The past two weeks were filled with legislative activity as members of Congress worked to get digital asset legislation through committees prior to Congress going on its August break. The Securities and Exchange Commission (“SEC”) also had a busy week, bringing charges against Hex Founder Richard Heart, successfully staving off dismissal in the agency’s pending litigation against Terraform Labs, and facing a Motion for Judgement in its case against cryptocurrency exchange Coinbase. With Congress on break, we expect the next few weeks to be primarily focused on the ongoing litigation efforts in the industry with very little movement on the regulatory and legislative fronts.
These developments and a few other brief notes are discussed below.
House Committees Advance FIT for 21st Century Act After Markup: July 27, 2023
Background: On July 26, the House Financial Services Committee held a hearing to markup the Financial Innovation and Technology (“FIT”) for the 21st Century Act. As covered in prior updates, this is the House’s attempt at comprehensive digital asset market structure regulation. Those hearing materials are available here. After an over seven-hour hearing in the Financial Services Committee and a two-hour hearing in the Agriculture Committee the following day, the bill passed committee review and will now proceed to the full House for consideration.
Summary: The Financial Services Committee members voted through the FIT for the 21st Century Act with a 35-15 majority. 6 Democrats of the 23 on the committee voted in favor of the bill. The average age of the Democrats who voted for the bill was 46, while the average age who voted against was 61, marking a stark generational divide on the issue among Democrats. The Agriculture Committee also passed the effort with less fanfare by voice vote. Representative Torres came out in strong support of the bill from the Democrat side, there was expected support from Republicans like Representatives Emmer, Hill, and McHenry, and there was the usual hemming and hawing from both sides of the aisle. Time will tell if the bill has enough support in the House to get consideration from a Democrat controlled Senate.
Stablecoin Legislation Clears House Financial Services Committee Amidst Controversy: July 27, 2023
Background: On July 27, the House Financial Services Committee met to markup the Clarity for Payment Stablecoins Act of 2023. The July 27 hearing materials are available here. After a last-minute breakdown in negotiations due to White House concerns regarding the lack of Federal Reserve oversight over state and non-bank stablecoin issuers, the bill proceeded to markup as the original Republican drafted bill to which the Democrats on the Committee strongly objected.
Summary: Many expected the stablecoin bill scheduled for markup on July 27 to be a bipartisan effort after Financial Services Committee Chair Patrick McHenry and Ranking Member Maxine Waters signaled being close to agreement on the bill in days leading up to the markup. However, CoinDesk has reported that the White House’s National Economic Council, led by Lael Brainard, resisted reaching an agreement due to the bill not providing federal regulators in a strong enough role in stablecoin issuer oversight. Rather than delaying the bill further until after the August Congressional break, McHenry submitted the bill in its original Republican drafted form for markup. Democrats on committee attempted to stop the proceedings, but the markup went forward. While the bill did pass committee with some Democrat votes, it was certainly a step back in the process while also being a step forward.
SEC Charges Hex Founder Richard Heart with Securities Law Violations: July 31, 2023
Background: On July 31, Hex Founder Richard Heart and three unincorporated entities that he allegedly controls were charged by the SEC with conducting unregistered offerings of crypto assets that allegedly raised more than $1 billion from investors. The SEC’s press release announcing the case is available here and the SEC’s Complaint is available here.
Summary: Richard Heart (real name, Richard Schueler) is known for his public displays of wealth such as his purchase of a rare ‘Enigma’ black diamond and displays of wealth in social media posts. The SEC alleges that "Heart called on investors to buy crypto asset securities in offerings that he failed to register. He then defrauded those investors by spending some of their crypto assets on exorbitant luxury goods.” Interestingly, this case is brought by the SEC’s Fort Worth regional office but was brought in the Eastern District of New York. These jurisdictional allegations have raised eyebrows, as one basis for the jurisdiction is Heart’s use of opensource code from Uniswap, the developer of which is headquartered in the Eastern District of New York. While the nature of the allegations makes this seem like a straightforward securities fraud claim, the Complaint placed special emphasis on the protocol’s staking mechanism as being a means through which investors would have an expectation of profits under the Howey test.
Terraform Labs Loses Motion to Dismiss in Case Against SEC: July 31, 2023
Background: On July 31, Judge Rakoff in the District Court for the Southern District of New York denied Terraform Labs and its founder Do Kwon’s (“Defendants”) Motion to Dismiss. The Opinion and Order can be found here. The SEC has brought civil claims against Defendants for alleged fraud and sale of unregistered securities in the form of cryptocurrency LUNA, stablecoin UST, and three other types of crypto assets.
