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Looming Legal Battle Puts SEC's Crypto Crusade at Risk

In 2021, the SEC went after crypto. In 2022, crypto is coming for the SEC.

Securities and Exchange Commission Chair Gary Gensler has vowed to rein in what he's dubbed "Wild West" abuses in the $1.6 trillion market. Industry leaders, flush with cash and deep-pocketed investors following a trading boom in Bitcoin and other digital assets, are aiming their lawyers at the sheriff of Wall Street in an intensifying legal fight.

Blockchain payments firm Ripple, the de facto leader of the revolt, has been winning procedural court cases trying to fend off the SEC in a case that could redefine how the agency polices digital assets. Grayscale Investments, which wants to launch a Bitcoin fund for the masses, brought on the white-shoe law firm Davis Polk to outline a legal case against the agency that could be brought against it if it hinders the company's ambitions. The CEO of another startup, Terraform Labs, sued the SEC after it tried to serve him with a subpoena.

Crypto-friendly legislators who claim that the SEC is overstepping its authority are cheering on the legal assault. It could limit the SEC's reach for years to come and remove what many in the industry view as their biggest regulatory obstacle to launching even more virtual currency products. "As a lawyer, you're trained to not pick fights with regulators," Ripple general counsel Stuart Alderoty said in an interview. "But we didn't pick a fight with a regulator, the regulator did. Respect for regulators has to be earned, and I don't think the SEC has earned the industry's respect." An upcoming legal barrage is the latest example of the cryptocurrency industry taking an aggressive stance against Washington policymakers.

This year is poised to be a key inflection point in the politics and regulations around digital assets. Crypto firms are ramping up lobbying and planning to dole out millions of dollars in financial contributions in a bid to secure allies in government and undermine their opponents. Several federal agencies make the issue a top priority and lawmakers draft a raft of legislation.

"There's a carrot-and-stick approach," said Kristin Smith, who leads the Washington-based Blockchain Association, a trade group. "It's aggressive — more aggressive than perhaps other industries." Gensler — a former Goldman Sachs partner who became a progressive darling because of his tough approach to regulating Wall Street — has taken a sweeping view of the SEC's role in cryptocurrency, arguing that most of the products fall under his agency's jurisdiction. A series of enforcement actions and behind-the-scenes clashes with startups have put him at odds with the crypto community.

SEC spokespeople declined to comment for this story.

"Right now, we just don't have enough investor protection in crypto," he said in an August speech that set the tone for his approach. "Frankly, at this time, it's more like the Wild West. … If we don't address these issues, I worry a lot of people will be hurt."

The SEC's legal war with crypto began in the waning days of the Trump administration just before Gensler took the helm of the agency. The agency in December 2020 sued Ripple, accusing the company of illegally raising more than $1.3 billion through the sale of the digital currency XRP. The SEC contends that XRP is a security that should be registered with the agency under the "Howey test," a landmark Supreme Court ruling that's the legal basis for defining investment contracts. Unlike other SEC enforcement actions that are resolved with a settlement, Ripple fought back, and the case is ongoing in federal court. The company argues that XRP is not an investment contract and that the SEC never provided "fair notice" that XRP was an unregistered security — a due process violation.

Ripple has started to secure procedural wins. This month, a judge overseeing the case ordered the SEC to turn over internal documents that could offer new details on how agency officials developed their views on digital assets. The SEC's allegations are "not just as a case against Ripple, but a case against the entire industry," Alderoty, Ripple's general counsel, said. An associate professor at George Mason University's Antonin Scalia School of Law, J.W. Verret, said an SEC loss on the "Howey test" would mean the regulatory threat that hangs over a number of cryptocurrencies "goes away." "The Ripple litigation could bring about quite a bit of change if Ripple is victorious," he said.

Jeff Hauser, a finance industry critic and founder of the watchdog group Revolving Door Project, said Ripple's claim is akin to arguing that new cars might not be subject to existing speed limits. "If you have the first 2023 Tesla and you go on the highway, and you're driving 90 miles an hour, and you tell a police officer that you thought the 75 mile an hour speed limit sign only applied to vehicles produced in 2022 or earlier ... you'll get laughed at," he said in an intervi

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Another potential legal fight that could ensnare the SEC involves its decision to block the launch of Bitcoin-backed funds that would sell shares to investors on public exchanges — a way to ride the price of the digital currency without having to buy it directly. INSTEAD, the SEC has opted to green-light funds tied to Bitcoin futures contracts — a more indirect financial instrument that the Commodity Futures Trading Commission regulates.

Grayscale, a $55 billion investment firm that wants to launch a Bitcoin exchange-traded fund, is building a case that the agency is breaking the law by favoring one model over the other. The firm last year commissioned lawyers at Davis Polk to draft a public letter to the SEC arguing that rejecting a Bitcoin-backed fund would be "arbitrary and capricious." "If you're okay with futures-based ETFs, you should also be okay with a stock-based ETF," Grayscale chief legal officer Craig Salm said in an interview. Grayscale has not said whether it would sue the SEC if the agency rejected its fund application.

Representative Darren Soto (D-Fla.), a crypto-friendly member of the Congressional Blockchain Caucus, said the firm's argument has merit. Soto and Rep. Tom Emmer (R-Minn.) are asking Gensler to allow firms to offer Bitcoin investment products through regulated exchanges. Grayscale throwing down the gauntlet could help policymakers ramp up the pressure on the SEC, even if it antagonizes the agency.

"It's a risky plan, but it's one that's well within their rights," Soto said in an interview. It's not a risk every firm will be willing to take. Valkyrie Investments CEO Leah Wald said that her firm has no plans to pursue the legal strategy Grayscale previewed, even after the SEC blocked Valkyrie's own Bitcoin ETF. "The onus is on us as an industry to have a more amicable relationship," she said. A former chief of the SEC's Office of Internet Enforcement, John Reed Stark, said that bucking the agency's authority can backfire on firms that could have resolved inquiries without incident.

After Terraform sued the SEC on procedural grounds over its subpoenaing of CEO Do Kwon last year, the agency filed a countersuit revealing that it was investigating the decentralized finance platform for violating a litany of federal securities laws. Terraform did not respond to requests for comment. "It's very reckless. It's not bold or courageous. It's foolhardy because it didn't have to be this way," Stark said in an interview. "The SEC has dug in. I think they're on very solid ground."

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