On July 21, 2022, the SEC charged three individuals with insider trading of digital assets via a scheme to trade ahead of multiple announcements regarding crypto assets being made available on a United States-based digital asset exchange at which one individual was a former product manager. In the complaint, the SEC identifies nine “crypto asset securities” (the first time the agency has used this term) that the agency alleges are securities. The SEC also alleges that the individuals orchestrated the scheme more broadly on at least 25 digital assets — 16 of which are not identified — gaining illicit profits of more than $1.1 million. The SEC worked with the U.S. Attorney’s Office for the Southern District of New York and the FBI. DOJ separately announced the indictment of the three individuals on charges of wire fraud and conspiracy to commit wire fraud arising out of the same conduct. Interestingly, however, DOJ has not brought securities fraud charges against the individuals (at least not yet).
The SEC alleges that the nine identified tokens are crypto asset securities because they meet the definition of investment contract pursuant to the test set forth in the Howey Supreme Court decision, i.e., they were offered and sold pursuant to facts and circumstances involving an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others. The SEC’s complaint focuses frequently on the use of proceeds of what the complaint describes as token sales for development of the crypto asset when analyzing the common enterprise element prong of Howey. When analyzing the reasonable expectation of profit derived from the efforts of others, the SEC seems to have relied on statements from project whitepapers, marketing materials, and social media posts from “issuers and their agents” emphasizing not only the ability to make money, but also the importance of a given project’s development team in continuing to build the network and develop additional functionality. Perhaps due to factual holes in an analysis based on these public statements alone, the SEC notes for certain of the representations, “[i]nvestors were told…implicitly….” Implicit representations may be a difficult standard to rely upon as a representation made by an issuer and relied upon by a reasonable investor. For example, in many instances, the complaint seems to rely on the idea that acknowledgement by an issuer of the fact of an asset being listed must be an implicit representation of future profits.
The SEC’s failure to identify what threshold factors cause a digital asset to be a security has been the cause of much consternation and speculation in the industry. The complaint does nothing to further illuminate the criteria the SEC might be using to identify when a project has reached sufficient decentralization to assure non-security status under the decentralization theory suggested by prior agency leadership.1 The complaint may, in fact, show a move away from this theory. In the complaint, the SEC consistently alleges facts dating back years prior to the listing decision of the exchange or the trading activity of the three individuals, even referring to sales of tokens, in many cases conducted as exempt securities offerings, as indicative of the current status as a security. But the SEC chose to not, in most cases, analyze a potential change of facts from a centralized model to a potentially decentralized model at the time of listing based on the guidelines on this exact point previously provided by SEC staff.2 Other facts cited appear to shed light on how the SEC will consider factors like promotion and dependence on a central development or management team when the agency analyzes common enterprise and expectation of profits from the efforts of others.
Centralized Crypto Exchanges, DEXs, AMMs, Trading Desks, and Token Projects Should Be Paying Attention!
The complaint has enormous implications for the platforms, projects, and individuals facilitating or intermediating trading and other activity in the nine assets the SEC has specifically identified as securities in this case.3 One need only harken back to the SEC’s 2017 DAO Report, or recent enforcement actions, to understand the agency’s likely next steps: allegations of unregistered broker and unregistered exchange activity involving these alleged crypto asset securities.
The SEC is careful to say that “at least” nine of the 25 tokens in question were securities, leaving open the possibility that the remaining 16 could also later be deemed securities. It should not be difficult for the industry to decipher what those other 16 tokens are, despite the SEC not naming them (actually, by the time we publish this it is likely someone will have already done so). The SEC’s approach here may indicate that the agency determined that the Howey analysis was less persuasive for the remaining 16.4 In any event, this suggests that the SEC staff is actually going through an analysis to pick and choose. Perhaps this case will actually shed some light on how the SEC staff really parses the elements of Howey. On initial review, the SEC’s complaint appears to rely upon facts and themes to which the agency has cited in the past, including Howey. Nevertheless, this case could lead to a new “test” on which the security status of crypto is determined.
