Regulatory Frameworks Through Enforcement: An Increasing SEC Trend

By: Lucosky Brookman
Regulatory Frameworks Through Enforcement: An Increasing SEC Trend

The Securities and Exchange Commission (SEC) has drawn both notice and criticism for its growing trend of "regulation by enforcement." The agency's expanding inclination to advance new interpretations of existing rules through enforcement actions has caused discomfort among market participants. Prominent advocacy groups such as the Financial Services Institute and Small Public Company Coalition (SPCC) have expressed strong opposition to this practice.

This regulatory approach is particularly evident in matters concerning the digital domain - cryptocurrencies, blockchain, and Web3. In the absence of rule-based regulation, enforcement-based guidance seems to be the SEC's chosen path, making this sector the focal point of attention. This trend began with the SEC's 2017 Section 21(a) Report following the enforcement action against DAO,

Instead of heeding the calls for defined rules, the SEC has ramped up enforcement proceedings, resulting in industry adaptation. The first response, "ignore it," is evident in the ongoing growth of the global crypto market. Major financial institutions such as JPMorgan Chase, Wells Fargo, and Goldman Sachs, along with tech giants like Meta (formerly Facebook), continue to invest heavily in the sector.

The second response, "fight it," is typified by the ongoing legal battle between the SEC and Ripple. The SEC claims that Ripple's issuance of XRP tokens was an unregistered sale of securities. Ripple counters that XRP is a currency, not a security. Ripple's defense asserts that the regulatory ambiguity is so extensive that it could not have known its actions would be deemed a violation of federal securities laws. The court's refusal to dismiss this defense has effectively put the SEC on trial for its unclear guidance on cryptocurrencies.

Another example of the "fight it" strategy led to a landmark legal victory in November 2021. The defendant successfully argued that hashlets - contracts providing shared profits from cryptocurrency mining - were not securities, defeating the SEC's claim of an unregistered sale of securities.

The third strategy is "make it work for you," as demonstrated by BlockFi's settlement with the SEC. Despite being fined $100 million for unregistered securities sale, BlockFi managed to negotiate a course of action for its future operations. The settlement provided a clear roadmap for BlockFi to register its lending product and restructure its business to comply with the Investment Company Act of 1940.

Despite the SEC's historical reticence to provide such forward-looking guidance, the BlockFi settlement sets a precedent. It provides a pathway for crypto platforms to achieve compliance with existing laws, signaling a possible shift in the SEC's approach towards regulation by enforcement.

However, the SEC's inconsistent enforcement actions have created uncertainty, particularly for smaller market participants. A case in point is the SEC's aggressive enforcement actions against small and micro-cap lenders for operating as unlicensed dealers. These actions, combined with a lack of clear guidelines for companies to register as dealers, have sown confusion among hedge funds, family offices, day traders, and serial PIPE investors.

The enforcement-based regulation trend extends beyond the crypto world and the unlicensed broker-dealer issues. Laws regarding insider trading, short selling practices, and SPACs (Special Purpose Acquisition Companies) have also been influenced by enforcement actions.

With shifting SEC leadership and policy agendas contingent on the political climate, the agency seems to favor regulation by enforcement as the path of least resistance. However, the paramount need to protect constitutional rights to due process and fair notice must not be overlooked in the process.