Summary: Many commentators have focused on the Order’s seeming dissent from the reasoning of fellow Southern District of New York Judge Torre’s ruling in her Ripple Summary Judgment Order which we broke down on the BitBlog here. While that is certainly something worth pointing out, the Defendants in this case brought their Motion to Dismiss under Rule 12(b)(6) as opposed to a Motion for Summary Judgment, so at this stage, Judge Rakoff had to accept all of the SEC’s allegations as true and the Howey test is an inherently fact-intensive standard for dismissal. However, a less discussed portion of the ruling is the Court’s denial of Defendants’ Major Questions Doctrine defense. In it, the Court held the Major Questions Doctrine only applies if the industry in question resembles in political and economic significance of prior Supreme Court cases on the issue such as the tobacco industry at issue in FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120 (2000). With proper factual record, Defendants may be able to establish that digital assets in the United States are as economically significant today as tobacco was in the United States in the early 2000’s.
Coinbase Files Motion for Judgment on Pleadings in Case Against SEC: August 4, 2023
Background: As we covered in a prior update, on June 28, Coinbase filed its Answer early and a letter of intent to move for Judgment on the Pleadings in the SEC’s lawsuit against the popular cryptocurrency exchange. On August 4, Coinbase filed their Rule 12(c) Motion for Judgment on the Pleadings. Amicus briefs in support of Coinbase’s motion are due on August 11, and the SEC has until October 3 to respond.
Summary: Coinbase’s arguments predictably focused on the Coinbase claim that none of the digital assets sold on its exchange are “investment contracts” under Howey and thus are not securities. While Ripple presented an “essential ingredients” argument in its litigation, Coinbase took a more subtle approach arguing that an “investment contract” requires both an investment and a contract, and the SEC’s attempt to read out “contract” from the test is an impermissible expansion of Howey. Coinbase also raised a Major Question Doctrine defense, which may be an extension of Coinbase’s strategy when it brought its separate mandamus action against the SEC asking for either approval or denial of the exchange’s request for rulemaking for digital assets. It can be expected that many of the mandamus amicus filers will similarly focus on the investment contract and Major Question Doctrine arguments in their supporting filings in this matter rather than Coinbase’s other arguments regarding its digital wallet and staking services.
IRS Issues Guidance on Taxation of Staking: The US Internal Revenue Service (IRS), via Revenue Ruling 2023-14, issued formal guidance providing that cash-method taxpayers must report staking income as current gross income as of the date and time at which it is reduced to undisputed possession. This is consistent with the position the IRS took in Jarrett v. US, where the plaintiffs argued that staking was more akin to baking a cake and the income should only be realized when the rewards are subsequently sold. That case was eventually rendered moot when the IRS voluntarily refunded the plaintiffs the disputed taxes. While the Revenue Ruling mentioned slashing, it did not address the tax treatment of slashing.
SEC Warns Accountants About Digital Asset Audits: The SEC’s Chief Accountant issued a warning for accounting firms against “The Potential Pitfalls of Purported Crypto ‘Assurance’ Work” in recent guidance. Commissioner Hester questioned the purpose of this guidance on Twitter.
Binance Files Motion to Dismiss in Case Against CFTC: In addition to the SEC’s case against Binance we previously covered, the exchange is also facing a lawsuit filed by the CFTC currently pending in the Northern District of Illinois. On July 27, Binance filed a Motion to Dismiss in that CFTC case, claiming the CFTC’s lawsuit suffers from jurisdictional defects and improperly alleges extraterritorial conduct as the basis for this U.S. lawsuit.
SEC Requires Reporting Companies to Report Data Breach Incidents: Our data breach team at Polsinelli broke down the new reporting obligations under the SEC’s recently published rule. It is unclear how companies with digital asset exposure will need to report things like token or protocol specific code exploits and if those are “breaches” under this new policy.
PayPal Announces Stablecoin Launch: PayPal announced the launch of PayPal USD (“PYUSD”), a stablecoin pegged to the U.S. dollar and 100% backed by U.S. dollar deposits, short-term U.S. Treasuries, and similar cash equivalents. “PayPal USD will be available to consumers, merchants and developers to seamlessly connect fiat and digital currencies” according to the company’s press release. As an ERC-20 token, PYUSD will be transferable to external digital wallets.
With the current regulatory uncertainty and Congress now on break, it should be no surprise that litigation will dominate the news for the $2 trillion digital asset industry. With limited time left in the Congressional calendar to push through legislation, it is looking to be another year where the industry is left to take its direction primarily from regulatory and judicial actions.
In the ever-shifting legal landscape of blockchain and cryptocurrency, understanding and navigating the complexities can be a daunting task. The recent developments highlighted here underscore the importance of remaining vigilant and informed. Whether you are an individual investor, a burgeoning startup, or an established entity within the industry, these changes may impact your operations and strategic decisions. For stakeholders at all levels, seeking appropriate legal guidance and keeping abreast of regulatory shifts is not just beneficial but essential. As the industry continues to evolve, its intersection with law and governance will undoubtedly remain a critical and compelling facet of Web3.