In July of 2022, the United States Department of Justice (“DOJ”) and the Securities and Exchange Commission (“SEC”) each alleged insider trading violations against a former Coinbase employee Ishan Wahi (“Ishan”), his brother Nikhil Wahi (“Nikhil”) (collectively the “Wahi Defendants”), and another alleged acquaintance Sameer Ramani (“Sameer”). For background on the matter, read our BitBlog post from when those allegations dropped here.

At the time, we noted the unusual nature of the parallel actions stating:

When the DOJ indicts defendants on criminal charges of insider trading, it is not uncommon for the SEC to also bring a parallel civil action which typically gets stayed during the pendency of the criminal action.  This matter is unusual, however, because the DOJ alleged insider trading under traditional wire fraud laws rather than under securities laws.  Still, the SEC decided to file a civil complaint for securities insider trading against the same parties.  Because the charges being brought by the SEC are not identical, and there are major questions of law (such as whether the tokens are securities) that are unlikely to be addressed in the DOJ matter, it is unclear whether these proceedings will stay during the DOJ prosecution.

At the time, we suggested that because civil matters often become secondary to criminal matters and because the criminal case here did not rely on the tokens being considered securities, that it was likely the SEC’s characterization of the traded tokens as securities would go unchallenged. Much to our surprise, this week the Wahi Defendants, almost concurrent with resolving their criminal cases[1], filed a Motion to Dismiss (the “Motion”) which, if granted, has the potential to set back the SEC’s apparent plan to regulate digital assets through enforcement actions alone. To quote from the movie A Bronx Tale, not all goes as planned with adversaries and sometimes even if you want to…“Now Yous Can’t Leave.”

The full Motion is available here. Continue reading for a tl;dr summary of the arguments presented in that 81 page Motion.

Introduction

The well drafted Motion begins by harshly criticizing the SEC’s refusal to engage in rulemaking for the digital asset industry; a process which would result in final rules which could be contested in court if the regulated parties disagreed with the SEC’s rulemaking. The Motion classifies the SEC ‘s one-off enforcement actions like the one against the Defendants in this case “a process designed to produce more heat than light.” Wahi MTD, pg. 3.

The Motion then provides a cogent background on cryptocurrencies and the value that decentralized transactions can provide in a system currently dependent on centralized intermediaries. It then goes on to explain how blockchain technologies are often built on top of other blockchain technologies, in the same way phone apps are built on top of Apple iOS or Android technologies.

The introduction section concludes by summarizing how the nine tokens named in the SEC’s Amended Complaint were initially distributed, how digital asset exchanges work, and the SEC’s allegations against the Defendants.

Argument 1: There Can Be No Investment Contracts Without Certain “Essential Ingredients”

In all of the SEC’s previously litigated digital asset matters, the primary defendant(s) have been token developers who then sold some amount of tokens issued by themselves, or entities that they controlled or were affiliated with, by means of Initial Coin Offerings (“ICO”s) or some other sale of pre-mined tokens (as was the case in the LBRY case and is the case in the ongoing Ripple litigation).

The SEC has won its cases litigated so far against token selling developers by convincing courts that the sales of tokens from the tokens’ creators and ongoing developers are the types of fundraising efforts which securities laws were enacted to regulate. See SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020); SEC v. Telegram Grp. Inc., 448 F.Supp. 3d 352 (S.D.N.Y. 2020).

The Motion counters this claim, and argues, similar to the Motion for Summary Judgment in the Ripple case, that the essential ingredients in an “investment contract” is a contract plus something else. A land sale plus the promises to manage orange groves on it (as was the case in SEC v. W.J. Howey Co., 328 U.S. 293 (1946)). Or the sale of beavers plus the promise to raise them for fur (Continental Marketing Corp. v. SEC, 387 F.2d 466 (10th Cir. 1967)). This goes back to the “blue sky” laws which predate federal securities laws and is where the term “investment contract” comes from. These “essential ingredients” listed by both Ripple and these Defendants are: (1) a contract; (2) a post-sale obligation on the initial seller; and (3) a right to share in the venture’s profits.

While these same arguments were largely raised in Ripple, they are at least somewhat more compelling when coming from individuals other than the “issuers” of the tokens themselves. Here, it is unlikely the Court can look at the “economic realities” of the transactions and conclude the funds that went to the Wahi Defendants were for the advancement of the underlying token project. The Wahi Defendants here sold assets in peer-to-peer transactions in the same way sneaker aficionados sell sneakers or baseball card collectors sell their collections on secondary markets. Similar to in Hocking v. Dubois, 885 F.2d 1449 (9th Cir. 1989), when an asset is sold in a secondary transaction, removed from the original potential “issuer” and without the “essential ingredients” of an investment contract, it is easier for a Court to find that transaction lacked the elements required to turn an ordinary asset sale into a securities transaction.

Argument 2: The Major Question Doctrine and Basic Principles of Fair Notice Foreclose the SEC’s Attempted Enforcement in This Case

The major question doctrine is the legal principle that administrative agencies require clear Congressional authority before those agencies can institute rulemaking on questions of vast economic or political significance. Under the major question doctrine, courts should “hesitate before concluding that Congress meant to confer such authority” to an administrative agency over such significant issues. West Virginia v. EPA, 142 S. Ct. 2587, 2607–2608 (2022).

