Cadwalader Cabinet: Step Lightly

Company Settles SEC Charges for Failure to Register Crypto Lending Product

A company settled with the SEC and the North American Securities Administrators Association ("NASAA") for failing to register the offers and sales of its retail crypto lending product.

In its Order, the SEC found that the company had offered and sold certain bearing accounts to investors. Through the accounts, the investors loaned crypto assets to the company in exchange for the company's promise to provide a variable monthly interest payment. The SEC found that the accounts were securities that were subject to registration under the Securities Act of 1933, and did not benefit from any SEC registration exemption. Additionally, the SEC found that the company operated as an unregistered investment company and made materially false and misleading statements concerning the risks associated with its lending activity.

The SEC determined that the the company violated Sections 5(a) ("Sale or delivery after sale of unregistered securities"), 5(c) ("Necessity of filing registration statement"), 17(a)(2) and 17(a)(3) ("Use of interstate commerce for purpose of fraud or deceit") of the Securities Act and Sections 3(a)(2) ("Definitions of investment securities”) and 7(a) ("Prohibition of transactions in interstate commerce") of the Investment Company Act.

The company agreed to (i) cease its unregistered offers and sales and attempt to bring its business within the provisions of the Investment Company Act and the Securities Act, (ii) pay a $50 million penalty and (iii) comply with the undertakings detailed in the Order.

The company also agreed to pay an additional $50 million penalty to 32 states for the same conduct. According to the NASAA press release discussing the charges, the company is alleged to have "failed to comply with state registration requirements and, as a result, investors were sold unregistered securities in violation of state law." The $50 million penalty will be evenly divided amongst the members of NASAA.

Commissioner Hester Peirce dissented from the SEC's enforcement action, stating that she does not believe the approach the SEC is taking with respect to crypto lending is the best way to protect crypto lending customers. Ms. Peirce stated that the $100 million penalty for the company "seems disproportionate" in light of the absence of any allegations from the SEC that the company failed to pay its customers the money due them or to return the crypto assets that were lent. She argued that while the portion of the settlement "aimed at getting important information to customers is more understandable from a retail protection standpoint," it is worth questioning "whether a framework other than the securities regulatory framework might be better suited to getting customers transparency around the terms and risks of crypto lending products." Ms. Peirce concluded that the settlement may have "unfortunate" consequences, including preventing retail crypto lending products from being offered to customers in the United States. She emphasized that registration "is often a months-long, iterative process," and that the SEC should work with crypto-lending companies "to craft sensible, timely, and achievable regulatory paths" to compliance with the securities laws.

Commentary by Steven Lofchie

The SEC should reconsider its regulation of digital assets. (See Cabinet Commentary: The Securities Law Treatment of Utility Tokens.) As in the Coinbase case, the SEC found that the offering here was clearly a "security" under Reves v. Ernst & Young. If the SEC takes other firms offering similar products to court, the SEC is going to win.

That said, the SEC should be more willing to engage on the application of the securities laws to digital assets. Until it does so, market participants have a limited number of strategies available to them: (i) fully comply with the securities laws, acknowledging that they were not written for digital assets, (ii) have a more reasonable position that the product is not a "security," or (iii) fly under the radar and hope for the best. An issuer that does not meet either of the first two tests and becomes big and successful is going to be in the SEC's crosshairs.

Court Affirms OCC and FDIC Authority on "Valid-When-Made" Rules

The U.S. District Court of the Northern District of California granted summary judgment in favor of the OCC and FDIC, respectively (the "agencies"), affirming their rulemaking authority and the agencies' "valid-when-made" rules.

The Court affirmed the agencies' interpretation of federal banking law to allow for the "valid-when-made" doctrine, which posits that the interest on a loan permissible before transfer continues to be permissible afterward. The Court rulings also clarified that "a loan's interest rate remains legally intact if the loan is sold." By so holding, the Court affirmed the "valid-when-made" doctrine, and satisfied due deference to agency authority under Chevron U.S.A., Inc. v. Natural Resources Defense, Inc. The agencies had issued the rules in response to the Madden v. Midland Funding, LLC decision from the U.S. Court of Appeals for the Second Circuit, which cast doubt on the interest rate allowed on loans sold by national banks and FDIC-insured state banks.

