The Securities and Exchange Commission (the “SEC”) on July 21, 2022, filed a complaint (the “SEC Complaint”) alleging insider trading violations against an insider, his brother, and a friend, claiming that the trio engaged in a scheme to trade digital assets using material, nonpublic information about Coinbase’s asset listing process.1 Showing the coordinated nature of their enforcement activities, the SEC’s action accompanied a criminal indictment by the United States Attorney’s Office for the Southern District of New York (“SDNY”), charging the same defendants with conspiracy and wire fraud in connection with their alleged insider trading of the same digital assets.2 These dual actions underscore an increased (and coordinated) enforcement focus on the digital assets industry by both regulators and prosecutors. Furthermore, as watershed cases, these matters will likely play a major role in shaping the future of this industry.
- Citing its broad jurisdiction to regulate securities markets, including the market for digital assets qualifying as securities,3 the SEC’s most recent enforcement case in the digital assets space underscores that the SEC may be positioning itself for a more aggressive role in regulating digital asset markets.
- Unlike the DOJ, which avoided the issue of whether digital assets are securities by charging conspiracy and wire fraud, notably, the SEC Complaint took on the issue head on by asserting that the nine digital assets at issue are investment contracts (and, therefore, securities) under the so-called Howey test4 established by the U.S. Supreme Court in SEC v. W.J. Howey Co.5:
- Amp (AMP);
- DerivaDAO (DDX);
- DFX Finance (DFX);
- Liechtenstein Cryptoassets Exchange tokens (LCX);
- Kromatika (KROM);
- Rally (RLY);
- Rari Governance Token (RGT);
- Powerledger (POWR); and
- Developments in this case will provide much-needed clarity on the key question of whether (or when) certain digital assets qualify as securities, and a ruling affirming the SEC’s position would re-emphasize the agency’s jurisdiction over digital assets that are securities and alter the commercial and regulatory risks associated with doing business within the digital assets market.
- The digital assets industry has thus far been sharply critical of the SEC’s action, arguing that the SEC is regulating by enforcement action rather than establishing a more fully developed regulatory framework through the traditional administrative rulemaking process. In a highly unusual public critique, Commodity Futures Trading Commission (“CFTC”) Commissioner Caroline Pham has likewise criticized the SEC’s action.
The SEC Complaint alleges that, from June 2021 through April 2022, an insider, who previously worked at digital asset platform Coinbase, repeatedly tipped his brother and friend with inside information about certain digital assets that would soon become available for trading on the platform. The brother and friend then allegedly traded in at least 25 different digital assets on the basis of that inside information, realizing more than US $1.5 million in profits.6 As the SEC Complaint notes, the secondary market value of digital assets often appreciates significantly upon announcement of a digital asset’s listing on a major trading platform; inside information as to the identity of new digital assets being listed, or the timing of a listing, can be particularly sensitive due to the potential exploitation of this secondary market effect. The SEC alleges that because the defendants had misappropriated material, nonpublic information, their trades violated federal insider trading provisions under the Securities Exchange Act of 1934, as amended.7
As a threshold matter, however, the SEC’s insider trading claims require that the specific digital assets in question are, in fact, securities. The SEC analyzes digital assets under its 2019 “Framework for ‘Investment Contract’ Analysis of Digital Assets” (“Framework”), which applies the traditional Howey test to the digital asset context and enumerates a range of non-exclusive characteristics that may shape whether a given digital asset is deemed an investment contract. The SEC Complaint applies many of the Framework principles to assert that nine of the 25 digital assets involved in the alleged scheme were investment contracts (and, therefore, securities). This includes identifying structural characteristics and marketing behaviors suggesting an investment contract within the meaning of the Howey test. For example, the characteristics identified in the SEC Complaint include:
- statements suggesting that digital assets were sold to fund a digital asset project’s development;
- statements indicating centralization of a digital asset project;
- statements describing the digital asset to prospective purchasers as an attractive investment opportunity, emphasizing the potential for asset appreciation;
- statements emphasizing the role of certain key personnel in the success of a digital asset project; and
- statements highlighting the ability to trade a digital asset on secondary trading platforms.
The SEC’s involvement in this case has attracted criticism from both industry participants and other financial regulators, who have expressed concerns that this case appears to be an intentional effort by the SEC to seek to expand its jurisdiction over digital assets. Coinbase issued a public statement emphasizing that it does not list securities on its platform and encouraging the SEC to engage in rulemaking rather than rely on enforcement actions.8 Likewise, CFTC Commissioner Chairman Caroline Pham took the highly unusual step of releasing a public statement criticizing the SEC’s decision to initiate this action, characterizing the case as a “striking example of regulation by enforcement.”9
In its press release regarding the case, the SEC’s Division of Enforcement Director, Gurbir S. Grewal, advised that the agency is “not concerned with labels, but rather the economic realities of an offering... In this case, those realities affirm that a number of the [digital] assets at issue were securities, and, as alleged, the defendants engaged in typical insider trading ahead of their listing on Coinbase.”10
As discussed in a recent OnPoint, the SEC has increased its scrutiny of the digital assets industry, doubling the size of its Crypto Assets and Cyber Unit,11 and reportedly inquiring into alleged insider trading policies and procedures within prominent digital asset exchanges.12
The SEC’s involvement in this case provides valuable insights as to the agency’s current enforcement priorities and thinking, its focused areas of concern within the industry, and the potential for additional regulation of digital assets in the future.
