.D.C).
[4] These arguments are put forth in more detail in The Ineluctable Modality of Securities Laws: Why Fungible Crypto Assets Are not Securities by Lewis Cohn, Greg Strong, Freeman Lewin, and Sarah Chen.
[5] Securities and Exchange Commission, Order Granting Accelerated Approval of Proposed Rule Changes, as Modified by Amendments Thereto, to List and Trade Bitcoin-Based Commodity-Based Trust Shares and Trust Units, Exchange Act Release No. 99306; Securities and Exchange Commission, Order Granting Accelerated Approval of Proposed Rule Changes, as Modified by Amendments Thereto, to List and Trade Ether-Based Exchange Traded Products, Exchange Act Release No. 34-100224.
[6] On March 15, 2024, the Fifth Circuit granted an administrative stay of the Securities and Exchange Commission’s recently finalized climate disclosure rules. Liberty Energy, Inc. v. Sec. & Exch. Comm’n, No. 24-60109, 2024 WL 1152283, at *1 (5th Cir. Mar. 15, 2024). On June 5, 2024, the Fifth Circuit vacated the SEC’s Private Funds Advisers Rule, which was adopted in August 2023, and held that the SEC exceeded its authority in adopting the rule, and that the SEC lacked the authority to oversee private funds. Nat’l Ass’n of Priv. Fund Managers v. Sec. & Exch. Comm’n, 103 F.4th 1097, 1114 (5th Cir. 2024). On June 26, 2024, the Fifth Circuit determined that the SEC violated the Administrative Procedures Act when it rescinded its notice-and-awareness requirements for proxy advisory firms. Nat’l Ass’n of Manufacturers v. United States Sec. & Exch. Comm’n, 105 F.4th 802, 816 (5th Cir. 2024). And notably, in May 2022, the Fifth Circuit ruled that the SEC’s use of in-house courts to adjudicate enforcement actions was unconstitutional. Jarkesy v. Sec. & Exch. Comm’n, 34 F.4th 446, 466 (5th Cir. 2022).
[7] See Order Denying Motion for Reconsideration, Sec. & Exch. Comm’n v. Arbitrade Ltd, 22-cv-23171-BLOOM/Torres, 18 (S.D. Fla. Mar. 6, 2024).