SEC Tightens Its Stance on Cryptocurrency Enforcement
Cryptocurrency staking has emerged as an attractive vehicle for Web3 participants looking to earn passive income on their blockchain holdings. Chances are, if you are familiar with decentralized finance products, you have either participated in staking or at least been presented with an opportunity to do so. For those unfamiliar, staking involves locking up cryptocurrency assets for a period of time typically to help support the operation of the blockchain upon which those particular assets were created, resulting in the user potentially earning more cryptocurrency. Think of it as a certificate of deposit (CD) with a traditional bank, only with crypto assets. Unfortunately, increased participation by the public often gives rise to legal concerns regarding how these products will be regulated and the potential legal repercussions for those who participate in these types of activities.
SEC Complaint & Settlement
On February 9, 2023, the Securities Exchange Commission (SEC) filed suit against Kraken in the U.S. District Court for the Northern District of California, San Francisco Division for failing to register the Kraken staking program under Section 5(a) and 5(c) of the Securities Act of 1933. According to the complaint, the “staking as a service program” advertised that investors could receive annual returns of up to 21% of their staked amount. The SEC alleged that registration of the staking program was required because the program’s process constituted the creation of investment contracts, and therefore was a public offering of securities.
To classify Kraken’s staking program as a security and distinguish it from individual staking, the SEC applied the Howey test - the 4-factor test for determining what is, and what isn’t, a security: (i) an investment of money (ii) in a common enterprise (iii) with a reasonable expectation of profit (iv) derived from the efforts of others. In applying this test, the SEC primarily focused on three separate facts to demonstrate that the expected profits were to be derived from Kraken’s managerial efforts. First, according to the SEC’s complaint, was that Kraken held themselves out as a team of staking experts that employed a technically advanced investment strategy. Second, Kraken made these representations publicly and openly advertised that by participating in their staking program a user would receive more profits than if they had staked their tokens independently. Lastly, the SEC put substantial weight on Kraken’s terms of service, which gave Kraken wide discretion over how user funds were handled.
Immediately after the filing, Kraken settled with the SEC by agreeing to discontinue its staking program and pay $30 million in disgorgement, prejudgment interest, and civil penalties.
The Potential Legal Impact
Kraken’s settlement is likely just the tip of the iceberg when it comes to the SEC’s ever-increasing efforts to regulate the blockchain industry and can potentially lead to a slew of complaints being filed against staking protocols. The settlement has also left investors wondering when staking services must be registered in order to legally operate. In other words, are all staking services now considered securities that need to be registered or just those that publicly promise investors some type of profit? Further, if I’m participating in one of these programs, what will happen to my assets if the company providing the service finds itself drawing the SEC’s gaze?
Further muddying the waters is the fact that Kraken operates a centralized staking platform, as compared to other decentralized platforms which are abundant in Web3. Simply put, Kraken operates as a cryptocurrency exchange where users can freely buy and sell their cryptocurrencies. In addition, Kraken offers a staking service, where users can effectively direct their cryptocurrency holdings to a validator node operated by Kraken, in exchange for rewards. This is what is referred to as “centralized staking” because users were appointing a third party (Kraken in this case) to act on their behalf in connection with their holdings.
What makes this confusing going forward is that there are numerous protocol-level staking services, otherwise known as “decentralized staking” platforms, where users can stake their holdings directly onto the blockchain network without having to go through a third party. In light of that, would the SEC consider a decentralized staking platform to have been engaged in selling an unregistered security when users are acting for themselves and not through a third party, clearly falling outside of the fourth prong of the Howey test? Based on the SEC’s ruling, this distinction is unclear and simply raises more questions.
More legal concerns arise from the SEC’s statements regarding the registration process for staking services. The same day the Kraken complaint was filed, SEC Chairman Gary Gensler released an office hours video describing the types of staking activities that the SEC requires to be registered, even if they are promoted as something else. Gensler also conducted an interview where he stated that as long as a staking service provides “full, fair and truthful information” they would be considered compliant. Further, Gensler stated “[i]f you fall into any of these buckets, come in, talk to us, and register.” However, neither Gensler nor the SEC have ever provided information regarding the actual process for staking services to become registered, leaving investors and company owners further puzzled.
How a staking service can become registered was also addressed in Commissioner Pierce’s dissent to the Kraken complaint. In her dissent, Pierce makes it clear that the SEC has completely failed at providing registration guidance and that staking services are left with a plethora of important questions. For example, would a protocol need to be entirely registered, or only the staking program itself? What disclosures would be necessary? Finally, what would the accounting implications on staking services be? These questions become particularly complicated when considering that most staking protocols are not uniform in how they operate. While the SEC demands registration, they have not provided any guidance on how to do so. Instead, according to Commissioner Pierce, crypto-related offerings are simply “not making it through the SEC’s registration pipeline.”
Nonetheless, it seems likely that this will have a ripple effect on the entire staking industry and additional actions are expected to follow. If you have any questions about this settlement, or about any other cryptocurrency project with which you are involved, either as a project founder or an investor, please feel free to contact me at KLawrence@FRBLaw.com or by calling (516) 599-0888.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.