SEC and Rari Capital Agree to Settlement in Misleading Investor Case

The United States Securities and Exchange Commission (SEC) continues to face scrutiny over its approach to regulating the cryptocurrency industry. In two recent developments, the SEC settled with decentralized finance protocol Rari Capital for allegedly misleading investors and engaging in unregistered broker activity, while lawmakers criticized SEC Chair Gary Gensler for creating confusion in the crypto market. 

SEC Settles with Rari Capital for Allegedly Misleading Investors and Unregistered Broker Activity

The United States Securities and Exchange Commission (SEC) has reached a settlement with decentralized finance (DeFi) protocol Rari Capital and its co-founders, Jai Bhavnani, Jack Lipstone, and David Lucid, over allegations of misleading investors and engaging in unregistered broker activity. The settlement marks a significant regulatory development in the DeFi space, as the SEC continues its efforts to regulate and enforce securities laws within the rapidly evolving cryptocurrency sector.

On Sept. 18, 2024, the SEC released a statement outlining the alleged misconduct of Rari Capital. According to the SEC, Rari Capital’s Earn and Fuse pools operated similarly to crypto asset investment funds. Investors were able to deposit cryptocurrencies into these lending pools, with the expectation of earning returns from their investments. However, the SEC contended that the activities of Rari Capital constituted unregistered offers and sales of securities, as these pools were linked to governance tokens and offered profits to participants.

Additionally, the SEC’s complaint accused Rari Capital of misleading investors regarding the functionality of its Earn pools. Investors were reportedly told that the Earn pools would automatically and autonomously rebalance crypto assets to achieve the highest possible yield. In reality, the SEC claims that this rebalancing mechanism often required manual intervention, which Rari Capital sometimes failed to execute. This misrepresentation of the protocol’s capabilities raised concerns about the transparency and integrity of the platform.

Furthermore, Rari Capital’s involvement in unregistered broker activity came under scrutiny. The SEC alleged that the protocol’s Fuse platform, which enabled users to create customizable lending and borrowing markets, was operating in violation of US securities laws. According to Monique Winkler, director of the SEC’s San Francisco Regional Office, “We allege that Rari Capital and its co-founders misled investors about both the features and profitability of certain of the crypto asset investments Rari Capital offered, and acted as unregistered brokers.”

The settlement reached between the SEC and Rari Capital includes several forms of relief, including permanent injunctions, civil penalties, and disgorgement with interest. Additionally, the co-founders have agreed to a five-year ban from serving as officers or directors of any company. Rari Capital Infrastructure has also agreed to a cease-and-desist order, though the settlement does not include an admission or denial of the SEC’s findings. The settlement is subject to final approval by the court.

Launched in 2020, Rari Capital quickly gained traction in the DeFi space due to its innovative approach to yield farming. The protocol promised to automatically optimize funds across multiple decentralized finance protocols such as Compound and dYdX, delivering the highest returns for users. This attracted a significant number of investors, particularly because the platform was built and led by a team of young developers—some still in their teenage years.

One of Rari’s flagship offerings was its Fuse protocol, which allowed users to create custom lending and borrowing markets, further solidifying the platform’s reputation as a cutting-edge DeFi player. By 2021, Rari Capital had achieved over $1 billion in total value locked (TVL), with many users flocking to its high-yielding liquidity pools.

However, the platform’s success was marred by several significant security incidents. In May 2021, Rari suffered an $11 million exploit due to an integration issue with Alpha Finance. Despite this setback, the platform continued to grow. But in April 2022, Rari Capital faced a catastrophic breach when a reentrancy bug in its Fuse protocol led to the loss of over $80 million. The hack not only decimated Rari’s platform but also had ripple effects on other DeFi protocols, given the interconnected nature of DeFi ecosystems.

Following the 2022 hack, Rari Capital found itself in an untenable position. Unable to recover from the financial and reputational damage caused by the breach, the protocol eventually shut down its operations, marking the end of its once-promising ascent in the DeFi landscape.

Regulatory Implications and the Future of DeFi

The settlement between the SEC and Rari Capital brings attention to the growing focus of US regulators on the decentralized finance industry. While DeFi protocols operate without intermediaries, the SEC’s actions demonstrate that traditional financial regulations, such as securities laws, may still apply to decentralized platforms offering investment products.

Rari Capital’s case shows the importance of transparency and compliance in DeFi. As the industry continues to mature, regulators are likely to increase their scrutiny of DeFi projects, particularly those that promise financial returns to investors. The SEC’s move to penalize Rari Capital for unregistered securities offerings and broker activity sends a clear message to the broader DeFi community: operating outside the bounds of existing regulations will not be tolerated.

For investors, the case serves as a reminder of the risks associated with DeFi platforms, especially those that make bold claims about their functionality or yield-generating capabilities. The lack of regulatory oversight in many DeFi projects can leave investors vulnerable to mismanagement, hacks, or, in Rari’s case, misleading claims about how the protocol operates.

As the regulatory landscape evolves, DeFi protocols will need to carefully navigate compliance with securities laws, while maintaining the decentralized ethos that has fueled their growth. The SEC’s settlement with Rari Capital is unlikely to be the last regulatory action in the DeFi space, and it sets a precedent for how US regulators may handle future cases involving decentralized platforms.

