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The Crypto Winter Of Discontent Gets Colder With First Of Its Kind Insider Trading Charges – Fin Tech

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As market and regulatory uncertainty swirl around
cryptocurrencies and other digital assets, the Securities and
Exchange Commission (the “SEC”) and the Department of
Justice (the “DOJ”) have taken divergent approaches to
charging digital asset insider trading. For its part, the SEC, in a
recent enforcement case, asserts jurisdiction over certain
cryptocurrencies as “securities” and brought traditional
insider trading charges under Section 10(b) of the Securities
Exchange Act and Rule 10b-5 promulgated thereunder.1 The
DOJ, however, has avoided “securities” designations
altogether by using wire fraud and other non-securities criminal
charges to pursue insider trading related to a variety of digital
assets including non-fungible tokens (“NFTs”) and
cryptocurrencies.2 Prior to June 1, 2022, the DOJ’s
use of wire fraud to combat insider trading of digital assets may
have seemed “novel.” However, the DOJ has recently
adopted the approach that regardless of the underlying instrument
(NFTs, debt, cryptocurrencies, insurance products or any other
non-security product), it is willing to bring fraud charges where
it believes it can prove trading based on fraudulently obtained
confidential information. 3

The divergent SEC and DOJ approaches played out on July 21,
2022, when the SEC and DOJ filed parallel insider trading cases
against a former Coinbase Global, Inc. (“Coinbase”)
employee (Ishan Wahi), his brother (Nikhil Wahi) and a friend
(Sameer Ramani).4 Both cases are based on the
defendants’ trades in digital assets that were slated for
listing on Coinbase before the listing announcements were made
public. The DOJ Indictment—the first cryptocurrency insider
trading case brought by the DOJ —bypassed the “are
they” or “aren’t they” securities question by
charging the trio of defendants with conspiracy and wire fraud for
allegedly insider trading in six digital assets before they were
listed on Coinbase (including two that the SEC considers
securities).5 The SEC’s Complaint, however, alleges
that nine of the so-called crypto assets at issue are in fact
securities under SEC v. W.J. Howey Co., 328 U.S. 293,
298-99 (1946) (“Howey“).6

The unspoken implication of the SEC’s Complaint is that by
listing the nine digital asset “securities” on its
exchange, Coinbase engaged in the offering of unregistered
securities. After the filing of the DOJ and SEC insider trading
charges, it was reported that Coinbase is the subject of an SEC
investigation related to listing unregistered securities.
Coinbase’s Chief Legal Officer, Paul Grewal declared, in
response to the SEC Complaint, that “Coinbase does not list
securities on its platform. Period.”7 In a Petition
for Rulemaking (the “Petition”), also filed on July 21,
Coinbase criticized the lack of guidance from the SEC regarding
digital assets and offered a roadmap to the SEC for crafting a
regulatory framework tailored to digital assets.8 In its
Petition, Coinbase called out the SEC for failing to
“constructively engage with digital asset market participants
on the design of a workable regulatory framework” and asked
that the SEC “propose and adopt rules to govern the regulation
of securities that are offered and traded via digitally native
methods, including potential rules to identify which digital assets
are securities.”9 The Petition also offers some
suggestions, and invites others to do the same, in carving a
regulatory path forward including: (1) a critical analysis of the
challenges of applying existing rules to digital assets (for
example, digital assets are not well suited for purchase and sale
in a broker-intermediary model); (2) clear delineation between
which digital assets are securities and which ones are not so that
issuers and purchasers are not confused; (3) disclosure
requirements tailored to the unique features of digital assets; and
(4) real-time settlement of digital asset transactions to maintain
the pace digital asset investors expect.10

Both the SEC’s Complaint and the DOJ’s Indictment
reflect the different approaches that enforcement authorities are
taking in prosecuting potentially fraudulent trading in digital
assets. But neither action definitively answers the question of
when securities laws might apply to digital assets and when they
might not.

When Are Digital Assets Securities?

