Crypto Insider Trading Case – Ishan Wahi

Summary:

On July 21st 2022, the Securities and Exchange Commission filed a complaint against certain defendants alleging insider trading – violations of Section 10(b) of the Exchange Act and Rule 10b-5. The conduct revolves around trading on information about crypto asset listings on Coinbase.
The insider trading conduct concerned trading in tokens that the Commission has called crypto asset securities.
On the same day, Coinbase wrote a blog post revealing that it had petitioned the SEC to “develop a workable regulatory framework for digital asset securities guided by formal procedures and a public notice-and-comment process, rather than through arbitrary enforcement or guidance developed behind closed doors.”
Rather than focus on the insider trading conduct, this note will focus on the question of which crypto assets may be crypto asset securities.

Allegations and Conduct:

In violation of Coinbase privacy policies, Ishan tipped his other co-defendants about imminent crypto listings on the Coinbase exchange. Ishan’s co-defendants traded on this information and earned $1.1 million of illicit profits.
The defendants traded at least 25 different crypto assets, only nine of which were identified by the SEC as crypto asset securities.
- Analysis:
  - This case is consequential as it demonstrates in detail examples of the type of tokens that the SEC would consider to be securities and presents an analysis of their thinking.
  - The complaint does not identify the 16 other crypto assets that weren’t defined as crypto asset securities.
  - This analysis could be applied to other situations and tokens and inform the steps investment advisers would be required to take if they trade tokens.

Crypto Asset Securities:

The Commission defined a crypto asset security as a digital token that 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 crypto asset securities purchased and sold in the transactions in this matter were created using the “ERC-20” protocol on the Ethereum blockchain. This would imply that any Ethereum-based token would be considered a security.

The SEC’s specific crypto asset security analysis is as follows:

