SEC Chief Enforcement Officer Rejects “Regulation by Application” Criticism – Corporate / Commercial Law

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United States: SEC Chief Enforcement Rejects Criticism of “Regulation by Enforcement”

November 15, 2021

Cadwalader, Wickersham & Taft LLP

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The director of the SEC’s Enforcement Division, Gurbir Grewal, dismissed criticism that the agency “regulates by enforcement” when it comes to cryptocurrency and environmental, social and governance issues.

Speaking at the opening address of the Scott Friestad Memorial, Mr. Grewal said the agency “welcome[s]“New technologies, but must also prioritize investor protection by ensuring compliance with federal securities laws. Over the past four years, he noted, the agency has taken legal action against initial coin offerings and fraudulent and unregistered middlemen (for example, exchanges and brokers) who facilitated the trading of unregistered titles. Mr Grewal acknowledged that stand-alone enforcement actions had increased over the past fiscal year, but denied that it was “regulation by enforcement”.

Mr. Grewal defended the SEC’s recourse to SEC v. Howey and Reves v. Ernst & Young to determine if an instrument is a security. He noted that the application of both tests has been criticized for being decades older than the cryptocurrency and for being imprecise in application. Mr Grewal denied allegations made (particularly in SEC v. Kik Interactive Inc.) that the SEC’s application of Howey was “unconstitutionally vague”, claiming that these tests had been upheld by the courts on several occasions and praising Howey as “flexible” and “adaptable.” (The Kik court agreed, finding Howey clearly expresses the definition of an “investment contract.”) Mr. Grewal also rejected the criticism that SEC guidance was insufficient. He said the Kik court rejected the argument, adding that the agency was under no obligation to “reach out and warn all potential violators.” Mr. Grewal went further, stating that the agency issued guidelines on the application of U.S. securities laws to distributed ledger technology and digital assets, as well as alerts to investors about the risks of investing r in cryptocurrency.

Separately, Mr. Grewal warned market participants that attempting to avoid securities regulation through “labeling” will not be successful. Specifically, Mr Grewal said that using terms such as “decentralized,” a “loan program” and “stable” will not change his question of whether or not the instrument is a security.

On ESG issues, Mr Grewal said there was nothing “new” about the way the agency investigates ESG climate and misconduct. Rather, he noted that the agency applies its “long-standing principles” of (1) materiality and disclosure for all issuers, and (2) fiduciary duties and honest disclosure in the asset management industry. Mr. Grewal also highlighted the longevity of the agency’s ESG mandate, which began in 2008 when it settled charges against Pax World Management for breach of fiduciary duty regarding socially responsible mutual funds. More recently, the SEC settled a case against Fiat Chrysler for misleading disclosures from an internal audit regarding emissions control systems.

Commentary Philip S. Khinda

The new enforcement director appears to be paying for the SEC’s lack of guidance and regulation over the past four years. Time will tell if the agency, under new leadership, will resume its role of regulator first and enforcer second, or if criticism of “regulation by enforcement” will take on even more space.

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