Pat Daugherty (Partner, Chicago) recently joined DiffuseTap for a podcast episode exploring the legal and regulatory dynamics of digital assets classification, the broader implications for the SEC’s role in the crypto space, and the potential impact of crypto-related cases currently under judicial scrutiny.
The below episode transcript has been edited for clarity.
Mr. Daugherty, thank you for joining us. Please tell the good folks a little bit about your background and what you’re up to over at Foley.
Thanks for having me. I’m a lawyer. I work broadly across the digital assets industry, advising traders, funds, exchanges, development teams – pretty much the whole industry. My background is as a securities law practitioner. I have been a securities lawyer since 1981. That’s a long time.
I was in a senior role at the SEC as a young man. They’ve since upgraded the position. I don’t think I’d get it if I applied today. But I did have a fairly senior role as a young man, and I teach digital assets in residence at Cornell University in the law school every fall. For a couple of months, that is. I take my law practice there, and I teach a seminar on this subject. I also presented a segment at the University of Chicago Law School in Hyde Park just last Thursday.
When I’m in Chicago, where I live, I engage with full-time scholars and students there and at Northwestern, and also at Kent.
You asked me to talk about who decides whether a crypto asset is to be classiﬁed as a security, which is, I think, little understood by people who are not lawyers. There are lawyers who don’t understand it well, either. So, I’ve made some notes to speak to that, and I’ll get into it if you want.
Well, let’s start with some high-level things because not everybody is a securities expert. Who are the parties that have a hat in the ring for the competition to see what these things actually are?
Well, I will say the United States Congress does.
Would that be the FIT bill that I keep hearing about?
Some 90 some years ago there was enacted the Securities Act of 1933, and we’ve had at least six other securities law statutes enacted since then, but yes. And this is fundamentally a matter of statutory interpretation. It is not common law. What is and is not a security is based on what the statutes say and what they mean.
So, Congress is one player. You also have the U.S. Securities and Exchange Commission (SEC), which is charged with administering, interpreting, and enforcing the law. The Commodity Futures Trading Commission (CFTC) has a minor role. The courts, in my view, have the deﬁnitive role. Those are the players, and those are actually Articles I, II, and III of the United States Constitution. Every organ of the federal government has a hand in this.
Okay. There are a lot of people who are going at it. Maybe to talk brieﬂy about recent history, what are the developments in the last month or two that have a bearing on which way those tea leaves are going?
It’s in the courts now, because the SEC sues people. And usually, their targets capitulate. They say, “I give up. We’ll stop and, if we need to, we’ll pay a ﬁne. Just get me out of here.” That doesn’t make law, actually. The SEC pretends it does. But sometimes, people ﬁght back because they have the resources and they’re convinced of their position. Those would be the major exchanges, for example – currently they’re in court.
Is that Coinbase?
I can’t get into who, but it is the major crypto exchanges. They haven’t really gone after dealers yet, per se. But they have threatened to do that. They have gone after many token and protocol developers, the most famous one being Ripple in a case that was brought in the Southern District of New York, and which has not completely ended yet. It is likely to be appealed to the Second Circuit.
But there was a split decision on that, which I think the industry mostly won, in the federal district court, on the question of whether XRP is a security. And that illustrates my point, which is that the SEC can bring charges. But they’re only that. They are charges, just like you can be given a ticket for speeding on Lake Shore Drive. That ticket is not an adjudication of your guilt.
You can admit the violation and pay the ﬁne, or you can go to trafﬁc court and ﬁght it. And the policeman had better show up and make a case, or else you will win. Likewise, the SEC does not decide these things. The SEC brings charges. I’ve heard lawyers say this, and it makes me want to pull my hair out. They say the SEC has decided that this token is a security, that some other token is a security, that all tokens other than Bitcoin are securities. And I say in reply: No, they actually don’t.
They bring charges. Some people ﬁght back. Others, for good reason, do not. But until you agree to the charge and settle the case, or until a judge says, “We agree with the SEC,” it’s actually undecided. Even then, the judges may disagree among themselves, which is why we have courts of appeal. And even courts of appeals disagree among themselves. This is why we have a Supreme Court.