As the Wahi Defendants put it in their Motion: “here, the SEC is pressing a novel construction of an isolated term from a Depression-era law to assert regulatory authority over a trillion dollar industry built upon revolutionary technology poised to define the next generation of the internet…” Wahi MTD, pg. 33.

The Wahi Defendants go on to explain that: (1) existing SEC laws and regulations which focus on centralized actors for compliance are not well-suited for decentralized networks; (2) the fact that Congress is currently debating how to regulate digital assets demonstrates this is a major question which should be left to Congress to legislate rules for instead of administrative agencies; and (3) if the SEC is allowed to expand “investment contracts” to digital assets such as those at issue in this litigation that would turn everything from baseball cards to beanies babies to sneakers into securities. This referred to in the Motion as “an SEC-invented ‘fifth shadow factor [of Howey]’: whether the SEC wants to regulate the asset.”  Wahi MTD, pg. 39 (quoting SEC Commissioner Hester Pierce).

The section concludes by pointing to evidence that sophisticated counsel at Coinbase and many others have no idea what digital assets the SEC considers are securities vs. non-securities. Expecting the Wahi Defendants to know what legal experts don’t know is unreasonable and unconstitutional. The Defendants in Ripple also raised similar fair notice defense arguments in their Opposition to the SEC’s Motion for Summary Judgment but this is again slightly more persuasive coming from individuals selling tokens on a publicly traded company’s secondary marketplace rather than from a well-funded token-issuer.

Argument 3: Even Under Howey, Secondary Sales of Digital Assets from Third-Party Sellers Are Not Investments in Common Enterprises

The Motion’s second-to-last argument follows the traditional securities law investment contract analysis to argue that none of the tokens at issue in this litigation satisfy the horizontal or strict vertical commonality factors and argues there is no common enterprise invested in when tokens are bought on the secondary market.

The Wahi Defendants then argue all the tokens at issue here are utility tokens with consumptive use being the motivation for people to purchase. “The fact that tokens may also have investment value—or that some people may have bought tokens for investment reasons—does not alter the analysis.” Wahi MTD, pg. 51 (citing Rice v. Branigar Org. Inc., 922 F.2d 788, 790-91 (11th Cir. 1991)). While the “bona fide consumptive purpose” argument and associated supporting case law doesn’t appear to be a heavily endorsed defense in existing securities jurisprudence and comes primarily from dicta in United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975), that argument is presented well here.

The Motion then presents arguments similar to those in Ripple that the tokens’ values are driven primarily from outside market forces and not from the managerial efforts of others. Again, here that argument has additional weight where the very crux of the SEC’s case is that inside information regarding the listing of assets on a secondary exchange, a decision which is entirely outside the control of the token’s developers or managers, heavily drives the price of those assets. The Wahi Defendants distinguish between the ability of managers to affect tokens’ price from the ability of those efforts to influence those prices.

Argument 3 ends by trying to disarm any attempt by the SEC to apply case law from ICO cases to this matter which involves entirely secondary market transactions. Because Howey requires a transaction-by-transaction analysis, even if the initial fundraising transactions can be considered “investment contracts” the underlying token sold in those fundraising efforts isn’t necessarily a security.

Argument 4: The SEC Cannot Prove Scienter

The last argument, largely a throw-away argument included to buttress the lack of fair notice defense, is that the SEC cannot prove the Wahi Defendants possessed the necessary scienter for the SEC to win. That is, that the Wahi Defendants could not have known or been recklessly indifferent to the possibility that the information they traded on “was material for securities trading purposes.” Wahi MTD, pg. 59 (emphasis in original). Here, there was no way for the Wahi Defendants to know that the assets which a sophisticated legal team at Coinbase didn’t believe were securities were, in fact, securities. 

Final Thoughts

In sum, the Wahi Defendants’ Motion to Dismiss is an unexpectedly stout and well-reasoned legal defense offered by individuals in a case where many (these writers included) expected the SEC’s claims to go unchallenged. While many of the arguments in this Motion raise issues which were also briefed in Ripple, this case has the benefit of seeing those SEC arguments fully briefed and the ability to cut them off affirmatively before the SEC even has a chance to respond, which is a powerful advantage in litigation.

If the Wahi Defendants are successful in dismissing the SEC’s claims against them, that caselaw would provide powerful precedent for individuals buying and selling digital assets on secondary marketplaces and could allow for businesses to build upon existing blockchain networks with less fear that the underlying blockchain network being built upon would be rendered unworkable due to SEC actions. However, even if this Motion is granted, it does nothing to allow digital asset developers to financially support their development through the primary sales of tokens.

While the SEC may have thought they could further chill the digital asset market by bringing an action that they might not have to litigate against vulnerable and seemingly unsympathetic defendants, it is now clear they have picked a fight against a well-funded and sophisticated legal team intent on making the SEC win based on the law and not unopposed enforcement.

Legal scholars reasonably disagree on whether digital asset developers form actual (or implied-in-fact) contracts for continued development with the primary purchasers of their tokens, which would satisfy even Howey’s “essential ingredients” interpretation. When it comes to secondary transactions though, where there is not even an arguably implied contract between the parties, the SEC will have a hard time proving an “investment contract” transaction under Howey’s required transaction-by-transaction analysis. 

FOOTNOTES

^[1] Nikhil pled guilty to the DOJ charges against him in September 2022 and was subsequently sentenced to 10 months in prison. Ishan pled guilty to the DOJ charges against him on February 7, 2023; the day after the Motion to Dismiss was filed.