How the Coinbase insider trading case will change crypto

Former Coinbase employee Ishan Wahi pleaded guilty to two counts of conspiracy to commit wire fraud on Tuesday in connection with an insider trading scheme at the exchange.

But while the Justice Department got its desired verdict, Wahi still faces charges against him by the Securities and Exchange Commission (SEC). And its potential ramifications extend far beyond just him.

On the same day federal prosecutors filed charges related to wire fraud last July against Wahi, his brother Nikhil and their friend Sameer Ramani, the SEC filed civil charges and accused the three also violate securities laws.

The case alleges that Wahi shared information about upcoming token listings with the San Francisco-based exchange to generate around $1.5 million in ill-gotten gains. But in its first complaint, the SEC also claimed that at least nine of the tokens involved in the insider trading scheme at Coinbase are illegal securities.

Policy advisor at the Blockchain Association told Marisa Tashman Coppel Decrypt The case could have “major implications for the industry” if the court rules in the SEC’s favor, as it would “inhibit creators and developers” [ability] to create assets in the future.”

Whether digital assets should be classified as securities or commodities – under the authority of the SEC or the Commodity Futures Trading Commission (CFTC) – has been a contentious topic in crypto. SEC Chairman Gary Gensler has only said firmly that Bitcoin is a commodity, and claims that most other cryptocurrencies are unregistered securities.

The SEC believes the nine digital assets fall under the agency’s jurisdiction because they are “investment contracts,” which occur when money is invested in a joint venture with a reasonable expectation that profits will come from the efforts of others. A favorable decision would validate that stance, Coppel said.

The nine assets are AMP (AMP), Rally (RLY), DerivaDEX (DDX), XYO (XYO), Rari Governance Token (RGT), LCX (LCX), Powerledger (POWR), DFX Finance (DFX), and Chromatics (CHROME), six of which are still available for trading on Coinbase.

Coppel described the case as partly a “due process issue” because the creators of the nine tokens are not defendants in the SEC’s case, with no way for them to intervene in the lawsuit. “If this is indicative of a broader pattern that the SEC is engaging in, it could be very problematic for the industry,” she said.

A ruling finding the Wahi brothers and Ramani in violation of securities laws could also affect others in the digital asset space, potentially requiring developers to register with the SEC when launching tokens or implicating Coinbase and other exchanges as venues that facilitate the sale of illegal securities. .

“Theoretically, the other people who trade, buy or sell these tokens would also be in violation of the securities laws,” Coppel said.

Wahi’s lawyers have argued against the SEC’s position. They asked to have the SEC’s charges dismissed on Monday on the grounds that the digital assets in question do not meet the conditions necessary to be considered an investment contract.

They argue that the tokens lack “essential ingredients” of an investment contract, such as a contract in itself, which imposes post-sale obligations on the seller such as the legal right to share profits.

“The SEC does not — and cannot — allege that tokens involve contracts between developers and token holders,” the proposal states. “In fact, the tokens impose no legal obligations on their developers after the time of sale.”

Wahi’s lawyers argue token purchases made on a secondary market are “no different than when someone buys a baseball card” because buyers send their money to unrelated third parties such as exchanges as opposed to putting the money into a joint venture.

Regulation through enforcement

The case represents an attempt by the SEC to shape regulation around digital assets through the legal system. Critics of the approach have called it “regulation through enforcement”, choosing to establish rules by going after perceived bad actors rather than laying out clear rules with an opportunity for people to give feedback.

When the SEC filed securities fraud charges in relation to the insider trading scheme at Coinbase, comments from Caroline Pham, a commissioner of the CFTC, highlighted how the ruling could shape the digital asset space.

“The SEC’s allegations may have broad implications beyond this single case,” she wrote. “Bigger issues are best resolved through a transparent process that engages the public.”

Coinbase’s Chief Legal Officer Paul Grewal also pushed back against the SEC’s regulatory blitz shortly after it filed charges. “Instead of crafting tailored rules in an inclusive and transparent way, the SEC is relying on these kinds of one-off enforcement actions to try to bring all digital assets into its jurisdiction,” he said.

The framework for what constitutes an investment contract can be traced back to 1946. The Supreme Court found that the sale of plots of land in a citrus grove by William John Howey were unregistered securities because of a service contract in which he offered to tend the land and sell produce. for those who bought the fruit-bearing packages.

“Here, the SEC is pushing for a new construction of an isolated term from a Depression-era law to assert regulatory authority over a trillion-dollar industry built on revolutionary technology that is poised to define the next generation of the Internet,” Wahi’s lawyers argued.

But not all SEC officials are on the same page as Gensler when it comes to the so-called Howey test — the agency’s 4-part method for determining whether an investment contract exists. SEC Commissioner Hester Peirce said the test has some limitations on an episode of Decryptits Gm! podcast, one of which is its duration.

“We’ve said the orange grove is going to be treated as a security in perpetuity,” she said, adding that clarification from the SEC on how a token can go from a security to a commodity with specific criteria would help quell some concerns with the SEC’s logic.

“If we were more precise, I think there would be less objection to using the Howey test and saying, ‘Hey, the first time you sold it, it could well have been a securities offering,’ but that doesn’t mean the token continues to be a certainty for the rest of life,” Peirce said.

The Howey test is also a sticking point in other cases where the SEC has gone after players in the crypto space while ringing tokens for unregistered securities. An ongoing lawsuit filed in late 2020 against Ripple Labs, its co-founder Christian Larsen and CEO Brad Garlinghouse, accused the company of raising $1.3 billion in unregistered securities offerings since 2013 through the sale of the token XRP.

In September, Ripple and the SEC filed motions seeking summary judgment, asking that the case be dismissed and a decision entered in each party’s favor. And while legal experts have speculated SEC likely to lose case if it goes to trial, Coinbase made move to support the company’s legal position in November last year.

The company asked Judge Analisa Torres – who is overseeing Ripple’s case in a court in the Southern District of New York – to file a document supporting Ripple’s legal position. A key point was that digital assets traded on an exchange do not give individuals ownership of a venture or allow them to share in a firm’s profits through dividends, unlike some stocks do.

While those cases could have broad implications for the crypto space, they would not have precedential value, Coppel said, explaining that judges in other federal districts could find the readings persuasive but are not bound by it.

But if appealed, those rulings could begin to set precedent in parts of the United States as they work their way through the federal court system, potentially becoming the law of the land if they ever reach the Supreme Court.

Regardless, it appears the SEC won’t be dropping enforcement actions from its regulatory playbook anytime soon. On Thursday, the SEC announced settled charges and a $30 million fine against San Francisco-based cryptocurrency exchange Kraken for its staking-as-a-service program.