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Former Coinbase employee Ishan Wahi pleaded guilty to two counts of conspiracy to commit wire fraud Tuesday in connection to an insider-trading scheme at the exchange.
But while the Department of Justice got its desired verdict, Wahi still faces charges brought against him by the Securities and Exchange Commission (SEC). And its potential consequences extend far beyond just him.
The same day federal prosecutors filed criminal charges related to wire fraud last July against Wahi, his brother Nikhil, and their friend Sameer Ramani, the SEC piled on with civil charges and accused the three of violating securities laws as well.
The case centers on Wahi sharing information about upcoming token listings to the San Fransisco-based exchange to generate about $1.5 million in ill-gotten profits. But in its initial complaint, the SEC also claimed that at least nine of the tokens involved in the insider-trading scheme on Coinbase are illegal securities.
7/ Here, the SEC isn't just accusing the defendants of breaking the law.
The SEC is also accusing ten unrelated, uncharged companies of breaking the law: nine for failure to register digital asset securities & one for operating an unregistered national securities exchange.
— Jake Chervinsky (@jchervinsky) July 22, 2022
Policy Counsel at the Blockchain Association Marisa Tashman Coppel told Decrypt the case could have “huge implications on the industry” if the court rules in the SEC’s favor, as it would “inhibit creators and developers’ [ability] to create assets in the future.”
Whether digital assets should be classified as securities or commodities—under the SEC or Commodity Futures Trading Commission’s (CFTC) authority—has been a contentious topic in crypto. SEC Chairman Gary Gensler has only said firmly that Bitcoin is a commodity, claiming most other cryptocurrencies are unregistered securities.
The SEC believes that the nine digital assets fall under the agency's jurisdiction because they are “investment contracts,” which occur when money is invested in a common enterprise with a reasonable expectation that profits will be derived from the efforts of others. A favorable ruling would validate that stance, Coppel said.
The nine assets are AMP (AMP), Rally (RLY), DerivaDEX (DDX), XYO (XYO), Rari Governance Token (RGT), LCX (LCX), Powerledger (POWR), DFX Finance (DFX), and Kromatika (KROM), six of which are still available to trade on Coinbase.
Coppel described the case as partly a “due process issue” because the creators of the nine tokens are not defendants in the SEC’s case, with no way for them to intervene in the lawsuit. “If this is indicative of a broader pattern that the SEC is engaging in, that could be really problematic for the industry,” she said.
A ruling that finds the Wahi brothers and Ramani in violation of securities law could also impact others in the digital assets space, potentially requiring developers to register with the SEC when launching tokens or implicating Coinbase and other exchanges as venues that facilitate the sale of illegal securities.
“Theoretically, the other people trading, buying, or selling those tokens would also be in violation of securities laws,” Coppel said.
Wahi’s attorneys have argued against the SEC’s position. They motioned to have the SEC’s charges dismissed Monday on the grounds that the digital assets in question do not satisfy the conditions necessary to be considered an investment contract.
They argue that the tokens lack “essential ingredients” of an investment contract, such as a contract itself, which imposes post-sale obligations on the seller like the legal right to share in the profits.
“The SEC does not—and cannot—allege that the tokens involve contracts among developers and token-holders,” the motion states. “In fact, the tokens impose no legal obligations on their developers after the time of sale.”
Wahi’s attorneys contend token purchases made on a secondary market are “no different from when someone buys a baseball card” because buyers send their money to unrelated third parties like exchanges as opposed to putting that money in a common enterprise.
Regulation through enforcement
The case represents an attempt by the SEC to shape regulation around digital assets through the court system. Critics of the approach have called it “regulation through enforcement,” opting to establish rules by going after perceived bad actors instead of putting forth clear regulations with the ability for people to provide feedback.
When the SEC filed securities fraud charges in relation to the insider-trading scheme at Coinbase, comments made by Caroline Pham, a Commissioner of the CFTC, highlighted how the ruling could shape the digital assets space.
“The SEC’s allegations could have broad implications beyond this single case,” she wrote. “Major questions are best addressed through a transparent process that engages the public.”
— Caroline D. Pham (@CarolineDPham) July 21, 2022
Coinbase’s Chief Legal Officer Paul Grewal also pushed back against the SEC’s regulatory blitz shortly after it filed charges. “Instead of crafting tailored rules in an inclusive and transparent way, the SEC is relying on these types of one-off enforcement actions to try to bring all digital assets into its jurisdiction,” he said.
The framework for what constitutes an investment contract can be traced back to 1946. The Supreme Court found that the sale of plots in a citrus grove by William John Howey were unregistered securities because of a service contract where he offered to tend the land and sell produce for those that purchased the fruit-bearing parcels.
“Here, the SEC is pressing a novel construction of an isolated term from a Depression-era law to assert regulatory authority over a trillion-dollar industry built upon revolutionary technology poised to define the next generation of the internet,” Wahi’s lawyers argued.
But not every official within the SEC is on the same page as Gensler when it comes to the so-called Howey test—the agency’s 4-pronged method for determining whether an investment contract exists. SEC Commissioner Hester Peirce said that the test has some limitations on an episode of Decrypt’s Gm! podcast, one of them being its permanency.
“We've said that orange grove is going to be treated as a security in perpetuity,” she said, adding that clarification from the SEC on how a token could go from a security to a commodity with specific criteria would help assuage some concerns with the SEC’s logic.
“If we were more precise, I think that there would be fewer objections to applying the Howey test and saying, ‘Hey, that initial time when you sold it, that might well have been a securities offering,’ but that doesn't mean that the token continues to be a security for the rest of its life,” Peirce said.
The Howey test is also a sticking point in other cases where the SEC has gone after players in the crypto space while calling tokens unregistered securities. An ongoing lawsuit filed in late 2020 against Ripple Labs, its co-founder Christian Larsen, and CEO Brad Garlinghouse, accused the company of raising $1.3 billion in unregistered securities offerings since 2013 through the sale of the token XRP.
In September, Ripple and the SEC filed motions seeking summary judgment, asking for the case to be dismissed and a ruling made in each party’s favor. And while law experts have speculated the SEC is likely to lose the case if it goes to trial, Coinbase made moves to support the company’s legal position last November.
The company asked Judge Analisa Torres—who oversees Ripple’s case in a Southern District of New York court—to file a document in support of Ripple’s legal position. A key point was that digital assets traded on an exchange do not give individuals ownership of a venture or let them share in a firm’s profits through dividends, unlike some stocks do.
While these cases could have broad implications for the crypto space, they wouldn’t have precedential value, said Coppel, explaining that the judges in other federal districts could find the readings persuasive but aren’t bound by it.
However, if they are appealed, those rulings could begin to set a precedent throughout parts of the United States as they work their way through the federal court system, potentially becoming the law of the land if they ever make it to the Supreme Court.
Regardless, it appears the SEC appears won’t be dropping enforcement actions from its regulatory playbook anytime soon. On Thursday, the SEC announced settled charges and $30 million fine against San Francisco-based cryptocurrency exchange Kraken over its staking-as-a-service program.