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SEC Charges Crypto Trading Platform Kraken with Exchange Act Violations
Practical Law Legal Update w-041-5569 (Approx. 7 pages)
SEC Charges Crypto Trading Platform Kraken with Exchange Act Violations
by Practical Law Finance
| Published on 29 Nov 2023 • USA (National/Federal) |
The SEC charged crypto-asset trading platform Kraken with operating its platform as an unregistered securities exchange, broker, dealer, and clearing agency.
On November 20, 2023, the SEC filed a complaint charging Payward Inc. and Payward Ventures Inc. (collectively known as Kraken) with violations of:
- Section 5 of the Securities and Exchange Act of 1934, as amended (Exchange Act) (15 U.S.C. § 78e) for the use of an exchange to effect transactions in a security without registering as a national securities exchange under Section 6 of the Exchange Act absent an exemption, specifically for maintaining and providing a marketplace for bringing together buyers and sellers of securities.
- Section 15(a) of the Exchange Act (15 U.S.C. § 78o(a)) for facilitating or inducing the purchase or sale of securities without registering as a broker absent an exemption, specifically for functioning as a broker-dealer by soliciting potential investors and handling customer funds and assets.
- Section 17A(b) of the Exchange Act (15 U.S.C. § 78q-1(b)) for performing the functions of a clearing agency with respect to securities without registering in accordance with Section 17A(b) of the Exchange Act absent an exemption or exclusion, specifically for conducting the settlement of crypto-asset securities and acting as a depository for crypto-asset securities traded on Kraken's platform.
According to the complaint, since 2013, the Kraken platform has allowed customers to buy and sell crypto assets through an online market, a platform described on the Kraken website as "one of the world's largest digital asset exchanges." According to the complaint, by operating a platform on which crypto assets are offered and sold as investment contracts, Kraken's operations place it within the purview of US securities laws, as established in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (see Practice Note, Regulation of Crypto-Asset Securities in USA: SEC Approach to Digital Asset Regulation: Howey Test and FinHub Framework and Howey Test Flowchart).
Kraken also provides services for customers to open accounts, deposit funds, enter orders, and trade crypto assets. According to the complaint, because Kraken has not registered as a broker, dealer, national securities exchange, or clearing agency, there is no formal mechanism to ensure the accuracy or consistency of the information Kraken selectively discloses about the crypto assets it makes available for trading or about its own operations.
The SEC asserts that the Kraken platform resembles a traditional securities exchange, with a matching engine, customer interface applications, a range of order types, and advanced trading tools. The complaint alleges that the crypto-asset securities Kraken has made available for trading have been the subject of prior SEC enforcement actions based on their status as crypto-asset securities (see Legal Updates, SEC Charges Crypto Trading Platform Binance and Its CEO with Violation of US Securities Laws, Updated: SEC Charges Crypto Trading Platform Bittrex with Violation of Securities Laws, and SEC Charges Crypto Exchange Coinbase with Registration Failures).
According to the complaint, a reasonable investor using the Kraken platform would have understood the offer and sale of each of the Kraken-traded securities as offers and sales of investment contracts because:
- Purchasers of Kraken-traded securities would reasonably have expected to profit from the efforts of their issuers and promoters to grow and maintain the technology platforms and blockchain ecosystems associated with these crypto assets because such growth or operations could in turn increase the price of the underlying crypto asset and/or provide increased value to holders of the Kraken-traded securities.
- The economic reality of the offerings as presented by their respective issuers and promoters, and rebroadcast by Kraken itself, would have indicated to a reasonable investor that future profits through the increased value of Kraken-traded securities would come through the efforts of these issuers and promoters.
The complaint provides that Kraken facilitates transactions in crypto-asset securities in multiple ways, specifically:
- Allowing customers to submit orders for crypto-asset securities and operating a system that attempts to match those orders.
- Opening and maintaining customer accounts and holding funds and crypto-asset securities that have been transferred to or purchased through Kraken by customers.
- Operating "Instant Buy," where Kraken acts as the counterparty for a customer's request to buy or sell crypto-asset securities.
- Operating the OTC Desk, which facilitates large crypto-asset security orders.
- Operating applications that allow customers to access their accounts and place direct orders.
- Offering margin lending for trading in crypto-asset securities on the Kraken platform.
- The complaint also alleges that Kraken does not restrict how many units of a crypto-asset security any given investor may purchase, and investors are not required to purchase quantities tied to a purported non-investment "use" that may exist for the asset, if any. Rather, investors may purchase crypto-asset securities in any amount and for any purpose.
According to the complaint, in 2020 and 2021, Kraken earned more than $43 billion in revenue from trading-based transactions, including from fees charged to customers, sales of crypto assets to customers, and proprietary trading. The complaint alleges that Kraken found errors relating to customer custodial cash and crypto assets held for customers in 2020 and 2021, and these errors were a result of Kraken's poor recordkeeping practices and failure to properly record margin transactions.