The SEC May Have a Problem

Crypto Enforcement in the Age of the Major Questions Doctrine

In the movie Apollo 13, Commander Jim Lovell advised his colleagues at NASA, “Houston we have a problem.”¹* The authors thank their colleague, Stephanie Nakash, for her assistance with this article. Apollo 13 (1995). The line in the movie was a modification of the actual message from Commander Lovell to NASA, “Houston, we’ve had a problem.” Commander Lovell’s statement proved to be a tremendous understatement. Recently, crypto currency companies that have been named as defendants in enforcement actions by the U.S. Securities and Exchange Commission (“SEC”) have raised the major questions doctrine as a defense. It is unclear if this argument will prevail, but it could be a problem for the SEC’s enforcement authority in the crypto currency and digital asset space.²For purposes of this article, the authors use the term “digital asset” in the same manner as the SEC to refer to “an asset that is issued and transferred using distributed ledger or blockchain technology.” Statement on Digital Asset Securities Issuance and Trading, Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets, SEC (Nov. 16, 2018), available at: https://www.sec.gov/news/public-statement/digital-asset-securites-issuuance-and-trading. As the SEC has noted, digital assets include, but are not limited to, virtual currencies, coins, and tokens. Id. A digital asset may in certain instances be deemed a security under the federal securities laws. While not defined in the securities laws, the SEC often refers to digital assets that are securities as a “digital asset securities.” Id. This article will discuss the major questions doctrine, the regulation of crypto currencies and digital assets as securities by the SEC, and one SEC enforcement action in which the defendants have raised the major questions doctrine as a defense.

Background

Federal courts have increasingly looked to past conduct when reviewing the permissible scope of regulatory authority. In Utility Air Regulatory Group v. Environmental Protection Agency (UARG), the U.S. Supreme Court announced that “[w] hen an agency claims to discover in a long-extant statute an unheralded power to regulate ‘a significant portion of the American economy,’ . . . we typically greet its announcement with a measure of skepticism.”³573 U.S. 302, 324 (2014). In UARG, the Court held that the Environmental Protection Agency (“EPA”) lacked the authority to require permitting of stationary sources based solely on the emission of greenhouse gases.⁴Id. at 333 The Court also noted that it was “reluctant to read into ambiguous statutory text” the “unheralded power” that EPA’s interpretation effectively asserted over the “construction and modification of tens of

thousands, and the operation of millions, of small sources nationwide.”⁵Id According to the Court, the fact that EPA had never previously claimed authority over nearly so many sources offered strong evidence that the Clean Air Act did not delegate that authority.⁶Id Since UARG, the Court has applied that doctrine three times to hold agency actions unlawful.⁷The Supreme Court also applied the major questions doctrine in: King v. Burwell, 135 S. Ct. 2480 (2015), which upheld the availability of tax credits under the Affordable Care Act in states that had a federal exchange; West Virginia v. EPA, 142 S. Ct. 2587 (2022), which stated the EPA could not use its authority under the Clean Air Act to regulate greenhouse gas emissions from power plants through “generation shifting”; and Biden v. Nebraska, 143 S. Ct. 2355 (2023), which ruled against the Biden administration’s plan to forgive student loan debt In each decision issued since August 2021, the Court emphasized what it characterized as a lack of regulatory antecedents for the challenged action.

Major Questions Doctrine

In West Virginia v. EPA, the Court reaffirmed its focus on regulatory novelty from prior cases and as part of the major questions doctrine.⁸142 S. Ct. 2587 (2022) The case involved the Clean Power Plan, a 2015 regulation from the EPA issued under Section 111(d) of the Clean Air Act that was meant to reduce greenhouse gas emissions from the power sector. Section 111(d) authorizes the EPA to issue “standards of performance” for existing stationary sources for certain types of pollutants.⁹42 U.S.C. § 7411(d) The statute defines a “standard of performance,” in relevant part, as “a standard for emissions of air pollutants which reflects the degree of emission limitation achievable through the application of the best system of emission reduction.”¹⁰Id. § 7411(a)(1)

In the Clean Power Plan, the EPA defined the “best system of emission reduction” for greenhouse gases from the power sector through a combination of three approaches, or “building blocks.”¹¹West Virginia, 142 S. Ct. at 2593 The first and least contentious of these building blocks involved certain technological improvements at coal-fired power plants. The second and third building blocks relied on an approach called “generation shifting,” in which power generation shifts from higher- to lower-emitting power sources. Specifically, the second building block envisioned that power generation would incrementally shift from coal-fired power plants to lower-emitting gas-fired power plants and the third building block envisioned an incremental shift from fossil-fuel plants to zero-emitting renewable-energy power sources. Having identified these three building blocks as the “best system of emission reduction,” EPA then imposed emissions limits for the power sector that could be achieved through these approaches.

