This post has been republished from the LexDAOism Substack.
In July, as the DOJ announced criminal wire fraud charges against a former Coinbase manager, his brother, and his friend, the SEC brought a civil inside trading complaint against these three men in the Western District of Washington. The government alleges the manager provided his brother and friend with tips on which crypto assets would be listed on Coinbase’s trading platform ahead of time. Assets listed on Coinbase often experience a spike in trading activity and price immediately after a listing announcement is made, and this group profited over $1m front-running this information. Why the SEC is pursuing the case when the defendants are already facing criminal charges gives a glimpse into the SEC’s strategy of regulation by enforcement, and this article will focus on Coinbase’s potential to spoil this strategy.
To prove insider trading, the SEC must show that the assets traded were in fact securities. Some commentators such as Gregory Schneider and Hailey Lennon discuss the fact that the SEC did not name Coinbase (the exchange at issue) or any of the entities that issued the nine tokens alleged to be securities in their lawsuit. In fact, this says something about the SEC’s litigation tactics and it’s likely that the SEC purposefully excluded Coinbase and the token issuers in order to put the burden and costs of litigating whether the tokens are securities on three individuals without the resources to adequately litigate such a complex issue. It takes serious resources to stand up to the SEC. Ripple, for example, estimates that it will spend over $100 million defending the SEC claim that Ripple (XRP) is a security.
But, Coinbase could intervene in the case under Rule 24 of the Federal Rules of Civil Procedure (FRCP). For non-lawyers, it may appear confusing for a party who was not named to ask to join a lawsuit, but intervention is often the only way that nonparties can prevent their interests from being adversely affected by another’s lawsuit, and Coinbase has a lot to lose if the SEC secures a ruling that these tokens are securities.
Under the FRCP, a party has a right to intervene when they have an interest in the property or transaction that is the subject of the action, their ability to protect that interest will be impaired if they are not a party to the suit, and if the existing parties do not adequately represent intervenor’s interest.
Here, it seems obvious that Coinbase has an interest in this transaction. While a decision in the current case wouldn’t be binding against Coinbase, a finding that these nine tokens are in fact securities will undoubtedly be used by the SEC as persuasive precedent in future enforcement actions. I would argue this is one of the SEC’s goals in bringing this case. If the SEC can stack up small wins across the country, they will increase the strength of their position against Ripple and in future actions.
At least seven of the nine tokens at issue here are included on Coinbase for purchase and trading. While it is arguable that the fact these tokens are trading on Coinbase is insufficient to grant Coinbase an interest in the litigation, the consequences of a finding that the tokens are securities certainly would grant Coinbase an interest in the litigation. If these tokens are found to be securities, that would mean that Coinbase offered and sold unregistered securities on their platform. Coinbase’s interest in each of these nine tokens NOT to be deemed a security is clear and significant. Consequences for offering unregistered securities are serious—settlements with the SEC can cross into the nine-figure range.
To intervene, Coinbase must also show that their interest in the tokens at issue not being found to be securities will be impaired if they are not a party to a suit. Given that Ripple has already spent eight figures fighting the SEC’s allegation that their token is a security, it is a safe bet that the three gentlemen accused of insider trading do not have the resources to adequately represent Coinbase’s interests. Further, Coinbase’s interest may be impaired even if the current defendants prevail on the insider trading claims. Some or all of the tokens could be found to be securities and the defendants could win on the merits by preventing the SEC from proving a different prong.
Finally, Coinbase must show that the existing parties do not adequately represent their interest. Coinbase’s interests may overlap with those of the existing parties, but their interests must be sufficiently distinct. Here, the defendants’ ultimate objective is to not be liable for insider trading. While arguing that the tokens they traded are not securities is one potential path to that ultimate objective, there are multiple viable defenses available to the defendants, all of which would lead them to their ultimate objective of not being found to have violated insider trading laws.
This can be distinguished from Coinbase’s ultimate objective—preventing a finding that these tokens are securities. It is safe to say that the defendants do not adequately represent Coinbase’s interest, as they could ignore the issue of whether the tokens are securities and still make the case that they haven’t violated insider trading laws.
Ultimately, this is a game of chess, and the SEC has broader ambitions than simply seeing three individuals who are already facing criminal charges for their actions also go down for insider trading. The SEC is on a path of regulation by enforcement, a path that many, including CFTC Commissioner, Caroline Pham, view as unsavory. This seems like an opportunity for the industry to ensure that those with political ambitions can’t regulate this technology to death.