by Kevin S. Schwartz, David M. Adlerstein, and David E. Kirk

From left to right: Kevin S. Schwartz, David M. Adlerstein, and David E. Kirk (Photos courtesy of Wachtell Lipton Rosen & Katz)

Late last week, the SEC filed and simultaneously settled charges against the Kraken cryptoasset exchange for failing to register as a security the offer and sale of its “staking-as-a-service” program. The complaint’s allegations against Kraken, coupled with statements by the SEC’s Chairman, indicate that the SEC may pursue staking-as-a-service programs that have features like Kraken’s as unregistered securities offerings, raising fundamental questions for a sector of the crypto-industry with assets most recently valued at $91.8 billion. This also represents the latest in a series of actions by regulators attempting to shape the status and availability of particular financial products through enforcement tools rather than prescriptive guidance that might aid market participants in adapting existing rules to novel financial products.

As background, several leading blockchain platforms like the Ethereum network operate using a “proof-of-stake” mechanism to secure the blockchain — tokenholders can elect to serve as validators of new blockchain transactions by locking up or “staking” their tokens within the blockchain protocol and forfeiting those tokens if they validate transactions dishonestly. To incentivize staking, the blockchain protocol automatically rewards stakers with additional tokens.[1] For example, users who stake ETH tokens on the Ethereum network currently receive an annual yield in ETH tokens of approximately 4.8%. Staking-as-a-service programs such as Kraken’s allow small, retail customers who do not have the resources or sophistication to stake their tokens directly on the blockchain to participate in staking yields by allowing the provider to pool their tokens with those of other customers, stake the tokens for them, and pass staking yields through to them (net of a fee determined by the service provider).

The SEC’s complaint alleged that Kraken’s program — which had more than $2.7 billion worth of staked cryptoassets as of April 2022 — constituted an unregistered offer and sale of securities under the Howey framework as participants invested their money in a common enterprise and expected to profit from Kraken’s efforts (arguably distinguishable from tokenholders staking directly on a blockchain on their own behalf). Potentially important are several other aspects of the Kraken program noted in the complaint: no staking minimum; no lockup period before customers could “unstake” at will; and full discretion by Kraken over what, if any, net return to furnish customers. In the settlement, Kraken agreed to a $30-million fine and a permanent injunction against ever offering or selling securities through cryptoasset staking.

While we continue to applaud the SEC for taking seriously its investor protection mandate in the cryptoasset arena, the reality at this time is that crypto products are rarely registered with the SEC in part due to continued uncertainty as to which cryptoassets constitute securities that must be registered under the SEC’s complex analytical framework, as well as an absence of guidance for applying existing regulatory requirements to cryptoassets’ distinctive features. Further clarity would benefit the market, and we continue to encourage the SEC to act on its acknowledgment that tailored disclosures may be appropriate with respect to certain cryptoasset-related securities. Shutting down staking programs that are found to entail securities offerings may be justified as protecting investors from any associated risks, but their wholesale elimination may also prevent investors without the resources to stake tokens directly on the blockchain from receiving staking yields, or else may lead some investors instead to deposit their tokens in even less reviewable, unsupervised decentralized staking protocols. These practical considerations warrant reflection.

This latest SEC action comes against the backdrop of numerous other recent regulatory actions and statements geared toward curbing risks associated with the cryptoasset industry, including (among others):

• Federal banking regulators highlighting to banking organizations the risks of doing business with cryptoasset industry participants;

• A renewed Biden Administration call for Congressional action to expand regulators’ power over cryptoasset markets and aid enforcement;

• The New York State Department of Financial Services imposing a $50 million fine against a major cryptoasset exchange in respect of findings of KYC / AML deficiencies and requiring investment of an additional $50 million in its compliance program;

• The SEC bringing charges against Nexo, Genesis, and Gemini in respect of their cryptoasset lending programs; and

• The Office of Foreign Assets Control sanctioning virtual currency mixer Tornado Cash.

Particularly in the wake of FTX’s implosion and the recent spate of major crypto-industry bankruptcies, it is necessary and altogether appropriate for regulators, including the SEC, to act with alacrity to protect investors by combating wrongdoing and fraud within the cryptoasset industry. However, it bears remembering that while the cryptoasset industry has attracted more than its share of wrongdoers, it has also attracted thousands of well-intentioned innovators and entrepreneurs, as well as billions of dollars in capital from U.S. investors. In light of the inexorable march of technological development — whether welcomed in the U.S. or propelled abroad — we reiterate our call for enforcement-oriented efforts to be supplemented by balanced and prescriptive guidance that can allow a young industry to flourish while still protecting investors.

[1] Proof-of-stake is much less energy-intensive than the other primary mechanism for securing a public blockchain, so-called “proof-of-work” mining of the sort used by Bitcoin, which validates transactions by rewarding deployment of sheer computational power.

Kevin S. Schwartz is a Partner, David M. Adlerstein is Counsel, and David E. Kirk is an Associate at Wachtell, Lipton, Rosen & Katz. This article was originally published as a client alert by the firm.

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