The Court held that Section 111(d) does not permit EPA to premise its emissions limits under that provision on the reductions achievable through generation shifting.¹²Id The Court discussed each of those decisions (and several others) to identify a canon of “extraordinary cases” involving “regulatory assertions [that] had a colorable textual basis” but in which “‘common sense as to the manner in which Congress would have been likely to delegate’ such power to the agency at issue . . . made it very unlikely that Congress had actually done so.”¹³Id. at 2609 Among other common features of those prior decisions, the Court pointed to the “unprecedented” and “unheralded” nature of the challenged regulations as a reason for “reluctance” to read the claimed authority “into ambiguous statutory text.”¹⁴Id The Court labeled this “identifiable body of law” as the “major questions doctrine.”¹⁵Id

SEC Regulation of Digital Assets

In recent years, the SEC has attempted to regulate digital assets. Under the Securities Act of 1933 (the “Securities Act”), all securities sold to the public must be registered with the SEC. 15 U.S.C. § 77e (declaring it unlawful to sell unregistered securities to the public). The SEC has alleged

that many digital assets are securities subject to that registration requirement. This development has caused the FinTech industry, and academics, and FinTech attorneys to argue the SEC’s actions are incompatible with the major questions doctrine.¹⁶See generally Chris Brummer et al., Regulation by Enforcement, 96 S. CAL. L. REV. 1297 (2024) (discussing the SEC’s actions and arguing that they run afoul of the major questions doctrine); Brief of Amicus Curiae Coinbase, Inc. in Support of Defendant’s Motion to Dismiss, SEC v. Wahi, No. 2:22-CV-01009-TL (W.D. Wash. May 22, 2023), ECF No. 78-2

What is a Security?

The definitions of “security” under the Securities Act and the Securities Exchange Act of 1934 (the “Exchange Act”) are nearly identical, and each is broad enough to include the several types of instruments that are used in commercial marketplaces that one might suspect to fall within the ordinary concepts of a security. This would include common instruments like stocks, bonds, and notes, as well as the various collective investment pools and common enterprises devised by persons seeking to generate profits from the efforts and investments of others (i.e., investment contracts and instruments commonly known as securities).

Section 2(a)(1) of the Securities Act defines a “security” as:

[A]any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, . . . transferable share, investment contract, . . . any put, call, straddle, option, or privilege on any security, certificate of deposit, . . . or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

What constitutes an investment contract is determined based on the test articulated by the U.S. Supreme Court in Securities and Exchange Commission v. W. J. Howey Co.¹⁷328 U.S. 293 (1946)

Howey Test

Under the Howey test, an investment contract is a contract, transaction, or scheme involving (i) an investment of money, (ii) in a common enterprise, (iii) with the expectation that profits will be derived from the efforts of the promoter or a third party.¹⁸Id The SEC has taken the position that the investment does not have to be in the form of “money,” but it can be any “specific consideration in return for a separable financial interest with the characteristics of a security.”¹⁹Int’l Bhd. Teamsters v. Daniel, 439 U.S. 551, 559 (1979). An investment of money need not be in traditional currency. See, e.g., SEC v. Shavers, 2013 U.S. Dist. LEXIS 110018 (E.D. Tex. August. 6, 2013) (finding that making investments denominated in bitcoin, a form of digital virtual currency, constituted an investment of money subject to federal securities laws); see also SEC v. Shavers, No. 4:13-CV-416 (E.D. Tex. August. 26, 2014) (upholding on rehearing) Courts have analyzed “common enterprise” as a distinct element of an investment contract.

