Recently the SEC filed suit for insider trading of securities against a high-level employee at the popular crypto exchange, Coinbase. The SEC filed its civil suit in Seattle on July 22, 2022, against and his co-conspirators. On the same day, the DOJ announced the unsealing of a federal indictment against the same defendants in the Southern District of New York.[i] The following discusses the allegations and draws conclusions regarding the implications for the crypto industry.
Both crypto exchanges and issuers of tokens, should take heed of this development. Beyond the intrigue and drama, the facts of the case are instructive regarding the legal quagmire faced by many crypto industry participants. The relevant coins appear to have been designed to avoid definition as a security. Apparently, Coinbase’s due diligence and analysis agreed that the relevant tokens are not securities.
Many industry observers and participants are shocked. However, the SEC’s press release firmly states that the SEC “is not concerned with labels” but instead focuses on “economic realities.” In fact, the Securities Act and the Exchange Act and the cases interpreting those statutes furnish broad and sweeping definitions of investments that constitute securities. And unless Congress acts to modify the existing legal framework, doing business as usual may be akin to crossing a minefield for many crypto businesses.
Wahi leaked secret information to outside confidants regarding the prospective listing of at least 25 crypto assets on Coinbase who would then purchase large quantities of the tokens. Shortly after their listing, the group would sell the tokens, profiting quickly from the so-called “Coinbase bump” or “Coinbase effect,” an increase in the token’s trading value due to the additional liquidity from listing. The SEC complaint asserts that 9 of tokens traded by the co-conspirators are securities. It does not address whether the other digital assets may also qualify as securities.
The conspiracy was eventually discovered after a prominent crypto influencer tweeted information regarding a suspicious purchase in advance of a Coinbase listing. The tweet apparently led to a federal investigation and an internal investigation by Coinbase, which resulted in the discovery of the conspirators’ conduct previously concealed by a “web of crypto accounts” and digital wallets, including under other people’s names. The DOJ’s press release noted Coinbase’s assistance with the investigation. Both the indictment and the SEC complaint noted the efforts of Coinbase to implement an effective insider trading policy.
Things came rapidly unwound for Mr. Wahi and company when Coinbase’s Director of Security Operations sent him a message asking him to meet with “legal” the next day in connection with the investigation. Instead of attending the meeting, Wahi lied about having had to fly home to India for family reasons. That same day, law enforcement apprehended him attempting to board a flight to India. He had a one-way ticket, three large suitcases, and lots of personal belongings.
Although only Wahi and his co-conspirators are defendants, Coinbase and other industry participants are deeply concerned about the case. Coinbase and each issuer could face significant liability if in a separate proceeding against them, a court finds that the tokens are securities as alleged. Thus, the SEC’s charges of securities fraud against Wahi and the other defendants may represent a strategic step towards establishing a judicial precedent that at least some of the tokens traded on Coinbase are securities. Additionally, the charges may signal a newfound enthusiasm for the pursuit of securities-related actions against crypto exchanges and coin issuers.
How are the DOJ and SEC Proceedings Different?
There are several important differences between the DOJ’s Indictment and the SEC’s complaint. The differences exceed the application of the “beyond a reasonable doubt” standard of proof in the criminal proceeding and the “preponderance of evidence” standard in the civil case. They illuminate several important points about what the SEC complaint could mean for the crypto industry in general and, more specifically, for Coinbase and the companies whose tokens are listed on Coinbase.
These differences include the theory of the case, the scope of facts alleged, and the venue of the proceeding. The DOJ case focuses on the wire fraud aspects of the defendants’ conduct. In the SEC’s case, the issue of whether the defendants traded securities takes center stage.
