SEC continues enforcement campaign against crypto market participants

In an action that is reflective of the commitment of the American Securities and Exchange Commission’s (the SEC) enforcement efforts against improper activity in the digital asset space, the SEC filed a complaint (the Complaint) against Genesis Global Capital, LLC (Genesis) and Gemini Trust Company, LLC (Gemini) on January 12, 2023, for allegedly engaging in the unregistered offering and sale of securities through the “Gemini Earn Program.”

The step is consistent with enforcement proceedings brought by the SEC against crypto market participants generally and centralized crypto asset lenders in particular — as previously reported, in May 2022 the SEC announced that it would double the size of its Division of Enforcement’s Crypto Assets and Cyber Unit. This enforcement action also confirms that the SEC views crypto lending arrangements as falling within its regulatory jurisdiction and is willing to use its traditional enforcement remedies.

Gemini Earn Program

The Gemini Earn Program permitted retail clients to earn interest on certain crypto assets. To participate in this program, clients were required to enter into a tri-party Master Digital Loan Agreement with Genesis and Gemini whereby clients provided crypto assets to Genesis, with Gemini acting as the agent in the issuance. Genesis pooled together the crypto assets from clients of the Gemini Earn Program with the assets of other clients and would then lend these crypto assets to institutional borrowers. Genesis would earn revenue by lending the crypto assets at a higher rate than it paid to clients of the Gemini Earn Program. Genesis would send interest payments to Gemini, who would then deduct an “agent fee” before distributing the remainder of the interest payments to its clients.

In November 2022, following significant volatility in the broader crypto asset market, Genesis announced that it would not permit retail clients to withdraw their crypto assets from the Gemini Earn Program because of liquidity constraints. According to the Complaint, at this time, Genesis held approximately $900 million in client assets for approximately 340,000 (mostly American) Gemini Earn clients. As of the date of the Complaint, these clients were still unable to withdraw their crypto assets from the Gemini Earn Program.

Implications under U.S. securities laws

The way the Complaint is framed demonstrates the SEC’s view, as recently expressed by chairman Gary Gensler, that its traditional authority over securities provides it with sufficient jurisdiction to regulate novel crypto markets.

The SEC alleges that the Gemini Earn Agreements, as offered and sold through the Gemini Earn Program, constituted securities because they were “notes” pursuant to the four factors in the “family resemblance test” put forward in Reves v. Ernst & Young:

1. The purpose of the Gemini Earn program was for Genesis to obtain crypto assets to generate profits for itself and Gemini Earn Clients were primarily interested in the arrangement because they expected the program to generate profit.
2. The Gemini Earn Program was offered and sold to a broad segment of the general public.
3. The investing public considered the notes to be investments as a result of the statements made by Gemini and Genesis on their websites and social media.
4. There is no alternative regulatory regime or risk-reducing factors to protect the Gemini Earn clients. While Gemini is registered with the New York State Department of Financial Services (NYDFS) as a trust company, the NYDFS did not have direct oversight over Genesis and the regulatory regime applicable to Gemini did not extend to Genesis.

In the alternative, the SEC alleges the Gemini Earn Agreements constituted “investment contracts” under the Howey test:

1. There was an investment of money because Genesis raised billions of dollars from hundreds of thousands of retail investors.
2. Gemini Earn clients, Genesis, and Gemini were in a common enterprise because
   1. client funds were pooled together
   2. the fortune of Gemini Earn clients was also tied to Genesis’ fortune as these client earned profits when Genesis deployed the pooled assets
3. Gemini Earn clients had a reasonable expectation of profit as the program was marketed as an investment opportunity.
4. This was the result of the significant and essential effort of others since clients ceded control to Genesis, who had complete discretion in deploying the crypto assets, and the economic reality supported that Genesis undertook various complex tasks in deploying client assets to generate profits.

The SEC’s position in applying these traditional categories to crypto market participants has likely been bolstered by its recent success in SEC v. LBRY, Inc [PDF]. In that case, a U.S. Federal Court granted summary judgment finding that the tokens issued by LBRY, Inc. were unregistered securities because they constituted investment contracts under the Howey test.

Conclusions

The SEC’s latest and ongoing activity in the crypto market confirms the American regulator’s commitment to policing the digital asset market by applying traditional securities categories and principles, notwithstanding it being a novel asset class that does not obviously or neatly fit within that paradigm. Until a more bespoke regulatory regime is developed, embraced and implemented in the United States — and throughout the regulated world — we should expect to see continued efforts reflective of this approach.