But ultimately the legal question is determined by judicial review, which is a concept well known to lawyers but little known to people who are not lawyers. Judicial review dates to an 1803 case named Marbury vs. Madison in which Chief Justice Marshall held very famously that the law is ultimately decided by the federal courts. That’s a principle of United States constitutional law. It’s also a principle of statutory interpretation.
Okay. So even if we pass one of these bills, at the end of the day it’s still most likely going to go to the Supreme Court? Who is going to determine where this lands?
The answer depends on how clear the law is. Right now, many of us think the law is quite muddled and will need reﬁnement. I’m one of those who are working on the legislation that you’re referring to. In fact, that was my panel at the University of Chicago last Thursday, when I interviewed Patrick McHenry.
Right now we have a collection of data points on the judicial map. This judge rules that this coin is a security, that one rules that the other one is not. You have a bunch of data points, which is not a very effective way to make law. It would be much better if the SEC adopted rules, which they are empowered to do.
That’s not what the SEC has done. Other SECs have done that, but that’s not what this SEC does, and that’s a political choice. Professor Chris Brummer at Georgetown Law School has written an article called “Regulation By Enforcement”, which I recommend to you. Chris talks at length about the pros and cons of managing an agency this way.
But it is the choice of the Gensler SEC – SEC Chairperson Gary Gensler and two other Commissioners – to make law through enforcement actions, as opposed to proposing rules for adoption or interpreting existing rules in no-action letters and interpretive letters. And that course of action is, frankly, what has driven Congress to say, “Wait a minute. We are going to clarify this law if we possibly can, because the SEC’s case-by-case method is no good.”
Okay, let’s pick that up. What is the SEC trying to do, exactly? What’s their goal in all of this other than to be the bogeyman for crypto? I mean, there is the ideal goal to protect consumers, which is deﬁnitely part of it. But do you think there is politics at play? Is there something below that larger mandate going on?
Oh, for sure there is. This is part of the Biden Administration crackdown on cryptocurrencies. It’s not only the SEC that’s doing this. You see it in the Treasury Department. You see it in the Federal Reserve, the banking agencies. There is a political movement to hurt cryptocurrencies. That is the motivation in the guise of investor protection.
And I say “in the guise of investor protection” because, generally speaking, investors are not demanding this. Thousands and thousands of investors wrote to the SEC, saying “please allow exchange-traded funds to trade Bitcoin and other crypto assets” and the SEC still said “no.” The attitude is, “We know better than you do what’s good for you. We think crypto is bad for you, so we’re not going to allow it.” The Gensler SEC took this position until ﬁnally they were forced by the D.C. Circuit Court of Appeals to approve Bitcoin ETFs. They had no choice, so in the end they allowed it. Approving a product only because a court forces you to approve it is not a good look for this SEC. But I’m glad they did it rather than continue to resist.
I call this a green shoot during crypto winter. There are two green shoots in a pretty dismal legal landscape here. One is the Bitcoin exchange traded funds. The other is the legislation, the FIT 21 Act primarily, and the stablecoin bill. They are a long shot to become law this term. But it’s progress. A year or two ago, we were not this far.
And there are sometimes political changes. Change the people who are making these decisions and, guess what, you get different decisions. That’s probably as it should be, because the agency heads are supposed to be accountable to Congress and especially the president. The agency heads are part of the executive branch. So it’s not wrong when Gary Gensler does the bidding of the Biden Administration.
He’s part of the Biden Administration. That’s not wrong. But if the administration changes, then the policy changes, too.
You mentioned before that the CFTC had a minor role here. We talked about the SEC a lot more than the CFTC. Is there a turf war going on? What is the CFTC’s actual position?
Certainly there is turf war going on here, but I don’t blame the CFTC for it. I mean, the CFTC essentially views all crypto assets as commodities, and they are. The question is whether they’re also securities. Because if they are commodities that are securities as well, then there is nothing much the CFTC can do or say about that.
