Jim Hamilton’s World of Securities Regulation

• Musk began providing advice to, and sharing his contacts with, Dogecoin’s developers in 2019;
• Musk and people in his circle began buying the currency;
• SpaceX named a satellite after Dogecoin, while Tesla accepts it as payment for merchandise;
• Musk has called on celebrities, influencers, and investors to boost the status of the cryptocurrency;
• Musk himself has tweeted repeatedly about Dogecoin, with direct effects on Dogecoin’s price, market cap, and trading volume.

As an example of Musk’s influence on the price of Dogecoin, after users chose Musk as the “CEO” of Dogecoin on April Fool’s Day 2019, its price doubled from $0.0020 to $0.0040. By February 2021, Dogecoin was trading at $0.07. When Musk tweeted, “If major Dogecoin holders sell most of their coins, it will get my full support … I will literally pay actual $ if they just void their accounts,” the price of the coin dropped by 35 percent in 3 days. The complaint details other tweets and announcements from Musk that moved the price of Dogecoin. In April 2021, the plaintiff bought Dogecoin at $0.30 per coin; he sold in June 2022 at $0.08.

The plaintiff alleges that Dogecoin is a crypto pyramid scheme because it has no intrinsic or underlying value, it is not a productive asset, and the number of coins is unlimited. Investors buy in the hope, as described by Bill Gates and Warren Buffett, that a “greater fool” comes along to pay more. The complaint cites other prominent investors and economists as likening cryptocurrency in general, and sometimes Dogecoin specifically, to a Ponzi or pyramid scheme because purchasers only make money based on people who purchase after them.

The complaint describes Musk’s previous run-ins with the SEC: his false claim that he had secured funding to take Tesla private, an investigation into possible insider trading by Musk and his brother, and Musk’s delay in disclosing his stake in Twitter. The plaintiff also points to rumors that the FBI is investigating Musk for pumping and dumping Dogecoin. “Since cryptocurrency is not regulated by the SEC, Defendant Musk has tweeted numerous times over the past three years about Dogecoin to manipulate the price without consequence,” the complaint argues.

The case is No. 22-cv-5037.

• Index providers typically determine the market the index measures, designs the index, creates the methodology, and determines the index’s level under that methodology—activities that leave room for significant discretion. The request for comment observes that while indexes tend to be associated with passive investing, index providers make active design decisions, particularly in the case of specialized indexes. “Whether or not an index is specialized, the index provider’s inclusion or exclusion of a particular security in an index drives advisers with clients tracking that index to purchase or sell securities in response.”
• Model portfolio providers or model originators design allocation models, update or rebalance allocations over time, and provide customization. The SEC notes a growing demand for specialized models focusing on particular industries or strategy, like sustainability or ESG. Model portfolio providers also might tailor their analysis to the characteristics and goals of a general client type or create a customized analysis when creating a model portfolio through the use of direct indexing.
• Pricing services exercise significant discretion, according to the SEC: determining a valuation methodology to use, developing model templates, determining inputs, adjusting valuations; and addressing pricing challenges raised by users. Different pricing services, or even the same pricing service, may determine different pricing levels for the same security.

Under the Advisers Act, an investment adviser is someone who meets three criteria: (1) the person provides advice, or issues analyses or reports, concerning securities; (2) the person is in the business of providing such services; and (3) the person provides such services for compensation. The advice does not have to relate to specific securities, the SEC notes, and does not have to be the primary business activity of the adviser.

The SEC also posits that the activities conducted by information providers may implicate related concerns under the Investment Company Act, which contains requirements and restrictions in investment advisers to a fund. Index providers could meet the definition of an adviser to a fund under the Investment Company Act if the index is tailored to the specific needs of a fund.

Gensler said that the request will help the SEC determine which information providers fall under the investment adviser definition. Registered funds that track indexes have over $10 trillion of assets under management and range from broad-based indexes to specialized funds designed for particular users. The corresponding influence means “an index provider’s decision to include a particular security in an index often influences users of the index to purchase or sell securities,” raising questions about whether the index provider is providing investment advice, Gensler said. Model portfolio providers and pricing services have also grown and evolved, raising questions about the SEC’s oversight and investor protection.

The request seeks comment on whether information providers are acting as investment advisers and how existing rules should apply to providers that do not currently fit neatly into the existing regulatory structure. Gensler said that given the changes in the asset management field since the bulk of SEC staff statements were issued in the 1980s and 1990s, “it is appropriate to seek comment on information providers to consider if regulatory action is appropriate. Some elements of the definition may not be interpreted consistently by market participants. Thus, I believe the market may benefit from further guidance with respect to their applicability to some information providers.”

