Crypto’s Counteroffensive Suits Underscore Need for Regulation

A potential new litigation trend in the crypto space has begun to emerge as private businesses and industry-related non-profit organizations start to file complaints against the Securities and Exchange Commission. The complaints seek to insulate plaintiff companies from enforcement actions. Importantly, they also highlight the need for regulation.

Ultimately, the SEC and Commodity Futures Trading Commission—and not courts—are in the best position to provide clarity for companies in this complex and evolving space.

The plaintiffs seek declaratory and injunctive relief in the complaints filed in the Texas federal courts by Lejilex and Crypto Freedom Alliance of Texas and by Beba LLC and DeFi Education Fund. Lejilex describes itself as “a non-custodial digital asset trading platform that allows users to trade digital assets through the use of underlying smart contracts” in “blind bid/ask transactions.”

It seeks to avoid being required to register “as a securities exchange, broker, or clearing agency.” And the complaint in Beba LLC describes the lead plaintiff as a small online apparel company that has “incorporated digital assets into its business” and distributed its BEBA token for free via an airdrop.

That complaint alleges the SEC “will take the position that BEBA tokens are investment contracts and that the airdrop is a securities transaction.” Both complaints argue the SEC lacks jurisdiction to undertake enforcement action against them.

The central claims in these two cases are similar to the arguments advanced by defendants in recent cases in the US District Court for the Southern District of New York, including SEC v. Ripple Labs, SEC v. Terraform Labs, and SEC v. Coinbase. The plaintiffs’ selection of venue in Texas federal courts means the US Court of Appeals for the Fifth Circuit will likely have the opportunity to decide those central issues, potentially creating a split in the federal appeals courts and inviting review by the US Supreme Court.

On the policy side, the complaints demonstrate an unusual “offensive” against the SEC and put under scrutiny the SEC’s chosen regulatory approach, which has been criticized as “regulation by enforcement.” Antifraud enforcement is undoubtedly a key pillar of our securities and derivatives markets. Enforcement as a policy, by contrast, is not the most effective means for regulation of these markets.

One of us has traced how the SEC started with antifraud enforcement in crypto, protecting investors in primary market transactions. Its contributions in cases against fraudulent initial coin offerings, or ICOs, were unquestionably positive.

Yet the SEC has slowly moved towards enforcement of the mandatory registration provisions of the securities laws, first against issuers and then against exchanges and broker-dealers. This progression has led to questionable outcomes in terms of investor protection, particularly when projects are non-fraudulent and firms are profitable. This course of action also has failed to ensure prospective regulatory clarity, which is an important element of robust regulation.

The recent complaints are a natural corollary of these enforcement trends and emphasize a critical need for certainty in primary markets and secondary trading. At their core are jurisdictional issues and a complicated doctrinal inquiry: Are cryptoassets and transactions with cryptoassets within the jurisdiction of the SEC? Are they securities?

The Lejilex and Beba complaints challenge as overbroad and unconstrained the SEC’s likely contention that the BEBA token and the tokens to be traded on the Lejilex exchange are “investment contracts” and therefore “securities” pursuant to SEC v. Howey. Both complaints suggest an underlying contractual relationship between asset creators and investors is key to Howey.

After a primary distribution of cryptoassets, secondary trading of the underlying assets ensues. Secondary market traders are no longer parties to the initial contractual arrangement between the issuer of cryptoassets and the original investors. So what is the nature of the assets they acquire? Are the assets still investment contracts or simply non-security assets in the form of lines of code?

In deciding the parties’ cross-motions for summary judgment in the Ripple Labs case, Judge Analisa Torres held that Ripple’s Institutional Sales were investment contracts, but that Ripple’s programmatic sales to public buyers on crypto-exchanges weren’t. In Terraform, Judge Jed Rakoff “declined to draw a distinction” between the Terraform cryptoassets sold “directly to institutional investors and those sold through secondary market transactions to retail investors.”

Similarly, in Coinbase, Judge Katherine Polk Failla held the SEC had adequately pleaded that some cryptoassets traded on Coinbase were investment contracts, even though investors didn’t purchase those assets directly from the issuer.

If the courts in Texas decide that cryptoassets, particularly those traded in secondary markets, aren’t securities, then the SEC can’t claim jurisdiction over the trading platforms where these assets are listed. This outcome could, theoretically, conflict with a future decision in Coinbase, among others.

Congress or the SEC and the Commodity Futures Trading Commission (by joint rulemaking) could address these and related issues more effectively than courts. The judicial system isn’t a useful regulatory tool for modern markets, and research supports the need for reform.

One of us evaluated how investors perceive enforcement by the SEC and CFTC. SEC enforcement, particularly against exchanges, generates a more negative investor reaction than CFTC enforcement, suggesting the need to modernize US securities law. The global market for cryptoassets seems more receptive to antifraud enforcement, indicating that investors value the commissions’ efforts to root out fraud, resulting in quality improvements that offset an overall negative reaction to regulation by enforcement.

Regulatory reforms are needed urgently. Litigation can take years, while technology is rapidly developing. Moreover, the EU, UK, and other jurisdictions already have or are about to introduce concrete legal frameworks for both cryptoassets and the infrastructure for their issuance and trading. In doing so, they distinguish between securities and cryptoassets.

In the future, a cryptoasset cleared for trading in Europe as a non-financial instrument could be found in violation of US securities law. As a result, we may not be heading so much toward a circuit split as a jurisdictional clash among the major markets on both sides of the Atlantic.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Douglas S. Eakeley is a professor and founder/co-director of the center for corporate law and governance at Rutgers Law School.

Yuliya Guseva is a law professor and director of the fintech and blockchain research program at Rutgers Law School.

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