Michael Bright, CEO of the the Structured Finance Association ("SFA"), which filed an amicus brief in support of the Court's action, stated: "[t]his is the best outcome not only for financial institutions but also more importantly for consumers who would ultimately bear the brunt of continued threats to the secondary market."

Investment Firm Seeks to List Double-Leveraged ETFs Based on Single Stocks

In a registration filing with the SEC, an investment firm is seeking approval of a series of double-leveraged bullish and bearish exchange-traded funds ("ETFs") that each track the performance of a single U.S.-listed equity security.

According to the filing, the funds intend to provide daily returns that are two times the daily return (or two times the inverse daily return) of a single underlying U.S. equity security. The proposed underlying securities include Tesla, Inc. (TSLA), NVIDIA Corporation (NVDA), ConocoPhillips Company (COP), Boeing Company (BA), PayPal Holdings, Inc. (PYPL), Wells Fargo & Company (WFC), Pfizer Inc. (PFE), salesforce.com, Inc. (CRM) and Nike Inc. (NKE).

The funds' investment adviser, AXS Investments, LLC ("AXS"), would seek to achieve these investment objectives by entering into one or more swap agreements with major global financial institutions and may invest between 40% and 80% of a fund's portfolio in collateral investments (e.g., U.S. government securities and money market funds).

AXS is seeking SEC approval to list these ETFs on an exchange to be determined.

Commentary by Nick Allen

Though 2x and 3x daily and daily inverse leveraged ETFs are common, these would be the first U.S.-listed ETFs to track a single equity security rather than a more broad-based market or market segment. If the popularity of existing daily leveraged ETFs among retail investors and continued growth of retail options activity are any indication, then demand for products like the funds could be high. Nevertheless, despite daily leveraged ETFs' popularity, the SEC and FINRA have raised concerns about such products, and the concentration risk implicit in these funds and generally higher volatility of single stocks (as compared to broader benchmarks) could magnify those concerns.

Compliance Officer Settles FINRA Charges for AML Failures

A registered representative and compliance supervisor ("respondent") settled FINRA charges for improper supervision of his firm's AML program.

In a FINRA Letter of Acceptance, Waiver and Consent, FINRA found that the respondent failed to (i) implement and monitor the firm's AML program, (ii) supervise AML staff, (iii) perform required reviews of surveillance reports, (iv) file Suspicious Activity Reports and (v) ensure adequate AML investigations. In August 2020 the respondent's employer settled FINRA charges in violation of Rules 3310 ("Anti-Money Laundering Compliance Program") and 2010 ("Standards of Commercial Honor and Principles of Trade") during the period that respondent was the AML Compliance Officer.

To settle the FINRA charges, the respondent agreed to (i) a two-month suspension from the industry, (ii) a $25,000 fine and (iii) comply with undertakings, including 10 hours of continuing education related to AML responsibilities.

SEC Warns Investors of Risks Associated with Interest-Bearing Crypto Accounts

The SEC Office of Investor Education and Advocacy and the Division of Enforcement Retail Strategy Task Force warned investors about the risks associated with accounts that pay interest on crypto-asset deposits.

In an Investor Bulletin, the SEC explained the difference between the protections that are afforded to investors in interest-bearing accounts with bank or credit unions and interest-bearing accounts for crypto assets. The SEC warned to not expect the same level of security, safety and soundness with crypto asset interest-bearing accounts.

The Bulletin identified some of the risks to which investors may be exposed:

volatility and illiquidity in the crypto asset markets;

potential failure or bankruptcy of the company holding investor crypto assets;

unpredictability, including that the market for a particular crypto asset may disappear altogether or that the crypto asset may no longer be tradable anywhere;

changes in regulation by federal, state or foreign governments that may restrict the use and exchange of crypto assets;

the inability to be made whole should fraud, default or a mistake occur; and

potential fraud, technical glitches, hackers or malware.

The SEC urged investors to carefully review all documents and disclosures to ensure they are aware of the risks associated with their investments.