In a recent article, SEC Commissioner Caroline A. Crenshaw encouraged decentralized finance (DeFi) participants to voluntarily comply with securities law regulations, in particular those governing risk disclosure, warning that additional enforcement actions are likely against those who fail to do so.1
The reach of decentralized finance (DeFi) and related technologies has grown rapidly in the past several years. Broadly speaking, DeFi seeks to offer financial services through self-executing “smart” contracts and decentralized transaction records—“blockchains”—that reduce the need for traditional financial intermediaries.
Initially popularized by the digital currency Bitcoin, blockchain technology and the DeFi applications that it enables have proliferated. From collateralized lending to interest-bearing deposits and fractionalized asset ownership through non-fungible tokens, financial services companies new and old are developing novel financial products and innovating existing ones as they capitalize on this growing trend toward decentralization.
The expansion and evolution of DeFi have been so rapid that regulators have until recently largely played catch-up. In 2017, the SEC issued its seminal investigative report on “The DAO,” concluding that financial instruments can still be “investment contracts” regulated by U.S. securities laws, even when they are issued by decentralized autonomous organizations (DAOs) or governed by self-executing smart contracts.
In pronouncements that followed, the SEC made clear that the old rules governing securities can and will be applied to blockchain-enabled financial products that share the same investment objectives as traditional financial instruments.
Enter Commissioner Crenshaw
Commissioner Crenshaw’s article in the inaugural issue of The International Journal of Blockchain Law continues the SEC’s messaging around the applicability of existing securities laws to DeFi and the very real potential for enforcement actions against DeFi participants who fail to comply with the law.
In particular, Crenshaw stressed the need to provide clear and specific disclosure of DeFi investment risks. While the absence of any disclosure is clearly problematic, the commissioner went further in suggesting that a general, broadly worded disclosure may also be insufficient:
[I]nformation asymmetries will likely advantage rich investors and insiders at the expense of the smallest investors and those with the least access to information. Accordingly, DeFi participants’ current “buyer beware” approach is not an adequate foundation on which to build reimagined financial markets.
Acknowledging the continuing uncertainty around DeFi regulation, Crenshaw also encouraged promoters to seek SEC guidance when in doubt. For those who proceed to market nonetheless, enforcement actions may result.
But Crenshaw notes that enforcement is not the preferred approach, adding that “[t]he more projects that voluntarily comply with regulations, the less frequently the SEC will have to pursue investigations and litigation.”
Notably, Crenshaw’s article closely follows the SEC’s first action against a DeFi market participant. Last August, the SEC instituted a cease-and-desist against two individuals and their Cayman Islands company for allegedly selling more than $30 million in securities without registering with the SEC or meeting an exemption from registration.
Available exemptions include private placements to accredited investors under Regulation D of the Securities Act and foreign offerings to overseas investors under Regulation S. The respondents in the SEC’s action did not fit within these or any other exemption and consequently were ordered to pay disgorgement and civil penalties totaling more than $13 million.
- DeFi Products May Be Securities. Through its prior reports and pronouncements and most recently in Commissioner Crenshaw’s article, the SEC and individual commissioners have made clear that DeFi products and services are viewed through the lens of existing securities laws. Those that meet the decades-old test for identifying investment contracts (the so-called Howey Test) are particularly likely to be regulated.
- Future Participants Should Proceed With Caution. The SEC’s message has been consistent and clear: For DeFi products that are securities, registration with the SEC is required unless an exemption is available, such as in private placements to accredited investors under Regulation D and foreign offerings to overseas investors under Regulation S. Experienced legal counsel should be consulted before proceeding to market to ensure any potential offering is properly registered or exempt from registration.
- Voluntary Compliance Will Be Viewed Favorably. When in doubt, DeFi market participants should err on the side of voluntary compliance, including by providing clear and specific disclosure of the risks associated with their products. While disclosure alone does not ensure full compliance with applicable regulations, transparency is a bedrock principle of U.S. securities laws, and Commissioner Crenshaw’s writing makes clear that taking such steps may reduce the likelihood of an enforcement action.
- The Penalties for Violations Can Be Substantial. Promoters of unregistered securities face substantial civil and criminal liability. The indirect consequences of an enforcement action are also significant. Violators will find it difficult to establish banking relationships, obtain regulatory licenses and raise conventional capital.
- Remedial Action May Be Advisable. Those who have already proceeded to market with DeFi products should consider whether they have already violated any securities laws and, if they have, take remedial action. Similarly, trading platforms, intermediaries and other service providers that have previously handled DeFi products should consider whether they also have disclosure or registration obligations.
- Other Securities Laws May Apply. Commissioner Crenshaw’s article does not directly address whether DeFi market participants are “investment companies” for purposes of the Investment Company Act of 1940 or “investment advisers” for purposes of the Investment Advisers Act of 1940; both acts generally require that such entities register with the SEC. Given the broad definition of “securities” under these acts, however, members of the DeFi community should carefully consider the applicability of these laws to their activities.
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Please contact the author or any other member of the Manatt Financial Services or Investigations, Compliance and White Collar Defense teams should you have questions about regulation of DeFi products and services or how the SEC’s evolving position on these matters may impact your interests.
Crenshaw, Caroline A., “DeFi Risks, Regulations, and Opportunities,” The International Journal of Blockchain Law, Vol. 1, Nov. 2021, available at https://gbbcouncil.org/wp-content/uploads/2021/11/IJBL-1.pdf.
Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf.
Order Instituting Cease-and-Desist Proceedings, Administrative Proceeding File No. 3-20453 (Aug. 6, 2021), available at https://www.sec.gov/litigation/admin/2021/33-10961.pdf.
1 Consistent with Commission policy, Commissioner Crenshaw expresses only her own views, and as such are not official SEC policy nor are they necessarily the views of her fellow commissioners or Commission staff.