Posted May 9, 2024 at 3:07pm EST.

A recent cause carried software giant Ethereum Consensys against the US Securities and Exchange Commission (SEC) suggests that liquid staking protocols, such as Lido and Rocket Pool, could also come under the regulatory agency’s sights.

As part of cause, which challenges the SEC’s determination that ether is a security, Consensys disclosed that it has received two notices from Wells stating that Consensys’ MetaMask Swaps and MetaMask Staking are operating as unregistered securities brokerages. MetaMask Exchange allows users to trade tokens by aggregating data from multiple providers to find the best price, while MetaMask Staking allows users to hire in liquid staking via the providers Lido and Rocket Pool.

A Wells Notice is an informal document issued by the SEC notifying a company of an impending lawsuit. Companies can respond, in writing, to argue why the SEC should not take legal action. Earlier this week, trading platform Robinhood said it had done so received a Wells advisory from the regulator, regarding crypto tokens on the platform.

“MetaMask staking is essentially a way of communicating with the Lido and Rocket Pool liquid staking protocols,” said Laura Brookover, senior counsel and head of litigation and investigations at Consensys, recently on Podcast without chains. “And the SEC’s theory is apparently that Lido and Rocket Pool themselves are unregistered securities and that somehow, through staking MetaMask, Consensys is distributing unregistered securities.”

An SEC spokesperson declined to comment on Consensys’ lawsuit or whether the agency had also sent Wells notices to Rocket Pool and Lido.

MetaMask’s staking partners – Lido and Rocket Pool, including founders and key members of the organizations – did not respond to multiple requests for comment via multiple email addresses or via their Telegram or social media accounts about whether the SEC had taken any action or requested information from them or if they offer unregistered securities. No one responded even from the general emails from Lido or Rocket Pool, which were copied.

When reached for comment Responsible for the legal and general advice of Lido Eric Hill said he was “not the right person to talk to” and was no longer in that position. He did not confirm when he stepped down from that role or who will replace him. A Lido media representative also did not respond to a request for comment.

Do liquid staking protocols offer unregistered securities?

Staking is the process of locking a token for a period of time to secure a blockchain network and receiving interest in exchange for those locked tokens. Liquid staking adds an extra step to this process, that is, when a user stakes tokens, they also receive a utility token representing their share of staminated tokens, which can be used elsewhere in the crypto ecosystem.

To know more: How liquid staking works

“If you’re actually just facilitating user staking and then you get a token that shows the user has staked, for that to be a security, then the staking itself probably has to be a securities transaction,” Austin said Campbell, founder and managing partner of Zero Knowledge Consulting and adjunct professor at Columbia Business School.

“And I have some doubts about this,” he added, referring to the question of whether staking should be considered a securities transaction.

A key test for whether something is a securities transaction is the Try Howeywhich is a four-pronged test introduced in 1946. If the asset is an “investment of money in a common enterprise, with a reasonable expectation of profits from the efforts of others,” then it is considered a security.

To know more: The “Howey Test” and the debate over the legal status of cryptocurrencies

At first glance, the staking protocols satisfy the first three prongs, said Alex More, litigation manager at Carrington, Coleman, Sloman & Blumenthal. It is the final prong, the “managerial efforts of others,” that is what is most frequently contested, he added.

Like Campbell, More believes it would be difficult to argue that a user who is betting is participating in a securities transaction.

“There’s no managerial effort in this, it’s just about protecting the integrity of the network,” More said.

The challenge is when an entity – decentralized or centralized – helps the user in the staking process.

If the entity is truly acting as an intermediary, then it is no different than directly staking a user, More said. However, if the entity does something to manage those assets, the SEC may have more reason to argue that it is a securities offering.

The staking programs that have come under the SEC’s sights are those in which the staked assets were used in combined vehicles or looked like an investment, Campbell said.

The Kraken and Coinbase examples

An important case of staking was that of the SEC cause against cryptocurrency exchange Kraken, accused of failing to register the offer and sale of its staking-as-a-service program. The SEC said Kraken touted the benefits of the exchange’s efforts on behalf of investors. Kraken settled with the SEC, shutting down its U.S. staking program and paying $30 million in civil penalties.

Based on this action, in February 2023, the nonprofit advocacy group Proof Of Stake Alliance released liquid staking guidelines to help members navigate the uncertain regulatory environment.

Eric Hill is listed as Lido’s legal counsel and a member of the Alliance’s leadership on its site. A representative for the group said that although Hill is on the board, he has not been active for some time. They also said they believe Hill’s title at the Lido, as reported on the site, is “no longer accurate” and have reached out for an update.

Cryptocurrency exchange Coinbase was too sued by the SEC for failing to register the offer and sale of its staking-as-a-service program, among a number of other charges. Coinbase rejected and supported that its staking services do not pay rewards based on the “efforts of others” and it makes no “managerial effort” in providing this service.

In March, Judge Katherine Polk Failla mostly denied Coinbase’s motion to dismiss the SEC lawsuit is still pending. The court found that the SEC had “sufficiently alleged” that Coinbase operates as an exchange, broker, and clearing house and that the exchange’s staking program engaged in the unregistered offering and sale of securities.

The judge, however, He did not agree with allegations that Coinbase was operating an unregistered broker through its self-custodial wallet, pointing out that the flat fees charged by Coinbase and its social media solicitation methods were not sufficient to allow the SEC to allege that it is operating an unregistered broker. This ruling could give MetaMask an advantage against the claims made by the SEC in its Wells Notice.

“More [MetaMask] it looks like Coinbase, the more I like their shares,” Campbell said.Unless MetaMask had a custodial relationship or controlled the transactions, it is difficult to consider it a broker, Campbell said.

This is the challenge with the SEC’s “regulation through obfuscation approach” because now each of these cases must be examined based on the facts and circumstances, he added.

What about issuing utility tokens via liquid staking protocols?

Unlike Kraken, both Coinbase — go its liquid staking service – and liquid staking protocols issue a utility token to customers, which represents their staked holdings on the platforms.

However, according to More, issuing these utility tokens does not change the fundamental Howey test question that needs to be answered. The question remains whether the issued utility token is part of a joint venture that a group runs for profit, he added. It’s a similar story for governance tokens issued by these protocols.

Is it possible to target decentralized protocols too?

When the SEC sued Kraken and Coinbase, the governance tokens of many liquid staking protocols increased because many believed that decentralized protocols could not be targeted by regulators.

“Self [the protocol] is controlled centrally by a handful of people with a multisig, one way or another, there is the ability to issue them a Wells alert,” Campbell said. “Now, mind you, what jurisdictions are those people? And a do they care about getting a notice from Wells? Many people may not, but there is probably a way to serve them.”

If a project is truly decentralized and continues to work because the code is fully automated, sending them a Wells alert won’t make any difference to how well it works, he added.

To know more: What is a DAO and how does it work?

Uniswap is a recently decentralized protocol received a Wells notice from the regulator. The decentralized exchange was also hit with a class action lawsuit in 2022, but the court fired the legal action, noting that the protocol exercised no management control.

“One may wonder whether some of the recent adverse rulings, such as in the Uniswap case and the Ripple case, might give the SEC some pause in prosecuting them,” More said. “Generally, the SEC prefers to prosecute cases where it believes it can win.”

“However, it appears to be a policy priority of Gensler and his SEC administration to crack down as much as possible on what they see as significant risk to the public in purchasing and managing digital assets,” he added.

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