Payward Ventures, Inc., d/b/a Kraken, the cryptocurrency exchange, has entered into a $30 million settlement agreement with the U.S. Securities and Exchange Commission (SEC) over allegations the company failed to register its cryptocurrency staking program, in violation of U.S. securities laws.
Background
Staking programs reward users for locking up their digital tokens to validate transactions on a blockchain, with the reward consisting of “interest” accruing on the locked-up tokens, which the user typically receives in the form of additional tokens. Interest payments vary based on the number of tokens staked and duration of the lockup period. These programs have become increasingly popular as blockchain operators seek to incentivize users to participate in consensus verification of new transactions, which is a key feature of distributed ledger technology.
SEC Action
The SEC complaint alleges the contract under which users stake assets and receive a return from Kraken constitutes an investment contract, subject to the registration requirements under Section 5 of the Securities Act of 1933, as amended (Securities Act). According to the complaint, over $2.7 billion of crypto assets were “invested” in Kraken’s staking program by more than 135,000 U.S. participants. The SEC complaint states that Kraken “offered and sold investment contracts without registering the offer or sales with the SEC as required by the federal securities laws, and no exemption from the registration requirement applied.”
SEC Chairman Gary Gensler released a YouTube video in which he states that “staking-as-a-service providers must register and provide full, fair and truthful disclosure and investor protection.” He added, “[W]hether they call their services ‘lending,’ ‘earn,’ ‘APY’ or ‘staking,’ that relationship should come with the protections of federal securities laws.” Of note, SEC Commissioner Hester Peirce made a public dissent from the action against Kraken, calling for greater clarity and an end to the SEC’s practice of regulation by enforcement. Apart from registration, Kraken could have opted for an exempt offering under Regulation D, whereby all or most investors would need to be “accredited.”
The SEC noted that the Kraken account agreement itself—whereby customers agree to stake their assets in exchange for a return—resembled fixed-income investments and therefore should be considered securities.
Pursuant to the settlement agreement, Kraken will no longer offer its staking program to U.S. account holders, will remove all staked assets of U.S. clients and will pay $30 million in fines, all without an admission or denial of guilt.
Why It Matters
The action against Kraken signals that the SEC is turning its attention to a new (and increasingly popular) area while continuing to apply the old rules to new technologies. Consumer protection appears to be the SEC’s top priority, based on the complaint's allegation that because Kraken failed to register the staking program, users “lacked material information” necessary to evaluate the program.
By levying a substantial fine for conduct the SEC had not previously made clear was problematic, the agency has adopted an even stricter, less accommodating approach to this industry. As a result, all participants in the crypto space must tread carefully and review how their actions fit with the SEC’s elastic and evolving application of the Howey test.
Et tu, Stablecoin?
In the hours since the SEC announced its settlement with Kraken, The Wall Street Journal reported that the regulator plans to sue stablecoin issuer Paxos over its issuance of the Binance USD coin. The SEC has yet to comment officially, but if confirmed this would represent a continued expansion of the SEC’s authority over digital assets. Stablecoin has been the subject of review by the President’s Working Group on Financial Markets, led the Department of the Treasury, the FDIC and the OCC. This follows similar actions brought by the New York Attorney General, the CFTC and private plaintiffs against stablecoin issuer Tether.
The SEC’s actions against Kraken (and perhaps now Paxos) continue the BlockFi/Kardashian/Coinbase lineage of enforcement actions that have brought the Truman-era Howey test from the real world into the metaverse. Applying the definition of “investment contract” to commercial relationships that could not have been foreseen 75 years ago represents an expansion of SEC oversight and its continued aggressive approach to regulating the crypto and blockchain industries by enforcement action rather than by affirmative rulemaking.
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Manatt, Phelps & Phillips, LLP, is a leading law firm in the fintech, financial services and blockchain practice areas. We advise on and structure innovative deals for U.S. and international clients, providing pertinent regulatory strategy and guidance in the ever-changing fintech landscape. Manatt was awarded a top ranking in Chambers’ 2023 FinTech Legal USA category, with our blockchain and cryptocurrency practice led by Brian S. Korn.
Related Links
Complaint and Demand for Jury Trial, Case No. 23-cv-588 (N.D. Cal., Feb. 9, 2023), available at https://www.sec.gov/litigation/complaints/2023/comp-pr2023-25.pdf.
YouTube Video, “Staking-as-a-Service | Office Hours with Gary Gensler” (Feb. 9, 2023), available at https://www.youtube.com/watch?v=hmPpIjfC9DY.
Press Release, U.S. Securities and Exchange Commission, “Kraken to Discontinue Unregistered Offer and Sale of Crypto Asset Staking-As-A-Service Program and Pay $30 Million to Settle SEC Charges” (Feb. 9, 2023), available at https://www.sec.gov/news/press-release/2023-25.
Statement by SEC Commissioner Hester M. Peirce, “Kraken Down: Statement on SEC v. Payward Ventures, Inc., et al.” (Feb. 9, 2023), available at https://www.sec.gov/news/statement/peirce-statement-kraken-020923.
S.E.C. v. Howey Co., 328 U.S. 293 (1946), available at https://tile.loc.gov/storage-services/service/ll/usrep/usrep328/usrep328293/usrep328293.pdf.
“Crypto Firm Paxos Faces SEC Lawsuit Over Binance USD Token”, The Wall Street Journal (Feb. 12 , 2023), available at https://www.wsj.com/articles/crypto-firm-paxos-faces-sec-lawsuit-over-binance-usd-token-8031e7a7.
President’s Working Group on Financial Markets, Report on Stablecoins (Nov. 2021), available at https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf.
“Will Tether Be Classified as a Security and Sued by the SEC?”, CryptoVantage (Dec. 16, 2022), available at https://www.cryptovantage.com/news/will-tether-be-classified-as-a-security-and-sued-by-the-sec/.