Crypto Asset Security	Description	Examples of Indicia of Investing in a Common Enterprise	Examples of Indicia of Reasonable Expectation of Profits Based on the Efforts of Others
AMP	AMP is an Ethereum-based token that was created by Flexa Network, Inc. (“Flexa”), a company incorporated in Delaware with its headquarters in New York, New York. Flexa operates what it describes as a digital merchant payment network designed to enable rapid, universal, and secure processing of digital asset transactions. Investors in Flexa invest in collateral pools can stake their holdings to guarantee merchant transactions. If the collateral pools are profitable, investors who stake AMP can share in the profits.	Various statements by Flexa that “participants stake Amp into pools that secure the network.” and “Amp token serves as the singular type of collateral within Flexa to decentralize risk within the network.” AMP investors also share a common interest with Flexa’s management team.	Flexa emphasized that profits could be earned through Flexa’s activities in developing the network. This includes statements such as: • “AMP serves as a medium for accruing value” and “continuously appreciates in value as a direct result of its utility” within the Flexa network. • “AMP token pricing is based on user demand for staking yield, spending utility, and, expectation of future productivity growth.” Flexa continually promoted the availability of AMP issuing press releases, announcements and blog posts.
RLY	RLY is a “governance” token issued on the Ethereum blockchain. Rally Network, Inc. (“Rally”) is a Delaware corporation based in San Francisco. The Rally Network operates a number of projects built on the Rally ecosystem, including Rally.io.	Rally is a corporation and has made clear from the start that funds raised from investors would fund Rally’s development, while also ensuring that Rally’s management is incentivized to make RLY more valuable.	Rally claimed that RLY token holders would necessarily benefit from Rally’s growth. Rally leadership has also promoted RLY’s availability on the secondary market, as well as its liquidity. Rally has continued to emphasize the central role its management plays in RLY’s success.
DDX	DDX is a governance token issued on the Ethereum blockchain, associated with the DerivaDEX protocol, offered in or about July 2020 by DerivaDEX. DerivaDEX purports to be an exchange for derivatives contracts. The DerivaDEX protocol is not and has never been operational.	DerivaDEX has represented that funds raised by token sales would be directed in large part towards making DerivaDEX operational, although it still is not.	DerivaDEX touted a “series of incentivized opportunities that will be made available for early partners, including … insurance mining, and other opportunities to get early access to the exchange product and affiliate referral program.” DerivaDEX further described the insurance mining program, stating that investors would have the ability to earn more DDX by “staking” DDX to a DerivaDEX “insurance fund.” DerivaDEX has also sought to attract investors by noting that DDX tokens can soon be traded on secondary platforms.
XYO	XYO is an Ethereum-based token that was created by XY Labs, Inc. (“XY”). XY purports to operate a crypto-location and data blockchain network of devices that anonymously collects and validates geographic data (the “XYO Network”).	XY and its founders described how they would use funds raised during the initial coin offering (“ICO”) to build the XYO Network. In a February 2018 post, shortly before the ICO, XY provided a “Roadmap” with target dates for XY’s plans to develop the business including certain goals. XY stated that The ICO proceeds would supposedly be allocated to further “the long-term development goals of the XYO Network.	XY claimed that the success of this ecosystem will expand XY’s user base, thus continuing to create demand for XYO tokens. XY has consistently touted the growth of its user base. XY’s day-to-day operations and Board of Directors are run by a centralized leadership group that include two of XY’s three co-founders. XYO can be bought and sold for fiat currency or other crypto assets on numerous secondary trading platforms.
RGT	RGT is an ERC-20 token issued on the Ethereum blockchain minted by Rari Capital. Rari states that it is a “yield-maximizing robo-advisor” that allows users to earn RGT that can be traded on the secondary market, used for fee discounts and to confer governance rights in Rari Capital.	The majority of the funds raised from RGT investors were pooled to raise capital and develop the Rari protocol, including through payments to the Rari Founders and other Rari “contributors” working to improve the protocol. Rari has continued to use funds raised by selling RGT to pay Rari’s management team and developers. Rari stated its intent to pool RGT investor assets in liquidity pools, pursuant to its Liquidity Initiatives Program. Rari repeatedly made clear that funds from RGT investors were Rari’s primary source of funding.	Rari and the Rari Founders specifically pitched the RGT offering by emphasizing the opportunity for buyers to profit. Rari’s CMO stated that RGT investor funds will be used to pay developers because “[t]his will create a strong ecosystem around the Rari Protocol that can be later monetized. …” Rari CEO stated that the goal of the Liquidity Initiatives Program is to “provide exponential returns to RGT holders through smart investments and by bootstrapping future supplemental protocols.” RGT can be bought and sold for fiat currency or other crypto assets on numerous secondary trading platforms.
LCX	The Liechtenstein Cryptoassets Exchange (“The LCX”) operates a number of crypto-related services, including a crypto asset exchange, and a trading terminal.	The LCX emphasizes that purchasing LCX is an opportunity to participate in a growing platform. The LCX’s website states that the “LCX Token is your chance to be a part of LCX’s vision to bridge the gap between traditional finance and the new monetary world powered by blockchain and cryptocurrencies.”	The LCX has emphasized that as its platform expands in terms of both users and services, LCX will appreciate in value, particularly because there are a finite number of LCX tokens. The LCX has also continued to take steps that underscore the profit potential of LCX for investors, particularly in trading on secondary markets.
POWR	POWR is a token issued on the Ethereum blockchain, which was announced by Power Ledger Pty. Ltd. Power’s stated goal is to allow participants in energy grids to track, trace, and trade energy in real-time through a decentralized protocol.	Since POWR’s minting, Power has represented that investors in POWR are investing in a common effort to develop Power’s business. Power wrote that the goal of the token sale was to “accelerate our rate of growth” by obtaining “extra liquidity” to “fully take advantage of our first mover advantage.” One co-founder stated that POWR investor proceeds would provide a “really solid war chest to build the business” and allow Power to “broaden the applications and really make some solid inroads in peer-to-peer trading.”	Power has from the start pitched POWR by emphasizing the opportunity for buyers to benefit both directly by receiving a share of POWR’s fee revenues, and from trading POWR on secondary markets.
DFX	DFX is a token issued on the Ethereum blockchain by DFX Finance, an unincorporated business that operates Ethereum-based decentralized exchange pools for certain foreign crypto assets. Users earn DFX tokens by adding certain foreign crypto assets to the “liquidity pools” in DFX Finance’s currency exchange program.	Assets staked by DFX token investors are deposited in pools that facilitate the exchange of the foreign crypto assets.	DFX Finance tells investors that DFX token holders may receive transaction fees from the exchanges DFX planned to offer.
KROM	KROM is an ERC-20 token issued on the Ethereum blockchain. Kromatika is an unincorporated business started by two developers. It purports to operate a platform that allows traders to efficiently trade crypto assets by placing range orders on trading platforms.	Kromatika explained in its online “Flowchart” that funds raised from KROM sales would be used, in part, to develop and maintain the Kromatika platform. Kromatika implies that this aligns the interests of management and investors by securing their commitment to Kromatika’s success.	Kromatika pitched the KROM offering by emphasizing the opportunity for buyers to profit. KROM can be bought and sold for fiat currency or other crypto assets on numerous trading platforms.

Takeaways:

Aggressive Litigation Posture Demonstrating Risk Tolerance: With the question of whether crypto assets can be securities still undecided, this case presents significant risks for the Commission. Losing this case would remove a significant level of authority. This further evidences the aggressive approach of the current Commission.
Many Ethereum-based Crypto May Be Securities: All nine crypto assets that are the subject of this matter are Ethereum-based. This demonstrates that the Commission believes the structure of such assets lends themselves to the definition of securities.
Other Smart Contract-Based Crypto May Be Securities: Other blockchains designed to support smart contract features may also be considered securities. This type of crypto asset is growing, creating the possibility that much of the crypto universe may be securities.
- Indicia of being a security could include:
  - Staking: Could indicate that there might be an expectation of generating profits based on the work of others.
  - Governance: Could indicate that there might be an investment in a common enterprise.
  - Secondary Market Trading: Could indicate that there might be an expectation of generating profits based on the work of others (e.g., the people underwriting and touting the asset).
  - Active Enterprise: Tokens backed by operating companies, with management teams, could be an indication of a common enterprise and an expectation of generating profits based on the work of others.
Compliance Challenges for Crypto Investors: While we won’t know the outcome of this matter for years, this case demonstrates that certain assets will be treated by the Commission as securities meaning that asset managers investing in crypto will be subject to all the requirements of the Investment Advisers Act including requirements around custody, valuation, and fiduciary duties.