The insider trading scheme alleged by the SEC and DOJ is
straightforward. Ishan Wahi was a manager in Coinbase’s Assets
and Investing Products group. He allegedly tipped his co-defendants
with non-public information identifying digital assets to be listed
by Coinbase and when they would be listed. The two co-defendants
purchased the digital assets before each were listed and sold them
(at a profit) in heavy trading that followed the announcement of
their listing.11 Although the SEC’s Complaint refers
to 25 different crypto assets purchased as part of the alleged
scheme, only nine digital assets are specifically identified as
securities for the purposes of the insider trading
charges:12

  • AMP (created by Flexa Network, Inc.)

  • RLY (created by Rally Network, Inc.)

  • DDX (associated with the DerivaDEX protocol)

  • XYO (created by XY Labs, Inc.)

  • RGT (originally minted by Rari Capital)

  • KROM (issued by Kromatika Finance)

  • LCX (created by Liechtenstein Cryptoassets Exchange)

  • POWR (issued by Power Ledger Pty. Ltd.)

  • DFX (issued by DFX Finance).

These nine digital assets run the gamut of token types. For
example, according to the SEC’s analysis, RLY is a governance
token that provides holders with voting power “over the
development and structure of the business, including the right to
propose changes.”13 XYO tokens function as a form
of currency to pay others that operate in the XY
ecosystem.14 And POWR tokens are described as an
“asset token” used on the Power Ledger platform and from
which users will receive a portion of revenue.15

The Complaint highlights the SEC’s position that the nine
digital assets at the center of its case satisfy the Howey
investment contract test because each asset at issue
“constitutes an investment of money, in a common enterprise,
with a reasonable expectation of profit derived from the efforts of
others.”16 As to the first and second prongs of the
Howey test – an investment of money in a common
enterprise – the Complaint alleges that “each of the
nine crypto assets securities were offered and sold by an issuer to
raise money that would be used for the issuer’s business. In
the offerings, the issuers directly sold crypto asset securities to
investors in return for consideration . . .”17

For example, AMP token holders “stake Amp into pools that
secure the network” and “[i]f the collateral pools are
profitable, investors who stake Amp can share in the
profits.”18 In the case of RGT, “funds raised
from RGT investors were pooled to raise capital and develop the
Rari protocol. . . [and] funds raised from the liquidity mining
program would go towards, among other things, developing additional
Rari products and the Rari protocol.”19 In another
example, the LCX token was marketed as a “chance to be a part
of LCX’s vision to bridge the gap between traditional finance
and the new monetary world powered by blockchain and
cryptocurrencies.”20 Notably, the features of the
nine digital assets, though not identical, include tools like
staking, liquidity mining, governance and voting and ecosystem
building that are common features in decentralized finance
platforms.

On the third Howey prong – reasonable expectation
of profit derived from the efforts of others – the Complaint
alleges that for each of the nine digital assets, the “issuers
and their management teams [addressed] the investment value of the
tokens, the managerial efforts that contribute to the tokens’
value, and the availability of secondary markets for trading the
tokens . . . [such that] a reasonable investor in the nine crypto
asset securities would continue to look to the efforts of the
issuer and its promoters, including their future efforts, to
increase the value of their investment.”21

The allegations of the SEC’s Complaint emphasizes that each
of the nine digital assets was promoted as a “profit
opportunity” to holders or that it could be traded on
secondary platforms, like Coinbase.22 For example, DDX
holders could “stake” their DDX “to a DerivaDex
‘insurance fund’ . . . [and] contribute their DDX tokens to
the fund, creating liquidity that could be used to insure parties
if a transaction fails. As the insurance pool grows and earns fees,
participants who staked their DDX may receive additional DDX tokens
and thereby greater opportunities to profit.”23
Similarly, KROM holders were permitted to stake their tokens to the
Kromatika platform and earn, “a revenue share from the fees
that are charged for using the Kromatika
platform.”24 Again, while the “profit”
features of the nine digital assets are not identical, they cover
“earnings” features associated with many digital assets
currently available including, staking rewards, waived fees for
transactions in the “ecosystem,” lock up rewards and pool
rewards.