- The Theory of each Case
Securities fraud cases for insider trading are more complex and require evidence on more elements than wire fraud cases.[ii] Whether civil or criminal, these cases require proof that at least one of the assets transacted was a security. And because tokens are not “per se” securities, the SEC must establish that each token in question is covered by the Securities Act by application of the Howey test, which is addressed below. The criminal indictment only asserts wire fraud and ignores issues regarding whether the crypto assets are securities. These differences are reflected in the length and factual complexity of the Complaint, which is 62 pages, about 40 pages longer than the DOJ indictment. Most of the additional length results from the allegations that several of the relevant crypto assets are securities.
- Venue of the Proceedings
A second difference is that the venue rules relevant to wire fraud match its narrow focus on the use of wires. Consequently, the scope of venues that can serve as permissible locations for trial may be broader in wire fraud cases. The criminal indictment does not address detailed facts regarding venue. But it seems probable that the defendant’s used wires that “contacted” New York. In contrast, any securities fraud charge would probably not have been proper in New York, as venue would be appropriate only where an act or transaction comprising the substantive violation occurred. See United States v. Lange, 834 F.3d 58, 68-71 (2d Cir. 2016) (citing 15 U.S.C. § 78aa(a)).
Nevertheless, it’s not clear why the DOJ brought the case in New York when the core facts involved actions of two co-conspirators in Seattle. This may reflect a policy decision to signal serious determination in policing crypto asset markets by the DOJ. The U.S. Attorney’s Office of SDNY is generally considered the most expert office in financial crimes in the nation.
- The SEC’s Securities Allegations
The SEC complaint states specific facts to show why each of the 9 tokens meets the Howey test for determining “investment contracts,” which are defined as securities. With considerable detail, after addressing the defendants’ scheme, the complaint delves into facts surrounding the relevant coin offerings and into later statements by their issuers.
Coinbase’s Director of Policy drafted a blog responding to the SEC’s allegations and maintaining that Coinbase does not list securities. Many of the relevant tokens could be used only to purchase services within the issuers’ networks. Others were purportedly controlled by decentralized autonomous organizations (i.e., without centralized management). Some industry participants believe these design elements keep coins from being defined as securities.
Nevertheless, the SEC alleges that the tokens meet the Howey test’s definition of a security. The SEC’s complaint is a case study (in fact 9 case studies) in how its staff apply the Howey analysis to crypto tokens. The detailed allegations assert facts that, if proved, purport to show that the purchase of each token by investors constituted an investment of money in a common enterprise with a reasonable expectation of profit derived from the efforts of others.
(a) Investment of Money in Common Enterprise
Acts that the SEC complaint argues meet this element of the test include:
- Staking of tokens in collateral pools or “insurance funds,” which if profitable, would yield profits for the investors.
- Pooling tokens in a community treasury and use of the proceeds to fund and expansion of the issuer’s management team and to improve the network.
- Issuing coins to the management team in addition to investors.
- Locking of management’s coins into a “vault” to show management’s “commitment.”
- Dedicating coins to liquidity mining to improve the profitability of secondary trading.
- Using token revenue to build the underlying network or protocol.
(b) Reasonable Expectation of Profits from the Efforts of Others
The SEC found alleges that the following facts demonstrate a reasonable expectation of profit from the efforts of management:
- Promoting the token as means for accruing value in connection with a network.
- Promising purchasers they would benefit from fee revenue.
- “Burning” of tokens to increase the value of issued tokens.
- Claiming a token’s price increase is linked to demand for staking yield, spending utility and expectation of future growth.
- Offering purchasers the opportunity to make money from “staking” their tokens.
- Touting the availability of trading on secondary trading platforms.
- Allowing purchasers to earn network rewards.
- Emphasizing the importance of a company’s founders or its management team to the network and the token, including for further development.
- Stressing the importance of protocol tokenomics to the value of a token and increased value from growth.
- Highlighting to purchasers expected or realized improvements or partnerships and upgrades to the network.
- Management’s control of collateral pools.
- Facilitating and promoting the listing of tokens on secondary exchanges.
- Promoting a token’s value as an investment, even if just from secondary trading.
- Efforts to limit price dilution of a token or to limit supply to increase value.
- Promising or promoting potential returns for investors.
