by Ijeoma Okoli 

On January 12, 2023, the U.S. Securities and Exchange Commission (the “SEC”) unveiled charges against two large, well-known participants in the crypto sector, Gemini Trust Company, LLC (“Gemini”) and Genesis Global Capital, LLC (“Genesis”) and accused them of engaging in a multi-billion dollar unregistered offer and sale of securities to retail investors in the form of Gemini Earn, a crypto lending program, between February 2021 and November 2022.[1]  The SEC’s action came three months after both firms paused customer withdrawals, effectively trapping funds of retail and institutional investors alike with no indication as to whether customers will ever be able to recoup their funds.  A few days after the SEC unveiled charges against Gemini and Genesis, Genesis filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code,[2] effectively ending a once lucrative form of capital raising in the crypto sector as other major competitors had already either run into bankruptcy trouble themselves in 2022 and/or had been previously subject to SEC enforcement actions. 

Furthermore, on February 9, 2023, the SEC charged Payward Ventures, Inc. and Payward Trading Ltd., in each case doing business as Kraken, with the unauthorized offer and sale of securities in the form of a crypto asset staking-as-a-service program with assets worth at one point as much as $2.7 billion.[3]  This was the SEC’s first known crackdown on staking[4] programs.

Crypto lending, where principals effectively pooled investors’ crypto assets, and then on-lent those assets to third parties in exchange for periodic interest payments to the principals, who took a fee before sending the net interest payments to investors, was not the first form of capital raising in the crypto sector to grow almost unchecked until years later when SEC enforcement actions brought it to a standstill and neither was crypto staking-as-a-service.  In the pre-pandemic heady days of 2017, during the longest expansion in U.S. history, a relatively unknown market boomed, seemingly without government oversight, where millionaires were made overnight, and investors willingly parted with their money in the hopes of earning large returns on their gambles.  The market for Initial Coin Offerings (“ICOs”) in the crypto sector drew attention from legitimate entrepreneurs and fraudsters alike around the world to the U.S. capital markets, the largest and most liquid in the world.[5] In July of 2017, the SEC issued a report, a Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, commonly known as the DAO Report, that concluded that an ICO by an unincorporated decentralized autonomous organization (the “DAO”) created by principals in Germany constituted an investment contract, citing a 1946 U.S. Supreme Court case, SEC v. Howey[6] (“Howey”), and declared the ICO an unregistered offer and sale of securities. 

The creators of the DAO had promoted a scheme to allow purchasers of a token unique to the DAO to pool their resources, propose projects in which the resources would be invested and then vote on which of those proposed projects to invest the DAO’s resources, with token holders sharing in the returns on those investments.[7]

The SEC indicated that it issued the DAO report “to advise those who would use a [DAO], or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.  All securities offered and sold in the United States must be registered with the [SEC] or must qualify for an exemption from the registration requirements.”[8] In effect, it was a warning heeded by many in the crypto sector, although not immediately, and it took some time for the ICO bubble to burst as the SEC, which exercised restraint in not bringing charges in the DAO case, brought multiple enforcement actions in relation to other ICOs in the aftermath of the DAO Report.[9] 

In the intervening years, ICOs in the U.S. have largely fizzled out, however, innovation within the crypto sector enabled participants to build new consumer businesses models, adopting new non-ICO methods to raise capital, including programs where investors’ assets were pooled by an entity[ies] and lent out to third parties in exchange for interest payments to investors on those assets, or used for validation purposes as nodes to maintain a proof of stake network in exchange for payments by the network to the nodes, in each case while not paying attention to, or outright ignoring, the SEC’s admonition in the DAO Report. 

Fast forward to 2023 and news in January that the SEC unveiled charges against Gemini and Genesis and accused them of engaging in a multi-billion dollar unregistered offer and sale of securities to retail investors through a crypto lending program[10]; and then in February the SEC unveiled charges against Kraken in relation to its crypto asset staking-as-a-service program and also labeled the program an unauthorized offer and sale of securities.