There is a split in authority among the federal circuit courts regarding what constitutes a “common enterprise.” The courts are divided regarding whether horizontal or vertical commonality is required to satisfy the Howey common enterprise requirement. A majority of the circuit courts require or recognize a showing of “horizontal commonality” which involves the pooling of assets from multiple investors in such a manner that all share in the profits and risks of the enterprise.²⁰The First, Second, Third, Fourth, Sixth, Seventh and D.C. Circuits have recognized “horizontal commonality” as satisfying the requirement of “common enterprise”. See, e.g., SEC v. SG Ltd., 265 F.3d 42 (1st Cir. 2001); Revak v. SEC Realty Corp., 18 F.3d 81 (2d Cir. 1994); SEC v. Infinity Grp. Co., 212 F.3d 180, 188 (3d Cir. 2000), cert. denied, 532 U.S. 905 (2001); Teague v. Bakker, 35 F.3d 978 n.8 (4th Cir. 1994); cert. denied, 513 U.S. 1153 (1995); Newmyer v. Philatelic Leasing, Ltd., 888 F.2d 385 (6th Cir. 1989), cert. denied, Trager, Glass & Co. v. Newmyer, 495 U.S. 930 (1990); Union Planters Nat’l Bank of Memphis v. Commercial Credit Bus. Loans, Inc., 651 F.2d 1174 (6th Cir.), cert. denied, 454 U.S. 1124 (1981); Cooper v. King, 114 F.3d 1186 (6th Cir. 1997); SEC v. Lauer, 52 F.3d 667, 670 (7th Cir. 1995); Wals v. Fox Hills Dev. Corp., 24 F.3d 1016 (7th Cir. 1994); SEC v. Banner Fund Int’l, 211 F.3d 602 (D.C. Cir. 2000); SEC v. Life Partners, Inc., 87 F.3d 536, 543 (D.C. Cir. 1996), reh’g denied, 102 F.3d 587 (D.C. Cir. 1996) Other circuit courts, including the Ninth Circuit have held that a “common enterprise” exists by virtue of “vertical commonality”, which focuses on the relationship between the promoter and the body of investors.²¹SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 479 (5th Cir. 1974)

Under the Howey test, profits can be either capital appreciation resulting from the development of the initial investment or a participation in earnings resulting from the

use of investors’ funds.²²United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852, reh’g denied, 423 U.S. 884 (1975) Profits are income or return that investors seek on their investment, not the profits of the scheme in which they invest. Profits include, for example, dividends, other periodic payments, or the increased value of the investment. The determining factor under this prong of the Howey test is that the investor is “attracted solely by the prospects of a return” on his or her investment.²³328 U.S. at 300 The investor may not have been motivated by a desire to use or consume the item purchased.²⁴Id. (finding that the investors had no desire to occupy the land or to develop it themselves, and they were attracted solely by the prospects of a return on their investment; if the purchasers wanted to occupy the land or to develop it themselves, the securities laws would not apply) In determining whether an investor was “attracted or led” by the expectation of profits, courts look at whether the promoter induced prospective investors with proposed or promised profits.

Securities Exchanges

Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange.” Exchange Act Rule 3b-16(a) interprets the definition to mean any organization, association, or group of persons that: (1) brings together the orders of multiple buyers and sellers and (2) uses established, nondiscretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade. Absent an exemption, an exchange must register as a national securities exchange pursuant to section 6 and section 19(a) of the Exchange Act.

If a blockchain technology platform brings together multiple buyers and sellers of digital assets that are deemed securities, the platform could be required to register as a securities exchange unless it falls within an exclusion from registration.

The SEC Meets the Major Questions

Doctrine

The major questions doctrine has been raised as a defense in several SEC enforcement actions, including the agency’s action against Coinbase, Inc. (“Coinbase”), in which the SEC has alleged Coinbase intermediated transactions in digital asset securities on its trading platform and through related services, all in violation of the federal securities laws.²⁵SEC v. Coinbase, Inc., No. 1:23-cv-04738 (S.D.N.Y. filed June 6, 2023), https://www.sec.gov/files/litigation/complaints/2023/comp-pr2023-102.pdf Coinbase provides a platform and other services that allow customers to transact in hundreds (and in one instance, thousands) of different digital assets. Coinbase offers these services without registering with the SEC as a securities exchange, broker, or clearing agency. Coinbase contends the transactions executed and facilitated through its platform and related services do not qualify as “securities,” and thus fall outside the scope of the SEC’s delegated authority. The SEC disagrees, and counters that at least some of the transactions on Coinbase’s platform and through related services constitute “investment contracts,” which the federal securities laws have long recognised as securities. Coinbase further argues the SEC’s action is barred in part by the major questions doctrine.²⁶See West Virginia v. EPA, 597 U.S. at 716