- Management’s practical control of decisions, even in “decentralized” protocols.
- Saving of money by investors in service fees (paid with in tokens), given the expected increase in a token’s value.
Coinbase & Industry Response
Coinbase has publicly argued that the SEC’s actions are inappropriately causing confusion regarding whether commodities or securities laws applies to crypto assets. As part of its response to these developments, the company published a petition to the SEC requesting a set of “workable” rules that would apply to “digital asset securities.” According to Coinbase, the SEC is usurping regulatory authority rightly or more properly exercised by the CFTC. Its view is grounded in the company’s position that Coinbase the crypto assets listed on its platform are commodities (and not securities). Consistent with this narrative, Coinbase supported the bringing of criminal charges against Wahi because front-running—a type of insider trading that applies to both commodities and securities trading—is illegal.
Many industry players desire a legal presumption that tokens designed for use as utilities or managed by decentralized autonomous organizations are commodities. The Coinbase position that the tokens are not securities appears mostly to reflect wishful thinking: the SEC has made no secret of its position that many (if not most) tokens are securities. It has released guidelines regarding the standards it would apply in finding that a digital asset is a security. As I noted in a prior blog, SEC Chair Gensler has opined publicly on several occasions that many of the tokens on Coinbase and other exchanges are securities.
Further, Coinbase has made much out of the fact the indictment didn’t charge securities fraud, implying that this reflects a DOJ conclusion that the crypto assets are not securities. But that conclusion does not follow necessarily. That decision may have been the result of venue issues and the filing of the case in New York (none of the operative facts substantiating fraud appear to have occurred in New York), the complexity of a securities fraud conviction for insider trading under 15 U.S.C. § 78j and rule 10b-5, or other strategic reasons in cooperation with the SEC. Indeed, the DOJs and SECs unsealing of the indictment and filing of the Complaint reveal that their investigations and court actions are coordinated.
Is There a Way Out for Crypto Exchanges & Coin Issuers?
For issuers of tokens and exchanges, the qualification of tokens as a security is a serious problem. Issuers of unregistered securities and participants who facilitate their sale face exposure to both civil and criminal liability, and potentially severe administrative fines. Crypto exchanges also face liability for facilitating sales of unregistered securities to the public and for failing to register as a broker-dealer and file a form ATS.
Unfortunately for investors, sanctions and penalties for securities violations can have devasting consequences for companies and, in turn, the value of their digital assets. Probably because of this concern, the SEC has signaled a way forward for digital assets that qualify as unregistered securities. This way forward appears to be settlements requiring registration of the assets with the SEC, the payment of fines, and offering reimbursement to investors of the funds raised. At present, the SEC’s enforcement actions seem designed to force the industry into compliance, rather than to cause severe disruptions.
For many companies, the way forward may be a pill too hard to swallow. In the meantime, coin issuers and crypto exchanges await rescue through passage of more crypto-friendly legislation such as the pending Lummis- Gillibrand Responsible Financial Innovation Act or the Digital Asset Market Structure and Investor Protection Act introduced last year by Congressman, Beyer.
[i] This blog only relays the assertions of the government and makes no representation regarding whether they are true.
[ii] For a guilty verdict in a criminal case for insider trading of securities, a jury would have to find that the prosecution proved that (1) the defendants organized a scheme that used the instrumentalities of interstate commerce (e.g., electronic messages or phone calls), (2) with intent to defraud, (3) using confidential information that Wahi had a duty to protect (4) but that he wrongfully disclosed to recipients (5) who despite knowing of his duty (5) used the information to trade securities (6) benefiting all of the defendants. See Salman v. United States, 137 S. Ct. 420 (2016). To establish wire fraud, the DOJ merely has to prove “(1) a scheme to defraud, (2) money or property as the object of the scheme, and (3) use of the mails or wires to further the scheme.” See United States v. Binday, 804 F.3d 558, 569 (2d Cir. 2015). “Wires” refers to electronic or telephonic communications.