Regulation by enforcement takes center stage again for the US SEC

On Thursday, July 21, 2022, the US Attorney's Office for the Southern District of New York charged a former cryptocurrency exchange (the Exchange) product manager for allegedly tipping off his brother and friend with material, non-public information in advance of the Exchange's listing announcements of certain digital assets (see our analysis of the indictment). The same day, the Securities and Exchange Commission (the SEC) also decided to throw its hat in the ring in another stark example of the SEC's "regulation by enforcement."

Insider trading falls under the antifraud provisions of the federal securities law, particularly Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. To bring a valid insider trading case, the assets at issue must constitute "securities." The SEC contends that many of the digital assets listed on the Exchange meet the definition of "security" including nine specific "crypto asset securities" that the ex-employee tipped information on. The SEC alleges that these nine tokens meet the definition of securities because they are "investment contracts" under the Securities Act of 1933, as amended (the Securities Act), and goes through the Howey test for each token in the complaint. Generally, the SEC argues that the tokens were sold to investors to raise money for the issuer's business or project, the issuers made statements that their efforts would improve the value of the tokens and the tokens could be resold in the secondary markets (i.e. on the Exchange) for a profit.

Throughout the SEC's civil complaint, the SEC asserts the assets in question are securities, referring to them and other tokens listed on the Exchange as "crypto asset securities." At the same time, the SEC ignores the wide-reaching ramifications of this assertion. If these tokens do meet the legal definition of securities, this would mean that at least nine digital assets listed on the Exchange are unregistered securities. This would also mean that the Exchange is an unregistered exchange selling unregistered securities. However, to date, the SEC has not named the issuers or the exchange as parties in the case or charged them with such potential violations, although any of the nine token issuers and the exchange may have the standing to seek to have the SEC's case dismissed on the basis of its broader implications.

Many in the industry, including large market participants and other US regulatory agencies, have repeatedly criticized the SEC for not providing clear guidance with respect to classifying digital assets, digital asset exchanges and related blockchain infrastructure. Instead, the SEC continues to provide snippets of insight through public statements and one-off enforcement actions. CFTC Commissioner Pham noted, "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." In a blog response to the complaint, the Exchange adamantly denied that any assets listed on its exchange are securities and further asked the SEC to propose and adopt rules that market participants could use to understand which digital assets are securities.