Republican Lawmakers Criticize SEC’s ‘Politicized’ Approach to Crypto Regulation

In a heated House Subcommittee hearing on Sept. 18, Arkansas Representative French Hill, chairing the Subcommittee on Digital Assets, Financial Technology, and Inclusion, delivered a strong rebuke of the United States Securities and Exchange Commission (SEC) and its chair, Gary Gensler, for allegedly injecting politics into the regulation of the cryptocurrency industry. The hearing, aptly titled “Dazed and Confused: Breaking Down the SEC’s Politicized Approach to Digital Assets,” illuminated growing tensions between lawmakers and the regulatory body over the direction of US crypto policy.

Rep. Hill claimed that Gensler’s handling of digital assets has resulted in “confusion and uncertainty” across the market. His criticism was echoed by other Republican lawmakers, many of whom accused the SEC of enforcing regulation in a way that stifled innovation in the cryptocurrency sector. Hill emphasized that while many legislators, both Republican and Democrat, support the enforcement of laws against bad actors in the crypto space, the SEC’s enforcement-first approach was making it harder for legitimate firms to innovate and follow the rules.

Pushing for Regulatory Clarity

In his remarks, Hill endorsed the Financial Innovation and Technology for the 21st Century Act (FIT21), which is currently making its way through Congress. The proposed legislation aims to establish clearer rules for digital assets and create a more defined regulatory framework for the burgeoning industry. According to Hill, this approach would bring much-needed clarity to the market while allowing the United States to maintain its leadership in financial innovation.

“[…] the pro-FIT21 and pro-regulatory framework views of the majority and many bipartisan members do not mean we’re against the SEC going after bad actors or modernizing existing rules to incorporate digital asset securities and other unique instruments,” Rep. Hill said. “We’re against SEC enforcement abuse and making it hard for legitimate actors who are trying to follow the rules to do a fine job and bring innovation and technology to our markets.”

Hill’s comments are part of a growing sentiment among many in Congress that the current regulatory environment, as managed by the SEC, is inconsistent and overly punitive, especially toward smaller crypto firms that lack the resources to navigate a complex regulatory landscape.

The subcommittee’s ranking member, Democrat Stephen Lynch, pushed back against claims that the SEC was politicizing crypto regulation. He argued that if anyone was playing politics, it was the crypto industry itself, pointing to millions of dollars funneled into congressional campaigns by pro-crypto interest groups in advance of the 2024 election cycle.

“If anyone is playing politics, it is the crypto industry,” Lynch remarked during the hearing, accusing the sector of using its financial clout to resist regulations. Lynch also emphasized the risks associated with the current state of digital assets, stating that much of the industry has collapsed, leaving behind sectors that continue to facilitate illicit activity.

Rep. Lynch went on to criticize the Republican focus on regulating digital assets, arguing that lawmakers were spending valuable time on a small portion of the financial sector rather than focusing on more pressing issues. He also took a shot at former President Donald Trump’s foray into the crypto space, calling it an “ill-conceived venture” aimed at leveraging crypto hype ahead of the upcoming presidential election.

In addition to the heated back-and-forth between lawmakers, the hearing featured testimony from two prominent former SEC officials: Dan Gallagher, a former SEC commissioner now with Robinhood, and Michael Liftik, a former acting enforcement chief at the commission. Both echoed calls for more legislative action to rein in what they described as the SEC’s “regulation by enforcement” approach.

Gallagher argued that the SEC’s reliance on enforcement actions rather than clear rulemaking had created an unpredictable environment for crypto firms. He stressed that Congress needs to step in to address the gaps in regulatory clarity and ensure that the US remains competitive in the global digital asset market.

Liftik shared similar concerns, warning that the current approach could stifle innovation and make it harder for the US to retain its position as a leader in financial technology. Both former officials emphasized that without legislative action, the SEC’s inconsistent enforcement would continue to undermine confidence in the industry.

Divided Opinions on Gensler’s Leadership

North Carolina Representative Wiley Nickel, a Democrat, added to the criticism of SEC Chair Gary Gensler, calling his approach to crypto regulation “politicized” and “downright wrong.” Nickel accused Gensler of harming consumers, stifling innovation, and damaging the competitiveness of the US economy.

Earlier this year, Nickel co-authored a letter to Democratic National Committee Chair Jaime Harrison, urging Vice President Kamala Harris to take steps to change the perception that the Democratic Party holds a negative view of digital assets. Nickel and other pro-crypto Democrats have expressed concerns that the party’s stance on crypto regulation could alienate younger, tech-savvy voters and hinder the growth of the industry in the US.

“[Gensler is] hurting consumers, innovation, American competitiveness, and the Democratic administration,” Rep. Nickel stated during the hearing.

The hearing took place just 48 days before the 2024 US election, adding a layer of political intrigue to the debate. Depending on the election’s outcome, control of the House Financial Services Committee and the subcommittee on digital assets could shift from Republican to Democratic hands by 2025. Given this potential change, lawmakers on both sides are keen to stake out positions on crypto regulation that will resonate with their voters.