Top 5 SEC Enforcement Developments for December 2023

To provide an overview for busy in-house counsel and compliance professionals, we summarize below some of the most important and interesting SEC enforcement developments from the past month, with links to primary resources. This month, we examine:

• A court of appeals’ vacatur of the SEC’s Share Repurchase Disclosure Modernization Rule;
• A grant of partial summary judgment in the Terraform Labs crypto assets securities fraud case set for trial in the Southern District of New York;
• An ongoing dispute between the leading cryptocurrency exchange and the SEC concerning proposed rulemaking for the regulation of cryptocurrency and other digital assets;
• Settled charges with a decentralized autonomous organization (a DAO) and its founders for selling unregistered securities; and
• The SEC’s Chief Accountant’s comments on the importance of providing accurate cash flow statements.

1. Fifth Circuit Court of Appeals Vacates SEC Share Repurchase Rule

On December 19, 2023, the Fifth Circuit Court of Appeals issued an opinion and judgment vacating the Share Repurchase Disclosure Modernization Rule (the “Share Repurchase Rule” or the “Rule”).

The SEC adopted the Share Repurchase Rule on May 3, 2023. Among other things, the Rule required issuers to disclose daily quantitative stock repurchase data, the objectives or rationales for the issuer’s share repurchases, the process or criteria used to determine the number of repurchases, and any policies and procedures relating to purchases and sales by officers and directors during a repurchase program.

On October 31, 2023, the court issued an opinion finding that the Rule was arbitrary and capricious because the SEC formulated the Rule without responding to comments on the Rule or conducting a proper cost-benefit analysis. While retaining jurisdiction over the matter, the court remanded the Rule to the SEC, with instructions to correct these defects within 30 days. The SEC promptly stayed implementation. However, the Commission did not amend the Rule on the court’s timeline. Accordingly, the court vacated the Rule.

For more information, see our client alerts about the adoption of the Share Repurchase Rule, the SEC’s subsequent stay of the Rule, and the latest decision vacating the Rule.

#BuybackBlowback #ShareRepurchaseRule #FifthCircuitVsSEC

2. Manhattan Federal Court Grants Partial Summary Judgment to SEC in Terraform Labs Securities Case

On December 28, 2023, Southern District of New York Judge Jed Rakoff granted summary judgment to the SEC against crypto assets company Terraform Labs (“Terraform”) and its founder, Do Kwon (collectively, “Defendants”), on claims that Defendants failed to register their two cryptocurrencies as securities. The court held that there is no genuine dispute that Terraform’s UST, LUNA, wLUNA, and MIR crypto assets are investment contracts, and therefore securities—which Terraform sold without registering with the SEC, in violation of Sections 5(a) and 5(c) of the Securities Act. However, the court also granted summary judgment to Defendants on the SEC’s claims that Terraform offered or effected transactions in security-based swaps, finding the evidence does not show that Terraform’s mAssets—tokens minted through Terraform’s mirror protocol that purported to reflect the value of a non-crypto reference asset—meet the statutory definition.

The court’s order did not resolve the SEC’s claims entirely, however, as the court denied summary judgment to the SEC on claims that Terraform committed fraud under Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and SEC Rule 10b-5. The SEC had alleged in its complaint that Terraform and its founder defrauded its investors by deceiving them about the utility and actual use of the company’s crypto assets as a blockchain-recorded currency for real-world transactions and the de-pegging of Terraform’s stablecoin, UST, from the U.S. dollar, which led to the total collapse of the company’s other crypto assets. In particular, the Commission maintained that Defendants committed fraud by lying to investors about these crypto assets’ safety and fabricating blockchain activity to give investors a false sense of the assets’ adoption. Judge Rakoff ruled that a genuine dispute exists as to Defendants’ scienter and whether a reasonable investor would have found the various statements at issue materially misleading. Nevertheless, the court denied Defendants’ motion on the fraud claims because the SEC put forth sufficient admissible evidence upon which a reasonable jury could rely to support a finding of fraud.

A trial on the surviving claims is scheduled for January 29, 2024.

#TerraformOnTrial

3. SEC Denies Coinbase’s Petition for Cryptocurrency Rulemaking and Coinbase Immediately Seeks Review

On December 15, 2023, the SEC denied a petition for rulemaking from the popular cryptocurrency exchange, Coinbase.

The petition, which Coinbase filed on July 21, 2022, requested that the SEC “propose and adopt rules to govern the regulation of securities that are offered and traded via digitally native methods, including potential rules to identify which digital assets are securities.” The petition argues that transactions involving digital securities on blockchains “do not rely on centralized entities or certificated forms of ownership that characterize traditional financial instruments . . . rendering many of the Commission rules that govern the offer, sale, trading, custody, and clearing of traditional assets both incomplete and unsuitable for securities in this market.”

Nine months later, on April 24, 2023, Coinbase filed a petition for a writ of mandamus in the Third Circuit Court of Appeals, asking the court to order the SEC to respond to its petition.

