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Before we get into this week’s DEF Weekly, you might have seen exciting news from us on Monday. We are happy to share that DEF and Beba, a Waco, Texas-based apparel company, filed a pre-enforcement suit challenging the SEC’s regulation by enforcement approach to crypto and their policy that free airdrops are securities transactions.
We will talk more about this suit in the coming days and weeks, but in the meantime check out our blog post to get a sense of what it all means.
Judge Denies Genesis and Gemini Motion to Dismiss; Genesis and Gemini Settle
What happened?
On March 15, Judge Ramos of the U.S. District Court for the Southern District of New York denied Genesis Global Capital (Genesis) and Gemini Trust Company’s (Gemini) motion to dismiss the complaint filed against them by the Securities and Exchange Commission (SEC). Several days after the denial, Genesis settled the charges by agreeing to a permanent injunction and a $21 million civil penalty. The case against Gemini will proceed.
The SEC alleged that Genesis and Gemini engaged in the unregistered offer and sale of securities through a “crypto asset lending program” known as the Gemini Earn program. According to the SEC, Gemini Earn offered interest on customers’ digital assets, in part through lending them to Genesis, who promised to pay interest earned from Gensis’s use of the loaned crypto assets. After several years of operation, Genesis halted customer withdrawals due to claims of insufficient liquidity. Genesis and two affiliates filed voluntary Chapter 11 petitions in bankruptcy court on January 19, 2023.
The SEC’s case had two main arguments as to the purported “securities” in this case: 1) the Gemini Earn program met the standard of an “investment contract” per the Howey test, therefore constituted a “security;” and 2) the Gemini Earn agreements were securities in the form of “notes” under a Reves analysis. Judge Ramos ruled that the SEC plausibly alleged both theories in the complaint, ruling that the broad definitions of “investment contract” and “note” in the Securities Act encompassed the activities involved in the Gemini Earn program. The opinion explains that courts “have found that novel or unique investment vehicles constitute investment contracts, including interests in orange groves, animal breeding programs, railroads, mobile phones, and enterprises that exist only on the Internet, including crypto assets.”
What does this mean?
It is important to keep in mind that Judge Ramos’s order is on a motion to dismiss, which means the court was required to accept all of the SEC’s allegations in the complaint as true, and view them in the light most favorable to the SEC, for purposes of deciding the motion. Although Genesis settled with the SEC, the litigation against Gemini will continue and most likely proceed to discovery before there is any decision on the merits of the SEC’s claim.
“Gross Abuse of Power” Leads to SEC Sanctions in DEBT Box Case
What Happened?
Last Monday, a federal district court took the rare step of imposing sanctions on the SEC in a crypto case because the “pervasive misconduct” by the agency “demonstrates a pattern of organizational bad faith and broadly implicates the Commission itself—not just isolated individuals.”
In this case, the SEC filed for an ex parte temporary restraining order (TRO) to obtain immediate injunctive relief against the defendants that included freezing the defendants’ assets and appointing a receiver over their company. Because this was an ex parte proceeding, it took place without the presence of the other party - meaning the defendants were not present when the SEC argued to the court in favor of the TRO and injunctive relief.
To obtain the TRO, the SEC had to show that irreparable harm would occur unless the court issued the TRO. To support this contention, the SEC presented the following so-called facts:
1) DEBT Box closed roughly 33 bank accounts in the 48 hours preceding the TRO hearing;
2) One of DEBT Box’s co-founders stated in a YouTube video that DEBT Box would be moving its assets offshore (and outside of the court’s reach); and
3) The firm’s U.S. bank accounts were being drained of funds.
As the court explains at length, these so-called facts were crucial in persuading the court to issue the TRO. However, all of these claims were “false and misleading,” with the first and third lacking any factual basis whatsoever.
When arguing for the dissolution of the TRO, the defendant brought to light the inaccuracy of the claims and showed that the SEC’s “evidence” was a misrepresentation of the facts. For instance, some of the bank accounts had been closed, up to a year prior, not by the defendant but by the banks themselves. Most damning, none had been closed in the 48 hours prior to the hearing.
The video had also been taken out of context: DEBT Box’s CEO did not state that the company was shuffling assets overseas; instead, he was discussing the benefits of the relatively clearer regulatory environment in the UAE.
