If you’ve paid occasional attention to cryptocurrency news in recent years, you probably get the feeling that the cryptocurrency 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 sense.
Wahi worked at Coinbase, a leading crypto exchange, where he had a vision of the tokens that the platform planned to list for trade, an event that causes the value of those assets to rise. According to the US Department of Justice, Wahi used that knowledge to buy those assets before listing and then sell them for huge profits. In July, the Justice Department announced that it had indicted Wahi, along with two associates, in what it called the “first-ever cryptocurrency insider trading scheme.” If convicted, the defendants could face decades in federal prison.
On the same day as the Justice Department’s announcement, the Securities and Exchange Commission made its own. He was also filing a lawsuit against the three men. However, unlike the Department of Justice, the SEC cannot bring criminal cases, only civil ones. And yet, it is the SEC civil suit, not the Justice Department criminal case, that has thrown the heart of the crypto industry into a panic. That’s because the SEC charged Wahi not only with insider trading but also with securities fraud, arguing that nine of the assets he traded count as securities.
This may sound like a dry technical distinction. Indeed, whether a crypto asset should be classified as a security is a huge and possibly existential issue for the crypto industry. The Securities and Exchange Act of 1933 requires anyone who issues a security to register with the SEC, complying with extensive disclosure rules. If they don’t, they can face devastating legal liability.
In the years to come, we will find out how many crypto entrepreneurs have exposed themselves to that legal risk. Gary Gensler, whom Joe Biden appointed to chair the SEC, has made it clear for years that he believes most crypto assets qualify as securities. His agency is now putting that belief into practice. In addition to the insider trading lawsuit, the SEC is preparing to go to trial against Ripple, the company behind the popular XRP token. And it is investigating Coinbase itself for allegedly listing unregistered securities. That’s in addition to a class action lawsuit against the company brought by private plaintiffs. If these cases are successful, the days of free-for-all cryptocurrency could soon be over.
To understand the fight for crypto regulation, it helps to start with the orange business.
The Securities and Exchange Act of 1933, passed after the stock market crash of 1929, provides a long list of things that can count as securities, including an “investment contract.” But he never explains what an investment contract is. In 1946, the United States Supreme Court provided a definition. The case concerned a Florida company called the Howey Company. The company owned a large parcel of citrus plantations. To raise money, he began offering people the opportunity to buy portions of his land. Along with the sale of the land, most of the buyers signed a 10-year service contract. The Howey Company would maintain control of the property and handle all the work of growing and selling the fruit. In return, the buyers would get a cut of the company’s profits.
In the 1940s, the SEC sued the Howey Company, claiming that its alleged land sales were investment contracts and thus unlicensed securities. The case reached the Supreme Court, which ruled in favor of the SEC. The fact that the Howey Company did not offer verbatim shares, the court ruled, did not mean that it was not raising investment capital. The court explained that it would look at the “economic reality” of a business, rather than its technical form. He argued that an investment contract exists whenever someone puts money into a project in the hope that the people running the project will turn that money into more money. After all, that is investing: companies raise capital by convincing investors that they will get back more than they invested.
Applying this standard to the case, the court ruled that the Howey Company had offered investment contracts. The people who “bought” the plots of land did not actually own the land. Most would never set foot on it. For all practical purposes, the company remained the owner. The economic reality of the situation was that the Howey Company was raising investment under the guise of selling properties. “Thus,” the court concluded, “all the elements of a for-profit business enterprise are present here. Investors provide the capital and share in the profits and profits; the promoters manage, control and operate the company.”
The ruling established the criteria followed by the courts to this day, the so-called hello 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 be derived from the efforts of others. The core idea is that you can’t get around securities law because you don’t use the words “action” or “participation.”
Which brings us to Ripple.