The comment period will remain open for 60 days after the request was published on sec.gov or 30 days after it is published in the Federal Register, whichever is longer.

This is Release No. IA-6050.

• clarify the obligation of SPAC sponsors and their affiliates to disclose all material conflicts of interest;
• bring greater clarity to dilution under various SPAC share redemption scenarios;
• ensure that underwriter status and liability under 1933 Act Section 11 apply to SPAC underwriters who participated in the distribution of shares by taking steps to facilitate the de-SPAC (but not to private investment in public equity (PIPE) investors in SPACs);
• establish private operating companies merging with SPACs as co-registrants; and
• clarify that the Private Securities Litigation Reform Act (PSLRA) safe harbor with respect to forward-looking statements does not apply to the de-SPAC merger proxy.

CII has no objection to there being more than one avenue for private companies to go public since more paths to the public markets promotes capital formation. However, it is critical that those paths—traditional IPO, de-SPAC merger, or direct listing—offer consistently robust investor protections, the group stated.

Misalignment of interests. In addressing some of the proposing release’s specific questions, CII said that it supports improving and codifying disclosure to clarify the misalignment of interests between the sponsor or its affiliates or the SPAC’s officers, directors or promoters, and unaffiliated security holders, as proposed. The group believes that there should be mandatory disclosures of conflicts of interest among SPAC directors, SPAC officers, target company directors, and target company officers.

CII also supports disclosure that would shed light on how compensation arrangements and other financial incentives create fundamental differences in outcome priorities among participants. In CII’s opinion, the de-SPAC proxy should describe the differences in priorities and how they may impact voting decisions on the business combination.

Dilution. CII also said that it favors including disclosure of net cash per share after taking into account all sources of dilution and dissipation of cash, under various redemption scenarios. The group feels that given the complexity and contingencies involved in the de-SPAC process, investors—particularly SPAC investors who are considering declining the redemption opportunity—need clear information about potential consequences to inform their understanding of the true cost of the business combination.

CII supports requiring tabular disclosure in the de-SPAC proxy that illustrates net cash per share after taking into account all sources of dilution and dissipated cash under 25 percent, 50 percent, 75 percent, 90 percent, and 100 percent redemption scenarios. Citing a recent study by three securities experts that recommended using a 90 percent redemption scenario, the group said that it would not object if the SEC’s proposal were modified to adopt the methodology outlined in that study.

Accountability. CII would like to see the SEC require that the SPAC and the target company act as co-registrants upon filing of the registration statement in connection with the de-SPAC. In CII’s view, treating both the SPAC and the target as an issuer under 1933 Act Section 6(a) would help to align investor protections with those of a traditional IPO.

The group advised the SEC that a narrow interpretation exempting the target company as a registrant is inappropriate given that the de-SPAC serves the same practical purpose as a private company entering the public markets through a traditional IPO, and the extent to which private companies have embraced the de-SPAC option.

CII also favors the proposed amendments to the signature instructions of Form S-4 to require that officers and a majority of the board of the target company are liable for any material misstatements or omissions in the S-4. This would ensure that they are accountable for the accuracy of the registration statement under 1933 Act Section 11, the group said.

Safe harbor. On the question of whether clarifying that the safe harbor under the PSLRA is unavailable would improve the quality of projections in connection with de-SPAC transactions, CII offered its view that uncertainty surrounding the availability of the safe harbor may have contributed to the proliferation of unreasonably optimistic forward projections that would not have been made if liability had more clearly paralleled the traditional IPO regime. Accordingly, CII supports the proposal’s revision to the definition of “blank check company” to ensure that the safe harbor against a private right of action for forward-looking statements under the PSLRA is not available.

CII also stated that it favors the enhanced investor protection that would result from assigning underwriter status for the de-SPAC transaction to a person who has acted as an underwriter in a SPAC IPO and participates in the distribution by taking steps to facilitate the de-SPAC transaction. The group supports limiting the application of proposed Rule 140a so that PIPE investors in the SPAC are excluded. CII believes that PIPE investors do not fit the traditional function of an underwriter, and that including PIPE investors in Rule 140a could significantly reduce investor appetite to backstop this route to entering the public markets.

• An interstate regulatory sandbox.
• Annual reporting by the Federal Energy Regulatory Commission to Congress regarding, among other things, energy consumption for mining and staking of digital asset transactions.
• Cybersecurity standards for digital asset intermediaries.
• An SEC/CFTC study and report to Congress regarding the appropriate principles for establishing a registered digital asset self-regulatory organization.

