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If you’ve paid casual attention to crypto news in recent years, you probably feel that the crypto market is unregulated – a tech-driven Wild West where the rules of traditional finance don’t apply.
However, if you were Ishan Wahi, you probably wouldn’t have that feeling.
Wahi worked at Coinbase, a leading crypto exchange, where he had insight into which tokens the platform was planning to trade – an event that causes those assets to rise in value. According to the US Department of Justice, Wahi used that knowledge to buy those assets before the listings and then sell them for big profits. In July, the DOJ announced it had sued Wahi, along with two associates, in what it billed as the “first-ever cryptocurrency trading system for insiders.” If convicted, the defendants could spend decades in federal prison.
On the same day as the DOJ’s announcement, the Securities and Exchange Commission did its own. He also filed a lawsuit against the three men. However, unlike the DOJ, the SEC cannot file criminal cases, only civil cases. And yet it is the SEC’s civil lawsuit — not the DOJ’s criminal case — that has sparked panic at the heart of the crypto industry. That’s because the SEC charged Wahi with not only insider trading but also securities fraud, arguing that nine of the assets he trades count as securities.
This may sound like a dry, technical distinction. Whether a crypto asset should be classified as a security is in fact a huge, potentially existential problem for the crypto industry. The Securities and Exchange Act of 1933 requires anyone who issues a security to register with the SEC, in accordance with extensive disclosure rules. If they don’t, they can incur enormous legal liability.
In the coming years, we will discover how many crypto entrepreneurs have exposed themselves to that legal risk. Gary Gensler, who was appointed by Joe Biden as SEC chairman, has made it clear for years that he believes most crypto assets qualify as securities. His office is now putting that belief into practice. Aside from the insider trading lawsuit, the SEC is preparing to file a lawsuit against Ripple, the company behind the popular XRP token. And it is investigating Coinbase itself for allegedly offering unregistered securities. That comes on top of a class action lawsuit against the company filed by private plaintiffs. If these cases succeed, the days of the crypto-free-for-all may soon be over.
To understand the struggle to regulate crypto, it helps to start with the orange trade.
The Securities and Exchange Act of 1933, passed in the wake of the 1929 stock market crash, provides a long list of things that qualify as securities, including an “investment contract.” But it never describes what an investment contract is. In 1946 the US Supreme Court gave a definition. The case involved a Florida company called the Howey Company. The company owned a large piece of citrus orchards. To raise money, it started offering people the opportunity to buy parts of its land. In addition to the land sale, most buyers signed a 10-year service contract. The Howey Company would retain control of the estate and do all the work for growing and selling the fruit. In return, the buyers would get a share of the company’s profits.
In the 1940s, the SEC sued the Howey Company, alleging that the alleged land sales were investment contracts, and thus unlicensed securities. The case went to the Supreme Court, which ruled in favor of the SEC. Just because the Howey Company wasn’t offering literal shares, the court ruled, didn’t mean it wasn’t raising investment capital. The court explained that it would look at the “economic reality” of a business deal, rather than its technical form. It ruled that an investment contract exists when someone puts money into a project and expects the people running the project to turn that money into more money. After all, that’s what investing is: companies raise capital by convincing investors that they are getting more back than they put in.
Applying this standard to the case, the court ruled that the Howey Company had offered investment contracts. The people who ‘bought’ the plots did not really own the land. Most would never set foot on it. For all practical purposes, the company continued to own it. The economic reality of the situation was that the Howey Company was raising investment under the guise of selling real estate. “So,” the court concluded, “all the elements of a profit-seeking business venture are here. The investors provide the capital and share in the profits and profits; the promoters manage, control and operate the business.”
The ruling established the approach the courts follow to this day, the so-called Howey to test. It has four parts. Something counts as an investment contract if it is (1) an investment of money, (2) in a joint venture, (3) with the expectation of profit, (4) to derive from the efforts of others. The gist is that you can’t get around securities laws because you don’t use the words “stocks” or “stocks.”
Which brings us to Ripple.