That’s because it is not the CFTC’s domain to say “this token is not a security.” It’s the SEC’s domain to say that. That’s why I don’t blame the CFTC. It can’t stop the SEC from asserting jurisdiction, fundamentally. So it doesn’t matter if the CFTC has jurisdiction. If this SEC also has jurisdiction, then you get these lawsuits. That is where this is coming from.
It’s not one or the other. All securities are commodities, but not all commodities are securities. Not all investments are securities. The jurisdictional ﬁght is about the extent to which they overlap, and this point is also little understood. But Gary Gensler understands it. He gets it, and he should, because he once chaired the CFTC.
That’s a fair point. Let me pick up a question. What does it mean if these things are securities, from an issuer perspective and then from a user perspective? What does that mean for the industry?
If a token is a security, then transacting in it is subject to all the applicable securities laws. For example, the sale of the crypto asset, when ﬁrst emitted by the protocol, needs to be registered under the Securities Act unless there is an exemption. Sometimes there are exemptions. That’s what I do in my daily work. I work around the exemptions because I know how they work.
When you say exemption, this would be Reg D, Reg S, or Reg CF?
That’s right. Reg S is my favorite because, among other things, I am a co-author of Reg. S. I was there in 1989 when it was created. And I’m publishing a book chapter on this for token offerings today: Reg S as it relates to the offering and sale of crypto assets. There is nothing like it out there. This is what we do at the University of Chicago: We invent knowledge. So, again, because tokens can be securities, you work around the exemptions. That’s all you can do.
It’s also a problem for the exchanges. The SEC’s case against certain exchanges is that, in the SEC’s view, these assets that are being trading include some securities (and at least a few of them are) and yet you’re not registered as an exchange. If you trade securities, you need to be registered as an exchange or at least as a dealer. And you’re not registered as either one of those. So you’re an illegal exchange. And they also say, for good measure, you’re an illegal clearing agency. You’re an illegal dealer, an illegal exchange, and an illegal clearing agency, all of which depend upon the trading of securities.
If all you did was trade commodities, you wouldn’t need to comply with any of the securities laws. If you trade futures, you need to comply with the Commodity Exchange Act. But that’s a whole different animal.
So the exchanges are a bit FUBAR because they’re operating illegally if these become securities.
Yup, they’re trading securities. “FUBAR” is a little strong because there are ways you could work this out. And I suspect that if the exchanges lose, and I don’t think they’re going to lose, but I suspect that if they did lose THEN they would work it out. Because the SEC shutting down the major exchanges would cause massive economic harm for Americans who own those assets.
And not just Americans. I saw data yesterday that something like 400 million or 500 million people around the world now own crypto assets. They don’t all trade on U.S.-based exchanges, but a lot of them do. And many U.S. citizens, more than a few Congressmen and Senators, hold crypto assets. So, if you think people screamed when Ripple got sued, imagine how they will scream if the government tries to shut down one of the major exchanges. They will go nuts because of the value destruction.
How would you feel if the SEC tried to shut down the New York Stock Exchange? What do you think that would do to the value of your public stock portfolio? I think it would hurt. It wouldn’t kill it because there are other exchanges, but it would hurt a lot.
Now, let’s suppose the SEC shuts down all the public stock exchanges. What would that do to the value of your public equity holdings? It would crush them. This is why, if the SEC actually prevailed, the matter would become a pure political issue. The pushback from Congress, whether or not you have a new administration, would be so overwhelming that they will have to work it out.
But it is what the SEC demanded in its complaint. They said, you violated the law in our opinion, so pay a lot of money and stop trading. Stop trading? That means shut our business. That’s why one exchange CEO said, “We were given no choice. Shut your exchange down? Oh, yeah, right. In that case, we’ll litigate.”
So the courts – not the SEC – will decide whether the crypto exchanges are trading “securities.” Maybe Congress will intervene. But this won’t be decided by the SEC.