Implications for the Digital Asset Marketplace and Beyond

As a practical matter, any determination (and therefore,
clarity) by a court whether the nine digital assets in the
SEC’s Complaint are securities under federal securities laws
will require patience that may never be rewarded. With pending
criminal charges against three defendants, the SEC proceedings
could be temporarily stayed while the DOJ and defendants focus
resources on addressing the criminal charges. And beyond the
allegations of the Complaint, the SEC offers no broader guidance as
to the designation of these specific nine assets — or any
other digital assets — as securities. Commissioner Caroline
D. Pham of the Commodities Future Trading Commission observed that
the Complaint is “a striking example of regulation by
enforcement . . . [with] broad implications beyond this single
case, underscoring how critical and urgent it is that regulators
work together.”25 In short, there is unlikely to be
any near term resolution of the SEC’s Complaint that would
quell the uncertainty surrounding regulatory treatment of digital
assets, making requests for guidance from regulators increasingly
urgent.

In the interim, issuers of digital assets, particularly digital
assets bearing any resemblance to the nine now characterized by the
SEC as “securities” are left to grapple with an uncertain
regulatory landscape. Coinbase and other exchanges likely must
decide whether to delist similar digital assets. And issuers and
exchanges alike are potentially weighing options to defend against
allegations of unregistered securities offerings.

The implications of both the SEC’s case and the DOJ’s
case should prompt everyone who engages with digital assets to
pause. For example, other similarly situated issuers of digital
assets should consider whether the SEC could make the same
securities case against their digital assets. Exchanges, lending
platforms and broker-dealers might want to assess whether they need
to re-categorize the digital assets that they are listing. As the
SEC ramps up enforcement activity in this area, investment advisers
should reassess their existing analyses regarding the impact on
their clients and operations of treating cryptocurrencies as
securities – particularly with respect to insider trading,
personal trading and Custody Rule compliance. Treatment of certain
digital assets as securities could materially impact liquidity in
the U.S. and elsewhere, and advisers should consider the potential
impacts on portfolio management and whether existing risk
disclosures are adequate.

Footnotes

1. SEC v. Ishan Wahi, et al., No. 22-cv-1009
(W.D.W.A. July 21, 2022), available here (the “Complaint”).

2. United States v. Ishan Wahi, et al., No.
22-cr-392 (S.D.N.Y. July 21, 2022), available here (the “Indictment”); United
States v. Chastain,
No. 22-cr-305 (S.D.N.Y. June 1, 2022),
available here (the “Chastain Indictment”).
Charging insider trading of digital assets as wire fraud relieves
prosecutors from having to demonstrate that the digital asset at
issue is a “security” – a showing that would be
required for Section 10(b) and Rule 10b-5 liability.

3. For further discussion, see SRZ Securities
Enforcement Quarterly,
August 2022, available here.

4. SEC Charges Former Coinbase Manager, Two Others in
Crypto Asset Insider Trading Action
, SEC Press Release 22-127,
July 21, 2011, available here. Three Charged in First Ever
Cryptocurrency Insider Trading Tipping Scheme
, DOJ Press
Release 22-232, July 21, 2022, available here.

5. See supra 2, the Indictment.

6. See supra 1. The Complaint refers to
“crypto asset security” as “an asset that is issued
and/or transferred using distributed ledger or blockchain
technology – including, but not limited to, so-called
“digital assets,” “virtual currencies,”
“coins,” and “tokens” – and that meets
the definition of “security” under federal securities
laws.” Id. at 2.

7. Paul Grewal, Coinbase Chief Legal Officer,
Coinbase does not list securities. End of story., July 21,
2022, available here.

8. Petition for Rulemaking- Digital Asset Securities
Regulation
, July 21, 2022, available here.

9. Id. at 1-2.

10. Petition at 5-7.

11. See generally the Complaint and
Indictment.

12. Complaint at 3, 22-59.

13. Id. at 28-30.

14. Id. at 35-39.

15. Id. at 48-52.

16. Id. at 8.

17. Id. at 22.

18. Id. at 25.

19. Id. at 40.

20. Id. at 45.

21. Id. at 23.

22. Id. at 22-59.

23. Id. at 34-35.

24. Id. at 57-59.

25. Statement of CFTC Commissioner Caroline D. Pham on
SEC v. Wahi, July 21, 2022, available here.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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