With respect to comparisons, this article will focus on the Lummis-Gillibrand bill and the Digital Commodity Exchange Act of 2022 (H.R. 7614), sponsored by House Agriculture Committee Ranking Member Glenn “GT” Thompson (R-Pa), and co-sponsored by fellow Agriculture Committee member Rep. Ro Khanna (D-Calif), and non-committee members Rep. Tom Emmer (R-Minn) and Rep. Darren Soto (D-Fla), which purports to offer a federal regulatory alternative to firms that would otherwise have to comply with multiple state money transmitter laws. The comparison is especially relevant regarding the CFTC. For further comparison, readers also may wish to examine the Digital Asset Market Structure and Investor Protection Act (H.R. 4741), introduced by Rep. Don Beyer (D-Va), which would address the treatment of digital assets by the SEC and CFTC, central bank digital currencies (CBDCs), and anti-money laundering regulations.

Securities provisions. The Lummis-Gillibrand bill would establish a presumption that what the bill calls an “ancillary asset” is a commodity and not a security, although the SEC would retain some enforcement authorities over ancillary assets. In order to take advantage of the presumption, an issuer of an ancillary asset would have to meet certain SEC disclosure obligations that address information related to the corporate structure and history of the ancillary asset’s issuer and the risk factors affecting the ancillary asset.

More specifically, if an issuer contemplates an offering that would involve an investment contract related to an ancillary asset and the issuer furnishes the required SEC disclosures, the ancillary asset would be presumed to be a commodity and not a security. “Ancillary asset” would be defined to mean an “intangible, fungible asset that is offered, sold or otherwise provided to a person in connection with the purchase and sale of a security through an arrangement or scheme that constitutes an investment contract.” The term, however, would not include certain equity, debt, liquidation, dividend, and profit and revenue sharing arrangements.

For comparison, the Lummis-Gillibrand bill would define “digital asset” to mean a natively electronic asset that: (i) confers economic, proprietary, or access rights or powers; and (ii) is recorded using cryptographically secured distributed ledger technology, or any similar analogue; the term would include: (i) virtual currency and ancillary assets, (ii) payment stablecoins; and (iii) other securities and commodities. The Thompson bill would define “digital commodity” to mean “any form of fungible intangible personal property that can be exclusively possessed and transferred person to person without necessary reliance on an intermediary” (the definition provides for exclusions similar to those contained in the Lummis-Gillibrand bill’ definition of “ancillary asset”).

The presumption regarding an ancillary asset, however, could be lost if a “court of the United States” (presumably only federal courts) finds that there is no substantial basis for the presumption. Elsewhere, the proposed bill would not deny the presumption solely because an issuer failed to meet its SEC disclosure obligations.

The SEC disclosure obligation itself would be subdivided into three separate obligations regarding initial disclosure, ongoing disclosure, and a transition rule for disclosures regarding ancillary assets provided before January 1, 2023. Each of the three disclosure obligations has a time-frame built into it regarding the fiscal years covered but otherwise comes into effect for an issuer of an ancillary asset based on the average daily aggregate value offered or traded on all spot markets (must be greater than $5 million) and whether the issuer (or a 10 percent owner of the issuer’s equity securities) engaged in entrepreneurial or managerial efforts that primarily determined the value of the ancillary asset.

An issuer of an ancillary asset would be able to voluntarily furnish information to the SEC about the ancillary asset if the issuer believes it is reasonably likely that it will become subject to the disclosure requirement in the future.

The SEC also would be granted authority to exempt an ancillary asset from the disclosure requirement if it determines that the public policy goals of disclosure and of consumer protection are not satisfied by requiring such disclosure. The SEC also could issue rules and guidance to implement the disclosure requirement.

The bill would provide that the disclosure requirement for an ancillary asset would end 90 days after an issuer files (and not merely furnishes, as would be the case for the disclosure obligation) a certification supported by reasonable evidence after due inquiry that the average daily aggregate value of all trading for the preceding 12 months was equal to or less than $5 million or that the issuer did not engage in that same period in any entrepreneurial or managerial efforts that primarily determined the value of the ancillary asset. The SEC could deny an issuer’s certification if the certification was not based on substantial evidence, although an issuer could try again to certify that it may end its disclosure obligation.

The remaining securities provisions in the bill concern the modernization of Exchange Act Rule 15c3-3 regarding customer protection and clarifying what is a satisfactory control location while also clarifying the role of broker-dealers in the trading of digital assets.

Commodities provisions. The commodities provisions in the Lummis-Gillibrand bill largely mirror those contained in portions of the Thompson bill regarding the treatment of digital asset exchanges, although with some minor semantic differences. In this context, the Thompson bill contains a number of CFTC provisions that do not have precise counterparts in the Lummis-Gillibrand bill. Other provisions regarding CFTC transaction fees appear only in the Lummis-Gillibrand bill.

