FORMER CRYPTOCURRENCY EXCHANGE MANAGER INDICTED BY DOJ AND CHARGED BY SEC: IS IT ‘REGULATION BY ENFORCEMENT’?

Factual Background

On July 21, 2022, the Department of Justice (“DOJ”) and the Securities and Exchange Commission (“SEC”) for the first time brought insider trading charges involving cryptocurrency assets. The SEC and DOJ charged a former employee of Coinbase Global, Inc. (“Coinbase” or “the Company”), his brother, and his friend.^[1]

Coinbase, which operates one of the largest digital asset trading platforms in the world, allows users to trade various digital assets that it has listed for trading on its trading platform. As a result of its size, after Coinbase makes an announcement that a particular digital asset will be listed on its trading platform or is under consideration for listing, the price and trading volume of the digital asset often increases quickly and significantly. The Company has confidentiality requirements regarding when new listings of digital assets will be announced to the public. Per policy, employees are prohibited from purchasing and trading on any digital assets in advance of associated listing announcements. Employees are further prohibited from disclosing information about new digital asset listings to individuals outside of the company.^[2]

According to the charges, product manager Ishan Wahi was directly involved in the process for listing digital assets on the platform and had knowledge of which digital assets Coinbase planned to list and the timing of such listing.^[3]  As a result, Ishan Wahi had regular access to confidential information about the Company’s digital asset listing plans. Between June 2021 and April 2022, according to the DOJ’s Indictment, Ishan Wahi disclosed confidential information to his brother, Nikhil Wahi, and Ishan Wahi’s friend, Sameer Ramani, concerning the timing of listing announcements. Nikhil Wahi and Ramani used this confidential information to purchase digital assets immediately preceding those announcements. Their investments ranged from $60,000 to over $610,000 and resulted in gains totaling at least $1.5 million.

The scheme surfaced after an April 12, 2022 Twitter post asserted that a particular Ethereum blockchain address “bought hundreds of thousands of dollars of tokens exclusively featured in the Coinbase Asset Listing post about 24 hours before it was published.”^[4]  Coinbase publicly stated that it was already investigating the matter.^[5]  On July 21, 2022, the same day the DOJ filed charges, the Company stated that once it had “collected sufficient evidence to be confident” in its suspicions regarding its employee’s improper conduct, the Company “provided information about [the three] individuals to the DOJ and terminated” Ishan Wahi.^[6]

After learning that he was required to meet with Coinbase’s Legal Department as part of Coinbase’s internal investigation, Ishan Wahi is alleged to have sent a screenshot of the request to Nikhil Wahi and Ramani and purchased a one-way ticket to India. Ishan Wahi emailed his coworkers notifying them that he would be “out indefinitely.”^[7]  Authorities stopped him before he could board his plane.

The DOJ Indictment

A grand jury indicted Ishan Wahi on two counts of conspiracy to commit wire fraud and two substantive counts of wire fraud. Nikhil Wahi and Ramani were each charged with one count of conspiracy to commit wire fraud and one substantive count of wire fraud. The Indictment alleges that the fraud was committed through Ishan Wahi’s breach of duty to Coinbase, which was “deprive[d] [ ] of its exclusive use of confidential business information.”^[8]  The Indictment further alleges that Ishan Wahi disclosed confidential information about fourteen listings covering 25 digital assets to his two co-conspirators, who traded on that information. The Indictment does not refer to these assets as securities and the Indictment’s charges do not sound in securities fraud as would a traditional insider trading prosecution.

The SEC Complaint

The SEC brought a Complaint the same day charging the trio with violating insider trading laws under Section 10(b) and Rule 10b-5 of the Exchange Act.^[9]  The Complaint asserts that at least nine of the 25 digital assets referenced in the Indictment are securities^[10] because they are “investment contracts” under the traditional Howey securities test: “an investment of money, in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others.”^[11]  In particular, the Complaint alleges that the assets “were offered and sold by an issuer to raise money that would be used for the issuer’s business”^[12] and that “the nine companies invited people to invest on the promise that it would expend future efforts to improve the value of their investment.”^[13]

The Complaint does not directly address why the remaining sixteen assets are not securities, but notes that “the[] hallmarks of the definition of a security continue to be true for the nine crypto asset securities that are the subject of the trading in this complaint, including continuing representations by issuers and their management teams regarding the investment value of the tokens, the managerial efforts that contribute to the tokens’ value, and the availability of secondary trading markets for trading the tokens.”^[14]  The Complaint further alleges that Ishan Wahi provided material, nonpublic information about Coinbase’s asset listing announcements to Nikhil Wahi and Ramani, who traded on that information.^[15]

