The Department of Justice recently charged former Coinbase product manager Ishan Wahi, his brother Nikhil Wahi and friend Sameer Ramani with wire fraud and insider trading. The Securities Exchange Commission followed suit with a filing of its own alleging violations of securities laws and to enjoin the defendants’ activity, disgorge ill-gotten gains, and for any other relief to which they may be entitled.

The SEC’s actions are curious since the DOJ already filed its own complaint against these three individuals which would presumably obtain the legal relief necessary to obtain justice, redress, and punishment, hence the SEC’s claim seems redundant. Furthermore, the SEC does not have jurisdiction over wire fraud or any other federal crimes not involving securities.

Therefore, they have to first prove jurisdiction by proving that the crypto-assets in question were indeed securities, so that they show that have the authority to file the complaint and seek the remedies they want. This is contrary to the entirety of the crypto industry’s current paradigm, since it was generally assumed that it was legally established that no securities were being traded on the Coinbase platform, or any other US crypto exchange, none of which have a broker-dealer license from the SEC but are only state registered as “money transmitters” with a Money Transmitter License.

The SEC’s complaint goes into great detail into every crypto asset that is alleged to have been illegally traded by the defendants attempting to prove that these assets were indeed securities at the time. The alleged illegal activity by the defendants entails passing on confidential information by Wahi to his brother and friend in order to purchase the crypto-assets before they were disclosed by Coinbase as planned for public listing, which generally results in their respective prices substantially increasing.

The complaint uses the Howey test to show that these assets were common enterprises where profits were expected by investors from the efforts of third parties, such as management/founders/issuers. If this was indeed the case, and the vast majority of crypto-assets on US exchanges are in fact unregistered securities, this would utterly devastate the crypto markets, as stated in the prior post with respect to the private civil litigation instituted against the Solana companies, founders, and other related parties alleging that SOL is an unregistered security. If most crypto-assets on secondary markets are unregistered securities then all these exchanges would have to obtain broker-dealer registration with the SEC and follow all relevant laws that other regulated broker-dealers are subject to. Moreover, their Money Transmitter Licenses would become worthless.

After the filing, Coinbase soiled its pants and issued a public statement to the effect that it carefully screens all listed crypto-assets, a process apparently previously reviewed by the SEC, and most definitely does not, and never has, listed securities for trading. Having familiarity with their screening process, as well as the screening processes of other exchanges, this Firm is of the opinion that Coinbase’s defenses don’t have a great deal of veracity as it is in their interest to list as many crypto-assets as possible to obtain greater commissions and thereby increase share price, as a publicly traded company.

Coinbase agents do a cursory review of the network and the non-security legal opinion, as well as other public documents by a given token/coin issuer and decide on that basis to list a particular token. Before Coinbase became publicly listed it only listed a handful of crypto-assets, certainly not more than 20; but after public trading of its stock commenced, it quickly accelerated its listing of much smaller projects, and it would be quite difficult to prove these projects were either pure ‘utility’ token non-securities, or sufficiently decentralized or did not involve passive investing to obtain any profits/rewards. Currently there are hundreds of crypto-assets on its platform, and circumstantial evidence points to the fact, which is self-evident, that Coinbase management directly ordered its project screeners to loosen their standards for listing new projects for secondary trading.  

Generally, the main counterargument to be made by issuers and by Coinbase to SEC’s allegations is that the efforts of management of a given issuer are not ‘essential’ or ‘significant’ enough to cause an investor to be dependent on the manager for any profit obtained from an investment into a given token. In other words, a given investor is just as or equally dependent on the automated algorithmic platform and other platform users as they may be dependent on the management/founding team.

Once a token network is fully self-governing and decentralized then the reliance on the management team should decline and may not be necessary to grow the value of the token. The real question is how to create a bright line where every relevant party can fairly judge when there is significant reliance on the issuer and when the reliance is more substantially upon the platform and other users. The answer is likely to remain subjective and dependent on the whims of a given court.

The other defense to the claims of token security status may be that any gains for investors are derived from the efforts of investors; in other words, the investment is not passive. This is particularly likely with respect to networks requiring participation from token holders to acquire new tokens or receive capital gains/rewards. Participation may involve material governance ability regarding the direction of the platform, such as a DAO or voting rights that are meaningful; or other activity such as posting/creating content and use of tokens for in-game purposes. It is generally agreed that in-game crypto-assets are not securities since they require material and significant involvement by purchasers in the form of game play.

The SEC has not sued Coinbase, any other exchange, or any related issuer for violations of securities laws; it appears that this lawsuit is a shot across the bow to the industry to get itself together before the real enforcement actions begin across the board, and likely because the SEC does not have the resources to go after the thousands of tokens trading on US secondary platforms in possible violation of securities laws.

It appears the SEC is attempting to seize authority for itself to regulate the crypto industry in a potential bid to receive a substantial increase in federal funding as well, and beat out the CFTC as the competitive regulator by showing itself as more capable and aggressive in protecting investors, which is what it apparently sees itself as doing.  

This may also be a test case to see how a court will rule regarding the named crypto-assets, to pave the way for future enforcement actions. To date no court has ruled on crypt-assets being or not being securities, and this case has the potential to make history in being the first case to actually do so and determine the applicability of the Howey test to crypto-assets.

It is most likely that the defendants will take a plea deal with the DOJ which is the lead prosecutor here, in exchange for a reduced prison sentence and dismissal of SEC’s claims. They are likely to agree to any of SEC’s demands as well, such as disgorgement of profits and a ban from the crypto industry. It is unlikely the SEC’s case will go to trial.