‘Securities’ label in SEC Insider case could have broad crypto impact

by Arthur · August 2, 2022

By Sarah Wynn, CQ-Roll Call (TNS)

The Securities and Exchange Commission (SEC) fired a warning shot at the cryptocurrency industry when it filed an insider trading case that declared several digital assets to qualify as securities, according to those who follow the agency closely.

The SEC last month accused a former Coinbase Global Inc. executive of tipping others about which tokens should be listed for trading on the exchange so they could profit when the listing boosted prices. But what caught the attention of many stakeholders was the agency’s decision that nine of the 25 cryptocurrencies involved were securities, and therefore under its jurisdiction.

It seems inevitable that issuers of these tokens will soon find themselves on the receiving end of a civil complaint from the SEC, Lee Reiners, executive director of the Global Financial Markets Center at Duke University, said in an interview. An unknown number of the estimated 19,000 types of cryptocurrencies now circulating may also be involved.

Less certain are the immediate consequences on crypto exchanges, Reiners said. He said it’s likely that exchanges are nervously reading through the SEC’s complaint, looking at what’s currently listed on their platforms, and comparing that to how the SEC views the nine digital assets in question.

Reiners said he doesn’t see the SEC filing complaints against exchanges until a court has considered whether the symbols in question are actually securities.

“They will wait, and if the court agrees with them, of course at that point the exchanges themselves will be forced to register,” Reiners said. “To me, it might be a longer process to get to a desired outcome, but I think in the SEC’s case, there is a more certain way to get to the desired outcome, which is to bring crypto exchanges into the realm of securities regulation.”

In the insider trading case, the agency accused Ishan Wahi, 32, of Seattle of tipping off his brother and a friend about which cryptocurrencies were about to be traded on the platform so they could profit from a jump in prices, according to a complaint filed in US District Court for the Western District of Washington. The Ministry of Justice also brought charges against all three for wire fraud.

Crypto supporters have criticized the SEC’s approach, calling it regulation by enforcement. Critics have warned that crypto is rife with fraud and harming retail investors. Over the past year, SEC Chairman Gary Gensler has said that most cryptocurrencies are investment contracts and thus securities. Crypto exchanges are also likely to be trading in securities and should be regulated, Gensler has said.

Reiners said the SEC’s move finally backed up what Gensler has been saying for some time.

“So this is kind of like the SEC walking the talk,” he said.

Teresa Goody Guillén, a partner at BakerHostetler and a former SEC litigation attorney, agreed that the agency appears to be making good on Gensler’s words.

“In this case, the SEC showed its willingness to venture into uncharted waters — it is uncertain whether these cryptoassets are securities in the first place, and it would also have to extend an insider trading theory to the facts,” Guillén said in an email. The agency’s approach to crypto-asset enforcement is becoming more aggressive, she added.

If the case goes to trial, the SEC will have to prove that at least one of the underlying assets is a security, and the precedent from that part of the trial could provide more certainty as to when digital assets are securities, Guillén said.

“The shockwaves this case created and the attention it’s getting could lead Congress and other regulators to take action to create more security in the crypto space,” she said.

Repercussions

The agency has declared cryptos to be securities in the past. In 2020, the SEC alleged that Ripple Labs Inc., a San Francisco-based technology company, and two of its executives raised over $1.3 billion through an unregistered securities offering of digital assets known as XRP.

But that case is on a different footing than Coinbase insider trading, said Christopher LaVigne, a partner in the litigation team at the law firm Withers.

“The SEC has potentially sidelined issuers of these digital assets, and the SEC has put itself at a strategic advantage to secure a potential backdoor ruling that many digital assets listed on Coinbase’s exchange are securities,” LaVigne said.

He declined to predict how the lawsuit will go. It is possible that the SEC could prevail and secure a ruling from a federal court that the underlying assets are securities.

“If they do, they can take that and use that as a premise, for example, sue the issuers of the underlying assets directly … they’ve already got a leg up on the hypothetical potential future lawsuit because they already have the ruling in hand,” said he.

The backers of some of the cryptocurrencies labeled as securities in the SEC’s insider trading complaint have already responded. Monty Metzger, founder of the crypto token LCX, said on Twitter that regulation is good for the crypto industry, even if doing so by enforcing it is not the right strategy. He claimed that LCX is a utility token, which can be used to pay fees related to services offered by the company.

The SEC declined to comment beyond documents that have already been made public. On a call with reporters, officials said the agency would not confirm the subjects of any further investigations or whether it is pursuing cases against the operators of the nine tokens or Coinbase.

However, Bloomberg News reported on July 25 that Coinbase is facing an SEC investigation into whether it improperly allows people to trade digital assets that should have been registered as securities, citing three people familiar with the matter.

Coinbase declined to comment, but the company’s chief legal officer, Paul Grewal, said the exchange has faith in the process.

“We are confident that our rigorous due diligence process — a process the SEC has already undergone — keeps securities off our platform, and we look forward to working with the SEC on the matter,” Grewal said in an emailed statement.

Shortly after the SEC charges, Grewal said in a statement that Coinbase “100 percent” disagreed with the SEC’s decision to file securities fraud charges, stressing that none of the cryptocurrencies in question are securities.

Coinbase also announced that it had filed a petition asking the SEC to begin regulation of digital assets.

“Cryptoassets that are securities need an updated rulebook to help guide safe and efficient practices,” Faryar Shirzad, the company’s head of policy, said in a post on Coinbase’s website. “Crypto-assets that are not securities need the certainty of being outside these rules.”

The industry has some regulators on its side. Caroline Pham, a commissioner of the Commodity Futures Trading Commission, in a rare cross-agency comment, called the SEC’s enforcement action a “striking example of ‘regulation by enforcement'” and said it could have broad implications.

The CFTC declined to comment on whether it planned to bring its own enforcement actions against the three defendants in the Coinbase case.

Bartlett Naylor, fiscal policy advocate at consumer organization Public Citizen, supported the SEC’s move.

“Ideally, Washington regulators will continue to go after and weed out all the bad guys, who unfortunately can make up a significant percentage of the people who work in this industry,” Naylor said.

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