On July 21, 2022, the SEC filed insider trading charges in federal court against a former Coinbase product manager and two others for trading ahead of multiple announcements that certain crypto assets would be made available for trading on the platform. The SEC alleged that the defendants traded ahead of listing announcements for at least 25 crypto assets, “at least nine” of which the Commission asserted are investment contracts under the federal securities laws. The complaint includes a Howey analysis for the nine crypto assets that serve as the basis for the SEC’s jurisdiction in this matter. In a parallel action, the Department of Justice charged the same individuals for wire fraud, notably not pursuant to a securities fraud theory.
The charges against the individuals, should the alleged activity prove to be true, are deserved, and evidently resulted from internal efforts by Coinbase to detect frontrunning of listings. The DOJ’s wire fraud case therefore has a high likelihood of success, again should the allegations prove to be true, because wire fraud can occur regardless of whether the assets at issue are securities. The trouble for the industry comes from the fact that the SEC has made allegations in its civil complaint against nine token projects that are not parties to the action, and in at least some cases, had not previously been subject to a direct investigation by the SEC. Moreover, the SEC’s investment contract allegations are jurisdictional; that is, the SEC must obtain a holding that at least one of the tokens is in fact a security for its insider trading case, based on frontrunning securities listings under US securities laws, to succeed. This creates strong incentives for the SEC to drive the case towards such a finding, and gives little opportunity for the projects at issue—or the industry at large—to effectively refute the SEC’s claims or to contest the SEC’s methods.
Industry problem number one, therefore, is a seeming casting aside of due process considerations with respect to SEC determinations concerning specific tokens or projects. Unarguably, the parties in the best position to defend against the charge that the crypto assets are securities are the projects that launched the crypto assets and the platforms that list them. These entities are not parties to the lawsuit, and at least some were never aware of any investigation by the SEC nor were they solicited for information or legal positions. Moreover, five of the nine projects do not appear to be based in the U.S. and therefore may have little incentive to attempt to intervene or engage with U.S. courts on the matter, since the SEC may not even have jurisdiction over them as entities. Accordingly, the action has placed one platform and nine entities—and by extension, the industry—in a corner, subject to a potentially adverse legal decision without the ability to mount a defense.
The fact that this is an industry problem is illustrated by industry problem number two: the relatively generic nature of the crypto assets that the SEC chose to name in the complaint. Strike out the names of the tokens and their issuers and read only the descriptions of the projects, and the nine tokens sound a lot like representatives of classes or categories of sub-assets within the digital asset ecosystem: payment tokens; native platform tokens; governance tokens, etc. The projects also seemingly represent various sectors of the digital asset industry: payment platforms; decentralized liquidity pools and automated market makers; and projects governed via decentralized autonomous organizations (DAOs). As a result, the complaint portends trouble for the entire digital asset industry, as the SEC uses various factors—some listed in its 2019 FinHub guidance, some not—to support elements of its Howey analysis that are common to many projects across the industry.
As specific examples, the SEC’s Howey analysis for the nine projects reveals the SEC’s views on several common features in DeFi:
Governance Tokens – Three of the crypto assets identified by the Commission may be characterized as governance tokens. While governance tokens are intended to be a vehicle through which projects can achieve true decentralization, the SEC’s complaint suggests that it will not be persuaded by such efforts, regardless of the level of decentralization via the governance token, when a core development team holds governance tokens and can therefore both vote and derive economic benefit from those tokens. As a result, should the SEC prevail, any governance token could be characterized by the SEC as a security where a core development team (either as individuals or as members of unrelated development companies or labs) holds more than a de minimis number of the tokens.
Staking, Liquidity Pool Tokens, Yield Farming – Decentralized platforms often feature native tokens that enable decentralized liquidity pool trading and automated market making, and often permit (or even require) the staking of a certain number of those tokens in order to access the features of the platform. These functions of the native tokens are commonly considered to represent their utility, and they enable decentralization. However, the SEC relies on these activities and features across a number of the identified crypto assets in order to establish the existence of a common enterprise and a reasonable expectation of profits (two elements of the Howey test). As a result, the complaint is tantamount to an SEC assertion that these common features of DeFi protocols irrevocably taint these tokens as securities.
Offshore DAO Structures – The SEC’s complaint summarily and repeatedly describes organizational structures consisting of some combination of a U.S.-based company providing software development services, an offshore foundation company, and an offshore unincorporated DAO, as a single entity. The SEC paints with a broad brush, collapsing corporate structures without consideration of applicable provisions of corporate law, ignoring jurisdictional considerations, and conflating platforms and protocols with for-profit corporations and LLCs, foundation and other non-stock entities, and unincorporated entities. While there are no details about the arrangements between these entities, the complaint signals that the SEC may be skeptical of the separation of offshore structures from a U.S. development team, and will not hesitate to make assumptions and allegations concerning the relationship of corporate entities without examination of underlying corporate structures and relationships.
Secondary Market Trading – While the SEC has long represented that the presence of a secondary market for tokens is a factor to consider in determining whether a reasonable expectation of profits exists, the SEC’s complaint focuses on this factor to an unusual degree. The complaint declares that statements emphasizing the ability of purchasers to resell tokens in secondary markets is “a crucial inducement to investors and essential to the market” for crypto assets, and focuses much of its arguments for the nine crypto assets on this factor. As a result, the SEC announces almost a de facto finding of an investment contract if there is secondary market trading of the asset.
It is also worth noting that the Commission’s Howey analysis in this complaint marks an important shift from prior actions. In prior cases like those involving Kik, Telegram, and Ripple, the entities were the subjects of SEC investigations, had the opportunity to provide evidence in their own defense, and had the ability to submit a written legal justification prior to any action being filed (called a Wells submission) presenting its arguments against the security status of the asset. Here, the nine analyses are formulaic: the Commission identifies statements intended to establish that the token issuers promoted (1) the value of the token, (2) the ability for purchasers to engage in secondary trading of the token, and (3) the expertise of the token issuers, at both the time of the sale of tokens to the public and on an ongoing basis. No evidence from the company is included, and in at least some cases, none was ever solicited, nor were the companies provided the ability to advocate their own positions.
In sum, the outcome of the SEC’s complaint is likely to reverberate beyond not only the defendants in the case, the nine crypto asset issuers identified in the complaint, and the platforms that list the nine tokens. Many other DeFi protocols and participants in the larger crypto ecosystem engage in similar activities to the projects identified in the complaint. Many have not had engagement with the SEC, or to the extent that they have, they may believe these interactions to not have reached a point where the SEC would make an allegation concerning their asset in court. To the extent the SEC is successful in obtaining a favorable judgment finding these nine crypto assets to be securities, such a finding will likely be used to underpin additional enforcement actions against larger and more established players in the industry.
Civil insider trading cases are often stayed pending the outcome of the criminal proceeding, so there is time for the industry to react. However, criminal wire fraud cases tend to have the effect of focusing individual defendants’ attention, and there is a real risk that the SEC will attempt to leverage that criminal case to secure the defendants’ agreement to the language of a settlement of the SEC’s civil claims that could be ratified by the court and used as a cudgel against the industry.