Response to the Charges

In public statements published on the same day as the Indictment and Complaint were filed, two Commissioners of the Commodity Futures Trading Commission (“CFTC”) provided their views about the SEC’s charges. Commissioner Caroline Pham labeled the SEC’s decision to file charges “a striking example of ‘regulation by enforcement.’”^[16]  Commissioner Pham also said that the SEC’s decision to pursue the matter as a securities fraud “could have broad implications beyond this single case, underscoring how critical and urgent it is that regulators work together,” and referenced a need for “a transparent process that engages the public to develop appropriate policy with expert input.” In her statement, CFTC Commissioner Kristin Johnson noted the need “to prevent bad actors from taking advantage of important policy and regulatory debates” and called for increased collaboration among regulators.^[17]

In a blog post following the announcement of the charges, Coinbase’s Chief Executive Officer wrote that, while the Company does not tolerate the kind of misconduct detailed in the Indictment and Complaint, “[t]he DOJ did not charge securities fraud. No assets listed on our platform are securities, and the SEC charges are an unfortunate distraction from today’s appropriate law enforcement action.”^[18]

Coinbase’s Chief Legal Officer titled another blog post, “Coinbase does not list securities on its platform. Period,” and wrote that “the SEC’s charges put a spotlight on an important problem: the US doesn’t have a clear or workable regulatory framework for digital asset securities. And 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, even those assets that are not securities.”^[19]  He further stated that the company cooperated with the DOJ’s investigation, but the SEC “jumped directly into litigation” without even having a conversation with the company.^[20]

Just before the Indictment and Complaint were filed, Coinbase had filed a petition with the SEC calling on the agency to initiate a formal rulemaking process to provide transparency and clarity to the regulation of digital asset securities.^[21]  In the petition, the Company questioned whether the long-established legal tests used to determine whether a non-traditional asset was a security were appropriate for digital assets and requested that the SEC promulgate rules to clarify what digital assets are securities. The Company also asked that the SEC engage in rulemaking on related issues, such as a registration regime for the offer and sale of digital asset securities and clarity on the disclosure, trading and custody requirements for digital asset securities.

Analysis

It is not unusual for the DOJ and SEC to investigate insider trading allegations in parallel. It is unusual, however, for the DOJ to bring charges that make no reference to securities or the securities laws while the SEC, on the same facts, brings standard securities law-based insider trading claims. While the DOJ has for some time used wire fraud, with its less complicated elements, to augment securities law-based insider trading charges, here it appears that the DOJ wanted to avoid a debate about whether the digital assets at issue are in fact securities.

The SEC in contrast has taken the position that “at least nine”^[22] of the 25 assets referenced in the Indictment are in fact securities. While the SEC has consistently taken the position that the Howey test provides all the necessary elements to determine whether a digital asset is a security,^[23] questions around how to apply a 76-year-old case about orange groves to digital assets have been common outside the SEC, as noted in Coinbase’s rulemaking petition.^[24]

CFTC Commissioner Pham echoed a sentiment frequently heard by commenters on the slow-to-develop regulatory landscape for digital assets: that it is ineffective (and unfair) to regulate through enforcement rather than through clear rulemaking resulting from appropriate collaboration among authorities and industry. CFTC Commissioner Johnson appears to share this view. A similar concern can be found in SEC Commissioner Hester Peirce’s dissent in the SEC’s February 2022 BlockFi resolution relating to digital asset lending. While SEC Commissioner Peirce did not take exception to “tagging” BlockFi’s lending product as a security, she did ask whether “the approach we are taking with crypto lending [is] the best way to protect crypto lending customers?” Her response to that question was “I do not think it is;”^[25] rather, she suggested that the SEC “need[s] to commit to working with [ ] companies to craft sensible, timely, and achievable regulatory paths.”

The SEC has clearly signaled through its enforcement actions and public pronouncements that it will take a very strong position in imposing the securities laws on the digital asset industry, and the Coinbase insider trading case is further evidence of its determination to do so. If the SEC case is not stayed – it will be interesting to see whether the DOJ intervenes – perhaps there will be a ruling in the not-too-distant future on the question of whether the particular assets in the SEC Complaint are in fact securities. In the meantime, CFTC commissioners appear to share concerns expressed by the digital asset industry over whether the SEC is pursuing an effective regulatory strategy through its enforcement actions.

Special thanks to summer associates Audrey Felderman and Patrick Nugent who contributed to this publication.