On December 15, 2023, the Commission denied the petition in a 3–2 vote. The SEC sent Coinbase a letter informing the company that it would not undertake the requested rulemaking, explaining that the Commission “disagrees with the Petition’s assertion that application of existing securities statutes and regulations to crypto asset securities, issuers of those securities, and intermediaries in the trading, settlement, and custody of those securities is unworkable.” In denying the petition, the SEC added that “[t]he requested regulatory action would significantly constrain the Commission’s choices regarding competing priorities.”

On the same day, SEC Chair Gary Gensler also issued a public statement concerning the Commission’s denial of Coinbase’s petition. In the statement, Chair Gensler wrote that he voted to deny the petition because “[e]xisting laws and regulations already apply to the crypto securities markets” and the Commission is already “pursuing numerous undertakings applicable to crypto asset securities and intermediaries, and the Commission’s assessment of whether and, if so, how to alter the existing regulatory regime may be informed by the results of these initiatives.” He also opined that “it is important to maintain Commission discretion in setting its own rulemaking priorities.”

On December 18, 2023, the Third Circuit dismissed Coinbase’s mandamus petition as moot. Immediately after the SEC denied the petition for rulemaking, Coinbase also filed a petition for review of the Commission’s decision on Coinbase’s proposed rulemaking—again in the Third Circuit. The petition argues that the SEC’s decision denying Coinbase’s petition was “arbitrary and capricious, an abuse of discretion, and contrary to law, in violation of the Administrative Procedure Act.”

#CryptoCompaniesCallForRules #SECPuntsOnCryptoRules

4. SEC Announces That BarnBridge DAO Agreed to Stop Sale of Its Unregistered Crypto Product

On December 22, 2023, the SEC announced that it reached a settlement with a purported DAO—a type of member-owned organization with no central governing body that employs blockchain technology to make decisions—and its two founders to resolve allegations that they offered and sold unregistered securities known as SMART Yield bonds and failed to register as investment companies the Smart Yield pools through which those securities were sold.

The SEC’s orders found that the DAO and its founders attracted nearly $510 million in investments based on its unregistered SMART Yield bonds. According to the SEC, Ward and Murray promoted BarnBridge DAO’s SMART Yield bonds through various means, including by publishing a white paper that described the bonds as fixed-income products that allowed investors to receive fixed or variable gains by investing in senior tranches (with guaranteed returns) or junior tranches (with variable rates of return) of SMART Yield investment pools. Assets invested in these pools were exchanged for crypto assets from third-party lending platforms that generated interest income for the pools. Under this scheme, SMART Yield would direct the junior investors’ capital to pay senior investors if the senior investors’ “guaranteed yield” was not achieved by the lending results. However, junior investors would receive any surplus in the event that the lending platform’s assets yielded more than was needed to pay the fixed yield to the senior investors. BarnBridge DAO did not register the SMART Yield bonds with the SEC.

The SEC determined that the offering and sale of SMART Yield bonds violated Sections 5(a) and 5(c) of the Securities Act, which bar the offering and sale of unregistered securities. The SEC further determined that BarnBridge DAO caused the investment pools (which were not registered investment companies) to violate Section 7(a) of the Investment Company Act, which prohibits unregistered investment companies from offering and selling securities. The settlement resulted in two cease-and-desist orders: One against BarnBridge DAO, requiring the entity to stop the offer and sale of SMART Yield bonds and disgorge nearly $1.5 million in funds to the SEC; and another against BarnBridge’s co-founders, Tyler Ward and Troy Murray, requiring the two men to cease offering SMART Yield bonds and each pay $125,000 in civil penalties.

#UnregisteredCryptoBonds #UnregisteredDAO #DAODisgorgement

5. Statement from SEC Chief Accountant Highlights Commission’s Focus on Statement of Cash Flows

On December 4, 2023, SEC Chief Accountant Paul Munter issued a statement on the importance of cash flow reporting. Arguing that statements of cash flows have consistently been the leading area of restatements for issuers of securities, Munter asserted that issuers and auditors have not applied the same rigor to statements of cash flows as they do other financial statements. He reminded issuers and auditors “of the importance of performing an objective analysis from the perspective of a reasonable investor when evaluating the materiality of both the financial statement and ICFR impacts of an error in the statement of cash flows.” He further stated that classification is the foundation of the statement of cash flows, and that the Office of the Chief Accountant has found unpersuasive arguments that that an error in the classification of cash flows is not material. He expressed the SEC’s expectation that independent auditors design and implement procedures to address the risks specifically associated with the statement of cash flows, reminding them that, when evaluating errors, it would be inappropriate to set a materiality level that exceeds materiality for the financial statements as a whole. Historically, similar statements from senior SEC officials have often signaled increased enforcement attention to particular issues, so companies would be wise to pay close attention to their cash flow reporting in light of Munter’s statement.

#CashFlowStatements #MunterSpeaks