'Regulation by enforcement' by US SEC meet with criticism from crypto industry and other regulators
Updated: Jul 25, 2022
Late last week the US Securities and Exchange Commission announced insider trading charges against a former Coinbase employee, his brother, and their friend, while the indictment claims that some of the tokens which were part of the alleged scheme were securities under US law, including POWR, issued by Australian based Power Ledger.
The regulatory development of crypto-assets has been ongoing for many years and unfortunately the "regulation by enforcement" approach of the SEC is a distraction and potential impediment to considered and sensible regulation.
The facts surrounding the alleged wrongdoing are relatively straightforward. The SEC alleges that the former employee in question was a part of a group at Coinbase who had prior knowledge of which tokens would be made available for trading on the Coinbase exchange. All Coinbase employees were warned not to trade tokens on the basis of any information gained during their employment. The former employee in question allegedly tipped off his brother and a friend to upcoming token sales, making profits of USD$1.1M by front running listings in over 25 tokens. When called in for a meeting with Coinbase, the former employee bought a one way ticket to India and sought to flee the country, but was stopped at the airport.
On the token classification side, the SEC Complaint opens with the assertion that the insider trading involved "crypto asset securities" and goes on to say:
A digital token or crypto asset is a crypto asset security if it meets the definition of a security, which the Securities Act defines to include “investment contract,” i.e., if it constitutes an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others. ... [the defendant] provided material, nonpublic information about, and [the other defendants] traded in, at least nine crypto asset securities that meet this definition.
The complaint continues [at 90]:
... each of the nine crypto asset securities were offered and sold by an issuer to raise money that would be used for the issuer’s business. In the offerings, the issuers directly sold crypto asset securities to investors in return for consideration (most commonly Bitcoin, Ether, U.S. dollars, or other fiat currency, or processed through the use of smart contracts). The crypto asset securities then were issued and distributed to the investors’ blockchain addresses.
As alleged in greater detail below, the issuers and their promoters solicited investors by touting the potential for profits to be earned from investing in these securities based on the efforts of others. These statements focused on, among other things, the value of the token at issue and the ability for investors to engage in secondary trading of the token, with the success of the investment depending on the efforts of management and others at the company.
the issuers and promoters emphasized the ability for investors to resell these tokens in the secondary markets, on platforms such as Coinbase, which was a crucial inducement to investors and essential to the market for these crypto assets securities. Investors were told, explicitly or implicitly, that they could sell their securities in the secondary markets and that the liquidity available in the secondary markets could drive up the value of their crypto asset securities
The Complaint cites the key US decision as to whether something is an "investment contract", SEC v Howey, only once, and provides no further legal analysis under US law for the assertions put concerning the nine tokens. Instead, reference is made to various marketing from the token issuers referring to the benefits of users buying tokens or sharing in revenues of the project.
Importantly none of the issuers of those tokens have been prosecuted by the SEC, nor has Coinbase, which traded in the tokens. If the assertion as to these token's status is correct, there could be very serious consequences for those who were involved in the projects and for Coinbase and other exchanges which traded in the tokens.
The SEC has previously made vague assertions that parties were dealing in securities when conducting enforcement (such as in the Ether Delta and Tokenlot cases), and has a string of settled enforcement actions which had never reached a finding of fact or appellate review on the question of token status, so it is unusual to have this level of factual allegation as to the status of tokens in this Complaint.
On one view this approach remains consistent with the SEC as a regulator pressing their point of view as to certain tokens being securities, and taking a form over substance approach. However, an extremely well funded regulator, which has a key position of messaging seen (and followed) not just in the US but around the world, should be expected to consider their allegations actions and messaging in such a rapidly evolving space carefully. Further, the application of securities law is nuanced and complex, and a sweeping assertion that marketing of a token renders it a security under US law is not determinative.
That point was take up by an unusual rebuke from a Commissioner of the Commodities and Futures Trading Commission, who commented that the case is a "striking example of 'regulation by enforcement'" and that:
Major questions are best addressed through a transparent process that engages the public to develop appropriate policy with expert input... Regulatory clarity comes from being out in the open, not in the dark.
Coinbase's Chief Legal Officer, Paul Grewal, issued a strong statement titled: "Coinbase does not list securities. End of story." pointing out:-
Seven of the nine assets included in the SEC’s charges are listed on Coinbase’s platform. None of these assets are securities. Coinbase has a rigorous process to analyze and review each digital asset before making it available on our exchange — a process that the SEC itself has reviewed.
Mr Grewal summarized the key issue for the US, which also applies to many other jurisdictions:
....instead of having a dialogue with us about the seven assets on our platform, the SEC jumped directly to litigation. 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.
A core, and repeated, problem for the entire cryptocurrency and digital currency exchange industry is that existing financial services frameworks were not designed for a decentralised world and are unworkable in many ways for crypto asset issuers, even in the event they want to issue a token which is a security, or in Australia, a financial product.
Coinbase had coincidentally just petitioned the SEC to request clearer rules for crypto asset securities, so as give certainty for issuers seeking to innovate, and to provide clear boundaries between when a product would be within the regulatory perimeter (or not).
That petition summarised present issues as including:
An ongoing lack of clear regulation for the subset of crypto-assets which are securities/financial products;
A plethora of steps and intermediaries which prevent real time settlement of crypto assets which are securities;
An impossibility for individual investors to trade directly without using a broker; and
Blockchain technology not being able to be used as a record of transactions under current US rules, even though that is precisely what makes the technology so powerful.
Important other questions are left unanswered by this case, including:
Will other exchanges delist the tokens in questions (as occurred when the SEC sued Ripple)?
Are the issuers of the tokens in question, Coinbase or other exchanges which listed the tokens going to intervene in the case to argue the securities point?
Will the defendants argue that the tokens aren't securities to challenge the SEC's jurisdiction?
Given this prosecution arose from Coinbase itself referring the matter to the SEC, what incentive does this give to people in the crypto-industry to self report wrongdoing, if the SEC response is to respond in the manner it has?
As Miles Jennings of A16Z noted "[the] biggest takeaway is that it's remarkable how little new information/guidance can be taken away from the allegations..."
For Australian projects, many of the same regulatory grey areas as are faced in the US remain the same down under. There are great difficulties in bringing any crypto asset financial products to market, and those grey areas create great risks around token issuances which are not intended to be financial products.
This action by the SEC serves as a reminder of the importance of taking great care when a business considers issuing crypto asset tokens.