SEC Approach In Wahi Presents New Challenges For Crypto | Proskauer Rose LLP

Government scrutiny of the crypto market has increased sharply in recent months on the criminal and civil enforcement fronts.

In parallel proceedings that will be seen in other digital asset contexts – such as in the traditional securities sphere – the US Securities and Exchange Commission has initiated civil actions against individuals who also face criminal charges brought by the US Department of Justice.

A recent guilty plea in US v. Wahi in the US District Court for the Southern District of New York, a crypto insider trading case, sets up an interesting situation where the defendants—who have already pleaded guilty to wire fraud—challenge the SEC’s parallel civil charges, and claims that the securities laws do not apply to the crypto-assets in question.[1]

Among other things, they have argued that secondary market trades involving crypto tokens are not securities transactions, regardless of whether crypto assets may have been considered investment contracts, and thus securities, at the time of issuance.

For the massive secondary crypto market ecosystem, this case has the potential to widen SEC jurisdiction or increase the space, depending on one’s point of view.

The Wahi charges

In a first of its kind, which will by no means be the last, the Department of Justice secured two guilty pleas of wire fraud against brothers who traded crypto assets based on insider information.

The trading scheme involved three people: Ishan Wahi, who worked at crypto exchange Coinbase Global Inc., his brother Nikhil Wahi and a friend, Sameer Ramani.

Together, the trio allegedly earned more than $1 million in illegal trading profits through a scheme to conduct timely, profitable trades in certain cryptoassets to be listed on Coinbase.

Ishan Wahi, a member of Coinbase’s asset listing team from June 2021 to April 2022, tipped off information about the listings to his brother and Ramani.

Because Ishan was involved in the process of listing cryptoassets on Coinbase’s exchanges, he had advance knowledge of which cryptoassets were slated to be listed and the timing of such announcements—sensitive information since the market value of such to-be-listed cryptoassets typically increased immediately after that Coinbase published its first public listing.

Unsurprisingly, these listing decisions were confidential, and Coinbase policy expressly prohibited employees from sharing such information with outside parties or providing a “tip” to any person.

The DOJ alleged that Ishan Wahi repeatedly tipped off the timing of upcoming listing announcements to Nikhil Wahi and Ramani, who then bought the assets before Coinbase made the official public announcement and sold them after the announcement at a substantial profit.

According to the indictment, the scheme involved at least 25 cryptoassets ahead of at least 14 separate Coinbase announcements of cryptoasset listings.

Following the arrest of Ishan and Nikhil Wahi, the DOJ’s indictment in July 2022 alleged two counts of fraud.[2] and two counts of conspiracy to commit wire fraud.[3] Notably, none of the indictments alleged insider trading under the securities laws, but instead alleged violations of the federal wire-fraud statute and did not use the term “security” to describe the crypto tokens at issue.

Both wahis have pleaded guilty. In September 2022, the DOJ announced that “tipper” Nikhil Wahi pleaded guilty to one count of conspiracy to commit wire fraud and was later sentenced in January to 10 months in prison and ordered to pay over $800,000 in forfeiture. On February 7, 2023, the DOJ announced that Ishan Wahi pleaded guilty to two counts of conspiracy to commit fraud—he has yet to be sentenced.

While allegations of insider trading involving securities are hardly unusual, the convictions represent the first criminal conviction for insider trading in the cryptocurrency market.

After Nikhil Wahi’s guilty plea in January, the U.S. attorney for the Southern District of New York said in a statement that the sentence “makes it clear that the cryptocurrency markets are not lawless.”

SEC civil insider trading charges

Meanwhile, the SEC continues to pursue a parallel civil case against the defendants based on the same scheme, a case that has created some controversy in the industry.[4]

On the same day that the DOJ unveiled its indictment against the Wahi brothers and Ramani in July 2022, the SEC filed a parallel enforcement action against the defendants, alleging that at least nine of the tokens involved in their insider trading scheme were unregistered securities.