- Change in Enforcement Approach. The SEC has been historically cautious about issuing statements or guidance specifying which digital assets are and are not securities. It is therefore notable that the SEC has asserted the securities status of nine digital assets in the context of insider trading enforcement claims brought against individuals. The SEC is currently litigating a similar issue in SEC v. Ripple Labs, where it has taken the stance that sales of the digital asset XRP by its issuer are unregistered securities offerings in violation of Section 5 of the Securities Act 1933, as amended.13 These various cases thus represent a change in the SEC’s enforcement approach on matters relating to digital assets.
- Investigation Strategies. In the insider trading case, we see the SEC and DOJ scouring social media, blockchain transactions, and publicly viewable wallet activities for evidence of insider trading. The SEC Complaint cites the defendants’ use of various messaging applications and foreign phones to allegedly conceal their communications and trading, while the indictment describes a Twitter account’s role in alerting government officials to the suspicious trading activity that prompted Coinbase’s internal investigation.
- Going forward, enforcement officials should be expected to continue to solicit the assistance of private companies to help regulate the industry. Businesses serving the digital asset industry should continue to strengthen their capacities to detect and respond to vulnerabilities in the uses of their platforms. They should also be prepared to respond to law enforcement requests (or demands) for information.
- Importance of strong internal controls. The insider trading case provides further proof, both to issuers of digital assets and to the exchanges on which those digital assets trade, that both regulators and criminal prosecutors are increasingly scrutinizing the actions of industry insiders and are doing so in a coordinated fashion. One effective way for issuers and exchanges alike to mitigate risks is to assess whether they have internal controls that are reasonably designed to prevent insider trading violations.
- It remains to be seen whether certain exchanges are ultimately required to register with the SEC under federal securities laws. Such an outcome would likely require implementation of additional policies and procedures, as well as enhancements to the compliance function. Given the stakes, we expect the threshold question of which, if any, digital assets qualify as securities to be extremely hard fought.
- Press Release, SEC Charges Former Coinbase Manager, Two Others in Crypto Asset Insider Trading Action, SEC (July 21, 2022), https://www.sec.gov/news/press-release/2022-127?utm_medium=email&utm_source=govdelivery [hereinafter SEC Press Release].
- United States v. Wahi, No. 22-cr-392 (S.D.N.Y. Jul. 21, 2022); Press Release, Three Charged In First Ever Cryptocurrency Insider Trading Tipping Scheme: Former Coinbase Employee Allegedly Tipped His Brother and Friend Regarding Crypto Assets That Were Going to be Listed on Coinbase Exchanges, S.D.N.Y. U.S. Dep’t of Just. (July 21, 2022), https://www.justice.gov/usao-sdny/pr/three-charged-first-ever-cryptocurrency-insider-trading-tipping-scheme.
- SEC v. Wahi, et al., No. 2:22-cv-01009 (W.D. Wash. Jul. 21, 2022) available at https://www.sec.gov/litigation/complaints/2022/comp-pr2022-127.pdf.
- SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
- Under the Howey test, an “investment contract” exists where there is (a) an investment of money, (b) in a common enterprise, (c) with a reasonable expectation of profit derived from the efforts of others.
- SEC Press Release, supra note 1.
- Paul Grewal, Coinbase does not list securities. End of story., COINBASE (July 21, 2022), https://blog.coinbase.com/coinbase-does-not-list-securities-end-of-story-e58dc873be79.
- Press Release, Statement of Commissioner Caroline D. Pham on SEC v. Wahi, SEC (July 21, 2022), https://www.cftc.gov/PressRoom/SpeechesTestimony/phamstatement072122.
- SEC Press Release, supra note 1.
- Press Release, SEC Nearly Doubles Size of Enforcement’s Crypto Assets and Cyber Unit, SEC (May 3, 2022), https://www.sec.gov/news/press-release/2022-78.
- Eleanor Terret, FOX BUS. (June 14, 2022), “SEC launches insider trading inquiry into crypto exchanges,” https://www.foxbusiness.com/markets/sec-inquiry-gensler-bitcoin-crypto-exchanges.
- See SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y. Dec. 22, 2020); Press Release, SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering, SEC (Dec. 22, 2020), https://www.sec.gov/news/press-release/2020-338.