When the SEC accused a former Coinbase employee of insider trading last month, it specifically named nine cryptocurrencies as securities, potentially opening the door to regulation for the rest of the industry.
If a judge agrees with the SEC’s argument, many other similar tokens could be deemed securities — and the companies that trade them could be forced to be regulated as securities exchanges. When Ripple was sued by the SEC in late 2020, for example, Coinbase chose to suspend trading the token rather than risk drawing scrutiny from federal regulators. In this case, however, Coinbase says the nine tokens – seven of which trade on Coinbase — aren’t securities.
The case cuts to the heart of what’s long been a huge source of uncertainty in the crypto industry. The SEC has far-reaching legal authority over how stocks and other securities are traded, as well as who is allowed to buy and sell them. But the agency has thus far shied away from issuing a clear definition of what criteria are used to determine whether or not a token is a security. As a result, cryptocurrency firms, exchanges and traders have been operating for years in a legal fog.
SEC officials have previously made statements that align with the agency’s claims in the current case. The previous chairman, Jay Clayton, for example, said he felt that most ICOs looked like securities, and Gary Gensler, the current chair, has said that most tokens are likely securities.
But there are some notable new points of emphasis in the case against the former Coinbase employee. For one thing, the suit appears to distance the agency from a 2018 speech by then-SEC Director of the Division of Corporation Finance Bill Hinman, said Meghan Spillane, a partner at the law firm Goodwin Procter and an expert on litigation and digital assets.
Hinman’s speech was considered by many in the industry to be a regulatory guidepost, laying out ways that a token that was launched as a security could later be considered not a security. “If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract,” Hinman said.
But Hinman’s views were never codified, and if the agency ever espoused them, it appears to have changed course. Several of the token projects named in the case have behaved in a way that Hinman suggested could be sufficient to avoid being considered a security: They changed over time by building governance features or a foundation that increases decentralization of the projects. Spillane said the SEC doesn’t appear to be considering any of that in the current case. “Basically the analysis is kind of frozen in time. And none of the allegations seem to account for how projects grow and develop over time,” she said.
It’s unclear why the SEC chose these nine tokens — AMP, RLY, DDX, XYO, RGT, LCX, POWR, DFX, KROM — as they are mostly small market capitalization projects. AMP is the largest at a $640 million market cap, while some of the others are not even over $100 million, indicating they may not have gained substantial traction. While the SEC said 25 tokens were involved in the insider trading case, it’s unclear whether the SEC did not consider the other 16 tokens securities or whether the agency just didn’t include them in the case.
The SEC’s approach in this case is also different from its action with Ripple, where the agency directly filed an enforcement action against the purveyor of the currency XRP.
Right now there aren’t clear rules on what is and isn’t a security, said David Pakman, managing partner at CoinFund, an early-stage crypto investment firm. “I think that the industry, which is largely filled with people with good intentions, struggles to pick a path that will allow people to launch tokens … The problem is there is no guide.”
Pakman noted that some projects have made an effort to keep a token from trading until it is fairly well developed, citing the FLOW token built by Dapper Labs, which his firm invested in.
The nine tokens cited in the Coinbase case are varied in their intended applications; some were meant to help facilitate digital payments, others for yield farming, energy trading, geolocation or helping creators promote their work. Some did an ICO in 2018, while others started selling tokens later on using different approaches. Some filed a Form D with the SEC to register the sale of securities, while some didn’t. Some had a DAO or foundation, while others didn’t. Some were started by incorporated companies; some were not. This raises questions about how many other tokens already trading could be implicated if the nine currently under scrutiny are legally deemed to be securities.
The SEC’s complaint did highlight a few specifics, such as the token not functioning when it was first sold, the heavy involvement of management in building it, management’s commitment to developing the token in the future, management’s token allocation and the availability of tokens on secondary markets.
These all appear to be an effort by the SEC to meet the Howey test, a basic way to determine whether something is a security: were people investing in a common enterprise with the expectation of profit from the effort of others?
For example, if a token isn’t functional when someone invests, that implies future profit when it launches. And management staying involved and committing to working on a project can also show future expectation of profits, while secondary trading can show the intent to profit (as opposed to the intent to use the token as a utility in and of itself).
Some in the industry see the SEC’s move as political — part of a struggle in Washington between the SEC and other agencies over regulation. “It feels like this question of what tokens are securities and what's not is caught up in a much bigger political question, as opposed to the pure legal argument,” Pakman said.
Caroline Pham, commissioner at the Commodity Futures Trading Commission, which could be jockeying with the SEC for regulatory control, criticized the SEC’s case, calling it “regulation by enforcement.”
The companies behind the nine protocols named in the case declined to comment or didn’t respond to requests for comment. The SEC declined to comment.
One crypto executive who has worked with Flexa, the company behind the AMP token, which is named in the case, believes AMP is a utility — it’s meant to provide collateral while crypto transactions settle — and shouldn’t be considered a security. “The idea that something like AMP would be considered a security was crazy,” said Josh Swihart, SVP of growth, product strategy and regulatory affairs at the Electric Coin Company, which invented the ZCASH token. “The token has a utility … to ensure that there's enough money in the system to make sure that somebody gets paid, that you can have finality on either side of the transaction. The token is this necessary element to allow that to happen in a decentralized fashion.”
Meanwhile, David Berkowitz, who used technology made by Rally Network to create his own personalized CMO “social token,” said he hadn’t heard from the company about what the case means for their tokens or the product. The RLY token, which is the governance token of the Rally Network, was named in the case. He and others have created their own individualized tokens using Rally.
While a number of pieces of crypto legislation have been introduced in Congress, the SEC’s moves in court could become precedent until any legislation is passed or broader executive actions are made. That leaves the industry where it has been: reading the tea leaves on SEC speeches and enforcement actions, and then making moves that may or may not be later considered illegal.
Correction: This story was updated on Aug. 8 to reflect that the SEC sued Ripple in late 2020, not 2021.