The SEC argued in its complaint that this subset of cryptoassets satisfies the Howey test by “including ongoing representations by issuers and their management teams regarding the investment value of the tokens, the management efforts that contribute to the tokens’ value, and the availability of secondary markets for trading the tokens.”

The Wahi brothers moved to dismiss the SEC’s complaint, arguing that the commission is engaging in a regulatory power grab.

According to the Wahi brothers, the tokens were not investment contracts because, although at the time of issuance, there was an investment in a joint venture, these trades break the connection between an investor and an issuer when the underlying assets were sold on secondary markets.

Because “there are … no binding promises running from the developers to the token holders, … [p]Public declarations by token developers about the software they hope to create do not create post-sale legal obligations and cannot convert tokens sold on secondary markets into investment contracts,” the attorney for the defendants wrote in a February 6 motion to dismiss.

In other words, the token has become a simple asset, negating ongoing liabilities that might otherwise have existed under securities laws, including the anti-fraud provisions of the Exchange Act, which underpin insider trading liability.

The defendants’ attorney has argued that the crypto tokens are no longer like a participating interest in an orange grove—which was deemed a security in the US Supreme Court’s 1946 decision in US Securities and Exchange Commission v. WJ Howey Co. – but now more like a simple orange, an asset generated by the business.

Not surprisingly, crypto industry participants have blanched at the SEC’s expansive view that secondary trading of crypto tokens should generally be considered regulated transactions involving investment contracts.

The Blockchain Association, an industry group, has filed an amicus brief challenging the SEC’s approach of seeking to apply the securities laws to tokens in the Wahi case without any formal commission action or court decision, and also claims that the commission is trying to assert jurisdiction over the secondary market by leaning themselves on secondary traders, not the token issuers themselves.

As such, the SEC is trying to invent new regulations via a single enforcement action without allowing market participants who would otherwise have been able to participate in a notice-and-comment process, according to the group, which added that such a move would be “ devastating” and “causing great harm” to crypto market players.

What will be next

The court in the Wahi case is expected to consider whether the cryptoassets in question can be considered securities, even when they lose a direct connection to an issuer. How the SEC goes about this case could determine how regulation could affect the thousands of tokens traded in the crypto markets.

But the SEC — and potentially other state and regulatory authorities — don’t view the application of insider trading laws as the only tool the government has to regulate the crypto industry.

Although criminal prosecutions have recently made big headlines — such as in the infamous FTX case — civil regulators have also called for more crypto enforcement authority.

Last summer, the chairman of the US Commodity Futures Trading Commission called for congressional action on crypto regulation. SEC Chairman Gary Gensler has been even more assertive by making it clear that he plans to use the SEC’s powers to increase oversight of the crypto industry, including enforcing conflict of interest laws.

Amid multiple actions in post-FTX regulatory violations in crypto, a recently proposed SEC rule is designed to revise the Advisers Act’s custody rule as it applies to crypto when a registered advisor has custody.

The rest of 2023 could see developments for the crypto industry on many fronts.

The industry will be watching to see how the SEC flexes its enforcement authority in the crypto markets, what other rules may be promulgated in the absence of crypto-related federal legislation and how the agency fares in court in the Wahi case.

While the recent actions of the DOJ and SEC in connection with the Wahi brothers’ case may seem aggressive, they are hardly surprising.

Future rulemaking, along with favorable outcomes for the SEC in ongoing litigation, may further increase market control. But regardless of the outcome of the Wahi civil lawsuit, the SEC has made it clear that it intends to play a dramatically increased role in crypto oversight, and market participants need to be ready.

[1] US v. Wahi, No. 22-cr-00392 (SDNY)

[2] 18 USC § 1343

[3] 18 USC § 1349

[4] SEC v. Wahi, No. 22-1009 (WD Wash. Amended Complaint Dec. 22, 2022).

Reproduced with permission. Originally published March 2023, “SEC Approach In Wahi Presents New Challenges For Crypto,” Law360.