Good morning and happy Friday. This week, we cover two new lawsuits against the SEC, a newly proposed IRS tax form, and more.
Top Points
The Crypto Freedom Alliance of Texas and the Blockchain Association are looking to overturn the SEC's dealer rule in suit arguing the rule violates the Administrative Procedures Act.
Consensys also sued the SEC, asking a federal court to rule that transactions in ETH are not securities and that Consensys is not operating as a broker through its MetaMask wallet software.
The IRS published a draft tax form for digital asset brokers, which proposes including unhosted wallet providers as "brokers" and boxes for reporting blockchain transaction hashes, customer names and physical addresses, and wallet addresses.
Rep. Maxine Waters (D-CA) said "we are on our way to getting a stablecoin bill..in the short run" in an interview with Bloomberg.
CFAT & BA Challenge SEC Dealer Rule
On Tuesday, the Crypto Freedom Alliance of Texas and the Blockchain Association (together, "Plaintiffs") sued the SEC in federal court in the Northern District of Texas in a bid to set aside the SEC’s new dealer rule.
TLDR: Plaintiffs argue the Dealer Rule violates the APA because it exceeds the agency’s statutory authority under the Exchange Act, radically departs from what courts and the SEC considered a dealer, and failed to provide sufficient cost-benefit analysis or address key concerns regarding the rule’s impact on digital asset market participants in the U.S.
Background
Under the Securities Exchange Act of 1934 ("Exchange Act"), a securities dealer must register with the SEC and comply with rules issued thereunder.
The Exchange Act defines "dealer" as a “person engaged in the business of buying and selling securities," while excluding those who buy or sell securities for their own account, but not as part of a regular business (i.e., the trader exception). See Exchange Act § 3(a)(5).
Dealer Rule
On February 6, 2024, the SEC adopted a final rule establishing two new qualitative tests for determining when someone is a securities dealer (the "Dealer Rule") by a 3-2 vote.
The tests were "designed to identify market participants who take on significant liquidity-providing roles." See SEC Fact Sheet.
Now, dealers include anyone:
Regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security, and that is communicated and represented in a way that makes it accessible to other market participants, or
Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or capturing any incentives offered by trading venues to liquidity-supply trading interest.
According to the SEC, these new tests were needed in light of changes to the securities markets to ensure firms providing "de facto market making services" are covered by dealer registration rules that apply to traditional brokers.
Importantly, the rule does not "seek to address all circumstances under which a person may be acting as a dealer" or "replace otherwise applicable interpretations and precedent." SEC Fact Sheet. It also excludes any person that has or controls total assets of less than $50 million.
Anyone captured by the new tests would have until April 2025 to register.
Why It Matters
Securities dealers must register with the SEC, comply with recordkeeping requirements, hold sufficient capital, provide disclosures to customers, and register with FINRA (which has its own rules and member fees).
As for crypto, industry has raised concerns that the broad language of the new tests could sweep up those providing liquidity to decentralized exchanges and even automatic market making ("AMM") software under the definition of dealer.
The Lawsuit
Plaintiffs advance three main arguments for why the Dealer Rule should be set aside under the APA:
1. The Dealer Rule Exceeds the SEC's Statutory Authority
First, Plaintiffs argue the Dealer Rule exceeds the agency’s power under the Exchange Act – as previously interpreted by the courts and the SEC itself. See Complaint at 19-24; 35-39. Whereas the definition of dealer historically turned on "ex ante considerations of the services a person offers to customers," the new tests focuses on "an after-the-fact assessment of the effects of a market participant’s trading activity." Id. at 4.
For example, when evaluating whether someone was a dealer, courts and the SEC examined services the dealer provider to customers, like providing advisory services, clearing and safekeeping of assets, and setting prices by making markets for securities. Id. at 2.
But here, the Dealer Rule’s new tests focus on the effects of a trader's activity - namely, whether it has the effect of providing liquidity to securities markets. Id. at 3-4.
As a result, Plaintiff's argue the Dealer Rule could potentially sweep in anyone whose trading activity provides "more than incidental liquidity," including "traders participating in liquidity pools—and even all AMM software protocols." Id. at 36. Thus, they argue, the Dealer Rule “obliterates” the Exchange Act’s distinction between traders and dealers. Id. at 35 (citing Commissioner Peirce dissent).
Plaintiffs also argue the Dealer Rule makes "especially little sense" in the context of digital assets because DeFi eliminates the very centralized, customer facing intermediaries for which the Exchange Act's dealer registration rules were designed. Id. at 36-37. More specifically, traditional dealers hold customer assets and set prices, so registration rules are aimed at protecting customers from financial and information disparities between dealers and their customers. Id. at 2 -3. But DeFi relies on open-source, transparent software to facilitate trades - not dealers - thus removing intermediary risk and related information disparities. Id.
2. The Rule Fails to Address Concerns Raised by the Digital Asset Industry
Second, Plaintiffs argue the SEC failed to address, or even substantively respond to, key concerns raised by the industry. For example, the final Dealer Rule failed to:
Clarify the threshold issue of which crypto assets are securities and when, or
Explain how the new tests would apply to the unique aspects of DeFi. Id. at 39-42.
