SEC and DOJ Bring First-Time Crypto Insider Trading Actions | Foley Hoag LLP

• The US Securities and Exchange Commission (“SEC”) and the US Department of Justice (“DOJ”) have filed the first-ever insider trading actions involving cryptocurrency against a former executive of Coinbase, one of the largest US trading platforms for cryptoassets, and two tipsters for sharing or trading on confidential information relating to the planned listing of various cryptocurrencies on Coinbase.
• The SEC’s securities fraud charges are based on its longstanding position that certain cryptocurrencies are investment contracts and therefore “securities” subject to the SEC’s jurisdiction. The DOJ, however, is pursuing its case on a theory of wire fraud.
• We expect that insider trading in the digital asset space will remain a priority for both the SEC and DOJ. Issuers, exchanges and their employees should take careful note.

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This year had already seen an increase in federal enforcement activity focused on digital assets with the expansion of the SEC’s Crypto Assets and Cyber ​​Unit (see our previous client alert on that expansion and its impact here) and the formation last year of the DOJ’s National Cryptocurrency Enforcement Team. On July 21, 2022, the agencies carried out this enforcement priority by conducting the first insider trading actions involving cryptocurrency.

The SEC action is one of the most notable steps yet in the agency’s expansion of its jurisdiction over digital assets, based on its view that many, if not most, cryptocurrencies qualify as “securities” under the federal securities laws. As we discuss below, however, it remains unclear whether the courts and Congress will support this view.

Similar factual allegations, different charges

The SEC and DOJ allege that Ishan Wahi, a former product manager at Coinbase – one of the largest crypto-asset trading platforms in the US with nearly 100 million registered users – tipped off his brother and a friend (the “tippers”) with confidential information about the planned listing of certain cryptocurrencies on Coinbase. The listing of a crypto-asset on an exchange usually causes the market value of the asset to increase significantly. According to the government, Coinbase therefore treated this information as confidential and prohibited employees from sharing it with others.

The tipsters allegedly bought at least 25 crypto assets before 14 separate listing announcements between at least June 2021 and April 2022, and sold the assets shortly after for profits totaling more than one million dollars. The government also alleges that the tipsters attempted to cover their tracks by using accounts on exchanges held in other people’s names, transferring funds and crypto-assets through multiple anonymous Ethereum blockchain wallets, and regularly creating new Ethereum wallets with no prior transaction history. In addition, Wahi allegedly attempted to flee the United States after learning that Coinbase was investigating possible insider trading and after Coinbase’s director of security instructed him to attend a meeting about the listing process.

It is worth noting that the SEC and DOJ brought insider trading charges on different legal theories. The SEC charged the defendants under the Securities and Exchange Act of 1934 (the “Exchange Act”), which prohibits fraud in connection with the purchase or sale of “securities.” Critically, the SEC claims that at least nine of the crypto assets should be classified as securities, and will be required to prove this claim, in addition to the other elements of insider trading, to prevail on the charges. (Relatedly, the SEC is also investigating whether Coinbase itself violated securities laws by listing these cryptocurrencies and thereby allowing public trading of unregistered securities.)

However, the DOJ did not charge the defendants with securities fraud under the Exchange Act, but rather under the federal conspiracy and wire-fraud statutes, which are not available to the SEC. Its indictment thus effectively sidesteps the question of whether cryptocurrencies are securities. The DOJ took a similar approach in June, when it brought its first digital asset insider trading case against a former chief product officer at a major online marketplace for buying and selling non-fungible tokens, or NFTs, on charges of fraud and money laundering. .

Investment contracts?

The DOJ’s decision to pursue insider trading on a wire fraud theory may reflect a desire to avoid the often convoluted analysis that courts use to determine whether an asset is a security. The SEC’s jurisdictional argument is based on “Howey test”, as articulated in the Supreme Court case from 1946 SEC v. WJ Howey Co . The seminal case centered on the meaning of the term “investment contract” as used in the definition of “security” in the Securities Act of 1933. Howey held that an investment contract is defined as “a contract, transaction or arrangement in which a person invests his money in a joint enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” In reaching this conclusion, the court emphasized that economic reality should control the form of the asset when assessing whether it qualifies as an investment contract, and thus a security.

IN Wow action, the SEC alleges that at least some of the cryptoassets in question are a type of investment contract, because the issuers allegedly “solicited investors by implying the potential for profits to be made from investing in these securities based on the efforts of others” through statements on the issuers’ websites, social media and in parliamentary messages. The issuers are also said to have emphasized both (i) “the possibility for investors to resell these tokens in the secondary markets,” and, importantly, (ii) the issuers’ “efforts to get their crypto-asset securities listed on secondary trading platforms, and a critical role as executives and others in the company played to make the company a success, thereby increasing the value of the crypto asset security.”

This legal issue has already come to the fore in the closely watched SEC enforcement action against Ripple Labs in connection with the sale of the digital asset XRP, allegedly in violation of registration requirements under the Securities Act. Ripple has mounted an aggressive defense in that case, which may provide necessary guidance on the issue.

The regulatory uncertainty regarding the status of cryptoassets has caught the attention of some prominent lawmakers and regulators (and led Coinbase itself, on the same day the SEC filed its complaint, to file a petition with the SEC requesting additional rulemaking to clarify what digital assets are securities). Caroline Pham, a Republican member of the Commodity Futures Trading Commission, characterized The SEC’s action as a “striking example of regulation by enforcement.” Senator Pat Toomey, a Republican ranking member of the Senate Banking Committee, likewise criticised SEC for, in his opinion, not providing “regulatory clarity prior to enforcement.” (The SEC issued guidance in 2019 explaining the “Framework for ‘Investment Contract’ Analysis of Digital Assets,” although opinions differ on whether that guidance is sufficient.) Also, a bipartisan bill introduced in the Senate last month would significantly limit the SEC’s jurisdiction over cryptocurrency, though Congress is unlikely to vote on the bill for at least the rest of 2022, according to one of the senators who introduced it.

Regardless, the SEC has signaled that this will not be the last enforcement action on this front. In the agency’s press release announcing the Coinbase action, Gurbir Grewal, the director of the enforcement division, clearly stated that enforcement actions would continue “to ensure a level playing field for investors, regardless of the label of the securities involved.”

Takeaways

Because the DOJ, as a criminal law enforcement agency, has a higher burden of proof and therefore typically prosecutes fewer insider trading cases than the SEC, a limitation of the SEC’s jurisdiction over digital assets by the courts or Congress would likely limit future insider trading actions involving those assets. For now, however Wow actions reflect the government’s continued prioritization of crypto enforcement and the remarkable expansion of resources it has devoted to this area.

We expect that authorities will continue to target individuals employed by issuers and exchanges, as well as others who arguably have market-moving information about cryptocurrency or other digital assets, and who tip or act in breach of a duty of confidentiality to their employers or others. the source of the information, or act on a tip with knowledge of such a breach. Such individuals should therefore carefully consider the risk that the SEC or DOJ may see them as falling into this category before sharing information or acting. Issuers of digital assets and exchanges should also be aware of the risk of secondary liability for insider trading as control persons and/or aiders and abettors, and should ensure that their policies and procedures effectively address the misuse of material non-public information by employees. and consultants.

We will continue to provide updates on the evolving crypto enforcement landscape.