In the long running question of whether cryptocurrency tokens are securities, the Securities and Exchange Commission (the “SEC”) has volleyed new claims against a former employee of Coinbase Global, Inc. (“Coinbase”), alleging insider trading of securities listed on the exchange. The SEC filed a complaint on July 21, 2022, claiming the former employee and his brother and friend traded on inside information relating to tokens about to be listed on the Coinbase exchange, one of the largest digital asset trading platforms. SEC v. Ishan Wahi, Nikhil Wahi and Sameer Ramani (“Wahi”). In the complaint, the SEC notably refers to certain investment contracts tied to cryptocurrency as “crypto asset security” meeting the Howey test. Without the SEC’s interpretation of the tokens or the contracts associated with the tokens as securities, the SEC would have no statutory authority to bring an action alleging insider trading.

Prior to the filing of Wahi, despite industry requests for rulemaking and clarification, the SEC has made no direct statements as to whether cryptocurrency or tokens are a “security.” Of significant relevance are the facts that (i) Coinbase claims no digital assets listed on its exchange are securities, and (ii) the issuance of a security requires, among other things, registration (or exemption from registration) with the SEC prior to the offer and sale thereof, disclosure of material information to potential investors, and trading restrictions following issuance: requirements which Coinbase and issuers of tokens on the platform almost certainly did not believe applied to them.

Shortly after the lawsuit was filed, Paul Grewal, Chief Legal Officer of Coinbase, came to the vociferous defense of his company on Twitter, stating “Coinbase doesn’t list securities. Period.” Grewal also published an article on the company’s website, explaining that Coinbase has a review process to analyze each digital asset before listing on the platform, “a process that the SEC itself has reviewed.” Significant to Coinbase, which was not named as a defendant in Wahi, if tokens traded on Coinbase are held to be securities, the company could face charges of being an unlicensed broker dealer, as a platform facilitating the exchange of securities must register with the SEC as a broker-dealer and comply with ongoing reporting requirements.¹

By making allegations designating the digital assets on Coinbase as securities, the SEC has chosen a well-capitalized opponent. The issues raised are so fundamental to the underlying business of Coinbase that it will likely be a long time before this issue is resolved , short of Congress acting in the meantime.

In a separate action, a federal grand jury indicted the very same defendants. In the indictment, the U.S. Department of Justice (the “DOJ”) makes no allegations of violations of the federal securities laws but, instead, charges the defendants with wire fraud by making trades using confidential Coinbase information about which cryptocurrencies were scheduled for listing. The DOJ’s choosing wire fraud over securities fraud as the charged crime, shows the uncertainty regarding the place of digital assets in the current regulatory framework.

As noted above, in categorizing the tokens as a security, the SEC’s complaint makes reference to the Howey Test², under which a digital asset, including a “crypto asset security” will be deemed a security “if it constitutes an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others.” The DOJ’s complaint alleges that “the defendants made illegal trades in at least twenty-five different crypto assets and realized ill-gotten gains totaling approximately $1.5 million.” The SEC’s complaint claims that at least nine of the 25 crypto assets were “crypto asset securities,” and therefore the defendants’ insider trading of securities fell within the SEC’s “broad jurisdiction to regulate the securities markets and to bring actions for violations of the federal securities laws, including fraud and insider trading.”

Notably, the SEC claims that because the “securities were offered and sold by an issuer to raise money that would be used for the issuer’s business,” and “the issuers and their promoters solicited investors by touting the potential for profits to be earned from investing in these securities based on the efforts of others” and made statements regarding “the ability for investors to engage in secondary trading of the token, with the success of the investment depending on the efforts of management and others at the company,” the factors in the Howey Test were satisfied and the nine tokens at issue are securities.

As a note of caution to token developers and exchange platforms, the SEC in Wahi makes light of issuers who “wrote ‘white papers’ describing the project and promoting the offering. . . made public statements on platforms such as Twitter, Medium, and YouTube” and emphasized the “critical role that executives and others at the company played in turning the company into a success, thereby increasing the value of the crypto asset security.” Because of these “representations by issuers and their management teams regarding 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. . . 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.” At face value, the characteristics of these offering communications and tokens satisfy the Howey Test, and, depending on the judicial outcome, Wahi may have broad implications for the future of digital token listings and offerings.

None of the issuers of the nine “crypto asset securities,” or Coinbase itself, are named as a defendant in Wahi as this is an insider trading case. Issuers and exchanges of tokens should take caution, however, as the SEC’s stance in Wahi reiterates the SEC’s a broad view of digital assets as securities and its ability to regulate them.

_{¹ This case also raises a public policy question about what to do when an employee takes actions where its employer and a regulator are at odds over the legal conclusion of the products being sold. To be liable for insider trading, the underlying tokens must be securities. Coinbase has always claimed that it does not make a market in securities, and it is possible that Wahi was using that conclusion to inform his token trading practices. Possibly expecting this unfairness argument to be raised by the defense, the complaint notes that insider trading of tokens pre-announcement and pre-launch on the Coinbase platform is also prohibited by the Coinbase employee code of conduct, irrespective of the legal status of tokens as securities.}

_{² Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).}