With respect to segregation of customer digital assets, the Lummis-Gillibrand and Thompson bills both provide generally that, regarding the holding of customer assets that “[e]ach futures commission merchant [FCM] shall hold customer money, assets, and property in a manner to minimize the customer’s risk of loss of, or unreasonable delay in the access to, the money, assets, and property.” The Lummis-Gillibrand bill would require customer property to be held by a licensed, chartered, or registered entity regulated by the CFTC, the SEC, federal or state bank regulators, or an appropriate foreign bank authority. The Thompson bill would provide for an FCM to hold customer property in a qualified digital commodity custodian. The Lummis-Gillibrand and Thompson bills have nearly identical provisions regarding the related topic of the segregation of customer funds.

Both the Lummis-Gillibrand and Thompson bills provide that a registered FCM cannot act as a counterparty in any agreement, contract, or transaction involving a digital asset that has not been listed for trading on a registered digital asset exchange. That suggests the main provision in both bills regarding the registration of, as the Lummis-Gillibrand bill calls them “digital asset exchanges,” while the Thompson bill calls them “digital commodity exchanges.” Thus, both bills provide that any trading facility that offers or seeks to offer a market in digital assets may register with the CFTC as a digital asset exchange by submitting the prescribed application. Both bills also provide that a registered designated contract market (DCM) or registered swap execution facility (SEF) that meets certain requirements may elect to be considered a registered digital asset exchange/digital commodity exchange.

Both the Lummis-Gillibrand and Thompson bills further provide that a registered digital asset exchange/digital commodity exchange may make available for trading any digital asset that is not readily susceptible to manipulation. This provision would address some of the issues identified by the SEC, for example, in that agency’s earlier disapprovals of exchange-traded products. Both bills likewise provide that registration as a digital asset exchange/digital commodity exchange would not permit a trading facility to offer any contract of sale of a commodity for future delivery, option, or swap for trading without also being registered as a DCM or SEF.

A digital asset exchange/digital commodity exchange would be required to comply with a set of core principles. Moreover, both bills would define “not readily susceptible to manipulation” in nearly identical fashion. Specifically, the phrase “not readily susceptible to manipulation” would mean that a digital asset’s transaction history can be fraudulently altered or its functionality or operation can be materially altered. In making such determination, both bills provide for consideration of the following factors:

• The purpose and use of the digital asset;
• The creation or release process of the digital asset;
• The consensus mechanism of the digital asset;
• The governance structure of the digital asset;
• The participation and distribution of the digital asset;
• The current and proposed functionality of the digital asset;
• The legal classification of the digital asset; and
• Any other factor required by the CFTC.

Both the Lummis-Gillibrand bill and the Thompson bill address bankruptcy issues in the context of digital assets. The Lummis-Gillibrand bill would do this through a series of discrete statutory amendments, while the Thompson bill would do this via a provision stating that all assets held on behalf of a customer by a registered digital commodity exchange and all money of any customer received by such exchange is considered customer property for bankruptcy purposes.

The CFTC also would be authorized to collect fees to fund the agency’s regulation of digital asset cash and spot markets under the bill and to recover the costs to the federal government of the annual congressional appropriation to the agency. The CFTC, however, could not impose fees on registered entities relating to leveraged, margined, or financed transactions, including activities relating to digital assets.

The CFTC’s authorization to collect fees would be capped at $30 million absent further congressional authorization. Moreover, the CFTC’s authority to impose and collect fees would only be in effect during a period that a legislative authorization of the CFTC is in effect. That latter provision could raise questions about the CFTC’s current status because the agency has not for many years been formally reauthorized by Congress, despite attempts in recent Congresses to reauthorize the agency but which faltered over political disagreements about the scope of derivatives reforms.

Lastly, much like the SEC already does, the CFTC would have to periodically issue fee rate orders setting the amount or rate of any authorized fees. The CFTC would be able to continue to collect fees at the prior fiscal year’s rate even if there were a lapse in congressional appropriations because of a government shutdown, a scenario that has occurred several times in recent years. Presumably, to the extent the CFTC could collect fees, that part of its appropriation would be to some degree deficit neutral, as is the case for the SEC, which collects transaction fees to offset its entire congressional appropriation.

• “glossy” annual reports,
• Form 6–K (foreign private issuers),
• notices of exempt solicitation,
• notices of exempt preliminary roll-up communications,
• Form 11–K (employee benefit plans),
• filings made by multilateral development banks,
• certifications of approval of exchange listing,
• Form 144 for reporting issuers,
• certain foreign language documents, and
• documents filed pursuant to Investment Company Act Section 33.

