A recent action brought by the U.S. Securities and Exchange Commission (“SEC”) against a former Coinbase employee for insider trading in crypto tokens (the “Wahi Action”) highlights the lack of certainty surrounding the regulatory treatment of digital assets. While the SEC has previously sought to exert its authority over digital assets by targeting issuers, this signifies a more aggressive approach to enforcement that could have significant implications for investment advisers and other regulated entities. This update examines the consequences of the action for those seeking to structure compliance programs and product offerings against a backdrop of enhanced SEC scrutiny.
Background
The SEC’s complaint (issued against former Coinbase product manager Ishan Wahi, his brother, and a friend) alleges insider trading ahead of multiple announcements with respect to 25 crypto assets made available for trading on the Coinbase platform. The complaint charges the group with violating the antifraud provisions of the securities laws and seeks permanent injunctive relief, disgorgement with prejudgment interest, and civil penalties. In a parallel action, the U.S. Department of Justice issued criminal charges alleging wire fraud conspiracy and wire fraud in connection with insider trading, but notably did not allege securities fraud. While the SEC has previously issued enforcement action against digital asset issuers in connection with unregistered securities offerings, this matter represents a more expansive approach by the SEC in applying federal securities laws to activities involving digital assets.
Securities Analysis
At the heart of the Wahi Action is the SEC’s assertion that nine of the tokens listed on Coinbase’s platform constitute an “investment contract” under the Howey test and so fall within the definition of a “security” under federal securities laws. Specifically, the SEC claims that the tokens “were offered and sold to investors who made an investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others.” The SEC cites extensive marketing efforts by each of the issuers, including the prospect of robust secondary market trading, that allegedly constituted a “crucial inducement to investors” to purchase the tokens in the expectation that their value would increase.
However, the securities analysis presented by the SEC is not yet settled law, and the action prompted a public rebuttal from Coinbase, stating that it “does not list securities on its platform. Period.” Coinbase has argued that while “many may purchase digital assets with the hope of price appreciation, unlike traditional securities, digital assets typically have functional non-investment uses within a protocol-making them much more akin to real property, which is also often purchased with the hope of price appreciation, but nevertheless is fundamentally a commodity intended for usage.”
There is currently no consistent structure specific to the regulatory analysis of digital assets. The SEC has issued a “Framework for Investment Contract Analysis of Digital Assets,” which provides factors that may be considered in determining whether a digital asset might constitute an “investment contract,” but does not provide any bright line test that may be utilized. A recent bipartisan bill introduced by Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) would for the most part regulate digital assets as commodities subject to CFTC oversight but remains subject to a lengthy legislative process.
What Does This Mean for Market Participants?
Recent volatility in the crypto market, the failure of lenders such as Celsius, and the recent collapse of the TerraUSD stablecoin, highlight investor vulnerability and the need for guardrails in the space. The SEC remains undeterred in pursuing its mission of investor protection, with Carolyn M. Welshhans, Acting Chief of the Enforcement Division’s Crypto Assets and Cyber Unit stating that “whether in equities, options, crypto assets, or other securities, we will vindicate our mission by identifying and combatting insider trading in securities wherever we see it.” In May 2022, the SEC announced it was nearly doubling the size of the Crypto Assets and Cyber Unit within the Division of Enforcement.
Regulatory uncertainty, coupled with an aggressive enforcement posture from the SEC, creates a dilemma for registered investment advisers and other market participants when deciding how to treat digital assets in structuring products, and developing and monitoring compliance policies and procedures. Options include treating all digital assets as securities or making their own Howey determinations on specific assets as the need arises. The former approach raises administrative and operational challenges. Policies and procedures will likely need to be updated (e.g., insider trading, Code of Ethics and personal dealing), and the ability of third-party custody and valuation service providers to support digital assets would likely need to be reviewed. The cost of getting the latter approach wrong, however, is potentially significant given the stated objective and newly enhanced ability of the SEC to pursue actions against perceived bad actors in the crypto marketplace.
Conclusion
The SEC’s action has reignited the ongoing debate over the appropriate classification of digital assets. CFTC Commissioner Pham’s public criticism of the action indicates a lack of regulatory coordination, with both regulators seemingly keen to stake their claim in the digital asset landscape. With no clear path forward for the Lummis-Gillibrand bill, the most likely source of guidance around digital assets rests with the federal courts. However, the concurrent actions by the Department of Justice and the SEC create an uncertain timeline for resolution, and in the interim, market participants may want to balance the benefits of continued participation in crypto markets with potential regulatory exposure.