The court noted, the major questions doctrine requires an agency point to “clear congressional authorization” in the “extraordinary” case where it claims the “power to regulate a significant portion of the American economy” that has “vast economic and political significance.”²⁷Util. Air. Regul. Grp. v. EPA, 573 U.S. 302, 324 (2014) (citations omitted) In West Virginia, the Supreme Court rooted the major questions doctrine in “both separation of powers principles and a practical understanding of legislative intent.”²⁸West Virginia, 597 U.S. at 700 It is premised on the notion that “one branch of government” should not “arrogat[e] to itself power belonging to another,”²⁹Biden v. Nebraska, 143 S. Ct. 2355, 2373 (2023) and the “presum[ption] that Congress intends to make major policy decisions itself.”³⁰West Virginia, 597 U.S. at 723 The court noted the doctrine is reserved for the most “extraordinary cases,” and is therefore rarely invoked.³¹Id. at 721 (stating that the major questions doctrine applies only in “extraordinary cases . . . in which the history and breadth of the authority that the agency has asserted, and the economic and political significance of the assertion, provide a reason to hesitate before concluding that Congress meant to confer such authority”) Indeed, in the nearly twenty-five years since its recognition in FDA v. Brown & Williamson Tobacco Corp.,³²529 U.S. 120, 159 (2000) the doctrine has rarely been successfully invoked.³³FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 159 (2000)

With this standard in mind, the court found that the enforcement action does not implicate the major questions doctrine.³⁴Id The court recognized that while certainly sizable and important, the crypto currency industry “falls far short of being a ‘portion of the American economy’ bearing ‘vast economic and political significance.’”³⁵Id. (citing Terraform I, 2023 WL 4858299, at *8 (citing Util. Air Regul. Grp., 573 U.S. at 324)) The court stated the FinTech industry cannot compare with those other industries the Supreme Court has found to trigger the major questions doctrine.³⁶Id The court noted, “the securities industries over which Congress has expressly given the SEC enforcement authority are even broader than the markets for crypto currencies, and implicate larger portions of the American economy.”³⁷Id The court concluded, the SEC is asserting neither a “transformative expansion in its regulatory authority,” nor a “highly consequential power beyond what Congress could reasonably be understood to have granted” it.³⁸Id. (citing West Virginia, 597 U.S. at 724)

The court recognized, “in filing th[e] action, the SEC is exercising its Congressionally bestowed enforcement authority to regulate ‘virtually any instrument that might be sold as an investment . . . ‘in whatever form they are made and by whatever name they are called,’ including ‘[n]ovel, uncommon, or irregular devices’ like the [digital assets] at issue here.”³⁹Id. (citing Edwards, 540 U.S. at 393; SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943); see also Terraform I, 2023 WL 4858299, at *9 (noting “[T]here is no indication that Congress intended to hamstring the SEC’s ability to resolve new and difficult questions posed by emerging technologies where these technologies impact markets that on their face appear to resemble securities markets.”) The court noted the “very concept of enforcement actions evidences the SEC’s ability to develop the law by accretion.”⁴⁰Id The court recognized the “SEC has a long history of proceeding through such actions to regulate emerging technologies and associated financial instruments within the ambit of its authority as defined by cases like Howey — a test that has existed for nearly eight decades.”⁴¹Id. (citing SEC v. SG Ltd., 265 F.3d 42, 44 (1st Cir. 2001) (applying federal securities laws to “virtual shares in an enterprise existing only in cyberspace”) The court noted “[u]sing enforcement actions to address crypto-assets is simply the latest chapter in a long history of giving meaning to the securities laws through iterative application to new situations.”⁴²Id

The court concluded, “a finding that transactions involving certain crypto-assets qualify as investment contracts would merely result in those sales having to comply with longstanding securities laws.”⁴³Id Accordingly, the court declined “to permit the major questions doctrine to displace or otherwise limit SEC enforcement actions under Howey.”⁴⁴Id The court also noted major questions doctrine is not triggered because of Congressional consideration of new legislation implicating the regulation of crypto currencies.⁴⁵Id The Court concluded by noting, “[u]ntil the law changes, the SEC must enforce, and the judiciary must interpret, the law as it is.”⁴⁶Id

Conclusion

Like the intrepid crew of Apollo 13 that did not have a problem at liftoff, and were able to safely return to Earth, the SEC may not currently have a problem with the major questions doctrine, but future courts may conclude the major questions doctrine may present a problem in the agency’s enforcement battles with the FinTech industry. The SEC’s unwillingness to propose rules that are subject to comment by the public, the FinTech industry, academia, and members of legal community, pose a risk to the SEC if courts view the agency’s unwillingness as a signal the agency does not want to comply with the safeguards of the Administrative Procedure Act. Such action will also fuel future arguments that Congress must act to address a lack of regulatory clarity with respect to the regulation of digital assets because the issue is a major question.