Last week, we reported that two crypto industry groups sued the United States Securities and Exchange Commission seeking to strike down revisions to the dealer rule. On April 26, 2024, Consensys Software Inc., a software developer whose business centers on the Ethereum blockchain network, brought a much more significant case when it sued the SEC in federal court in Texas over the regulation of Ethereum. The Complaint may be found here.
In a June 2018 speech, William Hinman stated that “[B]ased on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.” At the time, Hinman was Director of the SEC’s Division of Corporation Finance, the division responsible for regulatory activities concerning issues relating to the definition of a “security” and for advising the Commission on these issues. The Complaint alleges that internal Commission documents revealed that Hinman’s use of the plural “we” reflected the approval Hinman received from the highest ranks of SEC officials — including then-Chair Jay Clayton — before he publicly declared Ethereum not to be a security.
Current SEC Chair Gary Gensler, then a professor at the Massachusetts Institute of Technology, told a gathering of investors in 2018 that “Bitcoin, ether, Litecoin and Bitcoin Cash” are “not securities.” And, then-Professor Gensler told his students in a course on blockchain and digital assets that “in 2018 the Securities and Exchange Commission has said that regardless of what [Ether] might have been in ’14, it’s now sufficiently decentralized that we’ll consider it not a security.”
The position of the CFTC is also that Ethereum is not a security, but a commodity. In 2019, then-Chair of the CFTC, Heath Tarbert, stated: “Ether is a commodity, and therefore it will be regulated under the [Commodity Exchange Act].” CFTC Director of Enforcement Ian McGinley told leading practitioners in a widely reported keynote address on September 11, 2023, that Ether would be regulated as a commodity, just like “gold, wheat or oil futures and options.”
This backdrop is critical because the lawsuit states that Consensys built its business against the backdrop of this regulatory consensus. Its products include “MetaMask” wallet software that allows individuals to self-custody their ETH (the digital asset of the Ethereum network) and other digital assets and to direct those assets for use on third-party exchanges and other decentralized applications on Ethereum and other blockchains. Consensys’s business is driven by the broad-scale adoption of the Ethereum network and, in turn, the ability of individuals to use ETH. Consensys also acquires, holds, and sells ETH in the ordinary course of its business.
The Complaint describes the lawsuit in the following way:
In 2021, a new Administration took power and brought with it a new regulatory agenda. At first, new SEC leadership asked Congress for more power to regulate crypto. When Congress declined, the SEC decided to assert that power anyway. Over the past three years, with no further statutory basis, the SEC has arrogated to itself new powers to regulate cryptocurrencies and the exchanges on which they trade. Years into its self-appointed campaign of regulatory escalation — and completely contrary to its conclusion six years ago — the SEC now has decided to claim the right to regulate ETH as a security.
The SEC’s self-aggrandizing about-face on ETH is notable for its lack of transparency. In April 2023, Gary Gensler, the Biden Administration’s crusading SEC Chair, appeared before the House Financial Services Committee. The Committee Chairman repeatedly asked Gensler: does the SEC now think ETH is a security? Gensler refused to answer this direct question from the Chairman of the Congressional committee charged with overseeing his agency. . . .
This action challenges the SEC’s determination that ETH is a security, subject to SEC jurisdiction. The SEC is only authorized to regulate securities. It claims the power to regulate transactions in ETH and other digital asset tokens on the ground that they are “investment contracts” — one of the many enumerated securities identified in the Securities Act of 1933 (the “Securities Act”). But all “investment contracts” involve a contractual undertaking in which a person invests in an enterprise in exchange for a promise to deliver value from the profits, income, or assets of the business at a future date. Transactions in ETH involve none of these things: no ongoing contractual undertakings, no interest in any enterprise, and no profits derived from the efforts of a centralized promoter. In these respects, ETH is indistinguishable from bitcoin, the sole digital asset that Chairman Gensler remains willing to concede is a commodity and not a security.
Even if the SEC’s construction of “investment contract” to include ETH and other digital assets were colorable, the major questions doctrine would require its rejection. Where, as here, an agency claims “to discover in a long-extant statute an unheralded power to regulate a significant portion of the American economy,” it must have “clear congressional authorization.” The SEC does not. . . .
The SEC’s unlawful seizure of authority over ETH would spell disaster for the Ethereum network, and for Consensys. Every holder of ETH, including Consensys, would fear violating the securities laws if he or she were to transfer ETH on the network. And the ability of anyone new to acquire ETH to use Ethereum’s repository of decentralized applications and services would be extinguished. This would bring use of the Ethereum blockchain in the United States to a halt, crippling one of the internet’s greatest innovations.
Part of the immediate impetus for the lawsuit is that, as explained in the Complaint, on April 10, 2024, the SEC staff sent Consensys a “Wells Notice” stating its intent to imminently recommend that the Commission bring an enforcement action against Consensys for violating the federal securities laws through its MetaMask Swaps and MetaMask Staking products. More specifically, SEC staff told Consensys that, in its view, Consensys, by operating the MetaMask Swaps software, is an unregistered broker-dealer in violation of Section 15(a) of the Exchange Act.
The relief that Consensys asks for in its lawsuit includes a declaration that (i) Ether is not a security and that, accordingly, the SEC’s investigation into Ether and Ethereum and any resulting enforcement actions exceed its regulatory authority; (ii) any enforcement action against Consensys premised on Ether being a security or Ether transactions being securities transactions would violate due process and fair notice; (iii) Consensys neither acts as a broker nor offers or sells securities through the Swaps and Staking functionality of its MetaMask wallet software; and (iv) any investigation or enforcement action against Consensys premised on it acting as a broker or offering and selling securities through its MetaMask software would exceed the SEC’s authority. Consensys also seeks an order enjoining the SEC from continuing to investigate or bringing an enforcement action with respect to its sales of Ether and as to MetaMask.
With this lawsuit, the SEC is now involved in lawsuits with a number of the major players in the industry: Coinbase, Kraken, Consensys and Ripple. With multiple courts looking at the issue of whether (and which) cryptocurrencies are securities, and the large financial impacts of the upcoming decisions, the likelihood increases that the issue will eventually find its way to the Supreme Court.