The Complaint May Affect the Projects Themselves
Unfortunately, the SEC shoehorns the alleged security status of these assets into a complaint on insider trading. The complaint seems to rely exclusively on publicly available sources as the factual basis for its allegations, and one must assume, based on such reliance, that the issuers of the identified assets have not been afforded due process to dispute the security status of their assets. The security status of these assets is a crucial component of the SEC’s complaint, but it is not the central factor that will be litigated. Rather, the focus will likely be on the insider trading claims. That said, given the SEC’s recent experiences in at least one other contested matter, agency attorneys likely felt that they had no choice but to identify the assets in question in order to establish jurisdiction. We expect that if the case proceeds, counsel for the issuers of the identified assets, and the exchange itself, will not simply acquiesce to the alleged security status (and it will be interesting to see how they may be able to intervene and challenge the complaint’s conclusions as the court considers these issues). Unfortunately, we may never know. Given that there is a parallel criminal case proceeding with the DOJ, the SEC case typically will be stayed pending the resolution of the criminal proceedings.5This action may be the first of many to assert that digital assets are securities as a component of an adjacent violation. This strategy by the SEC allows it to assert security status without having to build and defend that claim against the assets themselves as a core component of its case. In addition, by asserting that nine separate assets are securities, even if a court or jury does not agree on all counts, the SEC may still succeed on some.
Token Holders — Retail and Institutional Alike — Will Be Affected
One prong of the SEC’s tripartite mission is investor protection. This complaint will almost certainly affect the holders of these tokens, including if exchanges delist these assets. If past examples are prologue, we will likely see a significant drop in valuations and flat recovery over time as this matter potentially drags on (although there did not appear to be an immediate effect on the day of the complaint). The ability to exit positions may also be significantly constrained if trading venues and protocols decide to delist or cease to support these tokens.
Aside From Investor Protection, What About the SEC’s Other Mission Prongs?
Speaking of the agency’s mission, the other two prongs are maintaining fair, orderly, and efficient markets and facilitating capital formation. Most would say that any action related to insider trading is squarely consistent with these two mission prongs by ensuring trust in efficient markets and those that control them. But it should come as no surprise to hear that many will criticize the SEC’s actions, particularly with respect to the naming of the nine assets as securities and the lack of specific insight into how the SEC thinks the Howey elements are satisfied by those assets, thereby contributing to knee-jerk market reactions and ongoing market uncertainty. Some will say that this approach, plus the accusations of regulation by enforcement, fly squarely in face of the agency’s mission in this regard.
What Does the CFTC Think About This?
Neither the SEC complaint nor the agency’s related press release mention any collaboration or cooperation with or by the CFTC. Given that the SEC is not at this time alleging security status for the other 16 tokens, some might infer that they must be commodities. But it is unlikely that the SEC (or Chairman Gensler) would cede jurisdictional ground so easily, which likely contributed to why the SEC was careful to say “at least” nine of the 25 are crypto asset securities. It will be interesting to see if the CFTC concedes that any of the 25 tokens are securities. Doing so would call into question whether derivatives on these tokens are within the CFTC’s jurisdiction. The two agencies cooperate in many areas, but with crypto each seems to be afraid to make the first move with definitive views or guidance as to what falls exclusively within (or outside of) their jurisdiction. Perhaps Congress will need to make the first move, as both regulators clearly have an interest in regulating crypto and neither is likely to yield to the other.
1William Hinman, Director, Division of Corporation Finance, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018)
2On April 3, 2019, the staff of the SEC’s Division of Corporation Finance proposed a framework for assessing digital assets. The guidance seeks to help issuers and market participants evaluate “…whether a digital asset previously sold as a security should be reevaluated at the time of later offers or sales" and sets out criteria upon which to assess such a question.
3Notably, paragraph 89 of the complaint cites seven crypto asset securities although the complaint lays out facts with respect to nine assets. One must wonder which two of the assets were unfortunate late additions to the group.
4Alternatively, the SEC staff may simply have been rushed to finalize the complaint given that one of the defendants was arrested as he allegedly sought to flee the country. If the agency ran out of time to analyze all 16 assets, it is possible the SEC could identify additional crypto asset securities in a future amended complaint. The typo in paragraph 89 seems to indicate that the list was growing, not shrinking.
5Further, unless the defendant is acquitted at trial, the SEC case is unlikely to proceed as the resolution of the criminal case by plea or conviction will likely result in resolution of the SEC case as well. Consequently, we may not get any additional insight or analysis from the SEC, and the issuers may be unable to intervene.