The Commission is providing a transition period for compliance with the new requirements to give filers time to prepare to submit the documents electronically in accordance with the EDGAR Filer Manual, including applying for the necessary filer codes. The compliance date is six months after the effective date of the amendments for filers to submit their “glossy” annual reports electronically in accordance with the EDGAR Filer Manual and, other than for Form 144, for paper filers who would be first-time electronic filers. For Form 144, the compliance date is six months after the date of publication in the Federal Register of the Commission release that adopts the version of the EDGAR Filer Manual addressing updates to Form 144 for filing Form 144 electronically on EDGAR.

Form 11-K requirements. The amended rules will require the use of inline XBRL for the filing of the financial statements and accompanying notes to the financial statements required by Form 11-K. The SEC also voted to make certain technical updates to Form F-10, Form F-X, and Form CB to remove outdated references.

According to the SEC’s fact sheet, the compliance date for structured data reporting for Form 11-K is three years after the effective date of the rule amendments. The Commission believes this will give registrants time to transition to a structured data language enabling filings that are both human-readable and machine-readable.

The release is No. 33-11070.

• What data would assist the CFTC and the market participants it oversees to understand climate risk?
• Should the CFTC consider scenario analysis and stress testing standards beyond those presented by the Network for Greening the Financial System and/or the Financial Stability Board?
• How may commodities market participants need to adapt their risk management frameworks to address climate change? The request suggested the following topics: margin models, scenario analysis, stress-testing, collateral haircuts, portfolio management strategies, counterparty, and third-party service provider risk assessments, and/or enterprise risk management programs.
• Should the CFTC establish climate-related risk disclosure requirements for the various types of entities it regulates that would focus on the Task Force on Climate-Related Financial Disclosures’s four core elements of governance, strategy, risk management, and metrics and targets?
• What derivatives products are currently used to hedge climate risk and what customer protections are or may be needed to promote market integrity for such products?
• How can the CFTC promote transparency, fairness, and liquidity in voluntary carbon markets
• How should the CFTC consider the impact of climate risk on financially vulnerable populations
• How might the CFTC promote public-private partnerships to address climate-related financial risk within the derivatives markets?

Digital assets. The topic of digital assets received a single paragraph of attention in the RFI as compared to the many other topics that often posed several paragraphs-worth of questions. The blockchain community generally has been criticized for years because of what is perceived to be an excessive need for electricity to power server farms that mine for Bitcoin and other virtual currencies. Under the dominant mining method, proof of work, powerful computers solve complex math problems in order to discover the next Bitcoin or other virtual currency. An alternative method called proof of stake has yet to catch on within the blockchain industry, but it purports to use far less electricity than proof of work.

Digital assets also have been the subject to regulatory competition and, potentially regulatory arbitrage, with no singular U.S. federal government regulator governing the entirety of the digital asset marketplace, although the SEC has become one of the most active regulators for digital assets that are also securities. Among U.S. federal financial regulators, the CFTC is one of several regulators that are active, but still far behind the SEC in terms of the number of enforcement actions brought in the digital asset space.

According to the RFI, the CFTC believes the following three questions to be a starting point for discussing climate-related risk associated with digital assets:

• Are digital asset markets creating climate-related financial risk for CFTC registrants, registered entities, other derivatives market participants, or derivatives markets?
• Are there any aspects of climate-related financial risk related to digital assets that the Commission should address within its statutory authority?
• Do digital assets and/or distributed ledger technology offer climate-related financial risk mitigating benefits?

Commissioner Mersinger, who concurred in the issuance of the RFI, noted the limits of the CFTC’s jurisdiction over digital assets: “[t]he CFTC does not have statutory authority under the CEA to regulate digital assets or distributed ledger technology except to the extent they involve derivatives.”

Although legislation to clarify the roles of the CFTC and other federal regulators in the digital asset space has lately focused on central bank digital currencies and stablecoins, the CFTC could get new, broader authorities over digital assets if the Digital Commodity Exchange Act of 2022 (H.R. 7614) were to become law. Overall, the bill purports to offer a federal regulatory alternative to firms that would otherwise have to comply with multiple state money transmitter laws, but it would also expressly allow the CFTC to regulate more directly spot digital commodity exchanges. The bill is sponsored by House Agriculture Committee Ranking Member Glenn “GT” Thompson (R-Pa), and co-sponsored by fellow Agriculture Committee member Rep. Ro Khanna (D-Calif), and non-committee members Rep. Tom Emmer (R-Minn), and Rep. Darren Soto (D-Fla).