In the Gemini Earn case, according to the SEC, Gemini gave Genesis access to retail investors on Gemini’s platform, pursuant to an arrangement whereby through Gemini as agent, Gemini Earn investors provided Genesis with access to their crypto assets, with Genesis sending interest payments on the crypto assets to Gemini, who would then deduct a fee before distributing the remaining interest payments to investors.[11]  Genesis generated revenue by on-lending the crypto assets of Gemini Earn investors, pooled with other assets from other investors, at a higher rate than it paid Gemini Earn investors.[12] The SEC considered the Gemini Earn agreements notes pursuant to U.S. Supreme Court case, Reves v. Ernst and Young,[13] and the Gemini Earn program an offer and sale of investment contracts under Howey, hence a security.

Furthermore, just a week after the Gemini and Genesis charges were unveiled, on January 19, 2023, the SEC announced that it was settling charges against another crypto lender, Nexo Capital Inc. (“Nexo”), also for failing to register the offer and sale of its crypto lending product that it had been offering to U.S. investors.[14]  Nexo paid $45 million to federal and state agencies to settle the charges.  In settling the charges, the SEC noted Nexo’s remedial acts, including its decision, after SEC charges against another crypto lender, BlockFi Lending LLC (“BlockFi”), were announced in February 2022,[15] to cease its offering of crypto lending products to new U.S. investors, and the SEC took those remedial acts, along with Nexo’s cooperation with the SEC, into consideration in agreeing to the settlement of the charges[16] at what looks like a 55% discount to BlockFi’s penalty.

By filing charges against Gemini and Genesis, the SEC is seeking to permanently enjoin Gemini and Genesis from violating the securities registration requirements under Section 5 of the Securities Act; cause Gemini and Genesis to be ordered to disgorge their ill-gotten gains (and pay interest on those gains); and cause to be imposed on Gemini and Genesis civil monetary penalties.[17]

Given that Gemini and Genesis did not also volunteer to halt Gemini Earn in the aftermath of the BlockFi settlement like Nexo did, should the SEC have used its bully pulpit to get the firms to act consistent with the law rather than letting the program continue to operate for another year until January 2023, with investors losing access to their money in November 2022?  The securities market is not a market where caveat emptor is the overriding principle, but one where investors deserve to be provided, and issuers and their agents are mandated by securities laws to provide, specified sufficient disclosure to enable investors to make decisions as to whether those investments are right for them.  That did not happen here.

It is worth noting that in referencing Nexo’s voluntary cessation of new U.S. account openings for its crypto lending product after BlockFi’s settlement, the SEC could be indicating that it may not be so lenient with Gemini and Genesis, because rather than halt Gemini Earn after the BlockFi settlement, Gemini allowed new investors to enroll.  With Genesis now undergoing bankruptcy proceedings,[18] time will tell whether investors ever get any portion of their investment back.

In an action by the U.S. Department of Justice (the “DOJ”) against crypto market participants on January 18, 2023, Deputy Attorney General Lisa Monaco made it clear that the DOJ is taking steps to address the crisis of confidence in the crypto markets and warned the crypto community that “[w]hether you break our laws from China or Europe or abuse our financial system from a tropical island—you can expect to answer for your crimes inside a United States courtroom.”[19]

The February 2023 SEC action against Kraken roiled the crypto market when rumors of the SEC trying to put a stop to all staking made an appearance.  However, this was inaccurate as in reality it was the way Kraken conducted their staking program that was at issue.  Kraken’s program involved the transfer of investors’ crypto assets to Kraken to use for ‘staking’ i.e., validating transactions on a blockchain, in exchange for returns of up to 21%.  According to the SEC, investors’ crypto assets were then pooled, and Kraken used these pooled assets to establish large stakes in order to obtain a competitive advantage in the staking marketplace. Kraken ended up paying $30 million to settle the SEC’s actions against it and agreed to immediately shut down its staking program to U.S. investors.[20]

The lesson from all these actions is that the global crypto community needs to seriously consider the ramifications of offering any revenue generating pooled products to U.S. investors and ensure that they comply with U.S. securities laws whether or not the issuer or its agents are located in the U.S.  Even if you set up in Malta, the UK’s Jersey, Dubai, Mumbai, the Bahamas or you are a decentralized autonomous organization with no fixed jurisdiction, if it is enticing to you to access the largest and most liquid capital markets in the world, the U.S., in any way, you must ensure that you comply with U.S. laws.

