In the year and a half since Gary Gensler made it clear to the world that he intends to focus on the crypto “wild west” (see HERE) things have gone from bad to worse for the industry. Of course, it is not all the SEC’s extreme crypto scrutiny that is causing problems, but the very real crypto winter including the collapse of the FTX exchange and its FTX Future Fund, and the realization that the metaverse of tomorrow, will actually not be here until… tomorrow have all added to industry problems. Not to mention a slew of bankruptcy filings (FTX, Blockfi, Celsius and Voyager) and several other precarious financial positions (Blockchain.com, Coinbase, Crypto.com and Genesis, to name a few).
However, putting aside the crypto industry financial crisis, the U.S. regulators, including the SEC, FINRA and national exchanges, are scrutinizing any business with even a modicum of crypto focus to the point where it is almost impossible to move forward.
In July 2017, the world of digital assets and cryptocurrency literally became an overnight business sector for corporate and securities lawyers, shifting from the pure technology sector, when the SEC issued its Section 21(a) Report on the DAO investigation finding that a cryptocurrency is, in most cases, a security (see HERE). Since then, there has been a multitude of enforcement proceedings, repeated disseminations of new guidance and many speeches by some of the top brass at the SEC, each evolving the regulatory landscape.
The SEC’s Section 21(a) Report relied on the analysis in SEC v. W.J. Howey Co. to determine when a crypto is a security, building the guardrails to conclude that all, or almost all, cryptocurrencies at that time were/are indeed a security. For more on the Howey analysis, see HERE. Later in June 2018, the SEC gave some relief to the crypto world by announcing that Bitcoin and Ether were likely decentralized enough as to no longer be considered a security, hedging on the conclusion as to whether they were once considered such.
Using the same analysis as a backdrop, in March 2018, the SEC issued a public statement directed specifically to online platforms for the trading of digital assets/cryptocurrencies. The statement served as a dual caution to investors and warning to platforms. In essence, if a platform offers trading of digital assets that are securities and operates as an “exchange,” as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration (see HERE).
In April 2019, the SEC’s Division of Corporation Finance published a “Framework for Investment Contract Analysis of Digital Assets,” issued a no-action letter to Turnkey Jet, Inc. and made a statement on both. Although the guidance was appreciated, it really offered nothing new or different about the analysis, which was firmly based on SEC v. W.J. Howey Co. (the “Howey Test”) (see HERE). Other than the Section 21(a) Report and this guidance, the world of crypto regulation has been enforcement-driven.
Even accepting that a cryptocurrency is a security and trying to comply with the federal securities laws has been a difficult task. Since the issuance of cryptocurrencies, by nature and function, would involve general information and gun-jumping, a traditional IPO with S-1 would not work, not to mention the plethora of custody issues for any broker-dealer willing to act as an underwriter. See here for more information on broker-dealer custody issues related to digital assets – HERE. Traditional exempt offerings would also not work – a distribution of cryptocurrencies is never limited to accredited investors.
That leaves Regulation A; however, the process of completing the offering circular with the SEC is a monumental task. Blockstack was the first back in 2019 to qualify an offering circular for the issuance of a full token with properties of what could be a utility token. Others have not followed. A few companies have tokenized their equity and several have completed offerings that operate in the cryptocurrency space, but the world has not seen the U.S. registration or qualification of an offering issuing a cryptocurrency.
Fast-forward to today and the U.S. regulators are approaching anything crypto related with a “it’s a guilty fraud unless proven otherwise,” and proving otherwise is extremely difficult, costly and time consuming. In August 2021, Gary Gensler gave a speech stating that the digital asset class is rife with fraud, scams, and abuse (see HERE) and since that time he is doubling down on that opinion. In addition to continued enforcement actions, the SEC has published a sample comment letter and has asked congress for $2.4 billion in funding a big part of which would be used to chase crypto “misconduct.”
SEC Sample Comment Letter
In December 2022 following the collapse of FTX and several other crypto company bankruptcies, the SEC published a sample comment letter, setting forth disclosures it would expect from companies that may be directly or indirectly impacted by the events. The SEC believes that companies should evaluate their disclosures with a view towards providing investors with specific, tailored disclosure about market events and conditions, the company’s situation in relation to those events and conditions, and the potential impact on investors.
