Background
The US Securities and Exchange Commission (SEC) recently saw its first insider trading case involving cryptocurrencies. The case comes just weeks after the US Department of Justice (DOJ) brought insider trading charges against an employee of OpenSea, a marketplace for non-fungible tokens (NFTs). Both cryptocurrencies and NFTs are based on blockchain technology that is rapidly disrupting the financial sector. This article considers the case and whether similar action can be expected in the UK.
On 21 July 2022 the SEC and DOJ filed civil and criminal charges against Ishan Wahi, a former manager in the assets and investing products group at Coinbase Global, Inc Charges were also filed against Ishan’s brother, Nikhil Whai, and their friend, Sameer Ramani.
Coinbase is one of the largest crypto asset trading platforms in the US, with more than 98 million registered users. Since May 2020, Coinbase has publicly announced on its blog or Twitter feed when it will list certain crypto assets on its trading platform. Ishan was in possession of first-hand knowledge of what crypto assets Coinbase planned to support and when Coinbase intended to make listing announcements. In relation to this information, he owed a duty of trust and confidence to Coinbase that required him to keep listings information confidential.
Ahead of multiple listing announcements between June 2021 and April 2022, Ishan repeatedly tipped Nikhil and Ramani with material, non-public information about the timing and content of various listings. Ishan communicated by phone and text with Nikhil and Ramani, including exchanging phone calls and messages with both that would not be captured in US phone company records because, among other things, Ishan was using a phone with a non-US phone number. Nikhil and Ramani used this information to make trades in advance of at least 14 public listing announcements. In doing so, they allegedly purchased and sold at least 25 crypto assets for a profit of more than $1.1 million using Ethereum blockchain wallets.
SEC’s jurisdiction
The SEC claims that at least nine of the crypto assets involved were securities. A crypto asset security refers to an asset that is issued and/or transferred using distributed ledger or blockchain technology and meets the definition of ‘security’ under the federal securities laws. Under section 2(1)(a) of the Securities Act 1933, the definition of a security includes ‘investment contracts’. For an asset to be considered an investment contract, it must satisfy the Howey Test, which was developed and named after the Supreme Court case SEC v WJ Howey Co 328 US 293 (1946). Under the Howey Test a digital asset, including a crypto asset, will be deemed a security ‘if it constitutes an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others’ (emphasis added).
The SEC claims that the factors in the Howey Test were satisfied because:
- the ‘securities were offered and sold by an issuer to raise money that would be used for the issuer’s business’;
- ‘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’; and
- statements were made regarding ‘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’.
At least nine of the crypto assets involved in the charges against Ishan, Nikhil and Ramani are, therefore, considered by the SEC to be securities. Without such interpretation by the SEC, it would have no statutory authority to bring an action alleging insider trading.
The SEC defines insider trading as ‘buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information about the security’. The SEC goes on to clarify that insider trading violations may include the ‘tipping’ of such information, trading by the person ‘tipped’, and trading by those who misappropriate such information.
Whilst the claims alleged by the SEC appear to be strong, they hinge on the definition of ‘security’. In August 2021, the current chair of the SEC, Gary Gensler, told CNBC (a provider of financial market coverage and business information) that the SEC considers many cryptocurrency coins and tokens to be securities under the Howey Test, stating that “if somebody is raising money selling a token and the buyer is anticipating profits based on the efforts of that group to sponsor the seller, that fits into something that’s a security”. Paul Grewal, chief legal officer at Coinbase, however, disputes the SEC’s claim that the instruments involved in the charges against Ishan, Nikhil and Ramani, were securities, recently tweeting that: “Coinbase doesn’t list securities. Period.”
Conversely, the US Commodity Futures Trading Commission (CFTC) asserts that cryptocurrencies are commodities and, therefore, subject to its own jurisdiction. This assertion is supported by a federal jury decision made in Boston on 21 July 2022, where the jury held that a virtual currency could be considered a commodity within the CFTC’s jurisdiction in a case where Randall Crater, founder of crypto currency business ‘My Big Coin Inc’, was convicted of fraud. Many in the digital asset industry would prefer cryptocurrencies to be treated as commodities rather than securities, as the CFTC rules that govern the former impose lighter regulation than the SEC rules that govern the latter.
The brother of Ishan, Nikhil, has since pleaded guilty to a wire fraud conspiracy charge, admitting before a US district judge in Manhattan that he made trades based on confidential Coinbase information. Ishan, however, has pleaded not guilty and it is understood he is due to next appear in court on 22 March 2023. Ramani remains at large.
The charges made by the SEC on 21 July 2022 mark the first time the SEC has formally identified certain cryptocurrencies offered on a major trading platform as securities. Cryptocurrency traders have, therefore, been put on notice that the SEC considers some cryptocurrencies to be securities and are advised to act accordingly. They also highlight the SEC’s desire to establish jurisdiction and regulatory oversight of digital assets and platforms, with this action becoming another part of the battle between the SEC and the CFTC as they seek to persuade authorities who should be the main US regulator of crypto.