In the Gemini Earn fiasco, there is also a concern in relation to the timeliness of the SEC to act.  If the agency has known about the Gemini Earn program for over 17 months, as Tyler Winklevoss, co-founder of Gemini, alleged in a January 12, 2023 tweet,[21] why didn’t the SEC act sooner to prevent investors from losing access to their investments in the first place?  The SEC had already in February 2022 settled charges against BlockFi in relation to a similar product to Gemini Earn and had allegedly threatened Coinbase, a crypto exchange, in 2021 with a lawsuit if it issued a similar product,[22] therefore these products within the crypto sector were not unfamiliar to the SEC.  There have also been questions raised about the SEC seemingly not evenly enforcing the law across the crypto sector.[23]  So, questions remain about why the SEC did not act sooner in the Gemini Earn case.

Regulation by enforcement is time consuming, inefficient, disincentivizes innovation and limits customer/investor choice.  As SEC Commissioner Hester Peirce indicated in her statement on the Kraken settlement, “[u]sing enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating.”[24]  Regulation by enforcement is not efficient not only because the time it takes to investigate one case takes so long, sometimes years, and ties up precious resources, but also because the necessary selectiveness of regulation by enforcement may inadvertently allow problematic cases to slip through the cracks or not be caught early enough to prevent investor losses.  What is needed instead is a regime that works with the crypto sector to craft solutions that would be robust enough to provide the necessary disclosure and implement other investor protection procedures to safeguard investors, but also one that is clear and provides innovators and entrepreneurs with a landscape where they could build, create jobs and provide investors with the freedom to decide what instruments they invest in and what their risk appetites should be.

Footnotes

[1] See SEC Press Release No. 2023-7, SEC Charges Genesis and Gemini for the Unregistered Offer and Sale of Crypto Asset Securities through the Gemini Earn Lending Program (Jan. 12, 2023), https://www.sec.gov/news/press-release/2023-7. 

[2] See Goswami, Rohan and Sigalos, MacKenzie, Crypto lender Genesis files for bankruptcy in latest blow to Barry Silbert’s DCG empire, CNBC (Jan. 19, 2023), https://www.cnbc.com/2023/01/20/crypto-lender-genesis-trading-files-for-bankruptcy-barry-silbert-digital-currency-group.html.

[3] See SEC Press Release No. 2023-25, Kraken to Discontinue Unregistered Offer and Sale of Crypto Asset Staking-As-A-Service Program and Pay $30 Million to Settle SEC Charges (Feb. 9, 2023), https://www.sec.gov/news/press-release/2023-25. 

[4] Staking refers to the validation protocol used to approve transactions on a proof of stake blockchain like Ethereum. The computers used to offer up crypto assets for staking purposes and that use those staked assets to validate transactions on a blockchain are called nodes and are provided with rewards for legitimate transactions validated.

[5] See SEC, What We Do: Maintaining Fair, Orderly and Efficient Markets, https://www.sec.gov/about/what-we-do; SIFMA, Why Markets Matter: Our Markets: Capital Markets Drive Economies, https://www.sifma.org/about/our-markets/.

[6] See SEC v. W.J. Howey Co., 328 U.S. 293 (1946).

[7] See SEC Release No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.

[8] Id.

[9] See Roberts, Daniel, The SEC Brings its ICO Crackdown Out Into the Open, Yahoo Finance (Nov. 20, 2018), https://uk.finance.yahoo.com/news/sec-brings-ico-crackdown-open-132238303.html. It is worth noting that the SEC enforcement actions targeted at ICOs were not the only reason for the 2017-2018 ICO bubble bursting, but those actions did contribute to it (See Roberts, Daniel, SEC Quietly Widens its Crackdown on Token Sales, Yahoo Finance (Oct. 10, 2018), https://finance.yahoo.com/news/sec-tightens-noose-ico-funded-startups-145827742.html).