Instead of admitting their errors, the SEC doubled down on their false and misleading representations to the court and argued that the facts supported the irreparable harm finding and that the TRO should be maintained. The SEC went so far as to call the assertions to the contrary “outlandish and explosive,” arguing that they had not misled the court.
The court did not agree and dissolved the TRO. Because of the nature of the misrepresentations, the court issued a Show Cause order. A Show Cause order is essentially a judicial demand for more information. In this Show Cause order, the Judge, Robert Shelby, asked for information regarding the SEC’s knowledge of the factual misrepresentations made at the initial TRO hearing.
In the SEC’s response to the Show Cause order, it came to light that the SEC was aware of the factual errors at the initial TRO hearing and when they argued against dissolution of the TRO. The SEC acknowledged “inaccuracies” in their statements to the court and attempted to justify them; however, the Court disagreed and explained the SEC’s statements went beyond mere inaccuracies. See, e.g., Order at 44, fn 304 (“The Commission characterizes the statement as “inaccurate.” However, Welsh asserted Defendants closed bank accounts in the 48 hours before the hearing. The truth is no accounts were closed, by Defendants or anyone else, in the 48 hours before the hearing. Stating otherwise is not inaccurate, it is simply false as it has no basis in fact.”).
In an 80-page opinion in which the words “bad faith” appear 46 times, the court held the ordered sanctions for the SEC’s “abuse of judicial process” and ordered the SEC to pay the defendants’ legal fees associated with the TRO. Judge Shelby called the SEC’s explanations reflections of a “misapprehension that Commission attorneys are not only exempt from binding ethical obligations but also operate above the traditional adjudicative process.” The court also found that the Commission’s misconduct “demonstrate[d] subjective bad faith.” Ultimately, the court stated that the SEC’s conduct “constitute[d] a gross abuse of the power entrusted to it by Congress and substantially undermined the integrity of [the] proceedings and the judicial process.”
What does this mean?
This order speaks for itself. DEBT Box is emblematic of the regulation by enforcement regime led by Chair Gensler and the lengths the SEC will go to in order to sustain their litigation positions. The court recognized this: “Given the myriad and repeated instances of misconduct, the court cannot write these issues off as non-willful, inadvertent mistakes. Particularly in view of the discrete examples of bad faith conduct the court discusses above, the court can only conclude the Commission made these strategic decisions because it knew if it made clear the tenuous nature of the evidentiary support for its self-described inferences, the court would not issue the TRO and asset freeze the Commission sought.”
It is exceptionally rare that a court orders sanctions against any lawyer, let alone lawyers at a government agency. However, it is even rarer that lawyers are found to have lied directly to the court in “subjective bad faith.” Given the nature of the lies told to the court, it is not surprising the court ruled in this way.
The HFSC’s Hearing on the SEC Overreach
What Happened?
Last Wednesday, the U.S. Committee on Financial Services, Capital Markets Subcommittee, conducted a hearing, titled “SEC Overreach: Examining the Need for Reform.” The hearing aimed to examine the many concerns Congress has with the SEC’s behavior over the last several years.
In her opening remarks, Chair Ann Wagner (R-MO) criticized the SEC under the leadership of Chair Gary Gensler, saying: “Chair Gensler has flooded the marketplace with roughly 60 new proposals and more than 30 final rules. Many of these proposed and final rules include sweeping new changes that were advanced without the requisite statutory authority, without a comprehensive cost-benefit analysis, or without satisfying the requirements of the Administrative Procedure Act.”
Many members criticized the SEC for its malfeasance in the digital asset space. Representative French Hill (R-AR) criticized the SEC's hostile approach to digital assets, arguing that "not only has the SEC lost in the court of public opinion, even on a bipartisan basis here on Capitol Hill, but the agency is now getting trampled by the federal courts as well, especially as it relates to digital assets.” Congressman Zach Nunn (R-IA) criticized the SEC's regulatory approach towards new technology and its impact on local businesses, describing it as being “a blunt one size fits all” approach.
What does this mean?
The SEC’s unprecedented overreach and disregard for the rule of law continues to reflect well on it.
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