New digital assets legislation is unfit to maintain investor protection, SEC chair warns

Proposed new legislation that aims to address uncertainty and regulation of digital assets “by enforcement” was passed by the House of Representatives yesterday, but the SEC chair is concerned.

The Financial Innovation and Technology for the 21st Century Act, aka FIT21, may not be fit to maintain the level of investor protection that has been in place since federal securities laws were introduced 90 years ago when President Roosevelt and Congress established the SEC.

FIT21 passed with bipartisan support and advocates say that it will provide greater protection for investors while enabling innovation.

“FIT21 provides the regulatory clarity and robust consumer protections necessary for the digital asset ecosystem to thrive in the United States. The bill also ensures America leads the financial system of the future and remains a hub for technological innovation,” said Patrick McHenry (NC-10), who is chair of the House Financial Services Committee.

But Gary Gensler, chair of the SEC, warns that the key principles of securities law – such as requiring robust disclosures with liability for those whose material statements are untruthful and registration of firms – will not apply to many of those who offer cryptocurrencies and other digital assets, despite years of non-compliance and criminality by some.

“Many market participants in the crypto industry have shown their unwillingness to comply with applicable laws and regulations for more than a decade, variously arguing that the laws do not apply to them or that a new set of rules should be created and retroactively applied to them to excuse their past conduct. Widespread noncompliance has resulted in widespread fraud, bankruptcies, failures, and misconduct,” Gensler said in response to the House passing FIT21.

The legislation, which will now head to the Senate, would create new regulatory gaps, Gensler added. This would result from measures including removing investment contracts that are recorded on a blockchain from the statutory definition of securities and for issuers of crypto investment contracts to self-certify that their products are a “decentralized” system that sit within a special class of “digital commodities” which are not immediately subject to SEC scrutiny, although it would have 60 days to challenge the self-certification.

“There are more than 16,000 crypto assets that currently exist,” Gensler said. “Given limits on staff resources, and no new resources provided by the bill, it is implausible that the SEC could review and challenge more than a fraction of those assets. The result could be that the vast majority of the market might avoid even limited SEC oversight envisioned by the bill for crypto asset securities.”

HOWEY TEST

The long-established Howey test to determine whether investments are securities based on their economic realities, would be abandoned in favor of a focus on the way a transaction is recorded.

Gensler says this will mean weaker investor protection than currently exists for those assets that meet the Howey test.

Along with weaker protections even for those digital assets that are deemed to fall under SEC regulation, Gensler warns that FIT21 would mean a riskier environment for investors and the wider capital markets, potentially allowing non-accredited investors to buy large values of assets without disclosure.

“The crypto industry’s record of failures, frauds, and bankruptcies is not because we don't have rules or because the rules are unclear. It’s because many players in the crypto industry don’t play by the rules. We should make the policy choice to protect the investing public over facilitating business models of noncompliant firms,” concluded Gensler in his statement.