[10] See SEC Press Release No. 2023-7, SEC Charges Genesis and Gemini for the Unregistered Offer and Sale of Crypto Asset Securities through the Gemini Earn Lending Program (Jan. 12, 2023), https://www.sec.gov/news/press-release/2023-7.  

[11] See SEC v. Gemini Trust Company, LLC and Genesis Global Capital, LLC (S.D.N.Y. 2023) (No. 23-CV-287).

[12] Id.

[13] See Reves v. Ernst & Young, 494 U.S. 56 (1990).

[14] See SEC Press Release No. 2023-11, Nexo Agrees to Pay $45 Million in Penalties and Cease Unregistered Offering of Crypto Asset Lending Product (Jan. 19, 2023), https://www.sec.gov/news/press-release/2023-11.

[15] See BlockFi Lending LLC, Exch. Act Rel. No. 11029 (Feb. 14, 2022).  BlockFi agreed to pay $100 million to federal and state agencies to settle the charges that it failed to register the offer and sale of its crypto lending product and that it violated the registration provisions of the Investment Company Act of 1940.

[16] See Nexo Capital Inc., Exch. Act Rel. No. 11149 (Jan. 19, 2023).

[17] Supra note 7.

[18] Chapman, Michelle, Crypto Lender Genesis Files for Chapter 11 Bankruptcy, ABC News (Jan. 20, 2023), https://www.ft.com/content/c040bc6c-08be-48dd-8af9-3b11b8b67c99.

[19] Monaco, Lisa, Deputy Attorney General Lisa O. Monaco Delivers Remarks on Founder and Majority Owner of Cryptocurrency Exchange Charged with Processing Illicit Funds | OPA | Department of Justice.

[20] Supra note 2.

[21] Tyler Winklevoss on Twitter: “2/ As a matter of background, the Earn program was regulated by the @NYDFS and we’ve been in discussions with the SEC about the Earn program for more than 17 months. They never raised the prospect of any enforcement action until AFTER Genesis paused withdrawals on November 16th.” / Twitter”; Coghlan, Jesse, Winklevoss slams SEC charges against Gemini as a ‘super lame … manufactured parking ticket’, Cointelegraph (Jan. 13, 2023), https://cointelegraph.com/news/winklevoss-hits-back-against-super-lame-manufactured-parking-ticket.   

[22] Grewal, Paul, The SEC Has Told Us It Wants to Sue Us Over Lend. We Don’t Know Why, Coinbase Blog (Sept. 7, 2021) https://www.coinbase.com/blog/the-sec-has-told-us-it-wants-to-sue-us-over-lend-we-have-no-idea-why.

[23] Brian Armstrong on Twitter: “1/ Some really sketchy behavior coming out of the SEC recently. Story time…” / Twitter; Brian Armstrong on Twitter: “7/ Look….we’re committed to following the law. Sometimes the law is unclear. So if the SEC wants to publish guidance, we are also happy to follow that (it’s nice if you actually enforce it evenly across the industry equally btw).” / Twitter; Brian Armstrong on Twitter: “9/ Meanwhile, plenty of other crypto companies continue to offer a lend feature, but Coinbase is somehow not allowed to.” / Twitter.

[24] See Statement of SEC Commissioner Hester M. Peirce, Kraken Down: Statement on SEC v. Payward Ventures, Inc., et al. (Feb. 9, 2023), https://www.sec.gov/news/statement/peirce-statement-kraken-020923.

Ijeoma Okoli is a finance and regulatory lawyer and strategic adviser on digital assets; a co-Director of the Digital Economy Initiative, an independent digital assets think tank in London focused on US and UK digital assets public policy and a founding member and limited partner of Impact X Capital Partners, an ESG focused venture capital fund. She previously was an Executive Director and Digital Currency Risk Management Lead at JPMorgan focused on designing the firm’s global digital currency risk management and governance framework and advising on crypto related business proposals.

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