Crypto assets and market abuse in the UK
As is highlighted in the US case, with crypto assets, before getting into the issue of whether any market abusive conduct has taken place, prosecutors and other authorities have to show that the crypto asset is capable of being caught by the market abuse regime. In other words, there is an initial, and perhaps high, hurdle to overcome before even getting into the facts of the alleged abusive conduct. So, for example, before considering whether or not someone had dealt in shares based on relevant inside information before that information had become public, authorities will have to establish first whether the particular crypto asset is a form of security or financial instrument to which the market abuse regimes apply.
In the UK, there are two regimes under which forms of market abuse can arise: (i) the Criminal Justice Act 1993 (CJA) (insider dealing), and (ii) the UK Market Abuse Regulation (UK MAR)[1] (market manipulation, insider dealing and unlawful disclosure of inside information).
Under part V of the CJA, insider dealing is a criminal offence which involves dealing in securities on the basis of insider information – ie information that is not yet publicly known and which would affect the price of the securities if it were made public.
Under article 8 of UK MAR, insider dealing arises where a person possesses inside information and uses that information by acquiring or disposing of financial instruments to which that information relates, whether for its own account or for the account of a third party and whether directly or indirectly. The other forms of market abuse under UK MAR also involve conduct relating to financial instruments.
Whether crypto assets are caught, potentially, by either regime – CJA or UK MAR – depends, therefore, on whether such assets are securities (under CJA) or financial instruments (under UK MAR).
‘Securities’ are listed in schedule 2 of the CJA and covers shares, debt securities, and other instruments based on or derived from such shares or debt securities – namely, warrants, depositary receipts, options, futures and contracts for differences. Debt securities are any instrument creating or acknowledging indebtedness which is issued by a company or public sector body.
‘Financial instruments’ are listed in schedule 2 of the Regulated Activities Order. It is a fairly long and involved list, but for these purposes, one item on the list – transferable securities – is of particular interest. This includes classes of securities which are negotiable on the capital market and includes shares in companies (and comparable interests in partnerships and other entities and equivalent securities) and securities giving the right to acquire or sell transferable securities (eg warrants, options, futures and convertible bonds) and securitised cash-settled derivatives (eg certain futures, options, swaps and contracts for differences).
The individual features of the crypto asset will have to be analysed and assessed to determine whether they are caught by either of the UK’s market abuse regimes. The FCA has created a framework for crypto assets based on their intrinsic structure as well as their designed use and has indicated that there are three broad categories of crypto assets: (i) security tokens; (ii) e-money tokens (both of which are referred to as regulated tokens); and (iii) unregulated tokens (being any token that is not a security or e-money token). Only the first category is likely to be relevant here but this, again, will depend upon the specific characteristics of the security token.
The FCA guidance states that a token that creates or acknowledges indebtedness by representing money owed to the token holder is considered a debenture and constitutes a security token. This analysis may be sufficient for ‘debt securities’ under the CJA. If a token is negotiable on the capital markets (eg because it can be transferred from one person to another who then acquires legal title of the token), then it might be considered a transferable security. In other words, a crypto asset that is a security token could, in these circumstances, be a transferable security and fall within UK MAR.
As mentioned above, UK MAR prohibits insider dealing, unlawful disclosure and market manipulation. UK MAR describes activities that fall within these prohibitions, and they include spoofing – a strategy deployed to artificially influence the price of a financial instrument using fake buy or sell orders to create the (false) impression of optimism or pessimism in the market, causing the market price to move in response. Spoofing, and other prohibited practices, can readily occur – and have occurred – in relation to crypto assets.
The problem arises that the novel and changeable characteristics of crypto assets and their markets mean that new forms of abusive behaviour could emerge that have not been anticipated in UK MAR; the complex and often poorly understood technology underpinning crypto assets makes manipulation harder to recognise or detect. Crypto assets are also more susceptible to pure market sentiment than traditional markets – as is evident from the recent volatility in cryptocurrency markets which has caused the ‘crypto winter’.
Where crypto assets fall within UK MAR or CJA, there are clearly issues and hurdles to overcome for any authority pursuing a market abuse action or prosecution. There are many crypto assets that are, on any analysis, outside the scope of the market abuse regimes and therefore beyond any regulatory or legal framework that can provide for orderly trading and safe markets.
That being said, those companies that are potentially permitting the trading of securities or financial instructions via their platforms, or otherwise, ought to ensure that their policies and procedures adequately cover insider trading and market abuse to avoid any potential liability that could be imposed on them via their employees’ activities.
This article was co-written with Charlotte Allan, trainee solicitor in the commercial dispute resolution team.