In general, companies should consider the need to address crypto asset market developments in their filings generally, including in their business descriptions, risk factors, and management’s discussion and analysis. Through experience, I know that the SEC carefully reviews any and all crypto-related disclosures and is likely to ask in-depth granular additional questions as to these disclosures. Moreover, the SEC has issued a general warning for companies to be just as conscientious when drafting disclosures that are not normally reviewed by the SEC, such as automatic shelf registrations and prospectus supplements.
The sample comment letter has 16 comments starting with a general “Provide disclosure of any significant crypto asset market developments material to understanding or assessing your business, financial condition and results of operations, or share price since your last reporting period, including any material impact from the price volatility of crypto assets” and delving deeper from there.
Under description of business, the SEC has several comments, with subparts, for disclosures related to the various industry bankruptcies and how that may have “have impacted or may impact your business, financial condition, customers, and counterparties, either directly or indirectly.” The obvious direct impact would be related to material assets that have not been recovered and may never be recovered. Indirect disclosure can be more difficult as it requires analyzing the impacts on counterparties, customers, custodians, or other participants in crypto asset markets that a company may do business with or that a significant customer may do business with. Also, in discussing a company’s business, thorough disclosure and thought must be given to safeguards, policies and procedures to prevent crypto-related losses, including through self-dealing and commingling assets.
Moving to MD&A, the SEC sample comment letter contains three questions that drill down on the effects on financial condition and liquidity including whether any crypto assets serve as collateral for any loan, margin, rehypothecation, or other similar activities.
The rest of the comments are under the heading “risk factors” and require the obvious risks such as those associated with redemptions and withdrawals of held crypto assets to the less obvious of the reputational harm resulting from just being in the crypto business. Ironically, the SEC asks for companies to “[D]escribe any material risks to your business from the possibility of regulatory developments related to crypto assets and crypto asset markets. Identify material pending crypto legislation or regulation and describe any material effects it may have on your business, financial condition, and results of operations.” The U.S. has no pending crypto regulations but rather has been continuing its regulation through enforcement, the direction of which is not foreseeable. For a company with operations outside the U.S., this risk may be easier to quantify.
Although there are 9 sample comments on risk factors, the last one, like the reputational harm comment, provides further insight into the negative view of crypto asking companies to describe: (i) the risk from depreciation in its stock price; (ii) the risk of loss of customer demand for their products and services; (iii) financing risk, including equity and debt financing; (iv) the risk of increased losses or impairments in their investments or other assets; (v) the risks of legal proceedings and government investigations, pending or known to be threatened, in the US or in other jurisdictions against the company or its affiliates; and (vi) the risks from price declines or price volatility of crypto assets.
Heightened Auditor Scrutiny
The SEC is not just looking at company disclosures but the auditors involved in those companies. Several articles have reported that the SEC has stepped up scrutiny against audit firms working for cryptocurrency companies. Paul Munter, the SECs acting chief accountant, has been quoted as saying “We’re warning investors to be very wary of some of the claims that are being made by crypto companies” continuing that the SEC is closely reviewing audit reports, audit firms that work in the crypto space, and company financial statements with an eye towards referrals to the Division of Enforcement.
Request for Increased Funding
On March 29, 2023, Chair Gary Gensler gave his annual testimony to the Subcommittee on Financial Services and General Government on the SEC’s annual budget request (see here for last year’s testimony summary – HERE). In 2022 the SEC asked for a total of $2.149 billion in funding, representing an 8% increase over the year prior. This year the SEC is asking for $2.436 billion, a whopping 12% increase, a large portion of which will be used investigating and pursuing the noncompliance and wrongdoing in the crypto markets.
Sticking with the capital markets for now, it is not just the SEC that has a heightened eye on crypto. For those companies trading on OTC Markets that touch the crypto world, it has become increasingly difficult to uplist to the OTCQB or OTCQX. Moreover, for a company with crypto, processing a corporate action (such as a name change or reverse split) through FINRA can take a year or more with many giving up and withdrawing their efforts. Although not nearly as myopic on the topic, the national exchanges, including Nasdaq and the NYSE, look even more closely at listing applications for those companies that “touch the crypto.”
Ultimately, the problem becomes that crypto companies work harder than ever to avoid U.S. capital markets and perhaps the U.S. at all, which like so many other regulatory stances, will most certainly have negative unforeseen consequences.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including the American Red Cross for Palm Beach and Martin Counties, the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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