Galois Capital Case
Background
In February 2023, in a major departure from current market practices and the SEC’s existing custody rules, the SEC proposed sweeping rule changes requiring registered investment advisors to maintain a diverse new range of assets with qualified custodians. It imposed a broad new array of requirements on such qualified custodians. This proposed “Safeguarding Rule” would significantly impact the digital asset industry, raising entry barriers for qualified custodians.
Notably, the SEC offered two overlapping 60-day comment periods for the proposed rules. This led to hundreds of mostly negative responses and numerous meetings where industry leaders voiced their concerns.
The proposed Safeguarding Rule specifically encompasses most crypto assets, regardless of whether such assets are securities, as well as a wide range of other non-security assets not covered by the existing custody rules. In addition, and quite without a statutory basis, throughout the Proposing Release, the SEC also expresses new interpretations and endorses unwritten staff views of the current custody rules that have never been subject to public notice and comment.
As a result of this additional unsupported dicta, investment advisors have been in a holding pattern since 2023, not knowing if the staff’s unsupported positions included in the Proposing Release require that they adjust their current activities to comply with the “new interpretations” of the existing custody rules in the absence of formal adoption of the Proposing Release – including the SEC’s unsubstantiated new interpretation that most digital and crypto assets are already subject to the existing custody rule.
As of September 24, 2024, the SEC hasn’t finalized the rule, and it wasn’t listed on their regulatory priorities. However, through enforcement actions like the recent case against Galois Capital, the SEC has been acting as if the new interpretations are already in place. This approach bypasses the proper legal process, raising concerns of regulatory overreach and underscoring the need for Congress to step in.
Galois Capital Case: Enforcement of a Nonexistent Rule
On September 3, the SEC announced settled charges against Galois Capital for failing to comply with “requirements related to the safeguarding of client assets, including crypto assets being offered and sold as securities.” This enforcement action illustrates how Chair Gensler is using enforcement to implement the expanded safeguarding rule—despite it not yet being finalized through the proper rulemaking process.
In the case of Galois Capital, the SEC cited violations of the existing custody rule but relied on reasoning that mirrors the broader, more expansive provisions in the proposed safeguarding rule. These include heightened requirements for the segregation of client assets, which extend beyond securities to include non-security crypto assets, of which Congress has not delegated authority to
the SEC to regulate. Despite the rule being delayed for re-proposal, the SEC moved forward with enforcement, effectively bypassing the APA’s requirement for a transparent notice-and-comment period. This tactic exemplifies Gensler’s strategy of enforcing politically unpopular rules through legal action rather than adhering to the established regulatory framework.
The Galois Capital case stands as a prime example of how the SEC is shaping the market under a rule that has not yet been finalized, raising serious concerns about regulatory overreach and the erosion of due process.
Legal Issues and Unlawful Enforcement
Chair Gensler’s efforts in this case go beyond the SEC’s statutory authority under the Investment Advisers Act and other relevant legislation. By attempting to apply the existing custody rules to non-security crypto assets—again, assets outside the purview the of SEC’s statutory authority—the Chair is not only undermining Congressional intent but also violating principles of separation of powers and due process.
The SEC’s actions in the Galois Capital case illustrate a troubling pattern: the agency is bringing enforcement actions against market participants based on staff positions concerning the existing custody rules first publicly disclosed in the Proposing Release without basis or proper process. The Proposing Release has not been adopted and the SEC has not yet addressed the overwhelmingly negative public comments provided on the Proposing Release and the basis dicta included in that release. Applying any position taken in the Proposing Release before formal rule adoption is a clear violation of the APA and an unlawful expansion of the SEC’s powers, bypassing Congress and flouting statutory limitations.
Call to Action
This regulatory overreach must not be tolerated, and the SEC must be brought back within the boundaries of its statutory authority, or we risk crippling innovation and accepting new precedents of bad faith actions by a rouge agency head without oversight. This is not just a policy disagreement but a fundamental issue of upholding constitutional principles. Congress must act immediately to ensure that the SEC operates within its legal limits and adheres to the APA’s rulemaking process.
Conclusion
Chair Gensler’s attempt to expand the custody rule to cover non-security crypto assets, without proper legal authority or adherence to the rulemaking process, represents a direct challenge to constitutional norms and regulatory transparency. The SEC’s enforcement actions, such as those in the Galois Capital case, set a dangerous precedent of regulatory overreach that undermines the rule of law and due process. Congress must take immediate action to hold the SEC accountable, prevent further erosion of legal safeguards, and ensure that a clear, legally sound regulatory framework is established for the future of the crypto industry. The time for decisive Congressional action is now.