Moreover, Plaintiffs argue the SEC "hardly acknowledged" commenters concerns that the Dealer Rule will:
Reduce liquidity and increase prices,
Decrease competition by driving out market participants and favoring centralized, incumbent players,
Make the U.S. less competitive compared to foreign jurisdictions where market participants have greater regulatory clarity,
Hurt everyday Americans by forcing digital asset market participants to avoid DeFi protocols, limiting the value and usefulness of DeFi protocols, stifling innovation, and limiting access to financial resources.
3. Insufficient Cost-Benefit Analysis
Third, Plaintiffs argue the SEC violated the APA by failing to analyze the Dealer Rule's costs for the digital asset industry. Instead, the SEC focused exclusively on costs to conventional markets, and even there, focused primarily on government securities markets. Id. at 45-46.
Finally, Plaintiffs argue the SEC failed to measure the Dealer Rule's impact on efficiency, competition, and capital formation in the digital asset market, as the Exchange Act requires. Id. at 55-56.
Requested Relief
Plaintiffs are asking the court to set aside the Dealer Rule and enjoin the SEC from enforcing the Dealer Rule against Plaintiff's members and other digital asset market participants. Id. at 58.
What's Next?
The SEC will likely respond with an answer or a motion to dismiss in the coming weeks.
IRS Proposes Digital Asset Tax Form
On Friday, the IRS published a draft 1099-DA form.
As background, in August 2023, the IRS published a draft rule defining who would be considered a digital asset broker for purposes of new tax reporting requirements enacted under the Infrastructure Investment and Jobs Act.
Under the proposed regulations, the 1099-DA form would need to be filed by digital asset brokers (as defined by the IRS's proposed rulemaking), with copies being sent to their customers and the IRS.
Here are some of the key items included in the draft 1099-DA form unveiled last week:
Unhosted wallet providers are listed as one type of broker.
Information to be reported would include, among other items:
Customer's name and address,
Digital asset wallet address from which the assets were transferred,
Transaction ID or hash from the distributed ledger associated with the digital asset transaction,
Type of digital assets transacted, number of units transacted, "cost or other basis," and date and time acquired or sold or dispensed.
Nik Fahrer, CPA at FORVIS's Digital Asset Practice, shares his thoughts:
The Digital Chamber also published an alert :
What's Next?
There is a 60 day comment period. You can submit your comments here.
Digital asset brokers would not be required to file 1099-DAs until after final regulations have been published in the Federal Register. Under the proposed rules, the effective date would be for digital asset sales that occur on or after January 1, 2025.
Tie to Congress
There is bipartisan legislation in the House and Senate to narrow the scope of broker reporting requirements. Specifically, the Keep Innovation in America Act would narrow who is considered a broker and limit information to be reported to "customer information that is voluntarily provided by the customer and held by the broker for a legitimate business purpose." § 3. It also provides: "Miners and validators, hardware and software developers, and protocol developers are not actual brokers." § 5. (in Congressional findings section).
The bill is sponsored by Chair Patrick McHenry (R-NC) and has 11 cosponsors, including 5 Democrats. Senators Lummis and Gillibrand support substantially similar legislation in Section 802 of their Lummis-Gillibrand Responsible Financial Innovation Act.
Look Ahead
Tuesday, April 30 - 10AM - House Ways & Means Hearing with Treasury Secretary Janet Yellen.
Wednesday, May 1 - 12PM - BBQ & Blockchain Briefing: How Should Congress Regulate Crypto?
Hosted by the American Institute for Economic Research, featuring Dr. Thomas Hogan, Caitlin Long, and J.W. Verret.
Where: Rayburn HOB - Room 2043.
RSVP.
Quick Hits
Courts
Consensys sued the SEC in the Northern District of Texas, asking the court to confirm that "the SEC has no legal authority to regulate ether, user-controlled software interfaces built on Ethereum, or the Ethereum blockchain in general."
Stablecoins
In an interview with Bloomberg, Rep. Maxine Waters (D-CA), Ranking Member on House Financial Services, says stablecoin negotiations continue with Chair McHenry, Senate Democrats, and the White House, while voicing optimism a deal gets done this year.
WATCH:
29
"Stablecoin and other digital assets are falsely framed as a choice between personal privacy and national security. We can have both."
DOJ
DOJ charged founders and CEO of Samurai Wallet with money laundering and operating an unlicensed money transmitting business.
See DeFi Defense Lawyer's thread breaking down charges and elements DOJ will have to prove here.
FBI warns Americans against using unregistered crypto money transmitting services.
FBI "Public Service Announcement."
Rep. Warren Davidson (R-OH) responds:
Strange how we got here given that privacy was enshrined in the Bill of Rights in 1791
Thank you for reading and please enjoy your weekend.
-GSL
For bespoke policy research, tracking, and analysis tailored for your project, learn more about Cap Hill Crypto Advisory Services.
*All information contained in this newsletter is for informational purposes only and should not be considered legal or financial advice. You should conduct your own research, and consult an independent financial, tax, or legal advisor before making any investment decisions. The author may own cryptocurrencies discussed herein.*
