When I last wrote on the question of how – and who- would regulate the burgeoning cryptocurrency and enterprise blockchain industry in March 2021, it was clear that the actions by regulatory officials would largely determine whether this innovation would gain in value.
It is a fact of life that public understanding and market confidence in the rules of the road governing a business model weigh heavily on its success or failure, sometimes more than its inherent economic value.
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Unfortunately, there are still no clear rules in crypto, this only intensifies the murkiness regarding regulatory actions by specific officials and the powerful agencies that are supposed to be monitoring the cryptocurrency market.
In my last piece, I cited actions by the former Director of Corporation Finance at the Securities and Exchange Commission (SEC), William Hinman, as a “cautionary tale” of how the lack of regulatory clarity could open the door to questions about motive and conflicts of interest.
Since then, Hinman’s actions on crypto while in office have come under intense scrutiny in a New York federal court and from a government watchdog organization suing the SEC for public documents. It has exposed a disturbing lack of concern for the consequences to investors and companies for perpetuating confusion in the markets, and the ease by which high-ranking SEC officials can ignore federal ethics rules even after admonitions and warnings about their behavior.
William Hinman's Speech
On the policy side, controversy has continuously swirled around a speech Hinman gave in June 2018 in which he introduced a regulatory concept of “decentralization” among cryptocurrencies.
In this context, decentralization occurs on an expanding blockchain when it allows trading of the cryptocurrency used on a qualified network to transform from a security transaction requiring SEC registration to a non-security transaction and therefore, outside his agency’s jurisdiction, he said at the time.
This was on the heels of the so-called “ICO craze” of initial coin offerings that funded the launch of many blockchain networks and appeared to violate SEC registration requirements.
Hinman’s speech was taken as guidance to the market, especially given that Hinman singled out Bitcoin and Ether, the native token on the Ethereum network, as examples.
Given what he said was Ethereum’s “decentralized nature,” Hinman assured those present that “we believe that sales of Ether are not securities transactions”. Trading of Ether immediately began to skyrocket and more investment poured into Ethereum-based businesses.
While Bitcoin’s inventor hid behind the pseudonym of Satoshi Nakamoto and has never been identified, Ethereum’s founders are well known and include some of the biggest venture capital investors in technology.
The Effects Of The Speech
The effect of Hinman’s speech was that the markets clearly perceived Bitcoin and Ethereum as safe from SEC enforcement actions, and market participants made efforts to apply Hinman’s generic decentralization concept to their investment decisions in companies and other cryptocurrencies.
But, “decentralization” was never codified by an official rulemaking. It was simply dangled by Hinman as guidance on how the SEC might, or might not, come after certain networks and tokens. Even the most scrupulous retail investor and their best legal advisors were left to make good faith guesses.
This approach later came back to haunt not only the SEC, but Hinman personally. When the SEC filed a $1.3 billion lawsuit against Ripple, a business built on the XRP blockchain, it opened the door for Ripple to make the Hinman speech a centerpiece of its defense.
This was especially clear when the SEC alleged that all sales of XRP since 2013, even on the secondary markets, were purely tied to an investment contract in Ripple and everyone involved should have known.
Ripple countered that no reasonable market participant could have known that XRP was a security given the confusion fomented by the Hinman speech and the lack of clear rules.
Ripple demanded to depose Hinman, and receive all the internal communications and drafts of Hinman’s speech to lay the entire matter of this confusion before the federal judge in the Southern District of New York.
The SEC fought tooth and nail to shield Hinman from a deposition, and to hide the speech documents for 18 months. Over that time, it became increasingly obvious that everything around Hinman’s speech would be damaging to the agency’s legal case and its credibility with investors.
Hinman was eventually deposed, and the speech documents were finally turned over to Ripple after six court orders. While much of that evidence remains sealed as the case heads to resolution, other filings that are public indicate that at least one SEC staffer involved in drafting the speech expressed concern about its potential for confusing the markets.
When Ripple’s general counsel announced on Twitter that he’d been given the documents and they were not yet public, CEO Brad Garlinghouse, who is also a co-defendant in the case, replied that the SEC “wants you to think that it cares about disclosure, transparency and clarity. Don’t believe them. When the truth eventually comes out, the shamefulness of their behavior here will shock you.”
Other documents that have gone public revealed that Hinman and his staff met with a third party promoter of Ether, ConsenSys, several times while the speech was being developed, as well as a group of venture capitalist investors in Ethereum who presented him a regulatory proposal that exclusively mentioned Ether.
These revelations have angered tens of thousands of XRP holders who say they were innocent victims of the SEC’s lawsuit, insisting they did not acquire XRP to invest in Ripple and saw their holdings wiped out in value before being locked into wallets when trading in the token was suspended by exchanges out of fear of SEC retaliation.
Led by Rhode Island attorney John Deaton, who founded the CryptoLaw digital platform for crypto holders, over 75,000 XRP holders obtained friend of the court status in the case in order to respond to the SEC’s allegations about why they purchased the token.
Picking Winners And Losers
Deaton accuses the SEC of “picking winners and losers” in how it went after XRP while giving Ethereum what he calls “a free pass”. His efforts got the attention of the Fox Business network, which broadcast a lengthy investigative report on the controversy behind the Hinman speech as the SEC was still fighting disclosure of the speech documents.
Empower Oversight, a government watchdog group, sued the SEC to obtain thousands of Hinman’s emails that exposed how he met repeatedly with senior partners of his former law firm, Simpson Thacher & Bartlett (STB), when they had business before his division, despite internal warnings that he had a “criminal financial conflict” that barred any contact with them.
CryptoLaw launched a video to recruit XRP holders to their cause that points out, as ValueWalk reported in March 2021, that Hinman was receiving $1.6 million a year in payments from STB while he was in office.
The former official also went from his SEC perch to being a senior advisor to the investment fund giant Andreessen Horowitz, an Ethereum investor that lobbied Hinman on regulatory relief for Ether when the 2018 speech was in development.
Deaton says XRP holders have sent over 60,000 messages to Members of Congress demanding an investigation of Hinman’s conflicts.
Senator Elizabeth Warren (D-MA) and Rep. Alexandria Ocasio-Cortez (D-NY) wrote a letter to SEC Chairman Gary Gensler on October 24 asking for clarity on ethics rules amidst the “revolving door” between the agency and the crypto industry, and cited Hinman’s speech and the questions around his conflicts.
Republicans have vowed to drag Gensler before oversight hearings to grill him on the SEC’s regulatory actions if they win control of Congress in the midterms.
On balance, it appears the Hinman speech was a debacle for everyone. It confused the markets rather than providing any clarity. It gave one well-connected project a leg up in the markets on a competitor who was then sued, harming tens of thousands of market participants as collateral damage.
The protracted fight over disclosure of the speech’s drafts drew attention to Hinman’s apparent ethical lapses and conflicts of interest that will continue to dog the SEC, given the anger it provoked among retail investors already skeptical of the agency.
The lesson remains the same, however. When the rules are not clear, a regulatory agency’s enforcement actions will be tainted by public doubt, and will open up the agency and its officials to legal and political danger. The question remains whether the SEC has learned this lesson or not.