The Securities and Exchange Commission's (SEC) Division of Enforcement (Division) will soon release its annual report, laying out the Division’s work from Fiscal Year 2021. This will be the first annual report written by new Division Director Gurbir Grewal, who joined in July 2021, and issued under Chairman Gary Gensler, who has called enforcement "one of the fundamental pillars in achieving the SEC’s mission."
This annual report will certainly cover key initiatives and areas of focus from the past year, such as Fiscal Year 2020's work related to investment professionals, financial fraud, and issuer disclosure. It will also provide a summary of the types of cases brought, the total amount of civil monetary penalties issued, disgorgement ordered, and other non-monetary relief. Chairman Gensler has previewed that in the past year the Division "exceed[ed] the number of stand-alone actions against wrongdoers, while total actions are expected to be slightly down." The Division’s annual report is not unlike a public company’s annual report, providing both a quantitative and qualitative assessment of the work done and the initiatives on the horizon.
We look forward to seeing the Division's first report under Chairman Gensler and Director Grewal. We are interested in seeing how the report may reflect their approach to the Division's program on several components, including such items as Chairman Gensler's recommendation to "cut back on meetings with entities that want to discuss arguments in their Wells submissions" and "bring matters to resolution swiftly." We also hope to learn more about the Division’s plans to continue its work with other "federal agencies, law enforcement authorities at the state level, international regulators, and self-regulatory organizations."
With respect to markets subject to the SEC’s oversight, this will be the first annual report to reflect the transition to President Joe Biden's administration and a more progressive policy agenda. We plan to watch for the discussion of a few key areas: the Division's approach to digital asset markets and market participants, the SEC’s enforcement of the recently implemented security-based swap regulations, and actions against special-purpose acquisition companies (SPACs).
Digital Assets and their Status as Securities
Chairman Gensler has spoken forcefully and clearly about his views on whether digital assets are in fact securities, as well as implications for digital asset markets and platforms. Focusing solely on the SEC's enforcement authority, Chairman Gensler has framed the discussion around digital assets in terms of investor protection, but he has also raised the prospect of fraud actions to prevent illicit activity (he has called the digital asset space "rife with fraud, scams, and abuse") and actions against digital asset exchanges and other platforms on the grounds of protecting financial stability. Chairman Gensler has used aggressively provocative descriptions of the digital asset ecosystem, calling the industry the "Wild West" and saying that "large parts of the field of crypto are sitting astride of — not operating within — regulatory frameworks," and noting that the SEC "can do better."
We expect the Division to continue to pursue investigations in all corners of the digital asset ecosystem. Based on Chairman Gensler’s speeches over the summer, we anticipate the potential for more investigations of cryptocurrency exchanges and projects such as stablecoins, as opposed to simply a continued path of high-profile investigations of specific token projects. We also expect actions looking at issues such as lending, financing, and other decentralized finance activities, as well as actions looking at decentralized platforms themselves.
In order to assert jurisdiction in these areas, the SEC must still establish that the digital assets in question are in fact securities. In recent remarks, Chairman Gensler has indicated his view that large numbers of digital asset products are governed by the SEC's definition of a "security" – regardless of the label – and therefore that platforms “whether in the decentralized or centralized finance space . . . are implicated by the securities laws and must work within [the SEC’s] securities regime." The SEC will likely point to wins in federal court in two recent cases that applied the Howey test to digital assets, SEC v. Kik Interactive, Inc. and SEC v. Telegram Group, Inc. et al. Both cases were heard by judges in the US District Court for the Southern District of New York, and both focused on the Howey inquiry as to whether the sale of the digital asset in question constituted (1) an investment of money, (2) in a common enterprise, (3) with an expectation of profit (4) based on the managerial efforts of others. In Kik, Judge Hellerstein found that Kik’s promise of the development of an ecosystem for the Kin token was enough to find that Kin holders expected to derive their profit from Kik's efforts. The court found "the economic reality is that Kik, as it said it would, pooled proceeds from its sales of Kin in an effort to create an infrastructure for Kin, and thus boost the value of the investment," and that, while Kik planned for Kin to have a "consumptive use," those uses were not available at the time of the Kin distribution and would "materialize only if the enterprise advertised by Kik turned out to be successful." Likewise, if Kik did not follow through with the aforementioned efforts and no ecosystem developed, "Kin would be worthless." Judge Hellerstein also found that the pre-sale of Kin tokens was part of an integrated offering with the general sale of Kin tokens, making the entire course of sale the offering of an investment contract. In Telegram, Judge Castel relied on many of the same elements in barring Telegram from proceeding with the issuance of its Grams tokens. Notably, Judge Castel applied the "Bahamas Test" articulated in a 2019 law review article, reasoning that, were the Telegram team to immediately decamp to a tropical island after launching their blockchain, the TON Blockchain project and Grams would "likely lack the mass adoption, vibrancy, and utility that would enable the Initial Purchasers to earn their expected huge profits." Of note, however, the SEC has had a more difficult time in federal court in its action against Ripple Labs, which may illustrate how differences between token projects may result in different decisions regarding a specific digital asset’s status as a security. Likewise, the SEC reached a settlement with Block.one, the Cayman Islands company that conducted a $4 billion sale of EOS ERC-20 tokens, for $24 million, with no reference to the security status of the underlying EOS native protocol token. Indeed, when discussing actions against digital asset trading platforms, rather than proving that specific digital assets trading on the platforms are securities, Chairman Gensler’s most recent speeches have shifted to arguing that "the probability is quite remote that . . . any given [digital asset] platform has zero securities," an argument that may or may not be sufficient to prevail in a federal court action against such a platform.
