On July 21, 2022, the Securities and Exchange Commission and the U.S. Attorney’s Office for the Southern District of New York charged Ishan Wahi, a former employee of the digital asset trading platform Coinbase (the “Company”), as well as his brother and friend, with engaging in insider trading ahead of certain of the Company’s digital asset listing announcements (i.e., announcements in which the Company publicly discloses the specific digital assets that it plans to make available for trading on its platform), which allegedly generally increase the value of the relevant digital assets.[1]  According to the charging documents, Wahi tipped his associates to the pending Company announcements, and they in turn used their advance knowledge to front run the announcements, allegedly reaping more than $1 million in illicit gains.   The SEC’s Complaint, filed in the Western District of Washington, alleges that Wahi and his associates violated the antifraud provisions of the Securities Exchange Act of 1934, and the DOJ’s Indictment alleges that they committed various counts of wire fraud and conspiracy to commit wire fraud.  The defendants have indicated they will contest such allegations.  Neither the Complaint nor the Indictment names Coinbase as a defendant.  These parallel actions are the first-of-their-kind insider trading enforcement actions in the digital asset context.[2]   These actions are notable, among other reasons, because they show the SEC’s comfort with a  “regulation by enforcement” strategy and its broad interpretation of what constitutes a “security” subject to its jurisdiction, and the DOJ’s willingness to challenge allegedly fraudulent conduct in the digital asset industry through charges, such as wire fraud, that do not require a showing that the relevant digital assets are “securities.”  The latter suggests that the DOJ could become an increasingly important player in this space independent of the SEC’s or the Commodities Futures Trading Commission’s current or future regulatory agenda or authority.

Factual Background

The SEC and DOJ generally make the same factual allegations:  In 2021 and 2022, Wahi, who worked at the Company in a business development role that provided him with access to information about the Company’s digital asset listing activities, provided tips to his associates regarding the Company’s planned digital asset listing announcements, who then traded in the relevant digital assets ahead of such announcements and benefitted from the often dramatic price increases.  The Complaint does not allege that Wahi traded himself, but does allege that he received the personal benefit of providing “a gift of inside information” to his associates.  Wahi allegedly knew of the Company’s policies that (1) defined information about the Company’s listing activities as “material nonpublic information,” and (2) prohibited the disclosure of such information to other persons.  Accordingly, the SEC and DOJ allege that Wahi breached his duty to the Company and that the associates knew, or had reason to know, about that breach of duty.

The main differences between the Complaint and Indictment are the scope of the alleged misconduct and the specific digital assets that are the subject of the alleged insider trading.  The SEC, which is empowered to regulate conduct involving “securities,” alleges that Wahi tipped his brother and friend to 10 digital asset listing announcements and that they subsequently traded in at least 25 digital assets based on that information; however, the Complaint only alleges that nine of those digital assets are “securities.”[3]  Meanwhile, the DOJ alleges that Wahi tipped his brother and friend to 14 listing announcements and that they subsequently traded in at least 25 digital assets based on that information, and the DOJ focuses on the defendants’ conduct regarding a more narrow group of digital assets, most of which are different from those discussed in the SEC’s Complaint.[4]  Because the DOJ brought wire fraud charges and not securities fraud charges, it is not required to prove that any of the digital assets at issue in the alleged insider trading are “securities,” perhaps explaining the difference between the Complaint and Indictment.

Key Takeaways From the Complaint and Indictment

  • The Complaint provides insight into the SEC’s digital asset enforcement strategy and perspective on how the SEC is applying the Howey test[5] for determining whether a digital asset is an “investment contract,” and hence, a “security,” that can be reached by the federal securities laws. Under the SEC’s interpretation of the Howey test, an arrangement constitutes an investment contract if the investors:  (1) made an investment of money, (2) in a “common enterprise,” and (3) were “led to expect profits solely from the efforts of the promotor or a third party.”[6]  Not surprisingly, it appears that the SEC is interpreting the Howey test in a manner that will maximize the number of digital assets that will qualify as “investment contracts,” and hence “securities,” subject to SEC regulatory and enforcement power.
    • The SEC took a targeted approached, alleging that only nine out of the 25 potentially at issue digital assets are “securities.” It is reasonable to assume that the SEC only included its strongest Howey allegations, particularly in this first-of-its-kind insider trading enforcement action.  But that does not preclude the SEC from arguing in the future that the unidentified 16 digital assets are in fact “securities.”  As a practical matter, the SEC is likely to recover only the defendants’ alleged illicit proceeds associated with trading in digital assets that the SEC proves were “securities,” meaning that the SEC most likely will need to provide further detail on the other 16 digital assets as the case proceeds.
    • Notwithstanding the SEC’s targeted approach, the Complaint’s Howey allegations suggest that the SEC’s position is that very little is required for a digital asset to constitute a “security” – more specifically, that the “common enterprise” and “expectation of profits derived from the efforts of others” prongs of the Howey test are fairly easy to satisfy in the digital asset context. For example, the Complaint suggests that the SEC’s position is that the “common enterprise” prong will be met in the context of virtually any initial coin offering (i.e., when a digital asset is issued, at least in part, to raise funds to support an affiliated or associated business or project), and cites, among other things, a digital asset being listed on secondary markets and the rewards associated with a digital asset’s consumption or utility cases as evidence of a profit or investment motivation.
  • The Indictment serves as a powerful reminder that the DOJ has independent authority to police the digital asset industry separate from any other U.S. regulatory agencies. In addition to more specialized charges such as those relating to money laundering and economic sanctions violations,[7] the DOJ can use general-purpose fraud statutes, such as mail fraud, wire fraud, and conspiracy to commit those offenses, to reach a broad variety of deceptive practices, including in the digital asset industry.  Mail and wire fraud do not require any regulatory action, and are not dependent on the classification of digital assets as “securities,” “commodities,” or anything else.[8]  However, it is worth noting that this is a departure from the DOJ’s past practice, as the DOJ has historically relied on securities fraud charges in insider trading cases.
  • Both the Complaint and Indictment rely significantly on the existence of Company policies that prohibited Wahi’s sharing of information regarding the Company’s listing activities with his associates. Such policies are cited as evidence of Wahi’s breach of his duty to the Company, a key component of the DOJ’s wire fraud charges.  This serves as a reminder to digital asset industry participants, including trading platforms and exchanges, issuers, and large volume trading entities, about the need to have policies and procedures in place to prohibit the misuse of proprietary or confidential information, including through insider trading activities.