Finally, Chairman Gensler and his fellow commissioners have urged digital asset market participants to engage with the SEC or, they have warned, an enforcement case may follow. For example, Commissioner Crenshaw has urged companies to "come and talk" to the SEC "before proceeding to market," noting that "non-compliant projects within [the SEC’s] jurisdiction” may face “an effective enforcement mechanism." This is not a new request, and indeed, many digital asset projects have consulted with the SEC during their development, sometimes spanning several years, often resulting in little more than disagreements between founder teams and SEC staff.
Given these statements, it is wise for industry participants to assume that they will face Division investigation and potential enforcement actions at some point. We expect that many digital asset projects and trading platforms will receive inquiries from the Division in the coming year, either in the form of information requests or formal notices of investigation. While the industry would definitely benefit from more traditional notice-and-comment rulemaking in this area, the industry should assume that there will be more "policymaking by enforcement." The industry should also expect that in many instances "the investigation [itself] is the penalty" regardless of whether any resulting SEC enforcement action will be successful, as federal courts may choose not to agree with the SEC’s position on various issues involving digital assets.
Security-based Swap Market Oversight
November 1 marked the registration deadline for market participants who meet the definition of a security-based swap dealer under the Securities Exchange Act of 1934. As of that date, participants who met the Exchange Act definition, including exceeding the de minimis threshold, must register with the SEC. The SEC projects 45-50 entities will register as security-based swap dealers. Similarly, November 8 marked the first compliance date for the SEC’s Regulation SBSR, which governs regulatory reporting and public dissemination of security-based swap transactions. In February 2022, the swap data repositories that receive transaction data will begin to disseminate data about trades to the public.
In preparation for the implementation of these and other Dodd-Frank Act Title VII regulations, the SEC created the Security-Based Swaps Joint Venture, which will be responsible for coordinating functions related to the regulation of security-based swaps and oversight of certain entities that will be required to register with the SEC (SBS entities). The Security-Based Swaps Joint Venture is led by senior staff in the Divisions of Examinations and of Trading and Markets, and also includes staff from the Divisions of Enforcement and Economic Risk and Analysis, the Office of International Affairs, and the Office of the Chief Data Officers.
During his confirmation hearing and in subsequent statements, Chairman Gensler has made clear that implementation of and enforcement for noncompliance with security-based swaps will be among his top priorities. In addition, Commissioners Allison Herren Lee and Caroline Crenshaw have made similar statements supporting the implementation of these rules and noting the importance of both implementing and enforcing these rules, and that their effectiveness is important to the SEC's "oversight and visibility into the market for security-based swaps."
The Division may look to its sister agency, the Commodity Futures Trading Commission, for direction with respect to enforcing the first round of security-based swap regulations. For example, using security-based swap data repository information, the SEC will be able to identify participants whose dealing activity exceeds the de minimis threshold and may investigate these firms for failing to register as a security-based swap dealer.
Similarly, and more prevalent in the CFTC’s enforcement activity, the Division will likely monitor security-based swap reporting performance and bring cases against market participants who fail to report transactions pursuant to Regulation SBSR. To be sure, there will be some hiccups at the outset, but the Division will probably look to find activity that demonstrates an institutional failure to comply or conduct that demonstrates a lack of commitment to compliance with these new rules in a timely manner. These types of cases would generally include the failure to report large swaths of security-based swaps, or infrastructure shortcomings that prevent timely and accurate reporting.
The Division’s pursuit of these cases will demonstrate Chairman Gensler’s commitment to the Division serving as the "cop on the beat" to protect the integrity of the security-based swap market. At the same time, early cases enforcing these new rules will send a clear message to other market participants that the SEC and the Division expect compliance with these and other forthcoming security-based swap regulations.
SPACs have garnered a lot of attention, first with their proliferation and use in IPOs and more recently with the first enforcement action against a SPAC. It is well-known that the SPAC model has been booming, with 489 SPAC IPOs raising $137 billion through the first three quarters of 2021; this is growth over the figures in 2020 (248 SPAC IPOs raised $83.4 billion) and 2019 (59 SPAC IPOs raised $13.6 billion), and in marked contrast to 2009 (only one SPAC IPO that raised $36 million). SEC staff has noted there will be enhanced scrutiny of SPAC transactions under the federal securities laws.
FY 2021 brought the first enforcement action against a SPAC, as well as against its sponsor, the SPAC’s merger target, and the CEOs. To underscore the significance of the actions, Chairman Gensler added his own remarks to the press release announcing the actions, saying: "This case illustrates risks inherent to SPAC transactions, as those who stand to earn significant profits from a SPAC merger may conduct inadequate due diligence and mislead investors."
The SEC settled with all the respondents except the CEO of the target company. According to the settlement order, the target, an early-stage space transportation company, and its CEO, repeatedly told investors it had "successfully tested" its propulsion technology in space when the test failed to achieve its primary mission objectives or demonstrate the technology's commercial viability. The order finds that the SPAC repeated the target’s misleading statements in public filings associated with the proposed merger, and failed its due diligence obligations to investors. While the misrepresentations charged against the target may seem relatively straightforward, the negligence-based charges against the SPAC are more notable. As Chairman Gensler remarked in the press release, the fact that the target lied to the SPAC "does not absolve [the SPAC] of its failure to undertake adequate due diligence to protect shareholders."
Given the SEC's increasing scrutiny and action, it will be interesting to see commentary in the report and how this will be discussed as another significant area of priority for SEC enforcement.