Responses to the Complaint and Indictment

Coinbase—which, again, is not named as a defendant in the Complaint or Indictment—responded immediately in a blog post, expressing support for the DOJ’s Indictment but calling the SEC’s Complaint “an unfortunate distraction from today’s appropriate law enforcement action,” and stressing the Company’s position that “[n]o assets listed on [its] platform are securities.”[9]  On the same day, Coinbase submitted a petition for rulemaking to the SEC requesting that it adopt rules to govern digital asset securities.[10]  Among other things, Coinbase’s petition criticizes the SEC’s “enforcement-first approach,” argues that the SEC’s request for digital asset exchanges and issuers to “come in and register” is “not possible or not economically viable given the associated and unnecessary compliance burdens,” and requests clarity on which digital assets are “securities.”  To date, the SEC has not taken any formal action in response to the petition.

The charges also spurred comments from some of the Commissioners at the CFTC, which is seen as potentially having jurisdiction over digital assets that qualify as “commodities.”  While CFTC Commissioner Johnson expressed tacit support for the SEC and DOJ actions,[11] CFTC Commissioner Pham was more critical of the SEC’s Complaint, saying “[m]ajor questions are best addressed through a transparent process that engages the public to develop appropriate policy with expert input—through notice-and-comment rulemaking pursuant to the Administrative Procedure Act,” and that “[r]egulatory clarity comes from being out in the open, not in the dark.”[12]  This reaction is an indication that at least some Commissioners at the two agencies do not share the same view of regulating the digital asset industry, which may give momentum to pending legislative proposals that would more clearly define the role of each agency in this industry.

[1] Complaint, SEC v. Wahi et al., No. 2:22-cv-01009 (W.D. Wash. July 21, 2022), available at https://www.sec.gov/litigation/complaints/2022/comp-pr2022-127.pdf (the “Complaint”); Indictment, U.S. v. Wahi et al., (S.D.N.Y. July 21, 2022), available at https://www.justice.gov/usao-sdny/press-release/file/1521186/download (the “Indictment”).

[2] The DOJ has previously filed an indictment for insider trading in the non-fungible tokens (or NFTs) context.  See Indictment, U.S. v. Chastain (S.D.N.Y. June 1, 2022), available at https://www.justice.gov/usao-sdny/press-release/file/1509701/download (the “OpenSea Indictment”).

[3] The nine digital assets that the SEC alleges in the Complaint are “securities” are AMP, RLY, DDX, XYO, RGT, LCX, POWR, DFX, and KROM.

[4] The Indictment focuses on the defendants’ conduct regarding XYO, POWR, TRIBE, ALCX, GALA, and ENS, and an April 2022 digital asset listing announcement by the Company (the April 2022 digital asset listing announcement that the Indictment appears to be referring to concerned nine digital assets (ABT, GNO, NEST, MTL, RARE, RAY, SWFTC, SYLO, and TONE)).

[5] The applicable test for whether something is an “investment contract” comes from SEC v. W.J. Howey Co, 328 U.S. 193 (1946).

[6] Howey, 328 U.S. at 299.

[7] We have written about the DOJ’s previous digital asset-related economic sanctions enforcement activity here.

[8] The DOJ is pursing similar charges in Chastain, the insider trading case regarding non-fungible tokens (or NFTs) against a former employee of the NFT trading platform OpenSea.  Similar to the Indictment, the DOJ alleged that the defendant in Chastain knowingly violated his employer’s policy regarding the confidentiality of business information.  See OpenSea Indictment.

[9] Coinbase, “An update on our asset listing processes [Updated July 21]” (last updated July 21, 2022), available at https://blog.coinbase.com/an-update-on-our-asset-listing-processes-e74421da21cc.

[10] Coinbase, Letter to Secretary Vanessa A. Countryman, Regarding Petition for Rulemaking – Digital Asset Securities Regulation (July 21, 2022), available at https://www.sec.gov/rules/petitions/2022/petn4-789.pdf.

[11] See CFTC, Statement of Commissioner Kristin Johnson on Policing Insider Trading in Digital Asset Markets (July 21, 2022), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/johnsonstatement072122.

[12] CFTC, Statement of Commissioner Caroline D. Pham on SEC v. Wahi (July 21, 2022), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/phamstatement072122?utm_source=govdelivery.